Quant Concepts: Want to Stay Invested?

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Ryan Strong: Welcome to Quant Concepts. The COVID recession in early 2020 was the shortest U.S. recession ever on record. But the question now remains, how long can this COVID economic rebound last and are we heading for a possible recession again?

The U.S. economy is still growing, and the labour market is very healthy – two main reasons why the Fed has felt comfortable raising rates and will likely continue over the next year. However, high inflation is weighing on investor sentiment and the Russian invasion of Ukraine has sent commodity prices even higher. This can ultimately threaten global economic growth. And perhaps, this is why the bond market has been flashing warning signs. When the bond market is healthy, yields are higher for bonds with longer-term to maturity. For example, a 10-year treasury bond will have a higher yield than a two-year treasury bond. This is because investors typically want a larger return for lending their money out over a larger period of time, thus, the yield curve has an upward slope.

Investors typically pay attention to the spread between the 2-year and the 10-year U.S. Treasury yield, the 2-year representing short-term rates and the 10-year representing long-term rates. If the yield curve flattens, meaning the spread becomes smaller, then it is a potential concern about the future of the economy. The 10 and the 2-year just inverted for the first time since 2019. Thus, I'm going to walk through a strategy that has outperformed in recessionary periods with a focus on consumer defensive stocks, commodities, utilities and communication services.

Let's start by ranking our universe of stocks. In the ranking step, we are going to look at four main variables, which you can see here. The first variable with a 20% weight is price to forward earnings. We are prioritizing P/E values as the price you pay for a stock becomes even more important in recessionary periods. Secondly, we are including the reinvestment rate on current year median EPS estimates. Reinvestment rate is a measure of a company's profitability. As this is the rate in which a company is expected to reinvest earnings back into the business, we are including reinvestment rate because as the market pulls back, investors have an increased preference for profitability over things like growth or momentum.

Next, we are including variability around the 5-year EPS. This calculates how often the company meets its analysts' estimates. Companies with low earnings variability are more predictable and can be counted upon during periods of economic uncertainty. Lastly, we are including 5-year beta versus the S&P 500. Beta is a measure of an asset's risk relative to the market. Thus, we want to prioritize companies with a lower risk for a smoother ride through any potential recession.

Now, let's run through the screening process. We are only going to be selecting stocks that rank in the top 25th percentile of that list we just created, keeping a very strict buy discipline. Then, we are going to identify four key buy rules. Each buy rule needs to be met before a company can be purchased into this strategy. First, the company must have annual earnings per share momentum above the median of the index. Currently, that is a whopping 31% year-over-year growth. Next, the company must have quarterly earnings surprise above 0%. This means that the company must have had reported earnings beat their expected earnings for the latest reported quarter. Next, price change over the last six months must be greater than the median of the index. Currently, this is about 0%. Thus, all qualifying stocks must have a positive price change within the last six months. Lastly, market cap must be greater than $5 billion.

Now, let's take a look at our sell rules. It is very important to identify a sell discipline to ensure we are moving on from names that no longer meet our requirements. In this case, we've kept things very simple with two sell rules. First, if a stock falls below the 50th percentile in the screen we created earlier, we will sell the stock. Secondly, if the annual EPS momentum goes into the bottom one-third of the index, a D+, then we will sell the stock from our strategy.

Now, let's take a look at our backtest page. In our backtest, we started the period from January 2000 until February 2022. Over that time, we've had relative outperformance with a total return of 8% annualized. This amounts to a 0.7% annualized beat over the S&P 500. This also comes with an 18% annualized turnover or roughly two stocks per year on a 10-stock portfolio. More importantly, I want to highlight the annual returns in years where the U.S. economy has been in a recession. The first recession I want to highlight was in March 2001 and it lasted approximately 8 months. In the year 2000, this strategy posted a positive return of 20.5% and the S&P that year was down 4%, leaving you with an outperformance of over 16%. In the next year, 2001, the recession hit, and this strategy fell about 12% while the S&P 500 fell about 11%. However, in 2002, the S&P was down 22% and this strategy only fell 6%, an outperformance of over 16%. Leading up to the next recession in 2007, this strategy posted a return of 21% versus the S&P 500 of about 5.5%, an outperformance of over 21%. And then, in 2008, this strategy was down 24%, but the S&P 500 fell 37%, an outperformance of over 12%.

To conclude, owning high-quality defensive names in recessionary periods can protect you on the downside while still being capable of providing alpha on the upside. I recommend this portfolio for those who want to stay invested despite the bond market signalling a potential recession in the U.S. markets.

From Morningstar, I'm Ryan Strong.

Find the buy list here.