A Tale of Two Market Regimes

Chief Investment Officer, Model Portfolios

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“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness…”

A Tale of Two Cities by Charles Dickens

Let’s begin our “tale of two market regimes” by comparing risk factor performances for the S&P 500 index for calendar year 2022…

For definitions of terms in the chart above, please visit the glossary.

…with YTD performances in 2023:

The contrast is stark. In 2022, the leading (in fact, dominant) factors were value, dividends and quality, with a massive 21% differential between value (+5%) and growth (-16%).

Compare that with YTD performance in 2023. There is once again a gap between value (+11.4%) and growth (+19.8%)—but in the opposite direction. Note as well that quality has hung in there (+14.4%), but dividends (+5%) lag far behind.

What happened? We think three things: (1) the banking crisis resulted in a decline in interest rates, which typically benefits growth stocks (by lowering the discount rate on future cash flows); (2) investor concerns over an impending recession resulted in a rotation out of value and into growth stocks (value stocks tend to be more sensitive to a decelerating economy); and (3) artificial intelligence (AI) became the ‘meme theme,’ which hugely benefitted the mega-cap tech stocks.

Take a look at the YTD performance of the S&P 500 index with and without the so-called AI-influenced stocks—almost ALL the positive performance in the S&P 500 index this year has been driven by mega-cap tech stocks.

The performance differentials between factors also extends to U.S. small- and mid-cap stocks. The value and dividend factors, which tend to be heavily allocated to Financials, were rocked by the regional banking crisis in March and April.

For definitions of terms in the chart above, please visit the glossary.

Something interesting in both market regimes (2022 and YTD 2023) is that the quality factor held up. We define “quality,” following the classic DuPont Analysis, as companies with stronger balance sheets, earnings and cash flows. Our own analysis indicates that the quality factor is, indeed, the most consistently performing risk factor, which is why it is the anchor factor for our Model Portfolios. Focus on the teal line, below.

Rolling 10-Year Excess Return vs. Market

So, What Does All this Mean?

Just like asset classes, risk factors rotate in and out of favor as we move through different market regimes. This is the reason we build Model Portfolios at WisdomTree that seek diversification at both the asset class and risk factor levels.

We believe that gives us the best potential for delivering more consistent performance over full market cycles. Note below that the quality factor, highlighted in brown, mostly occupies the middle two-thirds of the quilt, supporting our belief that it is the most consistent risk factor.

For definitions of terms in the chart above, please visit the glossary.

With respect to our market outlook, there certainly is the possibility that growth will continue to dominate factor performance over the short term. We think it will be highly dependent on Fed actions, investor sentiment and whether we decline into recession (and, if so, how badly).

From a valuation perspective, however, we believe small caps, dividends and value will regain superiority over the medium to longer term.

Growth is on a run, for sure (though somewhat narrowly within mega-cap tech stocks) but, as the market adage goes, “Trees don’t grow to the sky.” Or, as economist Herbert Stein famously put it, “If something can’t continue, it won’t.” There  will reach an inflection point when investors will stop paying ever-higher multiples for ever-inflating stocks.

Anyone who knows WisdomTree knows we are primarily (but not exclusively) a shop that tilts toward value, size, dividends and quality in both our product set and our Model Portfolios. We certainly have growth-focused products (e.g., QGRW and our own AI-focused product, WTAI), and we certainly seek to allocate to growth strategies (both our own and third-party) within most of our Model Portfolios, for risk factor diversification purposes.

But we maintain confidence in our ability to pursue more consistent performance with an anchor allocation to quality, surrounded by varying allocations to value, size, dividends and, yes, growth.

You never know when the next market “wave” will roll in, and we believe in being prepared to sail through whatever the market seas throw our way.

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About the Contributor
Chief Investment Officer, Model Portfolios
Scott Welch is the Chief Investment Officer of Model Portfolios at WisdomTree, a provider of factor-based ETFs, differentiated model portfolios, and digital asset solutions. In his role as CIO, he oversees the construction and ongoing management of the WisdomTree model portfolio solution set. He chairs the WisdomTree Model Portfolio Investment Committee and is an active member of the WisdomTree Asset Allocation team. Prior to joining WisdomTree, Scott was the Chief Investment Officer of Dynasty Financial Partners, a provider of outsourced investment research, portfolio management, technology, and practice management solutions to RIAs and advisory teams making the move to independence. Prior to Dynasty, Scott was a Co-Founder and the Chief Investment Officer of Fortigent, LLC, a provider of outsourced investment research, technology, and practice management solutions to RIAs and banks that targeted high net worth investors. Scott holds the Certified Investment Management Analyst (CIMA®) designation, and he sits on the Board of Directors of the Investments & Wealth Institute (IWI, formerly known as IMCA) and is an outside member of several RIA Investment Committees. Scott earned a Bachelor of Science in Mathematics from the University of California at Irvine and an MBA with a concentration in Finance from the University of Massachusetts at Amherst.