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Quant Strategies Misfire as Stock Gains Stoke Cost of Safety

Quant Strategies Misfire as Stock Rally Pumps Up Cost of Safety

(Bloomberg) -- U.S. stocks may be approaching their high-water mark, but beneath the surface of this year’s rally is a tide of unease.

For quant and fundamental investors that slice and dice equities based on their characteristics, the 2019 rebound brought with it a conundrum.

A toxic combination of fickle trends and macro angst is making factors -- investing based on share attributes like profitability and market capitalization -- behave in similar ways. At the same time, this cautious rally has juiced safer stocks offering low volatility or healthy fundamentals, making defensive assets pricey.

It’s a headache for asset allocators of all stripes.

“The market isn’t going up because of cyclical reasons, the market is going up because there’s no alternative in bonds,” said Lode Devlaminck, managing director of global equities at DuPont Capital Management. “We’re in a mechanical bull market, not a growth bull market.”

Quant Strategies Misfire as Stock Gains Stoke Cost of Safety

Nonetheless, the firm is trimming quality allocations, alongside exposure to growth shares, in favor of more beaten-down alternatives.

That’s because quality stocks, boasting facets like strong balance sheets, have gotten expensive. The style’s valuation relative to the benchmark is near a record high, according to MSCI indexes going back to 2013.

It dims the appeal of defensives, even while fears for the economy continue to swirl. As the quant team led by Inigo Fraser-Jenkins at Sanford C. Bernstein noted in research this week, “classic defensive factors are too well bid to be defensive.”

“It’s better to be diversified, which helps avoid crowding risks,” said Jonathan White, head of client portfolio management at the $22-billion quant equities arm of AXA Investment Managers. Investors should “actively select quality stocks to avoid the most expensive areas,” he said.

At the same time, elevated volatility and correlation across factors is making it harder to isolate and profit from particular style exposures, according to Evercore ISI.

Safety Premium

Blame the same macro tension playing out across all financial markets for those inflated valuations. Fears of an economic slowdown remain elevated and idiosyncratic risks like trade tensions and Brexit linger, even as dovish shift by central banks offers support to asset prices.

“The cyclical downturn has favored defensive styles that work through periods of secular stagnation, regardless of central-bank interventions,” Bank of America Corp. strategists led by Manish Kabra wrote in a note.

Yet the macro picture should look better in the coming months thanks in part to base effects, they said, and Societe Generale SA has warned against chasing already expensive bond proxies. Goldman Sachs Group Inc. points out high-growth equities are trading at their widest premium to their low-growth peers since 2000.

On the flip side, riskier styles look cheap. Value shares are trading near the lowest versus growth since 2000, and the quantitative whizzes at Sanford C. Bernstein reckon they are ripe for a tactical rebound thanks to the historic valuation gap.

Quant Strategies Misfire as Stock Gains Stoke Cost of Safety

But that’s an outlier view, and even those who are bullish on the outlook have their doubts about value because looser monetary policies don’t favor the style. The low-for-longer era is better for growth shares, or high-duration assets that can post expanding profits relatively insulated from shifts in the economic cycle.

“The Fed and ECB killed value,” said Cyrille Collet, head of quantitative investing at CPR Asset Management. Instead the firm is snapping up companies with high profitability, high sales growth and strong earnings and price momentum, as well as boosting exposure to those with low valuations.

“Economic growth will of course be positive for the next few years, but slow,” said Collet.

At its heart, the allocation quandary stems not only from broad macro angst, but also from the long-established debate about whether investors with reams of data on styles that outperform in different economic and valuation scenarios should try to time the market at all.

Factor proponents frequently point to the long time horizons of many strategies, which are expected to face potentially lengthy periods of underperformance. That may naturally be expected to happen in the kind of choppy market landscape of the past six months or so.

Underscoring the turbulence, riskier styles had been making a comeback at the start of the year, but they’re now ceding ground as investors return to more defensive strategies.

Quant Strategies Misfire as Stock Gains Stoke Cost of Safety

Momentum, a factor that by definition does well during reliable market trends, was hit hard by the late-2018 selloff and is down 3 percent this year, according to a Bloomberg-compiled portfolio. Amid market schizophrenia, it’s a decidedly unpredictable investing strategy.

“Just when you think momentum growth is going to roll over, it then bounces back again,” said Jason Williams, a fund manager at Lazard Asset Management. “That speaks to the frustration that any investor that’s had a major style bias has suffered over the last decade.”

Amid all the cross currents, the team at Evercore recommends investors be led by macro trends, which they argue are having an elevated influence on factor volatility. For them, that means favoring the growth style as economic activity matures.

“We expect some improvement in economic and earnings growth ,” they wrote in a March 29 note. “But until that forecast is resolved, growth factors and momentum should outperform value.”

--With assistance from Tim Smith.

To contact the reporters on this story: Justina Lee in London at jlee1489@bloomberg.net;Ksenia Galouchko in London at kgalouchko1@bloomberg.net

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, ;Blaise Robinson at brobinson58@bloomberg.net, Sid Verma

©2019 Bloomberg L.P.