Category: Chart of the Week

Activist Hedge Funds and Lackluster Returns

Activist hedge fund managers seek to outperform the equity markets over a market cycle by first purchasing a large amount of shares in publicly traded companies and then pushing these companies’ management teams to alter their approaches in an effort to unlock shareholder value. Some common practices include share buybacks, spinoffs, and strategic sales.

Activist hedge fund managers seek to outperform the equity markets over a market cycle by first purchasing a large number of shares in publicly traded companies and then pushing these companies’ management teams to alter their approaches in an effort to unlock shareholder value. Some common practices include share buybacks, spinoffs, and strategic sales.

Asset flows into activist hedge funds have more than doubled since 2011 and grown six-fold over the last 10 years making this a highly embraced strategy among hedge fund investors. Latest Hedge Fund Research, Inc (HFR) data estimates assets under management to be over $120bn among activist hedge funds.

Unfortunately, this week’s chart illustrates that returns produced by activist hedge funds have been quite underwhelming, trailing the S&P 500 index over the most recent 1-, 3-, 5-, and 7-year annualized periods through December 31, 2015 (data for the HFRI Activist Index does not go back far enough for us to run a 10-year return comparison between the two indices). Out of the approximately 120 activist hedge funds in business today, there are many who do not report performance to HFR so the comparison is not perfect. However, the index does serve as a reasonable proxy for the industry.

We show activist index returns relative to S&P 500 index returns because activist strategies are marketed as an equities substitute and most institutional investors view them as such. Therefore, the opportunity cost for investors tends to be returns which they would have otherwise obtained through an investment in a long only equity fund benchmarked to a broad market index like the S&P 500. Thus, while most activist funds’ strategies are well-intentioned, returns have struggled to maintain pace with the broad U.S. equity market.

Dividends and Buybacks are Flat… Just Like the Market

Following the recession, dividends and stock repurchases had a significant run, growing about 28% per year, reaching a new record of $241 billion in March 2014. While dividends continue to grow, buybacks have fallen in the last 18 months, leaving the combined total mostly flat. Not surprisingly, the market has also been relatively flat over the last year and a half.

Following the recession, dividends and stock repurchases had a significant run, growing about 28% per year, reaching a new record of $241 billion in March 2014. While dividends continue to grow, buybacks have fallen in the last 18 months, leaving the combined total mostly flat. Not surprisingly, the market has also been relatively flat over the last year and a half.

Stock buybacks reduce the amount of shares outstanding for a company which causes earnings per share (EPS) to increase since the same amount of earnings over fewer shares outstanding creates a higher EPS value. EPS is a metric used in the determination of stock price, so a higher EPS value provides support for the stock price to appreciate in the near term. 

A significant source of funding for stock buybacks in recent years came from the ability to borrow at short-term rates near zero. As interest rates continue to rise, companies will be less inclined to fund buybacks in this manner. While buybacks are estimated to be higher for the first quarter of 2016, going forward they could be scaled back significantly, which would be a further drag on equity returns.

Moving Currencies

Currencies are a popular topic in investment circles today, as their impact on total returns can be meaningful for investors. While many investment funds do not hedge currency exposure at the portfolio level due to the costs involved and the expectation of mean reversion over time, certain market participants are very active in the foreign exchange markets and seek to capitalize on price movements among currencies, which can be volatile in the short-term.

Currencies are a popular topic in investment circles today, as their impact on total returns can be meaningful for investors. While many investment funds do not hedge currency exposure at the portfolio level due to the costs involved and the expectation of mean reversion over time, certain market participants are very active in the foreign exchange markets and seek to capitalize on price movements among currencies, which can be volatile in the short-term. In this Chart of the Week, we look at carry trades, the fundamental strategy of market participants who speculate on currency movements. At its essence, a carry trade is borrowing money in a low-yielding currency and investing it in a high-yielding currency. At the close of the trade, the investor pockets the difference between the interest received on the higher yielding currency and the interest paid on the lower yielding currency (net of transaction costs).

This chart shows a collection of the top- and bottom-performing carry trades of 2015 and compares their returns with the year-to-date results of 2016. As the chart shows, speculating against the dollar generated severe losses for most currencies last year, as the dollar rallied throughout 2015. Many of the carry trades that lost against the U.S. dollar have seen positive gains through early March, but can the performance of these trades persist? On one hand, holding the U.S. dollar should remain beneficial as the currency is likely to show continued, albeit modest, strength vs. other major global currencies. Reasons for this include expectations of tightening by the Fed and diverging central bank policies. Even if the Fed does not raise rates for the rest of this year, it is unlikely that it would cut rates, so the supportive case for the U.S. dollar remains. The Euro, another major global currency, is contending with monetary easing from the European Central Bank. Furthermore, concerns over Euro-area growth and political tensions present a headwind for the currency.

On the other hand, emerging market currencies have shown strength thus far in 2016, as the turnaround in industrial metals prices elevated many commodity currencies, including the Brazilian real (BRL) and the Malaysian ringgit (MYR). Concerns over long-standing debt disputes in Argentina led to increased volatility for the Argentine peso (ARS) in recent years. The 2015 election of new President Mauricio Macri led to optimism over a deal with Argentina’s creditors, and the country reached an agreement with bondholders in early March. However, the country’s plan to raise new levels of debt in April caused a sharp downturn in its currency.

With the persistence of diverging central bank policies and the prospect of negative interest rates in many parts of the world, the outlook for many carry trades will continue to see meaningful impacts from macroeconomic volatility not only on a global level, but also on a country- and region-specific level.

Note: ARS=Argentine Peso; ISK=Iceland Krona; INR=Indian Rupee; BHD=Bahraini Dinar; JPY=Japanese Yen; EUR=Euro; DKK=Danish Krone; TRY=Turkish Lira; CLP=Chilean Peso; MXN=Mexican Peso; NOK=Norwegian Krone; CAD=Canadian Dollar; MYR=Malaysian Ringgit; ZAR=South African Rand; COP=Colombian Peso; BRL=Brazilian Real.

Another Warning Sign for U.S. Equities?

With U.S. equities posting their worst start to the year since 2009, opinions surrounding the path that equity markets will take during 2016 vary substantially. February saw a return to positive performance, yet equities remain in negative territory year-to-date.

With U.S. equities posting their worst start to the year since 2009, opinions surrounding the path that equity markets will take during 2016 vary substantially. February saw a return to positive performance, yet equities remain in negative territory year-to-date. Based on company or economic specific fundamentals, a case can certainly be made to support further market appreciation. However, an alternative method to analyze the stock market is technical analysis. This approach focuses solely on the price movements of a stock or index. The underlying thesis behind this kind of analysis is that fundamental data is already factored into a stock’s price.

The chart above shows S&P 500 index price levels from January 1999 through February 2016. Its 10-month and 20-month moving averages are plotted alongside it. Analysis of moving averages helps to identify bullish or bearish signals in the market. When the shorter time period moving average falls below the longer time period moving average, this indicates that negative price momentum is occurring and likely to persist. Conversely, when the shorter time period moving average rises above the longer time period moving average, this indicates that positive price momentum is occurring and likely to continue.

Over the time period shown, the 10-month moving average has only experienced a negative crossover event below the 20-month moving average on two occasions: March 2001 and May 2008. In both of these instances, equity markets subsequently experienced a significant decline. At the end of February 2016, the 10-month moving average officially crossed below its longer-term 20-month moving average. Utilizing this method of market analysis, equity markets may be signaling the early stages of a market drawdown. Only time will tell if this prediction actually comes true. However, as dire as this analysis may seem, it is important to note that equity markets have historically provided strong returns over the long term despite an occasional pullback.

Do Election Results Predict Equity Market Performance?

During election seasons we are frequently asked about what will happen to the market if a particular candidate or party wins, or whether certain years of the presidential cycle are better for investors.  

During election seasons we are frequently asked about what will happen to the market if a particular candidate or party wins, or whether certain years of the presidential cycle are better for investors. While there are numerous opinions about how differing public policies can affect the economy and financial markets — which goes well beyond the scope of this Chart of the Week — we can observe some trends from history. Since 1926, the first year of a presidential term on average is the weakest, while the third year generally performs well. The election year itself tends to be fairly average. Additionally, the market has generally performed better while a Democrat was sitting president, with an average return of 15% compared to 8.6% for Republican presidents.

While these trends seem interesting, it would be imprudent to make any market predictions based on this data. The historical data is extremely limited and undoubtedly a case of random patterns in a small data set rather than a legitimate correlation. For instance, an investor who only invested in the stock market when the NFC won the super bowl would significantly outperform one that invested when the AFC won (14.6% compared to 8.2%). Similar results can also be seen when investing in only odd years, or years that end with a certain digit (3, 5, etc). In order to be statistically significant, one would need over 2,000 election year data points to achieve a meaningful significance level. While there may or may not be particular reasons behind these realized returns patterns, from a statistical standpoint it would be unwise to base any investment decisions off of them.

Has Oil Driven Down the U.S. Equity Market?

Given the recent drops in oil and U.S. equity prices, many have concluded that the significant decline in oil prices has driven down the stock market.  Indeed, from the onset of oil’s sharp dip, correlation between the two daily returns has greatly increased to about 45% on a 6-month rolling basis.

Given the recent drops in oil and U.S. equity prices, many have concluded that the significant decline in oil prices has driven down the stock market. Indeed, from the onset of oil’s sharp dip, correlation between the two daily returns has greatly increased to about 45% on a 6-month rolling basis. Our chart this week examines if the correlation between oil prices and the equity market has always been so significant.

Going back to 1984, we graph the correlation between oil prices and the U.S. equity market (represented by the S&P 500 index) against the price of oil. Over this longer time period, it is quite apparent that the correlation is fluid, changing significantly across different time periods. Over the entire time period, the correlation averages only 7.7%. Certainly, in times of oil price volatility, correlation tends to rise between oil prices and stock markets, but it is not consistent over time and thus not a reliable indicator of future stock market direction. Though correlation does not imply causality, oil’s apparent influence on investors’ nerves, and consequently the market, may be a temporary indicator of market sentiment.

Is It Time to Buy MLPs?

MLPs recorded their second worst year of performance in 2015 (-32.6%), reaching levels not seen since the financial crisis when the Alerian MLP Index fell 36.8% in 2008. Performance in 2015 can be attributed to the following factors…

MLPs recorded their second worst year of performance in 2015 (-32.6%), reaching levels not seen since the financial crisis when the Alerian MLP Index fell 36.8% in 2008. Performance in 2015 can be attributed to the following factors:

  • Increased supply from U.S. shale producers and OPEC members (especially Saudi Arabia) and concerns about weak demand from China led to a sharp drop in oil prices.
  • As energy prices dropped concerns emerged about U.S. oil and natural gas production volumes and the potential impact on MLPs.
  • As MLP prices began to fall, closed-end MLP funds — which use leverage — were forced to sell into a declining market to maintain their leverage ratios.
  • Investors began to worry that lower equity prices and higher costs of debt would force MLPs to cut their distributions in order to conserve cash for future growth funding.

As a result, many wonder if now is an attractive time to purchase MLPs, given the significant price decline in 2015. This week’s chart compares one of the most commonly used metrics to value MLPs, the enterprise value to earnings before interest, tax, depreciation, and amortization (“EV/EBITDA”) relative to the S&P 500. A ratio above (below) the average represents a premium (discount) on MLPs (based on the Alerian MLP Index) compared to the S&P 500. In light of the recent sell-off in the MLP sector, MLPs are now attractively priced with EV/EBITDA multiples trading more than one standard deviation below their long-term average (since June 2006). However, given the uncertainty around future Fed rate hikes combined with persistently low oil prices and negative sentiment across the energy sector, MLPs may experience further volatility in the short term before the market returns to equilibrium. Over the longer term, we expect midstream MLPs to benefit as commodity prices stabilize and volume growth resumes.

Is the U.S. on the Brink of a Recession?

The combination of rising high yield spreads and falling equity markets has led many investors to question if the U.S. is headed for a recession. This week’s chart examines the probability of a recession using the yield curve as a leading indicator of future economic activity.

The combination of rising high yield spreads and falling equity markets has led many investors to question if the U.S. is headed for a recession. This week’s chart examines the probability of a recession using the yield curve as a leading indicator of future economic activity. The Federal Reserve Bank of New York publishes a model that calculates the probability based on the difference (spread) between the 10-year and 3-month Treasury yields. As the spread narrows, the probability of a recession increases. Conversely, as the spread widens, the probability decreases. As the chart shows, this model has historically been a good predictor of future recessions. Based on January’s data there is only a 4.6% chance of a recession twelve months from now. Like all models, there are no guarantees that the predictive power will continue into the future, but this provides investors another tool to formulate future expectations.

Will China’s Changing Workforce Slow its Growth?

Lost among all the chatter about China and its effects on oil prices, global economies, and capital markets is the evolution of its workforce, which can at least partially explain some of the “hard landing” scenarios discussed for the country. More specifically, the slowing growth in China’s working age population is not expected to reverse, and this trend could have a meaningful impact on future growth prospects, both domestically and abroad.

Lost among all the chatter about China and its effects on oil prices, global economies, and capital markets is the evolution of its workforce, which can at least partially explain some of the “hard landing” scenarios discussed for the country. More specifically, the slowing growth in China’s working age population is not expected to reverse, and this trend could have a meaningful impact on future growth prospects, both domestically and abroad. If its workforce is aging and growing at a rate slower than past generations, future economic growth may be muted.

Shown here in the red line is China’s working age population, using the left-hand axis, as it grew from about 800 million in 1990 to about 1 billion today, and its projected decline projected to about 750 million in 2050. We similarly plotted Japan’s working age population, using the right-hand axis, but 20 years earlier, in the blue line. Japan showed a similar trajectory of working age population growth, from about 70 million in 1970 to a peak of about 85 million in 1995, and is projected to drop to 70 million in 2030. In other words, China’s working age population growth and decline pattern are almost identical to that of Japan’s, but only one generation behind.

With Japan’s working age population currently less than its peak in 1995, economic growth has slowed as the non-working age population increasingly lives off of the economic growth generated by the working age population. Japan has had to resort to fiscal stimulus, monetary easing, and structural reforms (Japanese Prime Minister Shinzo Abe’s “Three Arrows” Abenomics policies) to battle this slowdown. If the current trajectory of its workforce continues, China may also have to implement similar measures in the decades to come. While continued technological and production efficiencies as well as a delay in the retirement age may help mitigate this slowdown, it is a dynamic that bears watching in the coming years.

The Implications of a Stronger Dollar on Emerging Market Investments

In 2015, the emerging market equity index declined 14.9%. While there are a variety of explanations for this, one can not underestimate the impact of a stronger dollar. In fact, currency losses were responsible for more than 60% of the decline for U.S.-based investors.

In 2015, the emerging market equity index declined 14.9%. While there are a variety of explanations for this, one can not underestimate the impact of a stronger dollar. In fact, currency losses were responsible for more than 60% of the decline for U.S.-based investors. This week’s chart of the week examines the mechanics of how a stronger dollar can drive losses for emerging market investments.

Typically when U.S. interest rates rise, the dollar strengthens relative to foreign currencies. Investors oftentimes onshore investments during rising rate periods, and as a result, the country as a whole “exports” less dollars. The commodity price declines — especially oil — have been a major contributor to the rise in the U.S. dollar as the U.S. exports fewer dollars per unit. In our chart, we use the quantity of oil imported multiplied by its price as a proxy for the amount of dollars exported each month. During 2014, the United States imported an average of $26 billion a month in oil. During the first ten months of 2015, the U.S. imported an average of $14 billion a month, clearly a large drop and in conjunction with dollar strengthening and emerging market equity declines.

So why do emerging market investments fall? Emerging market economies often depend on dollar-denominated revenues to service debts as well as manage interest rates and exchange rates. If emerging market countries are receiving less dollars from the U.S., they face increased pressures from higher borrowing costs and lower dollar-denominated revenues. In addition, with less revenue, it is more difficult to promote internal growth via exchange rates or interest rate policies. Unfortunately, as U.S. interest rates are poised to rise further in 2016, emerging markets are likely to experience heightened volatility as a result.