Charts of past cycles fail to convey the real uncertainty and anxiety of living one

Beta management isn’t easy. It takes the right expertise, process discipline and especially patience. Beta management should be employed in the right parts of an investor’s portfolio and usually only in moderation. We agree that success in equities is more about “time in the market” than “timing the market”, but we also believe that equity beta management and other tactical asset allocations can add value. Short-term deviation from strategic asset allocation, or what’s optimal long-term for an investor’s specific risk tolerance, can enhance returns and help avoid losses when asset classes and segments are offering different returns or risk from what was estimated when establishing optimal longer-term allocations.

As explained in past notes, we advocate managing beta and other tactical allocations at the highest level of portfolio construction. These tilts should be managed by macro minded asset allocators with a process for assessing available return and risk across all key asset classes. We don’t think active managers hired to select securities within core asset class segments should deviate in beta, duration or credit risk from assigned benchmarks. As tactical tilts within core categories could conflict with high level asset allocation positioning.

However, at certain higher risk sub asset class categories, some deviation implemented by segment active managers from benchmark systematic risk can be helpful. Particularly if strategy managers have more expertise than the asset allocator in evaluating the overall space. In our view, these categories include small caps, high yield, emerging market equity/ debt and various alternative asset allocations. But even in these categories, we think it best that managers keep systematic risk tilts moderate from benchmark and be in close contact with clients if their views are more extreme to help advise on higher level portfolio actions.

Because macro factors like beta are very uncertain and it’s difficult to diversify active risk taking on such factors given the limited outcomes over intermediate time frames, thus few opportunities to diversify actions, we advocate moderation in tactical allocation. For tactical equity allocation, we advocate moderate sized tilts to avoid dips and corrections, which are more frequent than bears, and to capture outsized gains from frequent periods of stronger than usual returns. Yet, we’re unlikely to have a huge under-weight on difficult to time bear market views. Similarly, we aim for moderate over-weights when confident in double-digit returns for a year or less, but unlikely to take a giant over-weight if 20%+ return is expected.

Our advice for better beta management: Employ dedicated expertise and process, place tactical systematic risk tilts in their proper portfolio place by adjusting aggregate weight of all respective security selection strategies (both active and passive), tilt in moderation, and find patience by seeking alpha opportunities elsewhere. We suggest stock pickers stay focused on selection and that asset allocators seek often overlooked macro-opportunities in sub regions, styles, sectors, themes, vol, isolated risk premiums, alternatives, etc. Our S&P sector strategy strives to balance beta & style tilts with sector preferences of similar beta & style. For instance, we prefer Financials over Energy/Materials, Health Care over Tech, Utilities and REITs over Staples, Communications over Consumer Discretionary. We have industry preferences in Industrials. Despite our beyond beta & style sector strategy, our beta is 0.85 and more value tilted than growth, ex. Health Care, which is “value growth”.

Debt ceiling fights will call more attention to deteriorating US fiscal health

Other than default, clearly the worst and unthinkable outcome, we’d be concerned about a small and especially a large and “clean” debt ceiling raise owing to higher interest rate risk. We think it important that the debt ceiling fight produces a compromise that improves the long-term debt/ gross domestic product (GDP) outlook. Right now, long bond yields and even 1-2yr treasury note yields are low because the bond market is focused on recession. After the recession, the bond market might turn its attention to deteriorating fiscal health and residual inflation risk.

Small gets cheaper: Near-term beta danger vs. the longer and alpha opportunity

Zero small cap returns year-to-date (YTD) lag large cap returns, but mostly due to mega cap Tech gains. The price-to-earnings (P/E) ratio discount at small vs. large widens on trailing earnings per share (EPS) ex. unprofitable companies. But more unprofitable firms are likely as estimates are falling with pressures on small banks and small Biotech. We prefer big banks and big medicine makers over small research firms. We see selective opportunities in small caps mostly at Industrials, Tech and Consumer.

Week 5 of 1Q EPS reporting: 1Q saved by big Banks and Tech, outlook tougher

Bottom-up 1Q EPS is $53.03, -0.8% y/y. We cut our 2023E S&P EPS from $222 to $220. Our standing 2Q and 3Q EPS estimates are $55 and $55, down 5% and 2% y/y respectively.