In my previous post, which provoked a wide range of reactions, I highlighted the fundamental link between the four main long-term factors behind equity outperformance - low volatility, value, momentum and quality - and Plato’s four cardinal virtues - prudence, justice, temperance and courage. In this post, the next one in this three-part series, I will revisit this allegory to discuss its relevance with respect to market phases as well as the importance of combining the virtues rather than “timing” them.
Once we recognise that there are several ways to outperform the market by selecting securities based on incorporating various investment philosophies, there is a strong temptation to time a particular style in order to add a tactical dimension to your strategic selection. Easily visible market conditions, highlighting the optimal environment for each philosophy, make this temptation all the more difficult to resist.
The first market dimension to examine is its overall trend: an “optimistic” style will fare better when aggregate markets are rising, while a “pessimistic” style will outperform during periods of bear markets.
The low-volatility factor is a pessimistic way of thinking, i.e. prudence must be adopted in the whirlwind of a storm. To this end, it is the most glamorous and volatile securities that don’t weather the storm well, while the more conservative ones hold up better. The temperance of momentum is another pessimistic ideology, highlighting observations of ‘sheep-like’ investors during bear markets, following the crowd, when the fear of risk takes precedence over the quest for returns. On the other hand, in good times, investors are more open about being themselves, expressing specific views.
When optimism returns, this individualism is primarily expressed through “bargain-hunting”, that is to say the value approach - as we saw in 2013, the ultimate end-of-crisis style. The other optimistic philosophy is courage, as the quality style relies on solid returns and accurate forecasts; this seems to be most palpable when everything is going well…
This leads us to the next division of market contexts: rupture and continuity. There are broken markets where “things are changing”, and then there are continuity markets, where the drivers of performances are not brought into question.
Moderation and courage of momentum and quality respectively, are two continuity approaches, as they are based on the idea that current trends or current returns will continue at their level or even strengthen. The justice of value, however, is a disruptive style, as it expects a re-pricing of overlooked securities and, hence, a change. It is this combination of disruption and optimism that makes this the perfect philosophy for the back-end of a market crisis. The prudence of low volatility is another disruptive approach, as it anticipates problems that are not yet there. The low volatility combination of rupture and pessimism make it the ultimate anti-crash philosophy, but also explains why this style is so unpopular and so rarely implemented.
So, all in all, it is easy to choose the most efficient style once you know the market context: bullish or bearish, continuity or rupture. This choice is clarified in the chart below, throughout a stylised market cycle:
Predominant style based on market cycle phases
This chart can be compared with the conventional curve, highlighting which sectors to overweight or underweight in each phase of the cycle: cyclical sectors (e.g. finance or IT) in an upturn, or defensive sectors (e.g. health or consumers) in a downturn. However, one must remember that these sectors are neither uniform nor stable over time, while virtues are. In other words, the emergence of biotechnology has largely transformed the traditional healthcare sector, doing away with its cautious side… Conversely, while IT is still, on the whole, a cyclical sector, certain companies in the sector (such as German industrial software company SAP) are far more representative of Plato’s philosophy of prudence than businesses which are highly cyclical (such as Apple or Google).
The categorisation of investment styles is quite useful in understanding a strategy and analysing its past-performances. Unfortunately, it is not very helpful in the optimisation of performance when switching from one style to the next. In fact, the hard part is forecasting future market contexts…and anyway, if you can, there’s no point in exposing yourself to complex factors to benefit; simply buy or sell equities as an asset class.
The true value of analysing these different approaches is to come up with solutions where outperformance does not depend too closely on future markets. This is done through the interplay of these virtues to cross the various market phases without trying to predict when they will happen. But that’s a topic for another time.