Charting the Market: An Updated Roadmap for the Year Ahead

Boston roads are often unpredictable: It’s not surprising to see a four-lane boulevard suddenly become a one-way street. Frequent changes in traffic patterns force drivers to adjust and make quick decisions based on new information—not dissimilar to the current market landscape, where an ordinary and easily understood trend can be abruptly upended by a new “traffic” signal or tweet. A strategic asset allocation framework can serve as a helpful “GPS” for investors, with changes made on the margins to ensure portfolios are able to steer through a new scenario—like a driver making a U-turn to bypass a traffic jam.

To navigate the year ahead, it’s important to understand how the past year and decade concluded. Here, we analyze key performance trends in active strategies, factors and sectors, gathering the latest data in order to update portfolio GPS programs and set a smart course for 2020.

Active environment barometer reads favorably for active small-cap managers
Each quarter, we publish our active environment barometer, providing the latest information on two market variables: Stock-level correlation and dispersion. These variables are helpful in classifying the environment for potential alpha generation. If correlations are low (meaning stock movements are differentiated and not clustered) and dispersion is high (meaning return differences are large, rewarding correct over- and underweight decisions), the environment should be conducive for active managers to outperform their respective benchmarks.

Based on these two metrics, the environment for active small-cap managers to deliver alpha is strongly favorable. Within small caps, three-month dispersion is well above the 90th percentile (i.e., high) and three-month pair-wise correlations are below the 10th percentile (i.e., low), as shown below. Both measures are more favorable than at the start of 2019. As such, it’s not surprising that nearly half of active small-cap managers outperformed their benchmark in 2019—and those managers who outperformed posted an average excess return of 4.8%.¹ Based on this strength, active small-cap managers that did not outperform in 2019 and are struggling at the start of 2020 should likely be subject to further due diligence.

Within the large cap universe, correlations and dispersion remain low. Performance trends reflect this environment, as only 29% of active large-cap managers beat their benchmark in 2019, following 38% in 2018 and 50% in 2017.² For the full decade, only 16% beat their benchmark. This follows 66% outperformance in the prior decade—a trend reversal that represents one of the primary reasons why active large-cap mutual funds lost $1 trillion in the 2010s.³

2020 GPS update: Some active large-cap managers are worth the fee, but some clearly aren’t. With fees averaging 1%⁴ and uninspiring performance trends, fee budgets could be spent more wisely in the large-cap space by implementing standard index approaches or leveraging smart beta multifactor exposures that seek to harness well-known and documented premia—a systematic active approach that is rules-based, transparent and typically carries low fees, much like traditional passive strategies.

Factor performance: Minimum volatility lagged in 2019
In the US, the minimum volatility factor posted negative excess returns in 2019, as shown below—a marked turnaround after it was the best-performing factor in 2018, beating traditional beta by 6%.⁵ The fourth quarter of 2019 was the most damaging for minimum volatility factor results as fading trade tensions and diminishing Brexit concerns tipped the market into risk-on mode.

Correlations between minimum volatility and momentum increased in 2019. Momentum, therefore, also posted negative excess returns for the year. Value staged a late-year rally as the yield curve steepened but was unable to produce positive excess returns for the full year—consistent with trends witnessed in prior business-cycle slowdowns. The lackluster performance of value weighed on dividend strategies, a relationship we have previously explored.

Quality was the only factor to produce positive excess return in 2019 as investors focused on companies with reliable cash-flow streams and healthy balance sheets amid concerns of sluggish growth and a three-quarter stretch of negative earnings growth. In fact, given growth concerns were not confined to the US, quality was the only consistent performer across the major regions, producing positive excess returns in developed ex-US and emerging markets in 2019.

In the US, fourth-quarter earnings are expected to be negative.⁶ This would mark the fourth straight quarter of negative earnings, the first such streak since 2016. Globally, earnings estimate revisions have a negative bias as downgrades have lately outpaced upgrades, a topic we investigate in this month’s full chart pack.

2020 GPS update: Investors may continue to seek quality firms, which may continue 2019’s performance patterns—but just because performance was strong one year doesn’t mean it will be equally strong the next, as illustrated earlier by the cyclical performance of minimum volatility and momentum. We favor diversified factor exposures instead of trying to time factors: Timing factors can be as tricky as trying to time traffic light changes.

US sector dispersions reached widest level since 2013
At its most basic level, sector investing is characterized by low breadth (i.e., a small number of securities) and high dispersion (as measured by the difference between top and bottom performers⁷). The ability to employ active decisions over a small number of securities with markedly different returns lends sector investing a powerful means to potentially deliver alpha.

As shown below, return dispersion across the eleven US sectors in 2019 reached 40%, the highest level since 2013. The level is also notably higher than the 17% return dispersion seen across the six traditional smart beta factors (yield, momentum, quality, minimum volatility, value and size) and much higher than traditional growth and value styles (10% return dispersion).⁸

2020 GPS update: These dispersion traits are not unique to 2019. Dispersion across sectors is, on average, six times that of traditional styles and three times that of traditional factors. As we discussed in our 2020 ETF Market Outlook, elevated valuations mean the margin for error—and opportunity—will likely be as small as it has been in a very long time. As a result, sector rotation portfolios may be the ideal vehicle to steer portfolios towards potentially higher returns and pathways for alpha generation.

The road ahead
Although central banks are likely to remain steadfastly accommodative, supplying the market with freshly paved roads in the form of liquidity, the confluence of macro risks and fundamental concerns may create a few twists and turns in traffic patterns this year. Staying up to speed with the latest data can help investors keep their portfolios from driving down a dead end.

For more market insights, continue following SPDR® Blog to keep up with my Charting the Market blog series. You can also download our full monthly Chart Pack.