Fixed and credit carry ARP have performed well in 2019 given curve moves

Fixed income rates carry and credit carry alternative risk premia strategies have done well for most of this year. These simple strategies have performed better than many well established equity risk premia. The carry strategy in fixed income attempts to take advantage of the higher yields associated with long-term bonds. A positive term premia, which is often constructed as duration neutral, will do well in stable and declining spread environments. The credit carry strategy usually takes advantage of high yield versus investment grade spread differentials.  

The reason for the fixed income carry gains has been the sharp decline in the yield curve during the summer. While curve flattening has been in place for years, the strong decline based on Fed rate cut expectations was especially profitable. However, there has been a giveback in return since the steepening of the yield curve.

The credit carry trade did especially well in the first two months of the year as high yield spreads compressed. The rest of the year has been mixed. The premia differential has stayed relatively stable but has seen more with greater changes in high yield spreads.

Given the Fed may be on hold in December, the fixed income carry trade may not see the same upside as earlier in 2019. ff equity markets remain stable, we expect the credit carry trade to be positive but more stable relative to behavior earlier this year.

Chicago Fed BBKI indicators of economic growth signal confusion

Recession or no recession? This question has been the focus of market discussion for most of the year coupled with the question of what the Fed will do about recession risk. The Chicago Fed does a good job of providing some exhaustive economic indices through their National Business Conditions Index and their National Activity Index. The Chicago Fed also provides leading and coincident indicators  through their Brave-Butters-Kelley Indices (BBKI) monthly index. Tracking these indicator provides useful information but there are risks when using them as investment signals.

There has been very mixed signals between the BBKI leading and coincident indicators over the last 18 months that have added to investor confusion. By definition, the leading indicator should turn early relative to any turn in actual economic growth. The lead time is variable but can be at least six months or more. The leading indicator index turned up at the end of last year and has been on a strong ascent. The coincident indicator turned down just under two years ago and is now in negative territory. 

Bond markets were discounting a recession for most of the summer. It is only in the last few months have some analysts turned slightly positive consistent with the BBKI leading indicator. There is the most risk and opportunity for investor when leading and coincident indicators are moving in opposite directions. The investor faces the risk of acting on leading information when the market may be focused on coincident information. Therefore, investors should spend extra care in timing trades and position risk when this occurs. Early action on the leading indicator would have lead to a switch from bonds to equity; however, current readings make this a more fruitful choice.  

Equity multi-factor long-short style factors - When will the odd performance return to normal?

Style (long-short) factors have a long history of positive performance but are time-varying. The classic long-short equity style factors of size, value and momentum are readily available through the Ken French data website. These factors can be bundled into portfolios to show their long-term benefit. The researchers at Factor Research looked closely at an equal-weighted portfolio of the value, size, and momentum long-short style factors over a long horizon from the 1920’s to the present in a post on the CFAInstitute Enterprising Investor website. It highlights the unusual behavior of these factors over the last ten years.

Holding a long-short factor portfolio provided a good positive return with minimal drawdowns over close to 100 years. However, there were two periods of strong drawdowns when the factor approach was ineffective: one, the period of the Great Depression, and two, the current post Financial Crisis period.

The breakdown during the Great Depression would seem to make sense. There was no hiding from the financial dislocations of firm during this period. It took the revival of the economy post-WWII to see returns moves to more normal behavior.

The current deep and prolonged drawdown is a little harder to explain given that these style factors are often associated with behavior biases that still seem to persist. There is limited evidence that financial flows have been the cause for this unexpected return persistent. The spreads based on factors such as P/B or P/E for value vary over time but there is not enough evidence to suggest that these styles cannot generate an expected return difference between extreme as theorized.

There has been a clear return advantage for large over small cap return premia and higher P/E stocks over low P/E names. The momentum factor, which has a tendency for “crashes” during periods of extreme market stress, has not been able to reverse the underperformance. The result has been an extended drawdown with other factors like low volatility being more attractive.

Given the long history of style factor return persistence, the play for investors is to look for these well-known style factors to move to normality. It is not clear what will be the driver for a return to normalcy, but investors should favor this over a structural change.

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Picking the wrong measure for value or growth is costly

There are a number of ways to measure or rank value and growth stocks. Unfortunately, if an investor chooses the wrong ranking metric, he will be severely penalized. Apply the concept of value and growth to the wrong country or sector and an investor will also be penalized. The value factor or risk premia is time-varying. The measures to find the value factor will vary. Value in one country may not exist in another at the same time. Making the value or growth decision needs careful analysis and some application of diversification.

For value, there are three major measures, price to book, price to earnings, and dividend yield. Value investors want a low price to book value. There is a preference for low P/E ratios, and high dividend yields. Each have unique problems which make them difficult to apply to all stocks. Dividend yield cannot be applied to all stocks because many stocks do not issue dividend. The book value of stocks in some industries is not easy to measure, and the P/E for stocks will differ across region and industry. The same argument can apply to growth stocks where earnings per share growth or sales growth may show wide dispersion across countries and industries.

Investors are also affected by value and growth decisions for different countries and regions. Value over the last three months has been positive for the US, Europe, Japan, and developed markets, but a problem for emerging markets. Projected earnings per share growth was problematic for developed, US, and European markets, but positive for Japan and EM. Value returns have been shown to be sensitive to different points in the business cycle. If country business cycles are not synchronous, then the value factor will not be correlated.

Investors will have to diversify across measures for value and growth as well as across countries and regions to get a smooth value return. Investors can also make focused decisions on what is the best measure based on behavior of other investors or point in the business cycle, but this is a difficult prediction problem. There is not a single value or growth stock decision, so there is no simple answer when someone says they want a value or growth tilt.