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What Are The Best Places To Be In The Equity Markets?

With US equities making new highs and monetary policy taking another step towards easing, I looked at the long term performance of different styles of equity investing to see if there were any simple strategic conclusions we could make.  This is an especially important time to take a close look at implicit bets that are hidden in every equity portfolio, since performance will likely be particularly dependent on the Fed and the politics surrounding their rate policy.

To perform the analysis, we took the publicly available returns from the website of renowned finance professor Kenneth French. Based on the 2014 paper of Nobel laureate Eugene Fama and French on their “five-factor model” of equity returns, this data gives us a unique perspective on the long-term history of US equity market strategies. It also gives us some signals on what we believe we can expect in the years to come under different scenarios.

The Fama-French five-factor model decomposes returns into the market factor, the small minus big factor, the high book value minus low book value (“value”) factor, the profitability factor, and the investment factor.  To summarize what these mean: the “market” factor is simply the excess return on the whole market over the risk-free T-Bill rate (RF).  The “small minus big” (SMB) factor signifies the return outperformance or underperformance of small companies over large companies. The “high minus low” (HML) factor does the same for companies that have a high book value relative to their market price versus the opposite, so it captures the return of “Value”.  The “robust minus weak” factor (RMW) looks at how profitability impacts returns, and the “conservative minus aggressive” factor (CMA) captures the difference between conservative companies that do not invest as much as the aggressive companies.  This model is a linear approximation to a return attribution problem, and not perfect, but for our objective, it is quite powerful.

In the first chart (Source: Ken French’s website) we show different time periods and compare simple averages of annual factor returns for those periods.  The obvious observation here is that all factors do well over the 50+ year long term history, and also do equally well over the almost twenty year history since the tech bust of 2000.  Since the financial crisis, it is no wonder that the market factor has on average trounced all the other factors, which is part of the reason why investors have fled en-masse from active equity management to passive, cheap, indexed exposures to the overall market (e.g. the large ETFs such as SPY and IVV).

Over the tech bust period of 2000-2003, the market factor on average had a negative annual return, while the other factors did extremely well. The aftermath of the tech crisis was indeed a great time to be an active equity manager who could implement relative value bets.  In the last three years, as global quantitative easing from Central banks has taken another leg down, the market factor has continued to beat most other factors.  Also note that during the financial crisis, it paid to be exposed to profitability over the other factors.

By grouping by factors across periods, as I have done in the second chart, it is again clear that over all long term and three year periods except the tech crash period of 2000, the market beta factor provided healthy returns. During this period, it is clear that all of the other factors did really well.  Also note that the value (HML) and size (SMB) factors have really done quite dismally since the financial crisis, as the open monetary spigot has predominantly favored large growth companies. Stock picking has simply not worked as well as exposure to the market as low cost market beta has been buoyed by ample liquidity.  We just need to look at the FAANG stocks to get anecdotal confirmation of this.



What general conclusions can one make regarding investments at this stage of the equity markets and expectations for the future?

First, over the long run there is compelling evidence that being long the equity market is the right decision, as long as one is not forced out in short term downdrafts.  As is often said, the S&P = GNP, so as long as we believe that there will be long term growth, there will long term growth in the stock market.  But the market can and will continue to frequently get ahead of itself. But even when the market has a significant correction, it has paid to hold on to risky assets. By building enough diversification and explicit protection, one can avoid liquidating at the wrong time and be a buyer when others are forced to de-risk.

Second, long term history shows that over time smaller companies do better than large ones.  In this context, the last decade is clearly an outlier. If there is reversion to the long term mean, we expect the smaller companies to again do better than larger ones. But we might be a few years away from that point, since things tend to get worse for smaller companies late in the economic cycle before they get better as fears of impending slowdown in economic growth rise.

Third, if we do have a deep correction in the mega-cap tech stocks, we should expect small and large value stocks to do relatively better. However, we might still have some more value factor underperformance in the immediate short run as the effect of low global yields find their way into the growth sector in US tech. Long value has been a quant equity favorite, and might be exposed to capitulation before it rebounds. But such turning points are impossible to capture.

One simple conclusion from all historical periods is that exposure to profitable companies is consistently valuable. But it is again very hard to discern whether the current profitability metrics are real, or a function of easy money, stock buybacks and tax cuts.  Similarly, companies that are conservative in investment also do well over almost every period. So look for companies and sectors where over-investing is not a problem.  Given the increasing buy-back and M&A activity on the back of easy money, this is an area where some care might indeed save one from a debacle.

And finally, the risk-free asset, T-Bills, is not a bad place to be for consistent income. With short term government yields in the 2% range, a healthy amount of cash should be in every portfolio.  In terms of a simple portfolio model, all of the above seems to suggest a conservative exposure to outright market exposure, downside risk mitigation, and plenty of liquidity in the form of good old Treasury Bills or money market funds with liquid, high-grade holdings.

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