Category: Chart of the Week

Are U.S. Equities Headed for a Correction?

So far this year several macroeconomic issues have threatened to negatively impact financial markets. Yet U.S. equities have shrugged off all of these headlines and outperformed most peoples’ expectations. This week’s Chart of the Week takes a closer look at this strong return for the S&P 500 through July. Year-to-date, all of the positive performance has come from valuation appreciation. As a result, the trailing 12-month P/E ratio is now over 20, which is near its highest level over the last ten years. EPS, on the other hand, has actually fallen during the year, which is in stark contrast to the previous ten years when EPS growth was the main driver of price return. This phenomenon can be observed across the cap spectrum and in both value and growth indices.

So far this year several macroeconomic issues have threatened to negatively impact financial markets. Yet U.S. equities have shrugged off all of these headlines and outperformed most peoples’ expectations. This week’s Chart of the Week takes a closer look at this strong return for the S&P 500 through July. Year-to-date, all of the positive performance has come from valuation appreciation. As a result, the trailing 12-month P/E ratio is now over 20, which is near its highest level over the last ten years. EPS, on the other hand, has actually fallen during the year, which is in stark contrast to the previous ten years when EPS growth was the main driver of price return. This phenomenon can be observed across the cap spectrum and in both value and growth indices.

Going forward, things may finally start to catch up with the U.S. equity markets. In addition to lower earnings, GDP growth has been weak the last three quarters, falling short of expectations each time. Furthermore, elections often affect markets negatively due to the increased uncertainty associated with a change in president, and with both candidates carrying unprecedented unfavorable ratings, the volatility impact may be magnified. If earnings do not reverse their recent downward trend, U.S. equities could be in for a rough second half of the year.

Expect Near-Term Volatility for U.S. Equities?

This week’s Chart of the Week examines the pattern of monthly declines for the S&P 500 which are 5% or greater. Data going back to 1945 shows the months of August and September to have historically seen the greatest frequency of equity market declines of this magnitude. In fact, nearly one third of all monthly declines that are 5% or greater occurred during August and September. While historical occurrences such as this do not represent an absolute for equity markets, investors are entering a period that has historically produced below average returns.

This week’s Chart of the Week examines the pattern of monthly declines for the S&P 500 which are 5% or greater. Data going back to 1945 shows the months of August and September have historically seen the greatest frequency of equity market declines of this magnitude. In fact, nearly one-third of all monthly declines that were 5% or greater occurred during August and September. While historical occurrences such as this do not represent an absolute for equity markets, investors are entering a period that has historically produced below-average returns.

The old adage of “sell in May and go away” did not materialize in 2016, but it is important to remember just how much ground equities have recovered since the substantial drop in equity markets at the start of the year. With a year-to-date return of +7.7% through the end of July, the S&P 500 has advanced +18.8% from its February 11th low. Additionally, the S&P 500 notched seven new closing highs during the month of July. With equity markets continuing to test new all-time closing highs, the historical pattern of consolidation during the third quarter looks to be increasingly probable in the near term.

Do Rising Interest Rates Mean Higher Cap Rates for Real Estate?

One of the best performing and consistently stable asset classes over the past several years has been real estate. Based on the NCREIF-ODCE Index real estate has returned an annualized 12.7% over the last five years.

One of the best performing and consistently stable asset classes over the past several years has been real estate. Based on the NCREIF-ODCE Index, real estate has returned an annualized 12.7% over the last five years. Much of the sector’s success has been attributed to strong fundamentals which have translated into cap rate1 compression. Although cap rates are at historical lows and unlikely to compress much further, the unusually low interest rate environment combined with the spread between cap rates and risk-free Treasuries continue to make real estate investments look relatively attractive. Going forward, in anticipation of the Fed raising interest rates, we expect the current relatively wide cap rate to Treasury spread will provide a measure of cushion to allow long-term interest rates to rise without drastically impacting cap rates and the overall value of real estate.

 

1Cap rate is the net operating income divided by property value

Global Bonds and Negative Yields

This week’s chart examines the change in yield for global sovereign debt. While we have been in a low interest rate environment since 2008, over the last three years, we have seen negative yielding bonds move from 0% of the developed bond universe to 38%. A staggering number indeed, this has been the by-product of anemic global growth and aggressive monetary policies in Europe and Japan.

This week’s chart examines the change in yield for global sovereign debt. While we have been in a low interest rate environment since 2008, over the last three years, we have seen negative yielding bonds move from 0% of the developed bond universe to 38%. A staggering number indeed, this has been the by-product of anemic global growth and aggressive monetary policies in Europe and Japan.

One of the consequences of a negative rate environment is increased demand for higher yielding assets. Through the second quarter, U.S. high yield and emerging market debt have returned 9.1% and 10.3%, respectively. In addition to attractive yields, these asset classes have benefitted from stability in commodity prices and minimal exposure to the Brexit event. Should these conditions persist going forward, expect investor preference for credit and higher yielding bonds to continue, given this historically low interest rate environment.

What Does the Brexit Mean for the Fed and Interest Rates?

While the Brexit won’t actually take place until at least sometime next year, many investors and economists are concerned about the ramifications this will have on the global economy. The Federal Reserve is no exception. Prior to the vote, the Fed warned about the effects the Brexit might have, and since then has indicated it would hold off raising interest rates due to these risks. M

While the Brexit won’t actually take place until at least sometime next year, many investors and economists are concerned about the ramifications this will have on the global economy. The Federal Reserve is no exception. Prior to the vote, the Fed warned about the effects the Brexit might have, and since then has indicated it would hold off raising interest rates due to these risks. Markets now are giving almost no chance of a rate hike at next week’s meeting and, as shown in the chart above, there is still only a small chance of an increase in September or November. Both the futures market, which is used to calculate the odds above, and most economists give about a 50/50 chance of a hike in December. So while the Fed initially expected to raise interest rates four times in 2016, it seems now there’s a strong chance that there won’t be any.

Fundamental vs. Quantitative Analysis

Most investors likely understand what is known as “fundamental” investment analysis: analysts assess a company’s health based on revenue, earnings, cash flow, and other financial and economic indicators. An alternative method of identifying attractive investments is “quantitative” investment analysis, and this approach has soared in popularity over the past few decades. Quantitative analysis features complex mathematical models which incorporate statistical and economic variables including valuation ratios, risk measurements, and trading behaviors of a stock, though the possibilities for variables are nearly endless. The advent of social media has even made it possible to include behavioral variables that adjust for investor sentiment.

Most investors likely understand what is known as “fundamental” investment analysis: analysts assess a company’s health based on revenue, earnings, cash flow, and other financial and economic indicators. An alternative method of identifying attractive investments is “quantitative” investment analysis, and this approach has soared in popularity over the past few decades. Quantitative analysis features complex mathematical models which incorporate statistical and economic variables including valuation ratios, risk measurements, and trading behaviors of a stock, though the possibilities for variables are nearly endless. The advent of social media has even made it possible to include behavioral variables that adjust for investor sentiment.

As charted above, the average “quant” fund has outperformed the average fundamental fund on a trailing 1-, 3-, 5-, and 7-year gross-of-fee basis within the eVestment universe, a database used to track investment products. This recent outperformance is in stark contrast to the same trailing numbers just seven years prior (2009), shortly after the Financial Crisis. Critics argue that because many models use similar inputs, there is a large overlap in holdings amongst quant managers and that during a negative inflection point in the market, many portfolios are trying to dump the same stocks; the trailing performance as of 3/31/2009 certainly supports this argument. However, quant managers that survived the financial crisis argue that they have since built more adaptable models. Additionally, the amount of data readily harvested and available has grown exponentially over the past decade, which could help quantitative models become more robust.

What lies ahead for quant funds if the markets are hit swiftly with a large downturn? If the Brexit is any indication, albeit a very mild one, quant managers may have in fact prepared themselves for such a situation. For the second quarter of this year, quant managers were flat with or slightly below fundamental managers on a gross-of-fee basis. Considering quant funds typically charge much lower fees than fundamental funds, if they are able to adapt in a swiftly changing market environment, then they may prove useful as a low-cost option within a portfolio.

Equity Returns Post Brexit

The United Kingdom’s (UK) vote to leave the European Union on June 23 was an unprecedented event that impacted markets across around the world. While this exit won’t actually take place for another two years, equities sold off in a knee-jerk fashion as investors feared the ramifications on the global economy. Due to the heavy exposure to Europe, non-U.S. developed markets suffered the most, losing nearly 10% before rebounding.

The United Kingdom’s vote to leave the European Union on June 23rd was an unprecedented event that impacted markets around the world. While this exit won’t actually take place for another two years, equities sold off in a knee-jerk fashion as investors feared the ramifications on the global economy. Due to the heavy exposure to Europe, non-U.S. developed markets suffered the most, losing nearly 10% before rebounding.

With the U.S. viewed as a safe haven, domestic equities have fared relatively well in the Brexit aftermath. The U.S. dollar appreciated following the decision while the British pound slumped to a 30 year low against the greenback. Emerging market (EM) currencies have also depreciated against the dollar however EM equities have been one of the stronger performers. This asset class has benefitted from the U.S. Federal Reserve indicating it will not make any significant interest rate movements due to the risk the Brexit poses to the economy. Only a few days after the UK vote, EM equities rallied for its biggest weekly gain since March. While the Brexit will undoubtedly have long-term ramifications, many of which are currently unclear, equity markets have rebounded from the initial sell-off.

Predicting the Brexit Vote

Today – Thursday, June 23rd – is the long awaited date of the “Brexit” vote in which the United Kingdom will choose to with draw from or remain in the European Union. In the weeks leading up to today’s referendum, many polls indicated a very slim margin between the “remain” and “leave” votes, thus creating another layer of uncertainty within the financial markets.

Today – Thursday, June 23rd – is the long-awaited date of the “Brexit” vote in which the United Kingdom will choose to withdraw from or remain in the European Union. In the weeks leading up to today’s referendum, many polls indicated a very slim margin between the “remain” and “leave” votes, thus creating another layer of uncertainty within the financial markets.

However, recent market movements indicate that investors are betting on the “remain” campaign, led by Prime Minister David Cameron. As shown in this week’s chart, the pound/dollar exchange rate (blue line) was pushed toward a five-month high earlier this week. In fact, the sterling leapt the most since the Global Financial Crisis of 2008, and is already trading at levels that economists predicted it would reach after the referendum on Thursday. Additionally, European stocks reached their biggest three-day gain in almost 10 months erasing the UK’s benchmark index’s monthly decline.

Though the results of the Brexit vote will not be known until after markets close today, the above data combined with early market movements on Thursday indicate that the Brexit vote will fail and England will remain in the European Union. Should that expected result change, we can expect heightened volatility in the short term, with longer-term impacts on financial markets less clear at this point. As always, we will keep our clients abreast of market developments and potential portfolio ramifications.

Time to Buy Biotech?

The biotech industry has taken a beating and dropped about 35% since its peak last summer as many investors have come to regard it as too speculative and risky. However, a contrarian view indicates that the Nasdaq Biotech Index is trading at a discount relative to its historical price-to-earnings and price-to-book ratios, and now may be an attractive buying opportunity.

The biotech industry has taken a beating and dropped about 35% since its peak last summer as many investors have come to regard it as too speculative and risky. However, a contrarian view indicates that the Nasdaq Biotech Index is trading at a discount relative to its historical price-to-earnings and price-to-book ratios, and now may be an attractive buying opportunity.

Charted, we see the recent dip in Nasdaq-listed biotechs, though earnings have recently recovered and book value has steadily grown since the beginning of the biotech rally. The majority of the book value growth has been in intangible assets indicating that companies are expanding their patent arsenal. This buildup of intellectual property is a positive sign given the increased expenditures in research & development. Though only a few of these advancements will come to fruition in the marketplace, the thought is that those that make it will pay off handsomely for investors.

While fundamentals appear steady, investor skepticism is beginning to impact fundraising. Only $483 million has been raised via 8 biotech IPOs through May of 2016 while over $2 billion was raised via 17 IPOs during the same time period in 2015. Larger and more financially stable firms, such as Celgene, have capitalized on lower valuations through share buybacks. Smaller firms seeking cash to develop their pipelines, however, may begin to suffer if the sentiment of investors does not change. For now, the current ratio of this index has remained stable, indicating that there is no near-term liquidity problem for the industry.

Ultimately, the industry retains great potential. Drugs are shifting from blanket treatments that may only be partially effective for a mass population to specialized approaches for smaller populations with significantly increased efficacy. This increases revenue opportunities as a few specialized treatments are now regularly combined for a more potent approach. In an age when manipulating a genome is commonplace, revenue and earnings growth potential is seemingly unbounded. Though many of these technologies may prove unviable, investor sentiment for the industry may be overly negative given current valuations, stable fundamentals, and the sea of promising advancements available in the field.

A Bifurcation in High Yield Defaults

The price of oil recently rose over $50 per barrel following a dip near $30 only a few months ago. Despite this price recovery, many high yield energy issuers are still finding it difficult to make their debt payments, and default activity surged in May.

The price of oil recently rose over $50 per barrel following a dip near $30 only a few months ago. Despite this price recovery, many high yield energy issuers are still finding it difficult to make their debt payments, and default activity surged in May. These defaults are defined as missed coupon payments, missed principal payments, bankruptcy filings, or distressed exchanges. Notable May defaults include Linn Energy, SandRidge Energy, Midstates Petroleum, Breitburn Energy Partners, and Penn Virginia.

The default rate of the overall high yield index is now 5.2%, as shown by the blue line in this week’s chart. The default rate has recently risen due to more defaults in the high yield energy and metals/mining sectors. Defaults of issuers in that space now stand at 17.8%, as shown in the red line. Meanwhile, excluding energy and metals/mining, the default rate is at pre- and post-crisis lows, at 1.7% as shown in the green line. This bifurcation means that while the energy and metals/mining sectors have suffered from low oil and metals prices, the rest of the economy — healthcare, technology, financials, etc. — have performed as well as ever, at least in terms of how defaults can reflect performance.

The 5.2% overall high yield default rate and the 17.8% high yield energy and metals/mining issuer default rate confirm our previous paper about expected defaults for the year. Based on March-end spreads as a measure of the market’s expectation of defaults, the market was implying a default rate of 4.77%. The range we provided was 4% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 10%, to 6.2% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 30%, to 8.4% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 50%. With the steady rise in the price of oil, we would be surprised to see the high yield energy and metals/mining issuer default rate reach as high as 50%, which should eliminate the worst case scenario for high yield investors. Of course, capital markets are dynamic and can change unpredictably, so we will continue to monitor this trend.