ANDREW’S ANGLE

Factors and That ‘70s Show

Sep 30, 2022

What have been the best performing factors during periods of stagnant growth and high inflation? Between 1970 and 19851 —the last prolonged period of stagflation—we find that low volatility, value, and momentum exhibited the strongest outperformance, along with size.2

My favorite character on That ‘70s Show was Fez—the Foreign Exchange Student (with Fez being his name, get it?) with out-of-control hormones, always flirtatious, and a terrific dancer. His country of origin is a running gag on the show and is never revealed. In the end, he does end up with the girl, Jackie, he always pines for. That ‘70s Show could be coming back. And I don’t mean spinoffs like That ‘90s Show, or the British TV remake of That ‘70s Show called Days Like These.

Return of stagflation?

In terms of inflation, we’re already like the 70s and early 80s. Inflation today is nearly 10%--with the June, July and August 2022 CPI inflation rates at 9.1%, 8.5% and 8.3%, respectfully. We last saw inflation this high in 1980.3 There’s also increasing talk of recession: in fact, the US has already entered a “technical” recession with two successive quarters of negative GDP growth at -1.6% and -0.9% in the first and second quarters of 2022. (We have to wait, however, for the National Bureau of Economic Research to declare that we’re “officially” in recession.)

A nifty way to summarize inflation and slow growth is the misery index4, which sums inflation and unemployment. The misery index was invented by Arthur Okun, the Chair of the Council of Economic Advisers under President Lyndon B Johnson.

Figure 1: A rise in unemployment and inflation indicate less overall economic well-being
U.S. Misery Index 1950 to 2022

Chart graph1

Source: US Misery Index http://www.miseryindex.us/rawdata.aspx as of September 2022. Unemployment rate figures obtained from the U.S. Department of Labor www.dol.gov. Inflation rate figures obtained from Financial Trend Forecaster® InflationData.com. Data from 1/1/1950 to 8/1/2022.

We had miserable conditions during the 1970s and early 1980s, where the sum of inflation and unemployment exceeded 10% and topped 20%. Since May 2021, we’ve experienced miserable numbers above 10%. By the misery index, we’re already looking like the ‘70s. If inflation remains high, and economic growth continues to slow, then we’ll be sauntering onto the set of That ‘70s Show.

How did equities perform over the 1970s? Equity returns experienced higher volatility alongside slightly poorer returns compared to its historical average. Over the period of 1970 to 1985, volatility rose to an average of 15.5%, in contrast to its long-run average of 14.9%.

Figure 2: Previous periods of stagflation were characterized by higher volatility and lower returns
S&P 500 Index historical averages vs. 1970-1985

Chart graph2

Source: Morningstar. S&P 500 Index returns and standard deviation for the period Jan 1970-1985. Historical average data from Bloomberg, SPX index (S&P 500 Index) covering Jan 1960 – July 2022.
Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Factors and stagflation

If the economy enters another potentially stagflationary environment, how might investors want to consider positioning their portfolios? How could factors help? Let’s take a look at factor performance over the last stagflationary period recorded, between 1970 to 1985:

Figure 3: Value, low volatility, and momentum factors have helped investors navigate previous periods of higher volatility and lower returns 
Factor performance 1970-1985 (annualized)

Performance chart

Source: Fama and French (https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html ) and AQR (https://www.aqr.com/Insights/Datasets) data libraries. Equity represented by Mkt-Rf. Size represented by SMB, Value by HML, Quality by RMW and Momentum by MOM in the Fama and French data set. Low Volatility represented by BAB in the AQR data set. SMB represents small minus big companies. HML represents high book-to-market minus low book-to-market companies, RMW represents robust operating profitability minus weak operating profitability companies. MOM represents high price momentum minus low price momentum companies. BAB represents Low beta minus high beta companies. Data period for all factors: Jan 1970-Dec 1985. Performance does not reflect any management fees, transaction costs or expenses. Past performance does not guarantee future results.

Value, low volatility, and momentum were the standout factors during this time.

  • Value: Value stocks have historically outperformed their growth peers over periods of high inflation. Even if the worst of high inflation has passed, our current levels of inflation at 8-9% are still miles away from the Fed’s target of 2%. High inflation has a significant effect on the present values of distant cashflows. Value firms have tended to have higher cashflows today compared to growth firms, and as seen in Exhibit 2 in my mid-year update, this has historically led to the outperformance of value relative to growth during higher inflationary environments.
  • Low Volatility: Not surprisingly, with high inflation and a shrinking economy, the 1970s was a period of high volatility. Minimum volatility strategies have historically outperformed in periods of high volatility. Less volatile stocks also outperformed more volatile stocks in periods of market uncertainty and volatile GDP growth.5
  • Momentum: The effects of inflation are not only pervasive—affecting all consumers and companies—inflation effects tend to also be very persistent. During stagflation it was difficult to transition from the regime of high inflation, and as those trends persisted, momentum strategies were able to ride this trend and outperform the equity market.6

Small size strategies also had positive returns, perhaps because they had an easier time adjusting to a new economic environment than larger companies with more fixed business models. The performance of quality was approximately the same as the market.7 At first glance, this is counterintuitive because higher quality companies typically have, all else equal, an ability to maintain margins and be more productive. On the other hand, the stability of earnings from companies that exhibit quality characteristics tends to extend further into the future, as opposed to those companies that exhibit value characteristics. As inflation increases, rising interest rates and hawkish monetary policy has tended to be more favorable for companies with shorter-dated cash flows compared to those with longer-dated cash flows.7

Stay the course

One of the most important things to remember for investors to meet their long-term financial goals is that time in the market, rather than timing the market, matters. While markets can cycle over regimes of high and low inflation, and high and low economic growth, the overall equity market has tended to appreciate over long horizons. But while today’s markets are not in stagflation yet—if you’re especially worried about That ‘70s Show returning, then within your equity allocation you might consider favoring factors like value, minimum volatility, and momentum that outperformed during our previous experience with stagflation.