Offense or Defense? Positioning for a Possible Recovery - Part 2

Today we continue our analysis of early stage market rebounds with the goal of helping uncover potential offensive and defensive sector strategies that may be useful for investors in the current market. Last week we tried to find commonalities in net momentum across sectors during recovery periods. The idea being that defensive sectors tend to underperform and more cyclical or “growthy” sectors tend to rally. We were unable to find any signficant commonalities in the 2009, 2011, and 2016 periods using momentum alone.

Today we expand our analysis to look at pure fundamental factors to better understand if we can associate each sector's contemporaneous relative increase & decrease in growth & profitability with the net momentum. As usual, we'll also share a quick rundown of factor trends we're seeing over this past week.

‍US Market

‍Despite headwinds of weakening data out of the eurozone and uncertainty around the trade dispute with China creeping back into the markets on Thursday, both the Dow and the Nasdaq barely eked out their seventh consecutive week of gains ending Friday (not pictured) of this past week.  

Factor Update

‍Here's an update on how some key factors have changed in our normalized return indicator over the past week:

• Market Sensitivity continues to ride high relative to other factors, but dips slightly this week to +3.09 standard deviations above its historical mean.
• After hitting a peak of +2.7 SD above the mean earlier last week, Volatility's downward drift has shown a bit of acceleration this past week down to +2.25.
• Profitability continues to sit flat compared to historical trend.
• Momentum has seen another sizable drop this week, and at -1.49 SD below the mean it now resides in “Oversold” territory.

Growth and Profitability

‍Last week we referenced How to Get Defensive With Your Portfolio which specified ETFs that would help managers assume a classic defensive posture (going underweight Beta & Volatility while holding Quality). To explore building a more offensive strategy for investors with a bullish outlook in this market, we first looked at sector relationships to the Momentum factor, but the results were inconclusive. Today we expand the analysis to include the pure fundamental factors of Growth and Profitability and how they relate to Momentum during market upturns.

As we were analyzing the data, we found some interesting relationships. Across the 3 recovery periods (2009, 2011, 2016), there were 30 instances of contemporaneous movements of sector Growth & Profitability in either a positive or negative direction. In 23 of those cases, we found that Net Momentum followed the same direction (77% of the time). This observation is unlikely to be random and calls further attention to the changing growth and profitability factor scores (which don't embed price in the metrics), so that we may better align to the sectors most likely to have increases in momentum (price-driven).

As a refresher, the Growth factor includes purely fundamental metrics such as sales growth, estimated sales growth, earnings growth, and estimated earnings growth. The Profitability factor includes return-on-equity, return-on-assets, cash flow to assets, cash flow to income, gross margin, and sales-to-assets. Meanwhile, Momentum is wholly price driven and calculated based on cumulative return over past year excluding the most recent month.

Methodology: We took a snapshot of sector exposures to the Medium-Term Momentum, Growth and Profitability factors* and measured the delta from beginning to end of each market rebound. We then green highlighted all sectors which experienced a positive change to each factor and blue highlighted all sectors that experienced a negative change vs. each factor.

Below we highlight the delta of Momentum, Growth and Volatility across 19 GICS sectors during the rebounds of 2009, 2011, and 2016.

Post-Global Financial Crisis: 3/1/09 - 7/1/09

Contemporaneous Net Factor Increase: Banks, Software & Services, Food & Staples Retailing, and Media.

Contemporaneous Net Factor Decrease: Capital Goods, Energy, and Internet Retailing.

Post-Sovereign Debt Crisis: 10/1/11 - 11/1/11

Contemporaneous Net Factor Increase: Banks, Commercial & Professional Services, Consumer Durables & Apparel, Food & Staples Retailing, Pharmaceuticals/Biotech/Life Sciences, and Real Estate.

Contemporaneous Net Factor Decrease: Capital Goods, Consumer Services, and Internet Retailing.

Post-Factormageddon 2016: 2/11/16 - 5/1/16

Contemporaneous Net Factor Increase: Commercial & Professional Services, Consumer Durables & Apparel, Internet Retailing, Materials, and Real Estate.

Contemporaneous Net Factor Decrease: Energy, Automotive, and Pharmaceuticals/Biotech/Life Sciences.

From the above analysis we can infer that investors can potentially position their portfolios along the relative change in a sector's FUNDAMENTAL FACTOR PROFILE representing pure fundamental growth and profitability metrics.

1. An increase in relative contemporaneous Net Growth & Net Profitability move is likely to lead to an increase in net momentum
2. A decrease in relative contemporaneous net growth & net profitability move is likely to lead to a decrease in net momentum

Over the next few weeks we will continue our examination of other factors and demonstrate portfolios that capture these effects.

Regards,
Omer