Equity factor risk premia will do better, on average, than the market premia, but that does not mean that these factor premia returns don't change through time. These factors will be highly sensitive to changes in the business cycle. Now the sample sizes are relatively small since we have had a limited number of business cycles, but if we allocate returns across four regimes and across regions, we will have some idea of how these factor premia returns change conditional on the economic regime.
The business cycle can be divided into four parts, recessions, slowdown (below trend growth), growth above trend, and recovery (the period after a recession). A close look shows which factors should offer higher returns during different cycle periods.
The intuition in the behavior makes sense. Hold low beta in a recession and drop during growth periods. Drop market risk during a recession and add during a recovery. Of course, the key problem is determining what is the current phase of the business cycle and predicting turning points. If stocks markets are forward-looking mechanisms, the impact of different business cycle regimes becomes all the more apparent. There is value if you can anticipate business cycle regimes before the market. Playing the factor premia investment game requires a sense of business cycle positioning. However, as history has shown, this is not an easy problem.
Know the current regime.Anticipate changes in the business cycle.Understand what has been discounted in the market.Exploit the difference between business cycle forecast and level of market discounting.
Recent research by Research Affiliates suggests that there are a number of added complexities with looking at factor premia across the business cycle. There is the change in fundamentals, a change in price ratios or valuations, and the impact of rebalancing since there is sorting or repricing of the factor premium.
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