Dividends and Low Volatility Were Among 2014’s Top Equity Factors. Will 2015 See a Repeat or a Change?

This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.

As investors settle into 2015, it may be useful to take a look back at factor performance in 2014.  Although past performance is no guarantee of future results, a review of the past can be helpful in understanding where the stock market has been and where it might be going.

Reviewing 2014

Returns by Investment Factor

 

• Despite the strength of the S&P 500 Index in 2014, strategies that focused on dividend, low volatility, and quality stocks were among the best performers. In other words, stocks with lower risk characteristics and defensive characteristics generally posted the strongest returns. Generally, this rebuts academic theory, which suggests higher risk is necessary for higher return.
• Even though US economic growth accelerated through the year, low interest rates overseas and declining commodity prices pressured the 10-year Treasury yield, benefiting factors with exposure to yield. The 10-year Treasury yield declined from 3.028% on Dec. 31, 2013, to 2.171% on Dec. 31, 2014,¹ generating a thirst for yield. The global economy decelerated in the second half of 2014. The JP Morgan Global Composite PMI declined from its peak of 55.5 in July 2014 to 52.3 in December 2014.¹
• We believe the performance of quality and low volatility was boosted by:

1. Recession risk in Europe.
2. A growth hangover in Japan post the spring sales tax hike.
3. China’s economic slowdown and real estate correction.
4. The poor performance of high yield in the second half of 2014.
5. Geopolitical risks in Russia.
6. Rising volatility in the second half of 2014 due to the end of Federal Reserve (Fed) quantitative easing (QE) and the drop in oil prices.

• Small-cap performance was weighed down by price consolidation after a strong rally in 2013 when the S&P 600 Index rose 39.7%,¹ and also by the dislocation in the high yield market.

What might 2015 have in store for investors?

At first blush, investors may be attracted to the idea of factor returns mean reverting – in other words, areas of strength in 2014 experiencing relative weakness in 2015, and areas of weakness in 2014 experiencing relative strength in 2015. Under this type of scenario, small-cap, active, fundamental and momentum factors may be set for a stronger year, and dividend and low volatility factors may be poised for softer returns. However the change of the year does not necessarily mean there will be a change in the underlying fundamental or market trends. Here’s how the landscape looks early in 2015.

• Trends supporting change in 2015. Strong US growth (especially compared with the rest of the world), the simulative impact of lower oil prices, and dollar strength should be favorable for small caps. As proof of US economic strength, December US payrolls rose by 252,000, and holiday retail sales were stronger than expected according to ShopperTrak.² Furthermore, the S&P 600 Index, a small-cap benchmark index, traded sideways through most of 2014, consolidating the rally that started from the October 2011 low of 334.10.¹ From a technical perspective, we believe the price action looks to be a pause before the sector starts a new leg higher. A solid rally above the 700 mark could potentially signal a bullish breakout that might spur trend-following investors to buy small-cap stocks. The main risks to the small-cap sector would be a sell-off in the high yield market or sudden change to the US growth outlook.

• Trends supporting more of the same in 2015. In contrast, we believe there is a continued case for high quality and low volatility outperforming this year. The Greek election is a risk to the stability of the eurozone, geopolitical issues linger with social strains in Europe starting to show given terrorist attacks in France, the high yield market has yet to clearly stabilize due to weak oil prices, and one has to wonder when the markets will put pressure on the Fed to raise rates in the face of stronger growth and job creation. The chart below displays the relationship between S&P 500 Index 30-day historical volatility and reserve bank credit (a measure of the assets held by the Federal Reserve). The 30-day historical volatility is still on the lower side of the chart’s history, but it appears to be showing signs of bottoming and has gyrated with expanding range. More clearly stated: The chart indicates that the macroeconomic environment is still supportive of low volatility and risk management strategies.

In addition, we believe the desire for yield is likely to be slow to disappear and that this is a benefit to high dividend strategies. Even with the Fed ending QE and the US economy showing signs of strength, low fixed income yields overseas, QE by the European Central Bank and the Bank of Japan, and demographic factors seem to be capping interest rates. The 30-year Treasury yield is flirting with the 2008 and 2012 lows around 250 basis points.³

Bottom line: A mixture of market and economic trends may be supportive to the small cap, low volatility factor in 2015. There is a case for relative strength in the small cap factor based on last year’s relatively weak performance and the backdrop of a strong dollar and firm US economy. At the same time, though there no assurance that the low volatility factor will provide low volatility or better performance than other factors mentioned, it appears that volatility management will still be necessary in the opening months of 2015 given the risks present in the global investment landscape. Learn more about the PowerShares S&P SmallCap Low Volatility Portfolio (XSLV), which seeks to give investors exposure to both the small cap and low volatility factors.

1 Source: Bloomberg LP as of Dec. 31, 2014

2 Source: Bloomberg LP as of Jan. 9, 2014

3 Source: Bloomberg LP as of Jan. 12, 2014

Important Information

Dividends/High Dividend: Shows how much a company pays out each year to shareholders relative to its share price. Companies characterized as high dividend tend to issue higher annual payouts. Securities that pay high dividends as a group can fall out of favor with the market, causing such companies to underperform companies that do not pay high dividends.

Dividend Growers: Ranks securities by their dividend yield while seeking to increase overall portfolio yield and potential for improved price performance.

Low Volatility: Utilizes volatility rankings while seeking to minimize the effects of market fluctuations. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time. There is no guarantee that low-volatility stocks will provide low volatility.