Equity factor risks and the business cycle - Changing dynamics offer opportunities

 

Equity risk factors are tied to the business cycle. Condition on where we are in the business cycle and returns will be markedly different. The researchers at FTSE Russell show this relationship in "Do factors carry information about the economic cycle Part 1: The Investment Clock: Linking factor behavior to the economic cycle"  They start their analysis by breaking up the economic environment into four phases that represent the business cycle: expansion, slowdown, contraction, and recovery. These can be identified through using a measure of inflation against a long-term average and growth through the ISM survey.

Equity risk factors do not all act the same, and each will perform differently over the business cycle. Quality will do well during the peak of the business cycle and into contractions. When the market hits a trough, value, size, and momentum will perform better. Size and momentum will do well during an expansion. This information provides investor valuable information on market headwinds and tailwinds associated with the business cycle.

Some equity risk factors provide information on future economic growth. Size and value have a strong positive relationship with economic growth while momentum has a negative relationship.

The gain from making equity risk factor adjustments conditional on the business cycle can be substantial. The market risk will perform the bets across the full business cycle; however, switching will offer upside and protection especially during slowdowns and contractions.