Mark Barnes, Head of US Research
The Covid-19 crisis has slowly pervaded equity markets. Even though the first case in the US was discovered in Washington State on January 21, equity markets did not give it much attention. In fact, the Russell 1000 hit an all-time high on February 19, before beginning its precipitous slide. On February 19, the Russell 1000 was up 5.4% and on track for another stellar year, but it finished the quarter down by 24.3%.
We are accustomed to thinking of different factors playing very different roles in different parts of the market cycle [1,2]; Value and Size tend to be cyclical factors that do particular well when markets are up, and Quality and Volatility are defensive factors that tend to perform better when markets are down. The market high in February gives us a good breakpoint to examine these expectations.
Chart 1 below illustrates the excess return of “pure” single factor indexes over the Russell 1000 Index for the first part of the quarter. The factor performance paints the portrait of a typical Momentum-driven up-cycle. The chart indicates that stocks that were doing well were relatively expensive large caps with high momentum. Quality and (low) volatility characteristics did not really enter the picture. We might expect to see this pattern in a bubble period.
Source: FTSE Russell as of February 19, 2020. Past performance is no guarantee to future results. Please see the end for important disclosures.
For example, if this were a market crash after a bubble, such as the dot-com bubble, we might expect to see a reversal of this factor performance, with Momentum crashing and Value making a come-back.
However, looking at the factor excess returns for the quarter after the February 19 peak, perhaps surprisingly, we see that Momentum continued to do well, and Value and Size continued to underperform (Chart 2). Where was the reversal?
How did industries perform in each period?
A final comparison of the two periods can be made by looking at the industry returns over the two periods. Chart 3 shows the excess returns of the R1000 industries. In the first period, the best performing industry was Technology, which outperformed by about 6.8%. In the period of the sell-off, Technology continued to outperform. What is more interesting is that the two best performing industries were Health care and Telecommunications.
This comparison reminds us that market sell-offs can be quite different. The reversal of a bubble can result in the reversal of factor performance, but the sell-off in the first quarter was not the bursting of a bubble. The same factors that performed well before the peak, also did well after the sell-off started. Investors considered the specific characteristics of the Covid-19 crisis when deciding how to protect their portfolios, and they elected to buy stocks with characteristics similar to the ones that had done well earlier.
We also have expectations that defensive factors would do well in a sell-off, and while Quality held up relatively well, Volatility did not. Again, investors looking for a safe haven sought stocks with good profitability and low leverage – and as can be seen, the volatility of the stocks was less of an issue.
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 Single factor indexes are the recently launched R1000 Target Exposure indexes. The Target Exposure methodology neutralizes non-targeted factors.
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