Seeking Alpha, Beta And The Economic Cycle

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 |  Includes: ITOT, IYY, ONEQ, SCHB, VTI
by: Shiv Kapoor

Summary

The market has run up. And as can be expected some high beta names have performed quite well while low beta names have underperformed.

Several of the high beta names are priced to deliver negative alpha. The negative alpha will offset beta driven gains going ahead.

On the other hand, several low beta names are priced to deliver alpha. The lower than market returns associated with low beta will be offset by high alpha going ahead.

This review which seeks out sector alpha is limited to the Dow simply to reduce the size of the universe of stocks.

A high beta stock is viewed as having high risk relative to the market. In this article, the beta I use is a five-year regression of weekly closing prices of the stock, versus the weekly closing price of the Dow. Because stock beta has a high standard error, I adjust the regression beta to account for beta's tendency of beta to tend towards one.

If the Dow is expected to rise 7.80%, a stock with a beta of 1.48 will be expected to rise more than 7.80%. If we have a long-term return expectation of 7.80% for the market, and a long-term risk free rate of 4.50%, then we have a long-term equity risk premium of 3.30%. The risk adjusted return for a stock with a beta of 1.48 is 9.38%: that is the risk free rate plus beta multiplied by the difference between market return expectations and the risk free rate. Thus, your returns driven by beta are expected to be 1.58% (9.38% - 7.80%).

Alpha is the difference between the actual return delivered by a stock, less the risk adjusted return, which we should expect from the stock. If the market does rise 7.80% and the stock with a beta of 1.48 rises 10.80%, we see an excess return over market returns of 3.00%. This is made up of 1.58% of beta driven return: it is what you earned because of your willingness to accept higher than market risk. The remaining 1.42% is alpha, which has arisen because of your stock selection and market timing strategy.

At the depths of bear markets, you are likely to find the highest alpha in high beta stocks. At the same time, for low beta stocks, alpha is compressed, because over the course of the bear market liquidity has flowed to low beta. Embracing high beta at the depth of bear markets has a profound impact on total return: at such times a high beta is also an alpha rich strategy.

As the bull market progresses, we will see a rapid contraction in alpha in high beta names. At the same time, the flow of capital out of low beta names will cause alpha to widen in low beta stocks. Nonetheless, at such times it is fairly common to find high beta with low alpha strategies, which outperform on a total return basis. Next will come a time when high beta stocks have negative alpha. It is a time when high alpha will be found in low beta stocks. As money flows out of high beta negative alpha stocks, the alpha in low beta stocks will narrow. When we are left in a market where we see low alpha in low beta stocks, and the alpha in high beta stocks is tending from negative to zero, we are into a mature bull market - it is a market where alpha is absent. Such an environment often precedes a market correction.

Beta changes very slowly. Alpha changes by the day. As we seek alpha, we allow alpha to guide us to or away from beta. At the depth of markets, a high beta strategy will also be a high alpha society.

Where are we in the market today? At present, there is potential alpha in low beta stocks. And there is negative alpha in the high beta stocks. There is scope for the markets to grind higher as money flows from high beta, low alpha stocks to low beta, high alpha stocks.

In the table below, you will find data relating to Dow stocks. In this table

  1. The beta is calculated as a five-year regression of the stock weekly close versus the Dow weekly close, adjusted for the stock's tendency to converge towards 1.
  2. The long-term return is my estimate based on a review of historic performance used to form forward expectations. Anyone interested in specifics for any stock can leave a comment, and time permitting, I will post a fresh article with more explicit details on SA, or on my Instablog.
  3. The Dow Weightage noted is the Price Weight system as it is applied by the Index.
  4. The target return is the risk adjusted return calculated as the risk free rate plus beta multiplied by the difference between the Dow return expectations and the risk free rate.
  5. Alpha is calculated as the column labeled LT Return minus the column labeled Target Return.
  6. The Dow return expectation is the price weighted long-term return expectation for each stock.

(click to enlarge)Click to enlarge

Source: Maxkapital Archives

This table below is identical to the table above, but it is sorted by Sector. This table says a lot.

(click to enlarge)Click to enlarge

Source: Maxkapital Archives

Financials display negative alpha. Negative alpha is a sign of past outperformance. This sector tends to outperform early in the business cycle. There is no clear pattern of under or out performance during mid-expansion or late expansion phase, or the recession phase of the business cycle.

Consumer discretionary displays negative alpha. Negative alpha is a sign of past outperformance. This sector tends to outperform early in the business cycle and underperform in the late expansion and recession phase of the business cycle. There is no clear pattern of under or out performance during the mid-cycle phase.

Technology displays strong alpha. Positive alpha is a sign of past underperformance. This sector tends to outperform early in the business cycle and in the mid cycle. In the late cycle and during recessions this sector underperforms.

Industrials display negative alpha. Negative alpha is a sign of past outperformance. This sector tends to outperform early in the business cycle and in the mid cycle. And it intends to underperform during recessions. There is no clear pattern of under or out performance during the late cycle phase.

The materials sector is displaying negative alpha. Negative alpha is a sign of past outperformance. The material sector displays a tendency to outperform in early expansion, it underperforms in mid expansion and then outperforms in late expansion. There is no clear pattern of under or out performance during the recession phase. Keep in mind that the material sector is very under-represented on the Dow. Thus, the negative alpha indicating past outperformance for the sector is not very meaningful.

Consumer staples displays positive alpha. This indicates past underperformance. This sector will normally outperform late in the business cycle and during recessions. Its performance in early and middle business cycles is unclear.

Healthcare displays mixed alpha with a negative bias. This indicates past performance in-line with markets. This sector will normally outperform late in the business cycle and during recessions. Its performance in early and middle business cycles is unclear.

Energy displays positive alpha. This indicates past underperformance. This sector exhibits a tendency to underperform in early cycle conditions, and outperform in late cycle conditions. There is no discernible pattern associated with performance for mid cycle and recession conditions.

Telecom displays positive alpha. This indicates past underperformance. This sector exhibits a tendency to underperform in early cycle conditions, and outperform in recession conditions. There is no discernible pattern associated with performance for mid cycle and late cycle conditions.

The utility sector is not represented on the Dow Jones Industrial average. But the sector tends to underperform in early and mid-cycle conditions and outperform in late cycle and recession conditions.

You can read more on how to use the business cycle here. This chart from Fidelity is the basis for my comments on sector performance through the business cycle.

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Source: Fidelity

On balance, in my view we are either in or fast approaching late cycle conditions. The sectors expected to outperform are materials, consumer staples, healthcare, energy and utilities. The sectors to avoid are technology and consumer discretionary. For financial, industrial and telecom, the pattern of performance during late cycle conditions lacks empirical support. My personal preference is to follow sectors where positive alpha is high: energy, technology, staples, telecom, and from outside the Dow, utilities.

Disclosure: I am long JNJ, PFE, MRK, GE, MSFT, INTC, CSCO, WMT, PG, VZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.