RESEARCH

FACTOR PERFORMANCE
IN THE EQUITY MARKET
CYCLE

A factor analysis study using the

equity market cycle framework of
Handelsbanken Wealth & Asset
Management

April 25, 2022

Prepared by:
• James Monroe, CFA
Senior Consultant
Investment Metrics, a Confluence company

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 FACTOR RESEARCH

Introduction
Factor premia are well established, but it’s important to understand that factor
performance varies depending on the market environment. In collaboration with
Handelsbanken Wealth & Asset Management, we applied factor analysis to their
Equity Market Cycle framework.
We measure the performance of different factors in the four-phase equity market
cycle in the US to understand which factors outperform or underperform in which part
of the cycle.

Summary findings
• Recession: Quality outperforms while other factors significantly underperform and
Momentum doesn’t have a clear signal.
• Early Cycle: High Volatility and Small Caps outperform most, as both Growth and
Value recover. Momentum and Quality are market neutral.
• Mid Cycle: Value outperforms while Quality and Small Cap are market neutral, and
other factors underperform.
• End Cycle: Value and Small Caps suffer while all other factors outperform
significantly.

Exhibit 1: The average monthly market relative return for each sub-period, 1980 through February 2022.
Source: Investment Metrics

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 FACTOR RESEARCH

The market cycle phases

Recession
Economic activity declines, but doesn’t trough. Unemployment spikes while
sentiment deteriorates as the economic output gap widens. The yield curve
steepens and volatility spikes. Equity performance is weakest among the four
phase. The average length of recession is 14 months.
Early Cycle
Following Recession, the market begins to recover, but economic activity and
consumer confidence decline and finally bottom. Unemployment peaks, but
investors price in a more optimistic economic outlook, raising valuations in
expectations of future profit growth. Returns during this period are highest.
The duration of this phase is shortest, around 10 months.
Mid Cycle
The economic output gap peaks during the Early Cycle and drops during the
Mid Cycle phase. The labor market shows strength as unemployment falls,
hiring picks up, and capital expenditure planning rises, while the output gap
closes. This is the longest period, on average 33 months.
End Cycle
The economy continues to improve, but at a slowing rate. Unemployment
continues to fall and the output gap is steady, or improving slightly. This is
sometimes where markets become frothy. This period lasts 20 months on
average.

Factor and sub-factor performance

We cast a wider net looking at 36 sub-factors. Each sub-factor market’s relative return
is calculated for each phase’s sub-period. For instance, October 2007 to February 2009
is considered one Recession period, of which there are 6 since 1980 (Exhibit 2).
Recession
Forecast growth measures underperform the most compared to other Growth factors,
as valuations of companies with high growth expectations are often overextended
during the End Cycle phase; these subsequently plummet. Earnings growth is almost
market-like, while sales growth moderately underperforms. Growth underperforms in
all Recession periods except for the COVID crash in 2020 where Growth outperformed
significantly. This is likely because companies with high growth expectations were
relatively insulated from the economic impacts of COVID-19. Quality factors
outperform in all periods, with stability measures (both earnings and sales)

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 FACTOR RESEARCH

offering the most downside protection. Small caps suffer significantly, while Value
measures such as sales-to-price and book-to-price see the biggest losses. Dividend
yield, EBIT to EV and EBITDA to EV are market neutral. Historically Value doesn’t
always underperform, and in fact during the Tech bubble crash, Value factors
outperformed significantly because Growth stocks experienced the harshest
drawdown. In more recent downturns (GFC and COVID), Value was hit the worst of
any factor group in any phase or period. Momentum doesn’t present a clear signal in
either direction while all high Volatility measures underperformed consistently in
every period.
Early Cycle
During this strong rebound phase, most factors perform well. Forecast measures
which were heavily discounted during the Recession tend to rally strongly, leading the
group, while earnings measures trail. Quality is mixed, profitability metrics are market
neutral, and other more defensive factors such as stability and leverage-based metrics
lag. Small caps outperform more than they underperform during Recession as does
high Volatility. Momentum again lacks a clear signal. Value stocks also see big gains
due to multiple expansion, like Growth, led by the worst performing factors in
Recession, such as sales-to-price and book-to-price. Among the six periods studied,
almost every factor in every category has a consistent directional signal. In other
words, Value did not underperform the market in any Early Cycle period.
Mid Cycle
Growth stocks typically underperform during the Mid Cycle phases. Much of the gains
in Growth made during the Early Cycle phase price in future profit growth. As the
output gap closes, the required rate of return for investors increases, and investors
pay a lower multiple for earnings. The two exceptions were during the Tech boom,
where Growth outperformed and the following 2000s bull market where Growth was
market neutral. In the current Mid Cycle period, Growth factors have trailed the
market significantly. Historically Quality is market-like, even slightly negative in some
periods, but has done very well in this current Mid Cycle period. Small Cap
performance is generally positive with some exceptions. Value stocks by nearly all
metrics have outperformed significantly in all periods except the last Mid Cycle period
during the 2010s. Momentum is generally negative except for during the Tech bubble,
while high Volatility always lags.
End Cycle
The End Cycle phase is the late-stage bull market just before Recession. During this
period, there is often excessive risk-taking among investors, and an influx of late
entrants into the market, especially retail. Valuations become overstretched while
investors become overly optimistic. In this period, volatile Growth stocks that are also
Momentum stocks lead the pack. Quality also outperforms significantly creating a
Quality-Growth-Momentum pattern that has been familiar in the past few years.

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 FACTOR RESEARCH

While some Growth stocks are high Quality, other investors position themselves
defensively into more blue-chip names – both boosting high Quality companies. Both
Value, and Small Cap consistently underperform in the End Cycle.

Exhibit 2: The average monthly market relative return for each sub-period, 1980 through February 2022.
Source: Investment Metrics

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 FACTOR RESEARCH

Appendix

Methodology
Factor returns are derived from a portfolio construction process where a country or
multi-country universe of equities is sorted based on fundamental stock data. For this
analysis, the stocks are sorted each month, highest to lowest factor value. Stocks are
added to the factor portfolio until 25% of the companies are selected for the portfolio.
A sector adjustment is applied to ensure this sorting process is done on a sector-by-
sector basis, such that the factor portfolio is neither underweight nor overweight in
any sector relative to the universe. This process is repeated each month.

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 FACTOR RESEARCH

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Important information

Handelsbanken Wealth & Asset Management Limited is authorised and regulated by

the Financial Conduct Authority (FCA) in the conduct of investment business, and is a
wholly owned subsidiary of Handelsbanken plc.

Handelsbanken Wealth & Asset Management Limited offer a wide range of wealth
management services to private clients, charities and corporate bodies throughout
the UK. These services include retirement, pensions, inheritance and tax planning,
and investment management.

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