In brief

• Factor performance was mixed, on balance, over the quarter with many factors following recent trajectories.
  
  
• Equity value continued to plumb new depths; quality was negative for a second consecutive quarter as fundamental factors generally underperformed.
  
  
• Merger arbitrage enjoyed a strong quarter; however, other event-driven factors have not bounced back from losses suffered earlier in 2020.
  
  
• Macro factors declined as reversals across currency and commodity markets impacted momentum positioning.
  
  
• We continue to see the outlook for equity value and equity quality as attractive; we have tempered our view across event-driven factors.

Factors in focus

Equity factors: Opportunity for the quality factor continues to improve

Equity factor performance in the third quarter matched patterns from last quarter: momentum led the way while value and quality lagged. The equity value factor continued to plumb new depths, with the current drawdown now extending well past what was experienced in the dot-com bubble of the late 1990s.¹ Equity value declined 7% over Q3, the factor’s fourth-worst quarter since 1990. Two of the next-worst quarters occurred in 2020, as well— in Q1 2020 it declined 11%, and in Q2, 9% (Exhibit 2). Losses were comparable across regions (the U.S., Europe, the UK, Asia and emerging markets), sectors (declining in all sectors save for energy) and ways of measuring value (e.g., earnings yield, cash flow yield, dividend yield, book yield).

Particularly noteworthy was how consistent losses were, whether considering the application of value within sectors or across sectors (Exhibit 3). As we have discussed in separate publications,² we generally favor a within-sector (or sector-neutral) approach in which stocks are evaluated relative to their sector peers with the objective of avoiding sector biases that may expose investors to ancillary risks. While this difference in construction has had a meaningful impact on long-term performance,³ it has not  mattered this year. This highlights the pervasiveness of the current value drawdown and that it goes beyond sector dynamics.

Value underperformance has been significant, regardless of how it is accessed

Exhibit 2: Value factor quarterly performance                        Exhibit 3: YTD Value factor  performance                                                                       

Source: J.P. Morgan Asset Management; data as of September 30, 2020.                                     Source: J.P. Morgan Asset Management; data as of September 30,
                                                                                                                                                             2020.

In evaluating the prospects for the value factor, we continue to monitor how much of the underperformance may relate to investor preferences (or even exuberance) for growth companies rather than to underlying fundamentals. If investor preference has been the primary driver of value underperformance, we would expect mean reversion and an eventual rebound in value performance. If the fundamentals have dominated, we would ascribe recent underperformance to market participants correctly anticipating value companies’ fundamental weakness and we would expect no such rebound in value stock performance. In prior quarters, we have highlighted how the value factor’s current drawdown was almost fully driven by market sentiment rather than trends in net income growth. As such, we said that we expected market leadership to eventually change. While this generally remains our stance, our outlook is less clear than it was previously, given uncertainties around the path of the coronavirus, in addition to the usual difficulty in predicting changes in market sentiment.

When assessing valuations of the value factor, such as by comparing the forward earnings yield of value companies vs. expensive companies, the factor remains historically cheap — spreads were wider only at the height of the dot-com bubble (Exhibit 4). In December 2016, the forward P/E on value stocks stood at 13.2x, while the forward P/E on expensive stocks stood at 25.8x—with both near their long-term P/E averages of 12.2x and 24.9x, respectively. Since then, multiples on value stocks have dropped by 7% (to 12.3x), whereas multiples on expensive stocks have risen by 98%, to 51.2x. From this per-spective, the outperformance of expensive stocks appears to be the continued inflating of a bubble.

The value factor has become increasingly attractive

Exhibit 4: Value factor valuation spread (Global)

Source: J.P. Morgan Asset Management; data as of September 30, 2020.
Note: Valuation spread is a z-score between the median P/E ratio of top-quartile stocks and bottom-quartile stocks as ranked by the value factor.

When assessing net income growth trends, however, we see that value companies have gone through a bout of weakness — which may be linked to the impact of COVID-19 on the economy and on markets.⁴ Over the past year, for example, the median net income growth of value companies declined 22%, vs. a 5% decline for expensive companies (Exhibit 5). While value companies typically exhibit slower net income growth than their more expensive growth counterparts, this gap is significantly wider now than in recent years, and wider than earlier in 2020. However, this gap is not unprecedented and reflects a look in the rearview mirror, with value continuing to look cheap from a forward P/E perspective, as described earlier.

This year net income growth has been considerably worse for value companies than expensive companies

Exhibit 5: Net income growth comparison

Source: J.P. Morgan Asset Management; data as of September 30, 2020.

Event-driven factors led by merger arbitrage

Event-driven factors were positive, in aggregate, over the quarter, led again by the merger arbitrage factor. While M&A activity has been below average in 2020, the merger arbitrage factor has fully recovered from losses in March when liquidity conditions tightened across markets and negatively impacted the arbitrage space. The spinoffs factor was positive while the share buybacks factor continued to underperform, extending a drawdown of a similar in trajectory to that of the equity value factors.

We have a tempered view on the outlook across event-driven factors, as a decline in corporate activity levels has limited investor ability to capture these factors while also remaining diversified. In addition, merger arbitrage spreads have compressed significantly and are now below average (after widening in March to spreads comparable to those during the global financial crisis of 2008–09).

Macro momentum continues to suffer market reversals

Momentum factors again experienced a challenging quarter, this time disrupted by reversals across currency and commodity mar­kets. Weakness in the U.S. dollar, particularly against the British pound and Norwegian krone, where momentum signals had been positioned bearishly, detracted over the quarter. Within com­modity markets, both relative value and time-series momentum models were hurt by strength across a range of soft commodities (coffee, corn and lean-hog markets in particular). Carry factors were again positive in aggregate, however, gains from positioning in fixed income and currency markets were offset by weakness from positioning in commodity markets.

Carry spreads are generally below long-term averages, particu­larly across G10 government bonds and FX markets. This sug­gests a diminished potential to capture carry in those markets. Among momentum factors, dispersion in price moves was aver­age across currencies and commodities. The number of signifi­cantly trending assets was neutral in aggregate; equity, fixed income and commodity positioning were mixed across markets.

Factor Opportunity Set

The table below summarizes our outlook for each of the factors accessed by the Quantitative Beta Solutions platform. It does not constitute a recommendation but, rather, indicates our estimate of the attractiveness of factors in the current market environment.

Factor Views Vs. Last quarter:

Source: J.P. Morgan Asset Management; for illustrative purposes only. 
*Other: Conglomerate discount arbitrage, share repurchases, equity index arbitrage, post-reorganization equities and activism.

Our framework for evaluating factor outlooks is centered on the concepts of dispersion, valuation and the opportunity for diversification. For equity factors, we measure dispersion and valuation spreads between top-quartile and bottom-quartile stocks on a market, region and sector-neutral basis. For event-driven factors, we measure implied carry and the level of corporate activity as indicative of the ability to minimize idiosyncratic stock risk. For macro factors, we measure the dispersion or spread between top-ranked and bottom-ranked markets as well as the number of significantly trending markets.