Profitability Lags While Beta & Volatility See Continued Strength

This week saw strong market performance amid a cascade of political and economic headlines. Here's an update on the factor story that we continue to find of most vital importance - the interplay between Volatility, Market Sensitivity, and Profitability as it relates to a sustained market recovery.

We hope you enjoy the long holiday weekend in warmth and health.

‍US Market

Our US Market factor (99% correlated to the S&P 500) continued its upwards trajectory, +1.44% since last Friday, without even taking Friday's sizable rally into account. All told, the S&P 500 gained ~3% this week, reaching its highest level in more than a month as investors received encouraging news of a potential thaw-out in US/China trade, along with robust December manufacturing numbers from the Fed. The market simultaneously shrugged off the University of Michigan's consumer sentiment index falling 7.7% as the prolonged government shutdown continues.

Factor Update

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

The “Recovery Trio”

‍As a reminder, since last November we've been keeping an eye on the relationship between the market and the relative performance of the “Recovery Trio” of Volatility, Market Sensitivity, and Profitability. In that article, we describe how the market recovery after the “Factormageddon” of 2016 was characterized by a sustained rally between all three of these factors. Following the collapse of Beta and Volatility (the primary arbiters of risk) in Jan 2016, they both saw a positive reversion between late Jan 2016 - March 2016. Profitability, on the other hand, enjoyed positive gains throughout that entire period.

Fast forwarding to today, we can see that as the first two factors have seen strong gains over the past few weeks, Profitability (while seeing positive performance), continues to lag behind.

Let's see how the recent performance trends for these factors compare to early 2016:

Volatility

Last week, Volatility was the beneficiary of the biggest normalized rally among the style factors. Since then, the factor has continued to enjoy gains on both a cumulative and normalized basis. In fact, at +2.56 standard deviations above the mean, Volatility is now flagged as “Extremely Overbought.”

‍Volatility: 1/11/19 - 1/17/19

Volatility: 1/01/16 - 3/10/16

Market Sensitivity

‍This week's big winner, Market Sensitivity (Beta) was up +1.08 SD on a normalized basis. The factor now sits at +2.35 SD above the mean, also placing it firmly in “Extremely Overbought” territory.

‍Market Sensitivity: 1/11/19 - 1/17/19

Market Sensitivity: 1/01/16 - 3/10/16

Profitability

‍As the third member of the “recovery trio,” Profitability did not enjoy a tailwind of the same magnitude as Volatility and Beta. It did drift slowly upwards, but not at a rate that gives us confidence in a coordinated recovery.

‍Profitability: 1/11/19 - 1/17/19

Profitability: 1/01/16 - 3/10/16

Conclusions

‍Compared to the sustained strength Profitability saw in 2016, the slow recovery the factor's seen over the past few months highlights a continued lack of real confidence in the market rally. At the same time, no other fundamental-type factors (e.g Growth and Value) are indicating any pronounced, sequential sign that investors are truly motivated to reenter the market.While the underlying metrics of Profitability (return-on-equity, return-on-assets, cash-flow-to-assets, cash-flow-to-income, gross margin, and sales-to-assets) are backwards looking, the lack of investor interest in bidding on this pillar of quality suggests that there might be trepidation that companies won’t have the same level of quality earnings going forward.

As normalized return for Beta and Volatility continues to reach extreme heights, and without the support of Profitability, we may expect to see a sell-off in both factors. It's especially important to keep an eye on them as we head into the bulk of 4Q earnings announcements. We've already seen a couple of warning signs between Alcoa's forecast of weakening demand in 2019 and Morgan Stanley's earnings shortfall.

We'll continue to monitor these factors as earnings start to roll in.

Regards,
Omer