Topic Tags: U.S. Equity

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.

BREXIT: The Results and What’s Next

June 2016

On June 23rd, the United Kingdom (UK) shocked markets with its vote to leave the European Union (EU). The Remain vote lost to the Leave vote, 48.1% to 51.9%, with a strong turnout throughout the UK. Younger voters sided with the Remain camp by a wide margin, while older voters supported the Leave camp (Exhibit 2). In the weeks leading up to the referendum, global equity/credit markets and the British pound experienced positive price movement in anticipation of a Remain verdict. Using polling information and odds makers as indicators, investors were caught off guard at the Brexit result, leading to dramatic losses for risk assets on June 24th.

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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 Continued Shift from Active to Passive in U.S. Equities

This week’s Chart of the Week examines the ongoing shift from actively managed to passively managed U.S. equity allocations. While active investing has historically been the predominant form of portfolio management, investors are increasingly recognizing that passive strategies are an efficient manner of capturing market beta.

This week’s chart examines the ongoing shift from actively managed to passively managed U.S. equity allocations. While active investing has historically been the predominant form of portfolio management, investors are increasingly recognizing that passive strategies are an efficient manner of capturing market beta. Within U.S. equities, the theme of fund flows migrating from active to passive has been dramatic over the past several years. Since 2007, passive strategies benefited from consistent fund inflows while active strategies continually dealt with fund outflows. With the exception of 2013, actively managed U.S. equity strategies saw net fund outflows over every calendar year since 2007. This trend continued during the first quarter of 2016 with outflows from actively managed U.S. equity strategies totaling $44.7 billion and flows of passively managed strategies gaining $27.1 billion.

Investors often view U.S. equities as an efficient asset class for which the case for passive management is the most compelling. Based on fund managers’ stated prospectus benchmarks, only 21% of large-cap U.S. equity funds who benchmark against the Russell 1000 index outperformed their index over a trailing 10-year period. Within small-cap where informational inefficiencies are greater, 52% of funds who benchmark against the Russell 2000 index outperformed their index over a trailing 10-year period. Given that the majority of actively managed funds often underperform their stated benchmarks and charge higher fees in the process, it should come as no surprise that investors are gravitating toward passively managed funds. While active managers who can generate excess returns over time are certainly desirable, identifying those consistent generators of alpha can be quite challenging, especially for efficient markets like U.S. large-cap equities.

Any Good Deals Out There in the U.S. Equity Market?

Given the current market environment right now, there are no real compelling “buy” opportunities, as measured by a variety of valuation metrics. On top of that, economic growth is slow, yields are low, and equity returns are weak. As such, one of the primary conversations we have with clients is around rebalancing, both at the broader asset class as well as between the underlying components of each asset class.

Given the current market environment, there are no real compelling “buy” opportunities as measured by a variety of valuation metrics. On top of that, economic growth is slow, yields are low, and equity returns are weak. As such, one of the primary conversations we have with clients is around rebalancing, both at the broader asset class as well as between the underlying components of each asset class. In particular, we have recently spent a lot of time discussing the relative valuations of large-cap and small-cap U.S. equities in an effort to identify the more attractive opportunity in today’s market.

In this week’s chart, we examine the P/E ratios of U.S. large-cap and small-cap stocks and compare today’s values to their 20-year averages, removing outliers for when earnings are near zero or negative. The intuition is that the farther today’s P/E ratio is from the long-term average, the more (or less) attractive it is from a valuation standpoint: a reading below the long-term average signals a discounted price, whereas a reading above the long-term average indicates the index is expensive. As seen in the chart, both are near their historical averages, suggesting there isn’t an overly compelling case for either.

How they have gotten to this point over the last 2–3 years, though, is very different. Large-cap companies have slowly returned to this average as a result of investor caution as well as the gradual — but consistent — rise in earnings from 2011 to 2015. Recently though, earnings have slightly fallen for larger companies, which has caused some concern for investors. Small-cap stocks, on the other hand, feature more volatile valuations, with swings in earnings the primary explanation of volatility. In theory, during times of “risk-off” sentiment, large-cap stocks should outperform smaller companies, and vice versa for “risk-on” periods. But with ambiguous market data and valuations so similar to historical averages, investor sentiment is unclear, thus making it extremely difficult to truly identify compelling value in either sleeve of the U.S. equity market.

Growth vs. Value: What Does Technical Analysis Tell Us?

Technical analysis enables speculators to make future market predictions based solely upon a charted historical past; the actions of the market are studied as opposed to the underlying fundamentals of a company. Analysts have studied these sorts of charts for years and in the process discovered trends that are believed to support specific future behavior. One of these trends is explored in this week’s chart as it applies to the market’s preference of style: value vs. growth.

Technical analysis enables speculators to make future market predictions based solely upon a charted historical past; the actions of the market are studied as opposed to the underlying fundamentals of a company. Analysts have studied these sorts of charts for years and in the process discovered trends that are believed to support specific future behavior. One of these trends is explored in this week’s chart as it applies to the market’s preference of style: value vs. growth.

Typically, these trends are applied to a single stock’s movement, but for the sake of assessing the future return prospects of value and growth, we will apply them to the Russell 3000 Value and Russell 3000 Growth indices. More specifically, we calculate the return differential between the two indices by subtracting the Russell 3000 Growth index from the Russell 3000 Value index. This differential is smoothed by using a 90-day moving average and indicates value’s outperformance versus growth when above 0. The 200-day moving average is used as an alarm to changing trends; if a stock price, or in our case a shorter period moving average, breaks upwards through the 200-day moving average, this is seen as a bullish sign, or in our case the outperformance of value over growth. The opposite can be said if our differential breaks through this line downwards. As pictured, value broke through its 200-day moving average line in November, suggesting its future outperformance over growth, which it has recently delivered.

Bollinger Bands, portrayed in green and blue, represent 2 standard deviations above and below the 200-day moving average. It is generally thought that breaking this upper band signifies the security is overbought, which in our case would suggest a trend reversal in growth’s favor and that perhaps, value’s brief period of outperformance is over. With sectors like Healthcare and Tech rallying lately — up 1.3% and 0.9% respectively in March — growth may truly be back in fashion. Given the oscillating nature of the differential, however, this may be a true case of ambiguity in which value and growth have yet to battle it out.

Reputational Risks and Takeaways for Investors

This week’s Chart of the Week examines the aftermath of three recent corporate scandals. 

This week’s Chart of the Week examines the aftermath of three recent corporate scandals.

On August 15, 2015, The New York Times released an expose of the work environment at internet retail giant Amazon, describing a cut-throat work environment where employees were pushed to their limits. The company’s stock price sharply dropped in the weeks following the article, but has since recovered and continued to rise. Amazon’s buoyancy can be attributed to its established presence among consumers, lack of direct competitors, and the absence of legal/financial ramifications following the article.

On September 18, 2015, the Environmental Protection Agency (EPA) issued a Notice of Violation of the Clean Air Act to Volkswagen (VW) alleging that the automaker used software to deliberately evade clean air standards in certain diesel cars. The Department of Justice (DOJ) is suing VW for up to $46 billion, and the automaker must provide a solution for the nearly 600,000 cars affected by April 21, 2016. VW stock fell 65% immediately following the EPA announcement and has seen a feeble recovery since.

On September 28, 2015, legislators called for a subpoena of Wall Street favorite Valeant Pharmaceuticals in response to concerns about inflated drug prices. Shares immediately fell 16%, a trend that continued as investigators uncovered that Valeant’s serial acquisition strategy was buoyed by questionable accounting practices and unfounded price hikes. In the six months following, Valeant stock fell nearly 90% – from a high of $262 on August 5, 2015, to a low of $27 by March 18, 2016.

Investor Takeaway: Some companies are more resilient against reputational damage than others. Investors often do not have access to all the information, and seemingly profitable companies may stand on shaky foundations. It is important to distribute assets across many stocks to ensure that the reputational risk of any one firm cannot cause dramatic effects. In other words, holding diversified portfolios of securities can help insulate investors from the effects of single stock volatility emanating from corporate scandals.

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.

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.