Topic Tags: U.S. Equity

How Will Tax Reform Impact Asset Class Returns?

On December 20, 2017, Congress passed the final version of the Tax Cut and Jobs Act (H.R. 1).  This tax reform bill is estimated to be a $1.5 trillion tax cut and represents the most significant reform to the U.S. tax code since the 1986 tax cut passed under President Reagan.  This newsletter will address the most important changes as it relates to the economy, markets, and our client portfolios.

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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 nor 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.

Shrinking Public Markets and Rising Valuations

Barring a correction in December, most U.S. equity indices are looking at another successful year of double-digit returns. While investors can rejoice in their strong portfolio performances, there is an air of caution as valuations are well above historical averages. This has been an area of concern for the last few years, yet markets continue to outperform and valuations keep rising.

One possible explanation for this is the decline in the total number of publicly traded companies. Since peaking in the mid-1990s, listed companies have fallen by nearly 50% to about 4,300 firms despite the total number of companies in the U.S. remaining about the same. More regulation as well as increased availability of private capital have made businesses less likely to go public. Most retail investors, however, do not have the capability to invest in private markets. With fewer investable options there is more money to go around to these publicly traded firms.

While most of the companies that choose to be public are larger than their private counterparts, this suggests the historic average valuation of about 20x earnings is too low of a benchmark for today’s publicly traded firms. These higher equity valuations may be the new normal and the bull run could continue in 2018.

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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.

2017 Investment Symposium Briefing

A quick recap of the 2017 Investment Symposium — from CEO Brian Wrubel’s opening remarks to the keynotes and flash talks. This year’s symposium covered the current market environment, emerging investment themes and investment stewardship challenges in the year ahead. Our flash talk format is designed to brief clients on pressing topics and encourage timely conversations with investment consultants.

Full keynote and flash talk videos available on demand:

U.S. vs. Non-U.S. Equity Allocation: Does Parity Make Sense?


Flash talk by David Hernandez, CFA, at Marquette’s 2017 Investment Symposium

In this session, we cover U.S. vs. non-U.S. equity allocation. Starting with the basics in determining an equity allocation, we examine both the historical and projected risk/return analysis for U.S. and non-U.S. equity. What are different types of investors doing with their equity allocations? How does diversification improve the risk/return profile? Are we nearing the end of the U.S. outperformance cycle?

 

 

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.

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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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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Passive’s Influence on U.S. Small-Cap

This week’s chart examines the percentage of active and passive ownership within the large, mid, and small-cap segments of U.S. equities. The longstanding trend of increased investor usage of passive strategies over time has been well documented. Since January 2000, the percentage of passive investments has grown from 15% to represent nearly 47% of total U.S. equity mutual fund and ETF assets through June 2017. While true that the bulk of passive assets are directed towards informationally efficient areas of the market such as U.S. large-cap, the overall percentage of passive ownership within each market cap segment varies.

As seen in the above chart, passive investments comprise a greater percentage of the small-cap segment than those for mid or large-cap. Critics of passive investing argue that these investments have the potential to distort the price discovery mechanism of the market should passive assets become too large a percent of total invested assets. The reason for this being that strong passive flows provide support or pressure to index constituents depending on the direction of asset flow regardless of a company’s fundamentals. Given the higher overall percentage of passive ownership in small-cap, the impact of passive investing is arguably greater in this market cap segment.

The situation is further compounded for active managers in small-cap since approximately one-third of stocks in the Russell 2000 index do not generate earnings. Active managers generally have a quality bias thus tend to underweight companies that exhibit no earnings, have low trading volume, or short operating histories. Strong passive flows provide support to this segment of small-cap that is underrepresented by most active small-cap managers. Active small-cap managers in aggregate have been able to generate greater consistency of value-add over their index than active managers within the mid and large-cap market segments despite the higher percentage of passive assets. The reason for this discrepancy is likely because of informational inefficiencies which remain among small-cap companies. If the strong inflow trend continues in passive products, small-cap managers may experience greater difficulties outperforming their index in the future.

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Quantitative vs. Fundamental Strategies: Who Has the Edge?

How do performance trends differ between quantitative and fundamental strategies? This week we explore those differences amongst U.S. large, mid, and small cap equities over the past business cycle.

Quantitative and fundamental strategies first differ in their approach to selecting stocks. Quantitative strategies rely on mathematical models weighing a varying amount of factors while fundamental strategies rely on solid company standing, outlook, and a more human touch through proprietary analyst research.

Within the large cap universe, quantitative funds, on average, were unable to provide much downside protection during the financial crisis. However, over the course of the ensuing bull market these funds were able to outperform the benchmark and eventually their fundamental counterparts. This could perhaps be attributed to quantitative funds having a greater ability to react nimbly to any buy signals generated as a result of massive inflows into the large cap benchmarks in recent years. Strategies within the small cap universe experienced a scenario on the opposite end of the spectrum. Here, quantitative funds were able to offer neither superior upside nor downside protection versus the benchmark; on average these performed worse than the index and over the course of the bull market were unable to outperform enough to recoup those extra losses. As this universe of smaller companies has less analyst coverage, perhaps quantitative strategies struggled to capture enough readily available data from which their models could generate accurate signals. Strategies in the mid cap space exhibit an interesting pattern of their own. Quantitative strategies were able to protect on the downside along with fundamental strategies and were also able to outpace the outperformance of fundamentals.

While these patterns are certainly not guaranteed to persist through the next business cycle, they may offer insight into which universes quantitative strategies have either an advantage or disadvantage, whether it informational or reactionary. As quantitative strategies continually adapt through additions of new factors or tweaks to their models, it will be interesting to see how the two strategy types compare over the next business cycle.

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Will the Yield Curve Invert?

The Chinese yield curve inverted recently. Does this mean that the U.S. yield curve might invert soon? What does inversion mean for investors? Inverted yield curves have been precursors of bad news for the equity market. In the past 20 years, the U.S. yield curve inverted twice, once in 2000 and once in 2006 and the S&P 500 subsequently dropped 48% and 53% following each inversion, respectively. When the yield curve inverts, it usually means that the market is pessimistic about the economy and drives up long bond prices as safe havens, thereby reducing their yields relative to short bond yields, which typically have been driven up by rate hikes.

This week’s chart observes several signals that appear just before the yield curve inverts. First, there are several years of a downward trend in the spread between 10-Year and 2-Year Treasury yields (also known as steepness) and an upward trend in the equity market, as the orange and red arrows show in the chart. Since the last inversion in 2006, we have seen this signal for a while. Second, GDP growth reaches its peak. For the last five years, GDP growth has been stable and at a moderate level, and it is unclear if it has reached a peak or could grow further. Lastly, it takes time for the spread to become negative and the change is not abrupt. Before the inversion, the spread was around 30bps in 2000 and 15bps in 2006. The spread as of May 2017 was around 50bps and still has room to contract.

Overall, there are several signals that suggest that yield curve inversion is coming. However, inversion is unlikely to happen in the near future. The current yield curve is reasonably steep, the market has a positive sentiment about the economy and other economic boosts from the Trump administration may come into play, such as job creation initiatives and tax cuts for businesses and consumers. Yield curve inversion is not yet impending.

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