The Quant Cycle

Abstract

Traditional business cycle indicators do not capture much of the large cyclical variation in factor returns. Major turning points of factors seem to be caused by abrupt changes in investor sentiment instead. We infer a Quant Cycle directly from factor returns, which consists of a normal stage that is interrupted by occasional drawdowns of the value factor and subsequent reversals. Value factor drawdowns can occur in bullish environments due to growth rallies and in bearish environments due to crashes of value stocks. For the reversals we also distinguish between bullish and bearish subvariants. Empirically we show that our simple 3-stage model captures a considerable amount of time variation in factor returns. We conclude that investors should focus on better understanding the quant cycle as implied by factors themselves, rather than adhering to traditional frameworks which, at best, have a weak relation with actual factor returns.

Keywords: asset pricing, factor models, business cycle, value, momentum, low volatility, quality, behavioral finance

JEL Classification: G11, G12, G14