Market Matters

Equity Opportunities Include Low-Volatility and Quality Stocks

14 October 2024

8 Minute Read

Global stock markets have been rallying for much of the past two years. Will the streak continue? And what opportunities are most compelling within equities?

Moderation in Equity Positioning

While we see opportunities in stocks, the nuanced balance of upside and downside risks argue for a moderate and risk-aware positioning.

Investors should diversify regionally and focus on quality and stable earnings, margins and return streams. One way to express this view is through tactical opportunities in low-volatility and quality equities.

From a macro perspective, we see a period of positive but slowing economic growth ahead in the US and globally. Inflation should moderate further in the coming quarters and interest rates have likely peaked. We think the market expects this soft-landing scenario: it’s consistent with positive but modest equity return potential, and will influence leadership patterns within the market.

Valuations are broadly benign globally, with Japan, the UK and China offering the largest discounts to historical averages. The US is the unsurprising exception, trading at a considerable premium versus both its own history and other regions.

Equity Valuations are Generally Benign… Except for the US

Current Valuation as Percentage of Historical Average

Historical analysis does not guarantee future results.

As of August 30, 2024

Source: FactSet, Thomson Reuters I/B/E/S and AB

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With the consensus expecting 10% US earnings growth overall, expectations are high, with growth for the largest 10 stocks - which include the ‘Magnificent Seven’ – expected to be 20%.

Source: FactSet and AB as of August 30 2024

Lofty Growth Expectations for US Stocks

Of course, US valuations remain massively skewed by the mega caps; stripping out the top 10 stocks makes the multiple considerably less extreme.

How worried should we be about these multiples? With the consensus expecting 10% US earnings growth overall, expectations are high, with growth for the largest 10 stocks - which include the ‘Magnificent Seven’ – expected to be 20%.

Overall, we don't think these growth rates are unachievable, and our models signal robust (if somewhat more modest) growth for the US market. Neither do the apparently high multiples necessarily concern us over the short to medium term horizon. US equities offer a source of superior growth, quality earnings and stable margins, which is a key theme underlying our equity positioning.

In our view, plenty of opportunities in the US deserve the valuation premium, given their better quality and growth prospects.

But there are risks. Revenues could slow and margins might remain under pressure as the economy decelerates, and US outperformance hinges a lot on the top 10 continuing to meet and beat ever-higher expectations. Within the US market, active management is required to avoid areas of over-valuation and uncover the many profitable opportunities that exist. More broadly, we also think investors should consider maintaining a balanced exposure to both US and international stocks.

Source: FactSet and AB as of August 30 2024

Style Factors: Low-Volatility and Quality

Another opportunity in the quarters ahead cuts across markets along the style dimension: exposure to factors, characteristics that persistently explain relative returns within an asset class.

Two factors seem particularly attractive.

Low-Volatility, which we’ll define as stocks with a low beta and lower return volatility than the market.

Quality, which we’ll define as popular indices do—stocks offering high profitability, stable earnings and healthy balance sheets.

Other key factors include growth, momentum and size.

Style Factors: The Short-Term and Strategic Roles

In our view, factor-based strategies have a key role in portfolios both strategically (over the long term) and over shorter horizons, with an ability to enhance return potential and diversify portfolios; we can show that the correlation among factors is a lot lower and more stable through time than the correlation between traditional asset classes.

Although factor effectiveness varies through the cycle, factors have outperformed the broad market or asset class over time. For instance, simple, passive, long-only US low-volatility and quality factor strategies have beaten the market by 4.8% and 5.6%, respectively, since 1963, and by 3.9% and 2.9% over the past 20 years (See display).

Other common factors premia have also outperformed, so exposure to a thoughtful, balanced mix of strategies with exposure to different factors should form a key part of investors’ strategic allocations.

Factors Have Outperformed Broad Markets/Asset Classes

Long-Term Factor Excess Returns (vs. Broad US Equity Market), Volatility and Information Ratios

Historical analysis does not guarantee future results.

Information Ratio is a measure of risk-adjusted returns relative to a benchmark. It’s calculated as excess returns (portfolio returns above those of a benchmark) divided by the volatility of those returns.

As of July 31, 2024

Source: Kenneth R. French Data Library and AB

Diversified, Balanced Factor Exposures—with Active Opportunity

An active approach to factor investing may further enhance alpha achievable through factor allocations. For instance, active equity strategies with a certain style tilt, such as value or growth, offer access to factor returns but also the potential for added alpha through security selection within their respective style universes.

Individual factors fare differently through the cycle, which has implications for how investors should consider integrating them. For instance, value stocks (at least those that are cheap on “deep value” measures such as price to book value or price-to-earnings) tend to do best in economic recoveries, and when interest rates and inflation are rising. Growth stocks fare better in late expansions and, other things equal, prefer stable or falling rates.

These different relationships with the cycle argue for maintaining diversified, balanced factor exposures over the long term. An active approach may be better positioned to maintain such broad factor neutrality. That's because indices – both broad market ones and even style benchmarks like the S&P Value index - aren't style neutral and may contain unintended biases. An active approach may be needed to manage these unintended exposures.

The cyclicality of factors also gives rise to more tactical return opportunities by tilting toward (or away from) specific factors based on the market and macro environment. This is yet another argument for an active approach.

A Near-Term Tilt Toward Low-Volatility and Quality

The near-term macro-outlook is a key reason why we think a tilt toward low-volatility and quality stocks makes sense in the coming months.

Both styles outperform in slowdowns and recessions, but could also be resilient if we see continued expansion.

Low-volatility tends to outperform the broader market in all scenarios other than significant rallies where the market returns more than 10% annualized. This fits with our expectation of positive but subdued equity returns in the near term.

Near-Term Outlook Supports Tilt to Low-Volatility and Quality

Annualised Factor Returns in the Economic Cycle (Percent)

Historical analysis does not guarantee future results.

Display shows the annualised return for factor portfolios in different economic cycles from January 1990 to September 2019. Factor portfolios have been rebalanced quarterly and returns are on an equal-weighted total-return basis. Economic cycle periods are defined by the normalised seasonally adjusted composite leading indicator from the OECD. The universe of the indicator is based on the OECD plus the six major non-member economies. We divided the world economic cycle into four phases: an expansionary level (>100) and the positive first differential of the leading indicator are classified as an “expansion”, an expansionary level with a negative first differential is a “slowdown”, a contractionary level (<100) and positive first differential are classified as a “recovery” and a contractionary level with a negative first differential is a “downturn”. As of December 31, 2020.

Source: FactSet, MSCI, Thomson Reuters Datastream and AB

Low-Volatility and Quality Are Attractive Strategically, Too

Low-volatility and quality factors are also attractive strategically. Based on our research, low-volatility equities, for instance, have tended to perform best when inflation is moderate but somewhat elevated—that’s where we expect it to settle over the strategic horizon. Quality equities may also bring the added byproduct of defensiveness.

Low-Volatility Has Tended to Outperform in Most Market Scenarios

Low-Volatility Performance in Different Market-return Regimes (Percent)

Historical analysis does not guarantee future results.

The chart shows annual data from 1988 through 2022 for the average annual US market and US Minimum Volatility factor return in different ranges of US market return from <0% to >10%

As of August 12, 2022. Source: MSCI, Thomson Reuters Datastream and AB

What Are Investors Buying with Low-Volatility and Quality?

An allocation to quality would imply exposures to technology (the largest weight in simple US quality indices), healthcare, telecom and staples—but also financials and industrials. Outside the US, the quality basket is somewhat broader, with a greater presence from cyclical sectors such as consumer discretionary and materials. Low-volatility is more sector-diverse, especially ex-US—exposure is less about tech and more about financials (the highest weight), with utilities and energy, too.

In Summary...

We believe that strategies with exposure to factors should play a key portfolio role as return enhancers and diversifiers. Near term, we expect slowing growth and full valuations in the US, so we have a positive, but risk-aware stance on equity markets. This leads to a preference for high-quality and low-volatility stocks: they have defensive qualities, tend to fare well in slowdowns and recessions, and cope effectively with “sideways” markets and moderately higher inflation.

One way investors can access these exposures is through active management, with the potential to add alpha by using fundamental analysis to identify strong companies with desired factor exposures.

Alla Harmsworth Investment Strategist

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The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

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