U.S. Equities

Q3 2019 Disciplined Equities Market Update

U.S. large cap equities finished the volatile third quarter in positive territory, whereas small cap equities underperformed.
October 2019

U.S. large cap equities finished the volatile third quarter in positive territory, whereas small cap equities underperformed. One of the most notable themes during the quarter was September’s momentum correction, which was accompanied by a brief rotation into value.

Bond proxies outperform

As investors remained cautious due to ongoing concerns over the U.S./China trade war, central bank policy, and the possibility of an economic recession, lower-risk bond proxies in sectors such as Utilities, Real Estate, and Consumer Staples were some of the best performers during the quarter. Longer-term, the continued outperformance of low-risk stocks has been a dominant theme driving U.S. equity market returns.

Momentum holds strong

Despite a significant correction in September, stocks with positive price momentum still finished the quarter with positive returns. This was almost entirely driven by the month of August, when previous winners outpaced previous losers by more than 10%.

Rotation into value

After a prolonged stretch of underperformance, attractively valued companies outperformed more expensive companies during the quarter, driven mostly by September’s rotation into value at the expense of momentum and growth. Albeit brief, September’s rotation into value was significant enough to overcome a rough start to the quarter for value stocks.

Factor performance

Source: FactSet, Axioma, Russell and BMO Global Asset Management

Observations from Market Monitor

September’s momentum correction was the catalyst for a sudden but short-lived rotation into value. In previous quarters, we’ve explored the recent challenges of value investing, which extended well into the third quarter with negative returns in July and August. However, September broke a remarkable stretch of underperformance, as investors rotated from growth and momentum into value (Chart 1). While the magnitude of September’s factor rotation was notable, it was relatively brief in duration, lasting approximately 5 trading days from September 3 through September 9 (Chart 2).

Source: FactSet, Axioma, Russell and BMO Global Asset Management

Upon dissecting this sudden market reversal, it appears that this was more about a momentum correction than a durable value recovery. For example, we found that deep value factors, such as price-to-sales and price-to-book, significantly outperformed relative value factors, such as price-to-earnings and price-to-cash flow (Chart 3). Similarly, valuation disproportionally outperformed within higher risk companies, consistent with a deep value rally (Chart 4). Finally, the magnitude of the momentum correction was greater than that of the value recovery.  In aggregate, our conclusion is that the deep value rebound was likely just the offset to a momentum correction.

Source: FactSet, Axioma, Russell and BMO Global Asset Management

Despite a better month for value investing, the opportunity remains for valuation. Even with September’s rotation into value, the valuation spread, which measures the difference in valuation between cheap and expensive stocks, remains extraordinarily wide (Chart 5). Historically, wide valuation spreads have been a reliable forward predictor for above-average returns to valuation.

Chart 5 | Valuation spreads (1982–2019)

Source: FactSet, Axioma, Russell and BMO Global Asset Management

As a result, the team maintains significant exposure to valuation as part of a well-diversified process, and September’s returns suggest we are well positioned when there is a more sustained value recovery.

The Russell 1000® Index is an index of approximately 1,000 of the largest companies in the U.S. equity market. The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. Investments cannot be made in an index.
The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe.
Beta is a measure of a portfolio’s volatility. Statistically, beta is the covariance of the portfolio in relation to the market. A beta of 1.00 implies perfect historical correlation of movement with the market. A higher beta manager will rise and fall more rapidly than the market, whereas a lower beta manager will rise and fall slower.

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