Topic Tags: U.S Economy

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.

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.

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.

2017 Market Preview

January 2017

Similar to past market preview newsletters, we enter the year with a new set of questions. What shape will Trump’s policies take and how will they impact the market? Will the formal start of the Brexit have an impact on portfolios? To what degree and pace will the Fed increase interest rates? These topics among many others are covered in the following articles as we offer our annual market preview newsletter. Each year presents new challenges to our clients, and other headlines will emerge as the year goes on; it is critical to understand how asset classes will react to each new development and what such reactions will mean to investors. The following articles contain insightful analysis and key themes to monitor over the coming year, themes which will underlie the actual performance of the asset classes covered. Recognizing that many of our clients may not have time to cover the following 30 pages of material, we offer the primary conclusions for each asset class heading into 2017.

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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.

2016 Asset Allocation Winners and Losers

January is a time to reflect on the past year and assess what went right and what went wrong, and asset allocation is no different in this regard. Elevated valuations at the start of 2016 did not hold back U.S. equities as they climbed to record highs; small caps were the outright winner with a 21% return. These smaller cap companies received a post-election boost as they were expected to be less affected by the strengthening dollar and potential trade policies enacted by Trump, since they do not typically conduct much international business. The knock-on benefits of a potential lower corporate tax rate also helped propel small-cap equities higher after the election.

January is a time to reflect on the past year and assess what went right and what went wrong, and asset allocation is no different in this regard. Elevated valuations at the start of 2016 did not hold back U.S. equities as they climbed to record highs; small-caps were the outright winner with a 21% return. These smaller-cap companies received a post-election boost as they were expected to be less affected by the strengthening dollar and potential trade policies enacted by Trump, since they do not typically conduct much international business. The knock-on benefits of a potential lower corporate tax rate also helped propel small-cap equities higher after the election.

Internationally, slowing growth concerns were a determinant of performance. The “anti-establishment” sentiment seen in Europe was a major source of uncertainty. Emerging markets were the most appealing in terms of relative valuations, which helped them deliver double-digit returns after three consecutive negative years.

Lastly, fixed income was led by high yield bonds which rallied back from an end-of-year dip in 2015, with lower quality issues leading the way. Long duration bonds were also a top performer within fixed income, as were bank loans. After the Trump victory revived inflation expectations, TIPS became a topic of discussion. Realistically, as policies will take time to implement, inflation will manifest slowly and will be only one of a few indicators to monitor.

Of course, 2016 is behind us and investors are at this point more interested in what the markets will bring us in 2017. While predicting market winners and losers each year is a difficult exercise, it is safe to say that we will not see a repeat of 2016 asset class performance, and maintaining a diversified portfolio with disciplined rebalancing will help to mitigate risk no matter what happens across the global markets.

Are Active U.S. Equity Managers Poised for a Rebound Heading into 2017?

This week’s chart of the week highlights the recent change in correlation between the stocks that comprise the S&P 500 as measured by the CBOE S&P 500 Implied Correlation Index. On November 18, 2016 correlation among stocks fell to a post-recessionary low of 26.5 compared to an average reading of 59.8.

This week’s chart of the week highlights the recent change in correlation between the stocks that comprise the S&P 500 as measured by the CBOE S&P 500 Implied Correlation Index. On November 18, 2016 correlation among stocks fell to a post-recessionary low of 26.5 compared to an average reading of 59.8.1 A lower measure signals to investors that sectors and styles in the S&P 500 have started to move independently after years of volatility and tighter correlation. This environment should allow active managers to generate alpha, as stock selection plays a key role in outperformance. As this trend continues, managers can focus on bottom-up fundamentals (i.e., company valuations) and less on macro-economic events that could cause dispersion within the asset class. For active managers, dispersion is critical because it allows them more opportunity to select winners and losers and thus outperform the indices against which they are measured. For investors with large allocations to actively managed U.S. equity portfolios, this is good news heading into the New Year.

 

1The Implied Correlation Index measures correlation on a scale of -100 to 100, rather than the mathematical scale which is between -1 and 1.

Will Cyclical Outperformance Continue for U.S. Equities?

This week’s chart highlights recent changes in sector leadership across U.S. equities.

The first half of the year was marked by global growth concerns coupled with reduced expectations for further interest rate hikes in 2016. As this sentiment became priced into the market, a flight to perceived safety ensued which helped to fuel the strong performance of defensive sectors. Telecom, Utilities, Real Estate, and Consumer Staples were the main beneficiaries of this trend. Additionally, these sectors tend to offer attractive dividend yields. Strong interest from yield seeking investors, given the current low interest rate environment, helped propel performance and valuations to elevated levels within these sectors.

This week’s chart highlights recent changes in sector leadership across U.S. equities.

The first half of the year was marked by global growth concerns coupled with reduced expectations for further interest rate hikes in 2016. As this sentiment became priced into the market, a flight to perceived safety ensued which helped to fuel the strong performance of defensive sectors. Telecom, Utilities, Real Estate, and Consumer Staples were the main beneficiaries of this trend. Additionally, these sectors tend to offer attractive dividend yields. Strong interest from yield seeking investors, given the current low interest rate environment, helped propel performance and valuations to elevated levels within these sectors.

The third quarter saw signs of improved economic growth in the U.S. along with positive earnings growth for the S&P 500. The third quarter earnings growth followed five consecutive quarters of negative year-over-year growth. Cyclical sectors were the main beneficiary of these growth improvements, and this trend has continued post-election given the pro-growth rhetoric of a Trump administration and the subsequent expectation of higher interest rates in the future.

This performance leadership from cyclical sectors may continue — at least in the near-term — given the headwinds facing defensive sectors (valuations trading at premiums to the broad market and expectations for higher interest rates) as well as the tailwinds for cyclical sectors (valuation levels relative to defensive sectors and higher expected GDP growth).

Why Small-Caps “Trumped” Large-Caps Last Week

The election of Donald Trump last week caught the market by surprise and created a significant amount of volatility and dispersion across the U.S. equity market. One area of note was the huge outperformance of small caps (up 7.7% from November 8 – 11) vs. large caps (up 1.2% November 8 – 11). The Republicans made it a clean sweep Tuesday night, winning the White House and maintaining control of the House of Representatives and the Senate. While there is a lot of policy uncertainty as a result of this election, the market now believes there is a high likelihood of corporate tax reform being passed sometime in 2017. Donald Trump’s plan calls for a reduction of the corporate rate from the current level of 35% (one of the highest rates in the world) to just 15%. Paul Ryan previously put forward a plan for corporate tax reform that would lower the rate to 20%.

The election of Donald Trump last week caught the market by surprise and created a significant amount of volatility and dispersion across the U.S. equity market. One area of note was the huge outperformance of small-caps (up 7.7% from November 8–11) vs. large-caps (up 1.2% November 8–11). The Republicans made it a clean sweep Tuesday night, winning the White House and maintaining control of the House of Representatives and the Senate. While there is a lot of policy uncertainty as a result of this election, the market now believes there is a high likelihood of corporate tax reform being passed some time in 2017. Donald Trump’s plan calls for a reduction of the corporate rate from the current level of 35% (one of the highest rates in the world) to just 15%. Paul Ryan previously put forward a plan for corporate tax reform that would lower the rate to 20%.

While a cut in corporate taxes is likely to benefit all companies, our chart of the week shows that small-cap companies pay a much higher effective rate (i.e., the rate they actually pay after deductions and credits) than their large-cap peers. This is primarily because large multi-national companies generate a significant portion of their earnings in lower tax countries, while small-cap companies tend to be domestically focused, and thus pay very close to the U.S. statutory rate.

If the corporate tax rate is cut to 20%, this will result in a much larger increase in earnings for small-cap companies compared to large-cap firms (shown by the green dots on the graph). Optimism that this increase in earnings from a tax cut will materialize at some point next year is one of the key factors that drove the outperformance of small-caps last week.