Some nice charts from Damien Bey as Credit Suisse give us context:
- Credit Suisse’s proprietary measure of risk appetite very briefly entered panic in mid-August 2018. It has since staged a modest recovery to less negative levels.
2. Past cycles show that after risk appetite enters panic, small caps tend to outperform in the following year, followed by value and momentum once recovery gains traction. In contrast, quality tends to offer fairly mundane performance.
3. This time could be a little different. Unusually, up to October, quality has been performing quite strongly, while value has been badly undershooting. The performance dispersion is almost statistically significant, even for this early stage of a risk appetite “recovery”.
4. Medium-term, investors need to be thinking about rotating out of quality and into value. However, the short-term picture is much trickier. We suspect that risk appetite has not corrected enough, nor have bonds become sufficiently overbought in a sovereign debt risk environment, to re-create the conditions for a value-quality rotation like we saw in 2012 or 2016.
Note that our article is not saying that we should be worried about quality because it has become expensive relative to value. After all, in any multi-style process, momentum, value and quality factors are usually present, meaning that using value to time any given factor adds no new information. Instead, we need to go one level up to asset allocation from stock selection, to add new information into the process. Our risk appetite measure gives us one such signal, especially when combined with bond market pricing.