Believe it or not, we finally made it to 2022. The biggest thing affecting all of our lives, COVID-19, has now been considered a global pandemic for almost two years now. Despite all the upheavals caused by COVID, many of our lives are beginning to return to some form of normalcy. For the most part, my day-to-day life is now at what I would consider my new normal. There are many things that I did before the pandemic that I don’t do now, but many of those things are activities I likely won’t return to at the same level of frequency. For example, I did kickboxing almost every day during the week, and on the weekends, I would usually go out somewhere with friends almost every weekend. My new normal has me cutting back significantly on both activities since COVID started. I stopped going to kickboxing when COVID began, and I likely won’t be returning. Now, it’s pretty rare for me to go out on weekends with friends, and I expect that going forward I will only be doing that 1-2 times a month at most. This all may seem like a loss, but for everything that is lost, something is gained. I now spend more time reading, I am working toward the CFA charter, I am learning Spanish, and I am able to spend more time cultivating my curiosity and honing my craft.
Looking back at 2021 from a personal perspective, it wasn’t bad for me, but it was quite a bit different. Volatility is a term often used to describe investment markets, but I think we can all say that volatility describes our personal lives and global events quite well over this time. Fortunately, investment markets are often one of the best feedback mechanisms for everything that’s going on in the world and in our economy. One way to gauge how everything is going is by looking at different factor performance. In investing, a factor is a specific variable that certain investments have in common with each other that could be a driver of their return. An example of a factor could be the letter factor. An example of a rudimentary factor we could look at would be the letter factor. We could divide different investments by which letter they start with to see if that has an impact on investment returns. If we start with “A” we have some big hitters. We have Apple, Amazon, Adobe, and even Alphabet (Google). If we then look at “B,” we would be looking at stocks like Boeing, Bank of America, Blackrock, and Biogen. If we then compare these two factors to each other using the example companies, we can see that stocks that start with the letter “A” have done significantly better than stocks that start with the letter “B.”
So, does this tell us that we would do much better if we only invested in stocks that started with the letter “A”? That’s what it may seem like, but if we run an analysis to determine the R2, we would find that there are plenty of stocks that start with “A” that have performed poorly, allowing us to conclude that the letter factor is not a reliable indicator of performance.
Fortunately, many factors have been identified that are indeed reliable indicators of performance. It has been found that the performance of various factors can be determined by different macroeconomic outcomes. For example, when we have strong, broad economic growth, the best performing stocks tend to be smaller companies in sectors that benefit from increased economic activity. The sectors that fit this category would be consumer discretionary, communication services, financials, industrials, information technology and materials. We can say that the companies that possess these characteristics are in the cyclical factor. These companies are considered cyclical because they cycle between generating high earnings when the economy is hot and struggling when the economy is slow.
The opposite factor would be the defensive factor. The characteristics of the defensive factor would be companies whose earnings don’t fluctuate all that much regardless of what is going on in the economy. These would be companies that customers would need to do business with regardless of their present financial position. Generally, the companies that fit these characteristics fall under the consumer staples, energy, health care, and utilities sectors.
If we compare how all the companies that fall under each of these factors have done, we will generally get a pretty good idea of the overall sentiment surrounding the economy since both factors perform so differently. If cyclicals are performing strongly and defensives are weaker, that would suggest the economy is strong. If defensives are strong while cyclicals are weak, that would suggest a slow or slowing economy. If they are both performing at about the same clip, well, then we’re getting a bit of a mixed message.
The chart above shows the performance of defensives and cyclicals every year since 2006. We can see that the performance in 2021 for both was very close. Both had strong performance, and defensives only outperformed cyclicals by about 1.5%. The last time we had performance of these two factors that was this close was in 2006, right before the global financial crisis. I don’t believe this means we are due for another global financial crisis, but the main takeaway of the closeness of performance of these two factors is that there is a lot of uncertainty among market participants right now.
An old proverb says, “there is nothing certain, but the uncertain.” That proverb couldn’t be more true now. It looks like 2022 could be another wild ride, so buckle up, and remember that in the face of uncertainty it is often discipline and patience that results in the best outcome.
As a sidenote, there are many other notable factors that I did not discuss, but if you’re curious, this chart from JPMorgan Asset Management outlines the performance of different factors every year. Note that the deviation in performance between their factors and mine is likely due to a difference in sector weighting.
