A considerable amount of ink has been spilled on the so-called Trump Trade that emerged after the 2016 U.S. presidential election. While many investors expected the selloff that took place after hours on election night to continue as U.S. markets opened on November 9, the opposite occurred. Within the U.S. stock market, investors bid up the prices of out-of-favor, cyclical stocks at the expense of growth stocks, which had been rallying prior to the election.
Even as the market rally has continued into 2017, however, performance trends have begun to reverse as measured by style factor indices. This reversal highlights the importance of looking beyond the headlines to interpret what investors are rewarding.
The Reflation Trade Favored Value
Following the U.S. election, investors extrapolated that President Trump, alongside a Republican Congress, would enact significant policy changes to loosen Washington gridlock and reignite economic growth, with a corresponding increase in inflation likely. In this environment, the yield curve steepened and value outperformed the broader Russell 1000 Index by 4.02% from November 9 to the end of 2016, and by 6.61% for the 2016 calendar year.1 As of November 8, the largest sector overweight relative to the Russell 1000 Index was the Financials Sector, while the largest underweight was Information Technology (IT). As one may expect, the value index’s exposure to financials was the largest contributor to positive returns during that period.
Interestingly, value tends to perform best in periods of economic recovery. So while performance may have been sharp, it was consistent with history. In addition to what was occurring in U.S., global growth was picking up relative to expectations.
As value was rallying, momentum stocks suffered considerably, underperforming value by 5.44% from November 9 to December 31 as momentum had considerable exposure to the underperforming IT Sector and an underweight to Financials.2 It is worth noting that the underweight to Financials was a much greater detractor than was the overweight to IT.
Quality Back in Favor
Since January, the post-election reflation trade has stalled and quality is now the best performing factor, with quality stocks up 15.98% in 2017.3 Historically, quality stocks tend to perform best in economic contractions. If the market is an effective discounting mechanism, then perhaps it is seeing something different in the data today than are many others, as expectations for a recession remain low. It is more likely that quality stocks were out of favor last year and, as such, have positive growth expectations compared to the Russell 1000 Index.
Underlying Fundamentals May Provide a Look Ahead
As earnings season begins to wind down, a review of certain fundamental characteristics of these style factors may offer insight to investors seeking the next performance catalyst. Notably, quality is the most expensive on all four valuation multiples, while value is least expensive, as one may expect. However, value has the second lowest expected EPS growth rate, the highest debt-to-equity ratio and the lowest return on equity. On the other hand, momentum has the highest expected earnings growth. In other words, for investors expecting that current market trends may continue, quality and momentum offer that exposure. For those anticipating a return to fundamentals, however, a rotation to value and size may be in order.
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