The factors to focus on now

The major equity style factors—value, quality, momentum, size and minimum volatility—have behaved differently depending on the phase of the economic cycle. Kate explains which factors to focus on now.

Today’s low-return environment poses a challenge to investors. We believe investing through a lens of equity style factors—broad, persistent characteristics driving returns—can potentially help investors increase diversification and enhance returns relative to broad market exposure, as we write in our June Global Equity Outlook Focusing on factors. So which equity factors should investor focus on today?

Investors can potentially benefit from exposure to all five major equity style factors for diversification purposes, but returns can be enhanced by tilting or adjusting these exposures through the economic cycle, research from BlackRock’s Factor-based Strategies Group suggests.

The major equity style factors—value, quality, momentum, size and minimum volatility (min vol)—have behaved differently depending on the phase of the economic cycle. We believe there may be years left in the current expansion, as detailed in our latest Global macro outlook. Investors have historically been best rewarded for exposure to momentum in such phases, our analysis of factor performance since 1990 suggests. See the chart below.

GlobalEquityOutlookChartsMay2017_SineOfTheTimes_R4_BlogVersion_060117

We prefer momentum (stocks trending higher) in today’s economic environment. We also see the value factor (the cheapest corners of the market) potentially performing well in coming quarters against a backdrop of stable cyclical expansion. In periods of stable growth, market trends have historically tended to persist while confidence in value stocks rises. Today’s expansionary economic regime favors risk-seeking factors over defensive ones, we believe.

Momentum and value have had a small negative correlation over the past two decades, our analysis of MSCI index data shows. Yet the relationship is not static—and we see the current economic regime supporting both factors in coming quarters. We see the valuations of both factors as fair. Quality and min vol have historically tended to outperform in economic decelerations, as the chart above shows. But we believe these factors can provide some diversification throughout the cycle to cushion against volatility. The performance of size may depend on U.S. politics. Further delays in tax reform could dampen interest in these more domestically geared companies.

So what are the risks? Momentum investors should keep an eye on market breadth, we believe. This is a measure of the sustainability of the market trend, which measures the number of advancing stocks relative to the number declining. Our analysis shows that nearly 80% of the names in the each of the major U.S., European and Japanese markets were trading above their one-year moving average as of mid-May. U.S. equity markets have posted solid gains in the six to 12 months following this level of breadth, our analysis of S&P 500 data since 1990 shows. We find similar results for other markets. Robust earnings growth in the first quarter reinforced our view that the breadth of equity performance can be sustained.

We see an unexpected economic regime change as the major risk to value. Lower growth and inflation would weaken the fundamental outlook for cheaper stocks. Factor tilting, rather than short-term in-and-out timing, can help balance opportunities with the aim to improve returns without disrupting the long-term benefits of a diversified factor portfolio, in our view. Finally, the economic regime is the biggest driver of factor performance, although combining this with other indicators such as relative strength, valuation and dispersion can produce better results, we find.

Bottom line: We prefer the momentum and value factors in the current environment, but caution that how investors implement them could lead to different outcomes. Read more in our full Global Equity Outlook.

Kate Moore is BlackRock’s chief equity strategist, and a member of the BlackRock Investment Institute. She is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal. Investing in small cap companies may entail greater risk than large-cap companies, due to shorter operating histories, less seasoned management or lower trading volumes.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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