Category: Chart of the Week

March Market Madness: No One Knows Who Will Win

Historically, two indices have moved hand-in-hand: the Global Economic Policy Uncertainty Index and the VIX Index. The former is a measurement of uncertainty surrounding economic and political policy on a global scale, while the latter is a gauge of the volatility level for the S&P 500 index. The relationship between the two should not be surprising: as uncertainty increases, equity volatility rises. What is surprising is the recent divergence of the two. While global economic policy uncertainty surged to recent highs, market volatility is close to 20-year lows. Since the late 1990s, the 3-month rolling correlation between these indices has hovered around 60%; a divergence of the two to this extreme has not been seen in recent history. So what has caused this disparity?

One answer could be the election of Trump, which could explain the directionality of both indices. The contradictory nature of White House statements versus direct quotes from Trump himself oftentimes leaves the public unsure of what to expect next, as it relates to policy direction. Meanwhile, markets have climbed from the “Trump Effect,” which reflects optimism about the successful implementation of new business-friendly policies. An alternative explanation could simply be that company earnings have been sufficiently strong to support current valuation levels. Though there is global policy uncertainty domestically and internationally — notably due to the populist movement in Europe — strong earnings have more than offset this policy uncertainty and thus driven markets higher and perceived risk lower.

Can both sentiments concurrently be correct? This trend certainly hasn’t been the case in recent years, however, the divergence has continued since Trump’s inauguration. Only time will tell if one of these indicators is truly victorious.

What Do Falling Correlations Mean for Active U.S. Equity Managers?

The Implied Correlation Index measures the average correlation of the stocks in the S&P 500 index. When the index is high, individual stocks are more likely to move in tandem with the broad index; when it is low, return dispersion among stocks in the index will be higher.

The Implied Correlation Index measures the average correlation of the stocks in the S&P 500 index. When the index is high, individual stocks are more likely to move in tandem with the broad index; when it is low, return dispersion among stocks in the index will be higher.

Looking at the 1 year chart above, the correlation downtrend is easily visible. With low correlation levels, opportunities should be present for active managers to find alpha and begin outperforming their benchmarks once again. With higher return dispersion, active managers will have an increased opportunity to pick winning stocks. If correlations continue this pattern, it should be easier to identify successful active managers rather than those who have ridden the macro trends of the market in recent years. If nothing else, falling correlations within the index provide an opportunity for active managers to recover from general underperformance versus the benchmark which has plagued them in recent years.

Diverging Market Opinions (aka The Bears vs The Bulls)

This week’s Chart of the Week examines a recent phenomenon seen in valuations for both bonds and equities. U.S. stock prices rose quickly over the last year and a half with the S&P 500’s P/E ratio climbing to 21.8, surpassing its 20 year average. Meanwhile the Bloomberg Barclays Aggregate Index saw its option adjusted spread (OAS) fall below its 20 year average to .43%. OAS is a primary metric for valuating bond prices and this tightening suggests that bond prices are relatively expensive.

This is a rare situation as it is counterintuitive for both indices to be valued highly at the same time. Highlighted in the gray bars on the chart are the months when this occurred. During the late 90s equity valuations hit historic highs with the tech bubble. Treasury rates during this time were as high as 7%, so even though spreads were low the total yield on the Agg was still relatively high. Today’s environment is much different with Treasury yields around 2%. Excluding a transitory period in 2003 this was the only other time when this happened.

What makes this so unusual is bond and equity prices typically move in opposite directions of each other. Stock valuations increase when investors are confident in the markets and want to take advantage of a strong economy. Bond prices typically rise during “risk off” periods when investors look to be more defensive. The fact that both are rising seems to suggest there is increasing polarization of opinions in the financial markets. Since there is so little precedence for this situation it is difficult to know what to expect, but something almost certainly will have to give. Only time will tell who will win: the bulls or the bears.

Do Emerging Market Equities Have Further Upside?

Through the end of January, emerging market equities are up 25.4% on a trailing 12-month basis. This asset class has benefitted from several changes to the macro-economic environment: stronger commodity prices, more stable currencies, and a better growth outlook. In addition to these favorable changes, company fundamentals have also shown strong signs of improvement. This week’s chart displays earnings per share (EPS) of the MSCI Emerging Markets Index.

Through the end of January, emerging market equities are up 25.4% on a trailing 12-month basis. This asset class has benefitted from several changes to the macro-economic environment: stronger commodity prices, more stable currencies, and a better growth outlook. In addition to these favorable changes, company fundamentals have also shown strong signs of improvement. This week’s chart displays earnings per share (EPS) of the MSCI Emerging Markets Index.

Since 2013 earnings have been on a sharp downturn but based on forward estimates they appear to have bottomed in 2016. Not surprisingly, much of the initial resurgence has come from the commodities space, however, improved earnings revisions have broadened to other sectors. This is a promising trend for investors and supports further upside potential for this asset class.

Are High Yield Bonds Overvalued Right Now?

High yield bonds enjoyed significant tailwinds in 2016:
During the year, the price of oil stabilized.
U.S. shale oil exploration and production defaults and bankruptcies worked their way through the pipeline and most are now behind us.
Trump’s win, with his promises of tax cuts and infrastructure spending, boosted investor confidence.
OPEC’s production cut agreement further added to the risk-on sentiment.

High yield bonds enjoyed significant tailwinds in 2016:

  • During the year, the price of oil stabilized.
  • U.S. shale oil exploration and production defaults and bankruptcies worked their way through the pipeline and most are now behind us.
  • Trump’s win, with his promises of tax cuts and infrastructure spending, boosted investor confidence.
  • OPEC’s production cut agreement further added to the risk-on sentiment.

All of this fueled a 17.1% return for high yield bonds during 2016, as measured by the Barclays U.S. Corporate High Yield Bond Index. Of course, “bond math” dictates that returns for any sector of the asset class have a ceiling on price escalation, and high yield bonds may be in overvalued territory right now. As we can see in this week’s chart, spreads1  — which are a primary valuation metric for bonds — are tight at the moment, at 388 basis points on January 31 for the Barclays U.S. Corporate High Yield Bond Index compared with its ten-year average of 606 basis points. In other words, current high yield bond spreads are more than 200 basis points tighter than long-term average spreads. If we exclude the financial crisis years of 2008 and 2009, the long-term average spread is 508 basis points and current spreads are still considered tight. Current spreads are about as tight as they were prior to the shale oil crisis of 2014-2015.

High yield spreads typically compress to the point when a market correction occurs. This market correction typically features spread widening. Because of such tight spreads at the moment, as well as other fundamentals that we track such as aggressive use of proceeds and aggressive lower-quality issuance, spreads are more likely to widen than further tighten. As such, we recommend that clients reallocate to policy weights and maintain a cautious and conservative outlook for high yield bond allocations.

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1 Defined as the excess yield above U.S. Treasury bond yields

Are Quant Strategies Poised to Replace Fundamental Managers?

As 2016 performance trickled in, the depth and prevalence of underperformance became very apparent. What made 2016 such a particularly difficult year for active management? Many have cited the tumultuous events throughout the year ranging from the market dip and subsequent recovery in the first quarter, to the Brexit, to the unexpected Trump victory. Rapidly reacting and adapting to these market changes – let alone capturing any alpha – was incredibly challenging.

As 2016 performance trickled in, the depth and prevalence of underperformance became very apparent. What made 2016 such a particularly difficult year for active management? Many have cited the tumultuous events throughout the year ranging from the market dip and subsequent recovery in the first quarter, to the Brexit, to the unexpected Trump victory. Rapidly reacting and adapting to these market changes — let alone capturing any alpha — was incredibly challenging.

Notably, quantitative strategies seemed to have an easier time reacting to these events than fundamental strategies. Quantitative, or “quant,” strategies rely heavily on statistical and mathematical screens and indicators which largely remove human emotion and judgment from the equation. These models arguably enabled portfolios to recognize the surprise market events of 2016 and adapt much more quickly than fundamental strategies. However, while quant strategies largely proved successful relative to their fundamental counterparts in 2016 during an array of smaller disruptive events, this pattern is not proven to hold during severe inflection points.

Will Investors Continue to Move Away from Active U.S. Equity Strategies?

This week’s chart shows asset flows between active and passively managed mutual funds and exchange traded funds (ETFs) in U.S. equities. Over the last eleven calendar years, active strategies experienced cumulative outflows totaling $864 billion, while passive strategies saw inflows of nearly $460 billion.

This week’s chart shows asset flows between active and passively managed mutual funds and exchange traded funds (ETFs) in U.S. equities. Over the last eleven calendar years, active strategies experienced cumulative outflows totaling $864 billion, while passive strategies saw inflows of nearly $460 billion.

Strong passive flows such as this can potentially have a negative effect on active performance since stocks are less able to differentiate themselves on fundamental factors. When passive strategies receive significant inflows, all stocks in an index are purchased and receive price support. This can have a material impact on stocks with limited trading volume, thus this is more of an issue for small-cap versus mid or large-cap. Within small-cap, passive inflows in 2016 totaled $7.6 billion while active outflows totaled $18.5 billion. The Russell 2000 Value posted the strongest return within the nine U.S. equity style boxes during 2016, while active strategy outperformance in small-cap value was especially challenged relative to the other style boxes.

With passive U.S. equity indices ranking in the top half or better of their respective peer groups in recent years, active strategies have largely lagged behind their benchmarks. This performance lag is a primary reason why asset flows have shifted to passive strategies. Since a passive strategy essentially owns the market, passive allocations have fully participated in the current bull market, while active strategy performance depends on how a particular fund’s bets fared relative to its benchmark. Passive investing represents a low-cost means of gaining exposure to an asset class and fees are often a small fraction of the fees paid for active management. With valuations at or close to all-time highs, active manager performance will be closely monitored in 2017 to see if their higher fees are justified in this current market environment.

Should Investors Allocate to EMD in 2017?

Recent events have strengthened the case for Emerging Markets Debt (EMD). Our chart of the week shows how yields for local and hard currency strategies are above their historical averages and are an attractive opportunity as we begin 2017.

Recent events have strengthened the case for Emerging Markets Debt (EMD). Our chart of the week shows how yields for local and hard currency strategies are above their historical averages and are an attractive opportunity as we begin 2017.

The European Central Bank extended stimulus by nine months, albeit at €60 billion per month instead of the original €80 billion per month. Trump’s trade policy proposal is largely isolated to China, and his immigration policy may have a positive effect on Mexico given that its consumer pool and labor force may grow as a result. Lastly, the price of oil is on the rise with the recent OPEC deal, which is a positive for EM oil exporters. All of these facts support an allocation to EMD.

If Trump’s infrastructure policy is enacted we would expect commodity prices to rise, which would be a tailwind for EM commodity exporters. If Trump’s trade policy is adopted, it should be a headwind for EM manufacturers. But overall, EMD fundamentals are attractive. Current accounts of EM countries are stronger and leverage is still low relative to developed market countries. Spreads are at wide levels and yields are high, which provide a cushion for any downside. In total, EMD offers diversification, yield, and upside potential and should contribute to positive returns for investors in 2017.

What Does the Buffett Indicator Tell Us About U.S. Equity Valuations?

As markets continue to reach new all-time highs many investors are wondering how much more runway is left for the current 8-year bull market. While different valuation metrics will tell different stories, it can be helpful to look at what Warren Buffett has dubbed the single best measure of long-term market valuations.

For this week’s chart of the week, we take a look at the “Buffett Indicator” which consists of the Wilshire 5000 index market cap divided by the quarterly nominal GDP of the U.S. economy. As of the third quarter, the reading stood at 121%, just below its two decade high and 45-year two standard deviation average. These readings would suggest that the market is overbought. However, there is no perfect market indicator, so while the Buffett Indicator can be used as a sign of caution to investors who are considering committing further funds to U.S. equities, it should not be relied upon as an exclusive predictor of future market returns. Although the Buffett Indicator suggests that valuation levels are high, positive earnings growth began to emerge in late 2016 and could provide further support for current valuations if companies can deliver on profit projections. These statistics will be watched closely as the year unfolds to gauge the future direction of the U.S. equity market.

Hedge Fund Assets Under Management Continue To March Higher

As the investment community continues to debate the role of hedge funds in the future, one thing is for certain, assets continue to flow into this much debated space. 

As the investment community continues to debate the role of hedge funds in the future, one thing is for certain, assets continue to flow into this much debated space.

The above chart goes back ten years to show the overall growth of assets in hedge funds. As it would be expected, 2008 saw overall assets under management decline following a difficult market environment. Since that timeframe assets have steadily increased year over year, despite high fees and at times disappointing performance. 2016 was no different with a difficult first half as overall returns underperformed the broader market indices, assets still flowed into this space. Hedge funds will still be a sought after asset class for institutional investors as they provide diversification, bond-like volatility, and low correlation to traditional long-only assets. To remain competitive, hedge funds will have to cut management and performance fees to remain attractive to the largest capital allocators.