Put Away Your Crystal Ball and Adapt as Market Conditions Change

Volumes have and will be written about the unique events of 2020.  It would be a dramatic understatement to acknowledge that none of us saw how the year would unfold.  This should provide healthy doses of humility and caution as we read the abundant financial market forecasts for 2021.

Our conclusion is not that homework, analysis, and preparation do not matter—interpretation of information matters now more than ever!  Instead, the problem lies in the tendency to apply a tight grip on predictions from a specific point in time rather than adapting to new information, data, and conditions.  In many cases, what we think should happen does not materialize.  Investment success requires careful analysis, a repeatable process, and the flexibility to change a seemingly sound investment thesis as events unfold.

At Lunt Capital, we focus daily on the details surrounding investment factors (i.e., characteristics of companies or stocks that can be measured).  We study factor attributes.  We analyze the historical behavior of different factors.  Our universe of investment factors extends beyond the traditional factors of High Momentum, High Quality, High Value, and Low Volatility to include their opposite sides or non-traditional factors of Low Momentum, Low Quality, Low Value, and High Volatility.  Using this expanded factor universe, we apply rules-based processes designed to adapt and rotate as investment factors move in and out of favor.

Even with all of our factor research, we would have been wrong in a prediction of 2020 factor performance.  In January of 2020, if you would have correctly told us during the year we would experience:

  • A global pandemic with tragic loss of life and dramatic health and economic impacts including the largest quarterly drop of GDP on record and the largest increase in the unemployment rate since the Depression…
  • Social unrest, protests, and significant property and business destruction in many areas of the United States…
  • An evenly divided electorate engaged in the loudest and most divisive presidential election in a lifetime…

Given this set of facts, we would have predicted the Low Volatility Factor would be the best performing factor of 2020.  The table below shows the 2020 performance for the S&P 500 factor indexes.

2020 Index Returns

The Low Volatility factor was negative during 2020, underperforming the S&P 500 by 19.51%.  The three factors on the list that outperformed the S&P 500 Index were Low Value (expensive stocks), High Momentum, and High Volatility.

Thankfully, our adaptive factor rotation process would have protected us from an incorrect but seemingly sound investment thesis.  Our rules-based, multi-factor investment strategy pointed us to the factors the market favored in 2020, particularly the Low Value and High Momentum factors.

We are diligently doing our investment homework as we begin 2021.  We are attempting to understand and interpret the endless data points on the economy, markets, and investment factors.  Why do homework on investment factors if markets seem unpredictable and things do not often turn out as expected?  Homework provides the framework and the conviction to follow a sound investment process or set of rules.  In our experience, investors are more inclined to follow sensible principles or correctly interpret dynamic data if they have done homework that contemplates a variety of scenarios.  Homework and analysis loosen the grip on rigid predictions and facilitates the adaptation and innovation necessary for long-term investment success.

2020 reminded us about the importance of an investment formula with less predicting and more adapting.  Let us resolve to put away our crystal balls for what we think will happen in 2021 and embrace rules-based processes that adapt as market conditions change.

Originally published by Lunt Capital Management