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Charting the Market: A High Preference for Quality
Quality was the best performing factor in Q1 2020 and over the one-year period
In light of fading economic and corporate profits, investors are seeking segments with repeatable cash flows and less leverage.
We are undoubtedly in uncertain times. Uncertainty is impacting almost every aspect of our daily routines and every corner of our society. Information, however, can help us gain perspective and orientation relative to the current dynamics. The charts below are intended to provide context around the historic market movements we have recently witnessed and generate insights about considerations for the next few months.
Quality outperforms across regions
Quality was the best performing factor in Q1 2020, as shown below, and was also the best performing factor over the past year. Momentum and low volatility—two factors that have seen correlations with each other rise in recent months1 —are the only other factors that posted positive performance in Q1 and over the one-year period.
Source: FactSet, as of March 31, 2020. Past performance is not a guarantee of future results. MSCI Minimum Volatility Index, MSCI Enhanced Value Index, MSCI Quality Index, MSCI Equal Weighted Index, MSCI High Dividend Yield Index and MSCI Momentum Index within each region are used to represent regional factor performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. The calculation method for value added returns may show rounding differences.
The outperformance of quality was not confined to the US. The quality factor produced excess market returns in both developed ex-US and emerging market equities, as shown below. The same return patterns for momentum and minimum volatility seen in the US held true in developed ex-US markets. Emerging markets also saw similar patterns, with only minor differences, indicating low factor diversity across regions.
Source: FactSet, as of March 31, 2020. Past performance is not a guarantee of future results. MSCI Minimum Volatility Index, MSCI Enhanced Value Index, MSCI Quality Index, MSCI Equal Weighted Index, MSCI High Dividend Yield Index and MSCI Momentum Index within each region are used to represent regional factor performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. The calculation method for value added returns may show rounding differences.
Source: FactSet, as of March 31, 2020. Past performance is not a guarantee of future results. MSCI Minimum Volatility Index, MSCI Enhanced Value Index, MSCI Quality Index, MSCI Equal Weighted Index, MSCI High Dividend Yield Index and MSCI Momentum Index within each region are used to represent regional factor performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. The calculation method for value added returns may show rounding differences.
Key takeaway: The returns for quality reflect the current market environment: Investors are seeking companies with high-quality balance sheets and stable earnings, as levered firms with volatile earnings patterns are likely to be challenged amid the economic turmoil.
March delivers markedly strong excess returns for quality in US
In the US, strong quarterly returns for quality were driven by an abnormally large +4% excess market return in March. This represents the second largest excess monthly return for quality on record and is three standard deviations above the mean excess return. Only the June dot-com bubble era return of +4.14% was higher, as shown below.
Source: FactSet, as of March 31, 2020. Past performance is not a guarantee of future results. MSCI Quality Index used to represent regional factor performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
In fact, the only periods when quality has posted an excess return greater than +3.5% have been during periods of crisis: March 2020, June 2000 and January 2009—but this doesn’t mean quality stocks suddenly became stronger performers.
Starting in 2017, we have seen strong and persistent investor preference for firms with stable earnings and healthy balance sheets. As shown below, the median monthly excess return for each of the last three calendar years was positive. From a persistency perspective, returns were positive in more than two-thirds of the months. This is the longest such streak of more than 66% (i.e., more than 8 months) of monthly excess returns in a calendar year being positive. It is also the longest calendar year streak of positive median monthly excess returns, with the positive returns in 2020 making it four so far. Not surprisingly, quality factor ETFs have taken in $10 billion in assets over the last twelve months—nearly doubling the category’s AUM during the time period. 2
What’s behind the strong performance over the last few years? Even before COVID-19 upended economic growth, we had started to witness a trend of slowing growth. If it were not for an earnings bump from the tax reform bill in 2018, growth would have been challenged—and it ultimately was, with multiple quarters of negative earnings growth registered in 2019.3
From an economic cycle perspective, the year-over-year change for the Conference Board Leading Economic Index (LEI) peaked in the middle of 2018 and has since fallen steadily before rising slightly in January of 2020.4 The longer-term trend for the LEI indicates a slowdown. Based on our historical analysis of economic cycles, quality has tended to outperform other factors on average, as shown below.
Source FactSet, as of 12/31/2019. Calculations by SPDR Americas Research. Past performance is not indicative of future results. MSCI Minimum Volatility Index, Russell 1000 Value Index, MSCI Quality Index, Russell 2000 Index are used to represent factor performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. The Conference Board Leading Economic Indicator Index (LEI) was used to segregate business cycles and evaluated sector performance over multiple business cycles and evaluated factor performance over multiple business cycles between 1988 and 2018. Recession: The LEI Index declines to a trough at an accelerating pace. Recovery: The LEI Index rebounds from a trough but below long-term trends. Expansion: The LEI Index YoY changes are positive and above long-term trends. Slowdown: The LEI Index YoY changes pass the peak and begin moderating, This resulted in 8 slowdowns, 7 recoveries, 3 recessions, and 3 recoveries.
Key takeaway: What we are seeing today is what we have seen before. In light of fading economic and corporate profits, investors are seeking segments with repeatable cash flows and less leverage, as these segments may be able to still provide organic growth while withstanding margin compression or possible debt service funding pressures.
Construction matters and the road ahead
How a factor is constructed strongly dictates performance , not only for the realized figures shown above but also for the future. For instance, the quality factor performance referenced above is not sector neutral. A sector-neutral US quality factor produced only 131 basis points of excess return in March and 40 basis points in Q1, as opposed to the non-sector neutral factor performance illustrated above of 402 and 464 basis points, respectively.5 In each case, however, from a style factor performance perspective, being overweight profitability and underweight leverage (two quality factor traits) were drivers in each methodology, as shown below. Non-sector neutral performance also benefited from being overweight high cash, low debt sectors like Technology and Health Care6 and underweight high leverage,7 low return-on-equity sectors like Energy and Financials.,8,9 For what approach is better, neutralizing sectors is just as much a philosophical choice as an empirical one.10
Source: Bloomberg Finance L.P. as of March 31, 2020 based on the Bloomberg US Equity Fundamental Model. Past performance is not indicative of future results. Sector Neutral Quality as measured by MSCI USA Sector Neutral Quality Index. Non-Sector Neutral Quality as measured by MSCI USA Quality Index.
As illustrated in our full chart pack , we have already seen 2020 earnings and economic growth estimates revised lower.11 Looking ahead, given the concerns around both economic and fundamental growth, it is likely that the quality factor will have a high probability of producing positive excess returns in 2020, specifically if the relationship to economic cycles holds.
This is by no means meant to reflect a view on factor timing, as there is weak evidence that timing is effective on a repeatable transaction-cost considered basis12—and the economic patterns mentioned above are averages. As a result, having a quality bias within portfolios may be the more beneficial implementation consideration. This can be accomplished by either overweighting those sectors with positive earnings sentiment13 and low leverage (Health Care, Technology ) or by including quality as part of diversified factor mix.
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1 90-day excess return correlation between MSCI USA Momentum Index and MSCI USA Minimum Volatility Index to the MSCI USA Index increased to 96% as of 03/31/2020. Long-term average correlation is 42%. FactSet as of 03/31/2020.
2 Bloomberg Finance L.P. as of 03/31/2020; calculations per SPDR Americas Research
3 S&P 500 firms’ earnings growth was negative in Q1, Q2 and Q3 in 2019, FactSet as of 03/31/2020
4 Given our current situation, this slight rise in January is likely to be an aberration
5 Sector Neutral Quality as measured by MSCI USA Sector Neutral Quality Index, Bloomberg Finance L.P. as of 03/31/2020
6 Technology and Health Care sectors have the highest median Free-Cash-Flow to Total Debt, Bloomberg Finance L.P. as of 03/31/2020
7 As a result of financials’ capital structure, they tend to have high debt levels but also a large asset base on their balance sheet, leading to a low debt-to-assets ratio. However, capital intensive industries could be impaired if capital is constrained in this environment.
8 Energy has the third worst Free-Cash-Flow to Total Debt figure while both Energy and Financials have below market Return-on-Equity, 2.1% and 12.9%, respectively, Bloomberg Finance L.P. as of 03/31/2020.
9 Sector effects contributed 47% of the overall quarterly excess return for the non-sector neutral quality factor, with style contributing 104% and selection effects (i.e., single stock differences not explained by factors/industry) detracted 52%, Bloomberg Finance L.P. as of 03/31/2020 based on the Bloomberg US Equity Fundamental Model.
10 “Bender, Mohamed, Sun,” Country and Sector Bets: Should They be Neutralized in Global Factor Portfolios, Summer 2019
2020 earnings growth estimates have declined from around the world with the upgrade-to-downgrade ratios for the US, Developed ex-US, and Emerging Market regions falling to less than 0.4.
11 As shown in our chart pack, 2020 earnings growth estimates have declined from around the world, with the up-to-downgrade ratios for the US, Developed ex-US, and Emerging Market regions falling to less than 0.4.
12 Numerous papers have been written on this subject, as summarized here: https://www.etf.com/sections/index-investor-corner/swedroe-no-point-timing-factors?nopaging=1
13 Technology and Health Care rank first and second in terms of earnings sentiment, FactSet as of 03/31/2020.
Russell 2000 Index
The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization.
Russell 1000 Value Index
Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
MSCI USA Quality Sector Neutral Index
The MSCI Sector Neutral Quality Index aims to reflect the performance of securities that exhibit stronger quality characteristics relative to their peers within the same sector.
MSCI Equal Weighted Index
The MSCI Equal Weighted Index represents an alternative weighting scheme to its market cap weighted parent index, the MSCI Index. At each quarterly rebalance date, all index constituents are weighted equally, effectively removing the influence of each constituent’s current price (high or low).
MSCI High Dividend Yield Index
The MSCI High Dividend Yield Index is designed to reflect the performance of equities in the MSCI Regional Parent Index (excluding REITs) with higher dividend income and quality characteristics than average dividend yields that are both sustainable and persistent. The index also applies quality screens and reviews 12-month past performance to omit stocks with potentially deteriorating fundamentals that could force them to cut or reduce dividends.
MSCI Minimum Volatility Index
The MSCI Minimum Volatility Index aims to reflect the performance characteristics of a minimum variance strategy applied to the MSCI large and mid cap equity universe. The index is calculated by optimizing the MSCI Parent Regional Index, its parent index, for the lowest absolute risk (within a given set of constraints).
MSCI Momentum Index
The MSCI Momentum Index is designed to reflect the performance of an equity momentum strategy by emphasizing stocks with high price momentum, while maintaining reasonably high trading liquidity, investment capacity and moderate index turnover.
MSCI Quality Index
The MSCI Quality Index aims to capture the performance of quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.
Conference Board Leading Economic Index (LEI)
An American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a non-governmental organization, which determines the value of the index from the values of ten key variables.
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