Category: Chart of the Week

Falling Correlations Boost Hedge Fund Returns

When looking at hedge fund performance in 2017, equity hedge has been by far the best performing strategy, with the HFRI Equity Hedge Index up 9.6% through the end of the third quarter.

What has made the environment so appealing for equity hedge performance in 2017? This week’s chart looks at the CBOE S&P 500 Implied Correlation Index over the past year. The index measures the expected average correlation of price returns between S&P 500 Index components, implied through SPX option prices and prices of single-stock options on the 50 largest components of the SPX. The index hit a low of 13 during the month of October, as correlations continued to trend lower.

An environment in which correlations are lower is a positive for active managers, particularly those that are both long and short individual stocks. When correlations fall, we expect stocks to trade more off fundamentals versus moving with the general market. We believe this is one factor that has helped equity hedge strategies during 2017, and should continue to be accretive to returns if correlations remain depressed.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

The Emerging Sector in EM Equity

This week’s Chart of the Week examines how investment opportunities in emerging markets have changed over the last seven years. Historically investors have associated emerging markets with commodities but this view is becoming outdated. In 2011, Financials, Energy and Materials were the three largest sectors within the MSCI Emerging Markets (EM) Index. The Information Technology (IT) sector constituted 12% of the benchmark. Fast forward to present day and IT has now more than doubled to 27% while Energy and Materials have both halved.

This evolution speaks to the economic developments several emerging countries have experienced over the last two decades, with increases in population and income. This can be especially seen in China where companies like Alibaba, Tencent, and Baidu have capitalized on the expanding middle class. Investors have taken notice of the growth potential and the IT sector within EM has led the way in 2017 returning just over 50% through September. Investors can debate whether these stocks have gotten ahead of themselves but the shift in investment opportunity over the last decade is unquestionable.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Increased Appetite for Private Equity

Over the past two decades there has been a steady decline in the number of companies listed on U.S. stock exchanges. In 1996, during the dot-com peak there were more than 8,000 public companies, but this has declined to just over 4,300 as increased regulation and consolidation has more than offset the number of IPOs and corporate spinouts. Over 2,000 companies were delisted between 1997-2003 as the maturity, composition, and fundamentals of these businesses were not able to attract institutional capital and thus failed to meet the listing standards of U.S. exchanges.

Meanwhile, the perception of the private equity industry continues to evolve as more capital and managers gravitate towards the space. There are over 7 million businesses in the U.S. and the number of private equity-backed companies has steadily increased to now over 7,100 companies. Investors continue to be attracted to the return potential, alignment, and innovation within the private markets. With nearly $1 trillion of dry powder in the private equity industry and near record fundraising we are almost certain to see the number of private equity-backed companies increase over the next decade.

Furthermore, it will not be surprising to see investors shift more of their allocations into private equity. Private markets offer a larger and growing opportunity set, and further upside than the fully valued equity markets. With both the number of managers and investment options increasing, we are likely to see a widening range of returns produced by the industry which will make manager selection even more critical for investors.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Where’s the VIX?

In a time when there is a lot of fear and uncertainty surrounding political turmoil, geopolitical issues, and tension with North Korea, the market appears remarkably calm. For this week’s chart of the week we take a look at the widely followed CBOE Volatility Index (VIX) which is considered to be the best gauge for expected fear in the markets over the next 30 days. On October 5th, the VIX dropped to a 23-year low closing at 9.19, a number not seen in almost two decades. Leading up to this record close was an impressive eight-day stretch of closes below 10, the longest streak of its history.

Why do the markets seem to be resilient to the ever-concerning news cycle? While impossible to know for certain, speculation includes positive macroeconomic signs, stronger earnings growth, gaining popularity of passive index investing, and complacency of the markets. Although the VIX is well below its historical average of 19, it is worth noting that fear can quickly resurface. In the meantime, it will be interesting to see if further VIX index levels can be achieved which would likely be paired with the markets reaching additional record highs.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Info Tech Surpasses Dot-Com Peak – Is This Time Different?

With U.S. equities enjoying the second longest bull market run on record, it has become a frequent occurrence to see equity indices hit new closing highs.  The S&P 500 has recorded 39 new closing highs during the first three quarters of 2017 alone.  A noteworthy milestone recently occurred for the S&P 500 Information Technology (“IT”) sector.  This sector now trades at levels above its prior March 2000 dot-com peak.  IT is the best performing sector of the S&P 500 thus far in 2017 with a year-to-date return of +27.4% through September and is now the largest weighted sector in the S&P 500 with a weight of 23.2%.  Like most sectors of U.S. equities, the information technology sector trades near the high end of its historical valuation range.  Strong performance from this sector in recent years has led to comparisons with the prior dot-com bubble, but is this time different?

While few would disagree that we are nearing the later stages of the current market cycle, the typical excess and euphoria seen in prior market peaks do not appear to be present.  Compared to the prior dot-com peak, the information technology sector today is on noticeably better footing.  Companies in this sector today tend to have healthier balance sheets and hold greater cash levels.  Valuations, while elevated, are not nearly as overvalued as the prior peak.  On a 12-month forward P/E basis, the IT sector trades at 19.5x versus a level of 56x seen in March 2000.  There are certainly individual cases of overvalued securities, but in aggregate the sector is valued much more reasonably than during 2000.  Additionally, the main driver of long-term stock returns has historically been growth in corporate earnings.  Today, the IT sector generates healthy levels of earnings growth and cash flows; many companies during the dot-com era did not have actual earnings to justify their lofty valuations.  While market bubbles are only identified on a post-mortem basis, investors today can at least take comfort in knowing that the IT sector possesses healthier fundamentals and less euphoric valuations than seen in the past.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Brick and Mortar is Still Alive

Contrary to popular opinion, not all shopping centers and retail stores are headed to the graveyard. Although some such retailers are already dead or heading in that direction, our chart of the week shows that while the absolute number of net store openings has dropped, they are still positive and expected to outpace store closings. Additionally, the overall composition of retailers has changed over the years. Today, store openings are less flashy than they used to be and companies are more cautious in their plans for growth. We are seeing strength in the retail space from discounters such as TJ-Maxx; “fast-fashion” retailers like Zara and H&M; beauty brands such as Ulta and Sephora; and fitness companies like Soulcycle and Orange Theory Fitness.

So what does all this mean for real estate investments? The majority of retail exposure for real estate funds in the NCREIF-ODCE index is typically in community and regional centers with heavy foot traffic. This includes grocery-anchor malls and areas where store openings remain positive with minimal exposure to the large mall anchor stores that dominate the headlines. These investments should flourish in today’s market, as real estate investment managers anticipate future shopping patterns of the ever changing consumer.

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The Return of Earnings

One of the biggest challenges investors face today is navigating the current equity environment as valuations are well above their historical averages. The P/E ratio for the S&P 500 climbed over 45% during the past five years resulting in several new all-time high index levels. Given the length of the current bull market many have begun to prepare for a correction over the past few years, yet we are still waiting.

In early 2016 equity markets appeared to be in trouble as earnings repeatedly disappointed. Instead, stocks ultimately rallied with Trump’s pro-growth agenda, as investors anticipated increases in infrastructure spending and lower taxes. But with the failure to pass any major legislation so far, it seemed these gains were in danger of being wiped out. However, this time it was earnings to the rescue, as they climbed more than 10% over the trailing 12 months. This allowed stocks to rise even higher while stabilizing valuations.

While earnings are unlikely to continue growing at this pace, during 2013 and 2014 they did average a more reasonable 6.5%. If earnings can maintain that level once again markets may be able to postpone a correction and further sustain the current bull market. Should they fall, however, there may not be other factors to support valuation levels and hold off significant losses.

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This Market is One Cool Cat

Hurricanes Harvey and Irma substantially impacted the lives and infrastructure of all that was in their paths. They also directly impacted certain investments, namely catastrophe bonds, (“cat bonds”). Catastrophe bonds can help diversify a bond portfolio’s rate, credit and currency risk with non-correlating nature risk. Cat bonds are issued by insurance companies that pool property and casualty policies. They pay coupons to the bondholder using the policy premiums received. However, when a natural disaster occurs, the principal of a cat bond can be used to pay insurance claims on the pool of policies. Historically, annual cat bond returns average 5% to 10%.

This week’s chart shows the Swiss Re Cat Bond Index on the top compared to the Credit Suisse High Yield Bond Index on the bottom. Hurricane Harvey caused only a negligible 0.3% decline in the cat bond index followed by a 0.5% rebound, since the most severe damage came from flooding. Flooding is generally not covered by cat bonds, as cat bonds primarily cover hurricane damages associated with wind. However, Hurricane Irma caused a 16% initial decline, as the index has roughly 20% exposure to Florida hurricanes. Moreover, the state of Florida requires that all homeowners hold hurricane insurance.

Hurricane Irma qualifies as one of the top 10 costliest natural disasters ever recorded, with damage estimates ranging from $50 billion to $100 billion. It is akin to the 2008 housing crisis for the corporate credit and equity markets. The bottom chart shows the high yield bond index declining during the 2008 housing crisis by 33% peak-to-trough, which was over twice the initial decline of the cat bond index due to Hurricane Irma. With recent damage estimates adjusted downwards from an initial overshoot, the Swiss Re Cat Bond Index has already rebounded by 10% only a few days after Irma struck. This makes its net decline 6% to-date as the index continues to recover, showing inherent resilience in the cat bond market. Our thoughts are with those affected by these recent disasters.

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Does the Impact of Natural Disasters Discriminate by Stock Sector?

To date, hurricane Harvey has caused more than 100 deaths in the United States and at least $70 billion in estimated losses. Without much time for recovery, hurricane Irma, recorded as the most powerful Atlantic hurricane in history, has already destroyed Caribbean islands and is now approaching Florida. As market participants’ sentiment is one of the most important drivers of asset prices, this week’s chart investigates how traders react to such natural disasters, and the impact on S&P 500 sector performance.

In this analysis, trader sentiment is measured by the number of messages about a specific company posted to the StockTwits website and then the PsychSignal algorithm computes their intensity (scaled from 0 to 4, 4 being the most intense), and groups the scores by sector. The mood score is calculated by bullish score minus bearish score. The more positive the score is, the more bullish the traders are toward that specific sector. The mood scores for each stock are averaged over 10 trading days since the outbreak and averaged again across stocks in the sector.

Considering that the maximum score is 4, the chart shows traders are slightly bullish but close to neutral across the board, and it is difficult to discern a profitable pattern based on these readings. If anything, traders tend to be more bearish on basic material and utility companies whose ability to process minerals and supply power can be tapered. On the other hand, traders are more bullish on consumer staples, energy and health care companies, which may see more demand amidst recovery efforts. During hurricane Harvey, traders have been bullish on energy companies and the sector returned 3.6%.

However, the series of natural disasters shown in the graph above reveals that there really is not a predictable correlation between sentiment and sector performance. For example, traders were bearish on basic material companies in 2009 and 2010. However, the sector returned 1.7% and 1.1%, respectively, during the earthquake (2009) and flood (2010) disasters. Traders were bullish on energy companies in 2011 but the sector returned -4.6%. This unclear relationship could be because the members of S&P 500 sector indices are large cap companies that are less influenced by short-term shocks than small cap companies. Also, StockTwits only represents a small portion of market participants and covers topics beyond natural disasters.

According to this analysis, how traders feel about the natural disasters cannot solely predict how the sectors will perform. Traders tend to keep quiet as natural disasters are an unknown factor and considered too risky upon which to make a buy/sell decision. It is interesting to observe how traders feel about natural disasters in terms of asset prices but not indicative of future returns.

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The Market’s Bad Breadth

While many are familiar with technical analysis and its claimed prophetic approach to the markets using historical performance, this week we look at a derivative of the 50-day moving average through the lens of breadth.

Crossing below the 50-day moving average is considered a point of weakness whereas crossing above this trendline is viewed as a sign of future strength and bullish activity for the market or index in question.  While the broad market, as proxied by the Russell 3000, had a strong May and June and remained above this moving average, it found weakness in August and has been below this trendline for the past few weeks. Instead of just analyzing the index as whole, we examine the behavior at a component level through market breadth which is a ratio of stocks with increasing prices to those with falling prices. A derivative of this metric is charted below as a ratio of stocks above their 50-day moving averages over those below; a ratio above 1 is a positive indicator for the market as this means more stocks are above their short-term average than below and indicates substantial market breadth. This is a good sign for the market as it means the majority of index constituents are exhibiting strength as opposed to only a few mega-caps lifting up the market.

Recently, however, this ratio fell below 1 which means stocks falling in price outnumber those increasing in price.  Less than 42% of stocks in the Russell 3000 universe are trading above their short-term moving average whereas back in July more than 70% were trading above their short-term averages. That the market is trading flat during this new trend means that the upward movement of only a few stocks relative to the universe is keeping the market flat; this does not make for a stable market.  While these are only technical indicators and are not cause for extreme alarm, the general indication of these data points is that market stress in the near future would not be completely surprising.

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