Catching the Run-Away Market

by Justin Lowry, CIO, Global Beta Advisors


“Don’t fight the fed” and “Don’t fight the tape” are expressions that have echoed from market professionals throughout the second quarter of this year. This has resulted in bubbling valuations in certain parts of the market. The second quarter has seen peculiar things such as oil futures trading at negative values, companies on the brink of bankruptcy being bid up, and a market in general that seems to be totally disconnected from the real U.S. economy. This have left investors wondering what is going on. The persistent market could be driven partly from the Federal Reserve indicating they will provide infinite liquidity to the financial markets. There is also anecdotal evidence suggesting stimulus checks emboldened people who were unemployed to participate in day trading. Finally, there is also a theory that, because professional sports around the world have ceased, “gambling money” has been redirected into the stock market, which is why we have seen some companies on the brink of bankruptcy rally.

Generally, what happens when a company is on the brink of bankruptcy, hedge fund managers try to squeeze any arbitrage that exists between the bonds of the company and the common stock of the company. They’ll typically go long the bonds and short the stock to hedge the downward movement and pick up any dislocation between the two. However, there were bids created on the common stock of these companies, which effectively created a short squeeze in those managers who were short the stock. This created a large rally in the stock, which left investment professionals dumbfounded. Whatever the reason for the persistent market, investors who have remained on the sideline have felt left out and wondering how they can participate in a market that seems fairly stretched, based on current forward-looking valuations.

The obvious question is:  how can one still participate in a market that seems to be running away from sidelined investors?  Global Beta believes it is imperative to consider valuations when investing in any asset class.  Our research has indicated that simply reducing your overall exposure to securities with high valuations improves long-term outlook.  Although there are many different valuation metrics to consider, however, Global Beta has found that price-to-sales has the strongest indication of forward-looking returns.  Our theory is that factors such as earnings, book value, and free cash flow can be influenced through different accounting methods.  Price-to-sales is potentially more reliable because, in contrast to the aforementioned metrics, sales cannot be influenced by general accounting practices.  Sales is effectively the life blood of an organization and the growth of which is critical to the viability of a company.  This stands to reason that a valuation multiple that measures a company’s price relative to sales will likely provide the greatest indication of how cheap or expensive that particular stock is.

In order to measure that effect, we decomposed the S&P 500 Index into quintiles by the aforementioned valuations in order to test which had the strongest average one-year return growth.  Below is a chart that decomposes the S&P 500 into what we believe are the four key fundamental metrics.    The “top quintile” represents securities in the S&P 500 with the lowest ratios, while the “highest quintile” represents the end of the spectrum of securities in the S&P 500 with the highest ratios.

Forward Return Probability by Valuation

Data from Factset Research systems from 1/1/90 through 3/31/20

What we found was the average one-year forward return in the quintile with the lowest price-to-sales ratio was higher than that of the other valuation metrics and their respective quintiles observed.   However, this isn’t to say that price-to-sales is the only metric to determine investment viability.  Simply taking stocks with the lowest price-to-sales will preclude an investor from broader factor exposure.  How does one improve the dynamics of their portfolios while staying disciplined with price-to-sales valuation?

This is where the importance of building a dynamic set of factor exposures within your portfolio comes into play.  Given the current macro environment, investors seem to be seeking sources of yield and growth with some level of downside protection.  In terms of identifying sources of growth, we believe it is imperative to select securities by sales growth.  We believe a combination of sales growth in the largest market cap securities is the most effective and efficient way to gain exposure to growth.  Utilizing sales growth also naturally brings the price-to-sales ratio down, which as mentioned, improves an investor’s probability of future return.  Additionally, we found this can also provide downside protection.  For example, we looked at the valuations of our index versus a comparable index in the S&P 500 Growth Index.  As of 12/31/19, the Global Beta Momentum-Growth Index had a price-to-sales ratio of 3.31 versus 4.03 in that of the S&P 500 Growth Index (Source:  Factset Research Systems).  Now, we want to see how that may have impacted performance going into 2020 and throughout the COVID crisis.  Below is a chart illustrating the live index performance of our Global Beta Momentum-Growth Index versus the S&P 500 Growth Index as well as the standard S&P 500 Index.  Please note that the “net” index accounts for management fees that may be charged for this strategy.

IndexYTD (6/30/20)YTD (3/12/20)
Global Beta Momentum-Growth Index (Gross)9.54-18.06
Global Beta Momentum-Growth Index (Net)9.39-18.11
S&P 500 Growth-Gross Return7.93-19.03
S&P 500 – Gross Return-3.08-22.91

Source: Factset Research Systems

This not only illustrates the strength of our index for the year but also illustrates relative downside performance in the midst of when the S&P 500 crossed into bear market territory on 03/12/20.  This is an important finding as it demonstrates the protection we believe is offered through a portfolio with a better price-to-sales valuation but also with the strength to offer strong returns when market volatility settles.

Another example of gaining exposure to a factor, particularly in this environment, in what we believe to be the most efficient and disciplined way is with our Global Beta Low Beta Index.  This is designed to provide an investor with exposure to low volatility.  However, as we have observed over the past decade, the prevalence of low volatility strategies has increased valuations of those baskets of stocks, leaving investors more exposed to downside risk than before.  This is why we designed a strategy where we identify stocks with low beta relative to the broad market, which lowers an investor’s systematic risk rather than simply allocating to securities that have lower price movement, such as that of the S&P 500 Low Volatility Index.  In order to stay disciplined and reduce our price-to-sales exposure, we revenue weight our index universe.  By weighting those securities by revenue, it effectively brings down our price-to-sales ratio in the overall index.  For example, we looked at the valuations of our index versus a comparable index in that of the S&P 500 Low Volatility Index.  As of 12/31/19, the Global Beta Low Beta Index had a price-to-sales ratio of 0.95 versus 2.10 in that of the S&P 500 Low Volatility Index (Source:  Factset Research Systems).  Now, we want to see how that may have impacted performance going into 2020 and throughout the COVID crisis.  Below is a snap shot of live index performance for the Global Beta Low Beta Index versus the S&P 500 Low Volatility Index as well as the standard S&P 500 Index over the same horizon in which we observed the Global Beta Momentum-Growth Index.  Please note that the “net” index accounts for management fees that may be charged for this strategy.

IndexYTD (6/30/20)YTD (3/12/20)
Global Beta Low Beta Factor Total Return Index (Gross)-7.04-18.10
Global Beta Low Beta Factor Total Return Index (Net)-7.17-18.15
S&P 500 Low Volatility – Gross Return USD-13.53-18.48
S&P 500 – Gross Return-3.08-22.91

Source: Factset Research Systems

Again, this illustrates the relative downside protection that a low beta approach coupled with an improved price-to-sales ratio by virtue of weighting by revenue can accomplish.  Furthermore, the fact that the Global Beta Low Beta Index was able to separate itself further from the S&P 500 Low Volatility Index, following the point in which the S&P 500 entered and endured a bear market, provides further evidence that a portfolio with a lower price-to-sales has on forward-looking return probability.

In the fractured market environment that we are in, stemming from the COVID-19 global health pandemic, finding growth and protection at relatively attractive valuations have become more important now than ever.  Furthermore, if past recessions are any indication, there are going to be many more securities that remain laggards in broad index investing.  Investing in a recovery from bear markets can be equally or even more difficult than investing heading into one, especially in a market that seems to be running ahead of the economy.  It is critical that investors understand the importance of valuations when positioning in the market.  We believe utilizing targeted, factor based investment strategies that focus on attractive relative valuations, such as what we have done with our factor indexes, will allow investors to maximize their probability of robust returns without chasing frothy market valuations.

Justin Lowry is the Chief Investment Officer for Global Beta Advisors, in Philadelphia, PA.