FLASH NOTE Flash Note Equity investment strategies Market leadership of US Value' strengthens considerably in the aftermath of US elections Pictet Wealth Management - Asset Allocation & Macro Research 1 December 2016 The US Value equity strategy s outperformance has accelerated since the US elections. Over the 15 trading days following the elections, our Value index returned 9.8% (in US dollars), compared to 8.2% during the preceding 6 months. Value stocks exhibit more than twice the volatility of Low Vol equities (27.3% vs. 11.9% annualised, between 10 March 2009 and 5 July 2016). An extension of the arbitrage trade of Value over Low Vol depends on conviction regarding the underlying macro risk factors driving these investment strategies. The dynamics underlying the recent outperformance of US Value equity strategies over Low Vol strategies and the S&P 500 are best assessed within a risk factor-based framework. The risk factor framework has become a new standard for asset allocation decisions. Risk factor-based indices, equity investment style funds and exchange traded funds (ETFs) have gained significant popularity in recent years. At Pictet Wealth Management (PWM), we have identified three main tactical categories of risk factors to explain economic and : 1) macro risk factors; 2) market risk factors; and 3) investment risk factors. Our risk factor framework In light of the most recent academic research, we have developed our own methodology for applying these tactical risk factors to investment strategy. Among well-known equity investment risk factors are value, size and momentum. We currently use 7 investment risk factors, including two that are distinctive to PWM (innovation and visible growth). PWM Tactical risk factors Three categories in a top-down approach AUTHORS Wilhelm SISSENER, CFA wsissener@pictet.com +41 58 323 3475 Jacques HENRY, CFA jhenry@pictet.com +41 58 323 2916 Pictet Group Route des Acacias 60 CH - 1211 Geneva 73 www.pictet.com Source: Pictet WM - AA&MR If exploited in a timely and proper way, investment risk factors can be a source of market outperformance for investors. Precisely to secure a clear-cut
reading of equity markets, we decided to develop our own risk factor-based indices 1. To determine the current state of investment risk factors and analyse equity investment strategies, we first examine the other two groups of risk factors (Macro and Market) in a top-down approach. To illustrate our reasoning, current economic and equity reveal an opportunity to arbitrage between two distinct equity investment strategies: US Low Vol (low price volatility equities) and US Value (stocks that have lower relative valuations and more sensitivity to economic shocks). Low Vol is being arbitraged in favour of Value The US election result confirmed Value as a superior equity investment strategy to Low Vol and the S&P 500 index. In the space of 15 trading days following the Republican win, the Value investment strategy returned slightly more than it did over the entire preceding six months (see chart 1). Chart 1: Returns for US Value since US elections better than for preceding 6 months 6 Months preceding US Election Total Return USD Post-US Election (8 November) Total Return USD -2% 2% 6% 10% 14% 18% 8.2% 9.8% PWM - AA&MR US Value TR (USD) Index 3.8% 2.9% S&P 500 TR (USD) Index -0.7% 0.4% PWM - AA&MR US Low Vol TR (USD) Index Between the mid-march 2009 market bottom and the beginning of July 2016 (when shifted, according to our quantitative indicators), Low Vol equities periodically attracted the attention of investors looking for safe and stable returns, in the context of recurring uncertainties surrounding the economic recovery. During this period, our Low Vol index offered a compound annual return of 17.2% for an annual volatility (standard deviation) of only 11.9%. This compares to a compound annual return of 23.7% for the Value strategy, but at the price of much higher volatility (27.3% 2 ). Consequently, there were periods during which Low Vol outperformed Value and vice versa, depending on trends in the macro and market-risk factors driving these investment strategies. 1 For example, to precisely track the Low Vol risk factor, we periodically select the 10% (decile) of the S&P 500 exhibiting the lowest historical volatility. For the Value risk factor, we proceed in a similar way, selecting the decile of stocks with the lowest valuations. Our indices are weighted by market capitalisation. They are rebalanced and reshuffled yearly through a systematic quantitative methodology. 2 Hence the more favourable return/risk profile for the Low Vol strategy, i.e. a Sharpe ratio of 1.42, versus 0.85 for Value (using an average USD 3 Month Libor rate of 0.37% over the period). 1 December 2016 FLASH NOTE - Equity investment strategies PAGE 2
US Value outperforms both Low Vol and the S&P 500 Among macro factors, inflation expectations are among the most relevant for explaining the regime shift toward the Value investment strategy that occurred in early July 2016. As a proxy, we use the 10-year US breakeven inflation rate. The regime shift coincided with recovery in sentiment in the aftermath of the UK s Brexit vote and better-than expected US employment data. Chart 2 highlights the strong relationship between inflation expectations and the Value investment strategy. As inflation expectations rise, Value gains traction relative to the S&P 500. The red line displays the decile of S&P 500 equities with the lowest valuations relative to the S&P500. Chart 2: US 10-yr inflation expectations driving US Value relative to the S&P 500 120 110 PWM - AA&MR US Value Index Total Return (USD) Relative to S&P 500 Index Total Return Level (Rebased at, Left Scale) 10-Year Breakeven Inflation Rate, NSA, Percent - United States (Right Scale) US Election 4.6 4.1 3.6 90 3.1 80 2.6 2.1 70 1.6 60 01.01.2014 22.06.2014 11.12.2014 01.06.2015 20.11.2015 10.05.2016 29.10.2016 1.1 Since the regime shift of early July 2016, Value equities have not only significantly outperformed Low Vol, but also the S&P 500 benchmark (by 29.1% and 18.5% in USD, respectively, see table 1) Table 1: Return and risk characteristics of each strategy compared to the S&P 500 Since 5 July 2016 (New Regime) 6 Months 1 Year Compound Annual Total Return (USD) Standard Deviation (Volatility) Information Ratio In contrast to Value, the Low Vol investment strategy exhibits a strong negative correlation with long-term interest rates. We can use 10-Year US Treasury yields to explain and forecast the tendency of this investment strategy (see chart 3). Sharpe Ratio PWM - AA&MR US Value TR (USD) Index (1) 24.7% 16.2% 8.2% 23.7% 27.3% 0.87 0.85 PWM - AA&MR US Low Vol TR (USD) Index (2) -4.4% 0.8% 11.2% 17.2% 11.9% 1.45 1.42 S&P 500 TR (USD) Index (3) 6.2% 5.9% 8.1% 19.0% 16.6% 1.14 1.12 Outperformance of (1) vs. Total Returns (USD) as of 01.12.2016 Annualized figures (9 March 2009-5 July 2016) (2) 29.1% 15.4% -3.0% (3) 18.5% 10.3% 0.1% 1 December 2016 FLASH NOTE - Equity investment strategies PAGE 3
Chart 3: US Low Vol poised to underperform in a rising yield environment 120 115 PWM - AA&MR US Low Vol Index Total Return USD Relative to S&P 500 Index Total Return Level (Rebased at, Left Scale) US Benchmark Bond - 10 Year Yield (Right Scale) US Election 6.5 5.5 110 105 4.5 3.5 95 2.5 90 85 1.5 80 01.01.2014 22.06.2014 11.12.2014 01.06.2015 20.11.2015 10.05.2016 29.10.2016 0.5 An investor can further dissect the US equity market according to Value and the Low Vol risk factors (see chart 4). The two curves also illustrate the early July 2016 shift in. Investors are now clearly eschewing US Low Vol equities in favour of US Value. We obtain the cumulative return curves for each strategy by subtracting the total return of the bottom decile from the total return of the first. Chart 4 shows that since the July 2016 regime shift: The least volatile stocks have been underperforming the more volatile ones. The least expensive shares have been outperforming higher priced ones. Value has been outperforming Low Vol. Chart 4: Cumulative return for Low Vol and Value (top decile minus bottom decile) 400 350 300 250 200 150 50 0-50 % Cumulative return PWM-AA&MR US Low Volatility Strategy (first-last decile cumulative return) PWM-AA&MR US Value Strategy (first-last decile cumulative return) Under certain conditions, the US Value investment strategy is likely to continue to outperform US Low Vol and provide investors with sizeable returns. But in order to do this, long-term inflationary pressures have to be sustained, without getting out of control: 1 December 2016 FLASH NOTE - Equity investment strategies PAGE 4
Healthy gradual inflation pressures (i.e. increasing US wage expectations) could further drive the performance of the US Value investment strategy relative to the S&P 500. By contrast, if bad inflation arise, (for example, an over hasty rise in commodity prices and/or the price of imported goods), a shift in the Market/Macro risk factor driving both strategies could occur, with more negative consequences for the Value strategy likely than for Low Vol. In terms of relative valuations, the Low Vol strategy reached extreme levels in late June, when the relative price-to-book for Low Vol stocks vs. Value rose by more than two standard deviations above the average that had prevailed since mid-2015 (see chart5). Chart 5: Relative price-to-book of our US Low Vol index vs our US Value index 4.0 Relative Price-to-Book (PWM-AA&MR "Low Vol" Index vs PWM-AA&MR "Value"Index) Average 3.5 +2 Standard Deviations +1 Standard Deviation 3.0 2.5-1 Standard Deviation -2 Standard Deviations Notice: This document is not intended for persons who are citizens of, domiciled or resident in, or entities registered in a country or a jurisdiction in which its distribution, publication, provision or use would violate current laws and regulations. The information and data furnished in this document are disclosed for information purposes only; Banque Pictet & Cie SA (hereinafter the Bank) is not liable for them nor do they constitute an offer, an invitation to buy, sell or subscribe to securities or other financial instruments. The information contained herein is not the result of a financial analysis within the meaning of the Swiss Bankers Association s Directives on the Independence of Financial Research, which therefore do not apply to this document. Except for any obligations that the Bank might have towards the addressee, the addressee should consider the suitability of the transaction to individual objectives and independently assess, with a professional advisor, the specific financial risks as well as legal, regulatory, credit, tax and accounting consequences. Furthermore, the information, opinions and estimates in this document reflect an evaluation as of the date of initial publication and may be changed without notice. The value and income of the securities or financial instruments mentioned in this document are based on rates from the customary sources of financial information and may fluctuate. The market value may vary on the basis of economic, financial or political changes, the remaining term, market conditions, the volatility and solvency of the issuer or the benchmark issuer. Moreover, exchange rates may have a positive or negative effect on the value, the price or the income of the securities or the related investments mentioned in this document. Past performance must not be considered an indicator or guarantee of future performance, and the addressees of this document are fully responsible for any investments they make. No express or implied warranty is given as to future performance. The content of this document can only be read and/or used by its addressee. The Bank is not liable for the use, transmission or exploitation of the content of this document. Therefore, any form of reproduction, copying, disclosure, modification and/or publication of the content is under the sole liability of the addressee of this document, and no liability whatsoever will be incurred by the Bank. The addressee of this document agrees to comply with the applicable laws and regulations in the jurisdictions where they use the information reproduced in this document. This document is issued by the Bank. This publication and its content may be cited provided that the source is indicated. All rights reserved. Copyright 2016. 2.0 Relative valuations have since moved back to slightly below their historical average. Investors may well continue to arbitrage Low Vol in favour of Value however, as relative valuations could have further room to diverge from the mean. The drivers for this divergence are higher healthy inflation and higher interest rates stemming from: A sensible implementation of new supply-side economics by the Trump administration, including lower corporate and personal taxes, as well as a significant infrastructure spending plan; Sound US monetary policy, which could temporarily let inflation run slightly above the 2% Federal Reserve target, while keeping the labour market from overheating; and A gradual normalisation of long-term US interest rates towards levels in line with nominal GDP growth rates. We will keep you informed through our regular publications on the evolution of these indicators. 1 December 2016 FLASH NOTE - Equity investment strategies PAGE 5