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.