Topic Tags: U.S. Equity

Creating Social Impact Through Responsible Investing

August 2015 Investment Perspectives

A growing population of socially conscious investors has energized socially responsible investment (SRI) strategies in the past decade. The Forum for Sustainable and Responsible Investment defines SRI as the process of integrating personal values and societal concerns into investment decision making. SRI has increased in the U.S. from $639 million in 1995 to $6.6 trillion in 2014. These assets account for roughly 17% of total dollars under management in the U.S.

This newsletter outlines a brief history of SRI, approaches to implementing an SRI program including positive and negative screening and shareholder activism; impact investing; example products and solutions in equities, fixed income, and real estate; investor concerns around performance and fiduciary liability, and considerations for implementing a sustainable investing program.

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Time to Buy U.S. Small-Cap Value Stocks?

Through the first seven months of 2015, growth stocks have far outpaced their value brethren in the U.S. equity market. While the theme has played out across all size sectors of the market, this trend has been most obvious for small-cap stocks.

Through the first seven months of 2015, growth stocks have far outpaced their value brethren in the U.S. equity market. While the theme has played out across all size sectors of the market, this trend has been most obvious for small-cap stocks. The Russell 2000 Growth index has returned 9.18% while the Russell 2000 Value index has dropped 2%. Given this disparity, it is worth examining whether now is an appropriate time to re-allocate to small-cap value stocks, since their recent struggles have driven prices lower. To help answer this question, we turn to a comparison of the current index price versus its 200-day average, a common valuation metric used to measure the relative value of a particular stock or index versus a longer-term average. As shown in the chart, the index dipped below its 200-day trading average in July and is now trading at a discount relative to its historic values.

From the broader perspective of portfolio construction, small-cap value stocks have historically offered upside potential and outperformance versus other style and size sectors in the U.S. equity market. In addition, since smaller companies’ operations tend to be more domestically focused, they could potentially provide a sanctuary from the rough geopolitical turmoil that is occurring in Europe and Asia. On a related note, the potential drag from a stronger U.S. Dollar would also be muted due to small-cap companies’ limited international exposure. Given the long-term benefits of small-cap value stocks along with the current valuation of the index, now may be an attractive opportunity to either rebalance or create exposure to the asset class.

How Will the High Level of M&A Activity Impact Investors?

For this week’s chart of the week we take a look at quarterly M&A deals, measured by volume. Typically, summer is a quiet period for M&A activity; however, we have seen the volume of deals for the month of July already surpass $475 billion dollars which would put it on pace to surpass the previous quarter high that was last seen in 2007, just before the start of the great recession.

For this week’s chart, we take a look at quarterly M&A deals, measured by volume. Typically, summer is a quiet period for M&A activity; however, we have seen the volume of deals for the month of July already surpass $475 billion dollars which would put it on pace to surpass the previous quarter high that was last seen in 2007, just before the start of the great recession. There are a variety of explanations for the increased M&A activity: pressure from activist investors, hostile takeovers, and companies with large cash positions beginning to deploy their savings as they better position themselves for future growth. Whether it is a close competitor or a company that compliments current operations, we have seen a great increase in deals over the previous two quarters.

One of the concerns with the elevated M&A activity is that companies are stretching for valuations when acquiring other firms, and given the elevated prices they are paying, it will be difficult to realize a profitable return on the size of their investments. Comparing deal counts to their respective volumes, we have seen less deals over the past two years, but higher dollar volumes than during the 2006–2007 boom years for M&A. The next two months bear watching to see if the furious M&A activity continues, or if the pace begins to abate. Of course, the real result of this activity will not be known for years, but the success – or lack thereof – of these mergers and acquisitions will no doubt manifest itself in capital market returns.

Downside Protection for U.S. Equity Managers

This week, we take a look at down market captures (DMC) relative to top, middle and bottom tier managers for U.S. large-cap equities. Down market captures illustrate how active managers perform during periods of negative benchmark performance. In this case, we are comparing the last 12 years of rolling 1-year down market captures for U.S. large-cap core managers who feature the S&P 500 index as their primary benchmark.

This week, we take a look at down market captures (DMC) relative to top, middle, and bottom tier managers for U.S. large-cap equities. Down market captures illustrate how active managers perform during periods of negative benchmark performance. In this case, we are comparing the last 12 years of rolling 1-year down market captures for U.S. large-cap core managers who feature the S&P 500 index as their primary benchmark.

Theoretically, passive management is less beneficial than active management in down markets as passive management will capture 100% of the index returns during the negative periods. In examining the median manager down market captures (red line in chart), we see that the majority of the time active managers are able to outperform the benchmark in times of market declines (a reading below 100 indicates that the manager lost less than the benchmark).1  This is more evident when looking at the DMCs of managers in the 25th percentile. These managers are consistently outperforming the benchmark during the down market, and losing less capital for their investors. Managers in the 75th percentile consistently have DMCs greater than 100%, meaning they captured more than the negative performance of the benchmark, thus failing to protect in a downside market.

Given the overall efficiency of the U.S. large-cap equity asset class, many investors have moved away from active management over the last five years. And while this trend is not likely to reverse itself anytime soon, those who have identified above median managers may face less downside risk in the event of a market correction.

1It should be noted that outperforming the benchmark in times of market drops does NOT equate to positive returns; the manager just loses less than the benchmark.

Do Current Valuation Levels Suggest an Upcoming Correction?

Over the past few years, investors have become concerned about higher equity valuations and the potential for another pullback or crash. The U.S. equity market is currently in its third longest bull market dating back to WWII, increasing worries that the run may be coming to an end soon.

Over the past few years, investors have become concerned about higher equity valuations and the potential for another pullback or crash. The U.S. equity market is currently in its third-longest bull market dating back to WWII, increasing worries that the run may be coming to an end soon.

This week’s chart examines modern valuations for the S&P 500 to give us a snapshot of where the equity markets are relative to the last 35 years of market data. Using the trailing 12-month P/E ratio, we see that historical valuations are somewhat normally distributed, with the mean falling between 16x and 18x earnings. As of June 18th, the P/E ratio was at 18.75, with its range highlighted in red on the chart. Though this is above average historical valuations, it is still far below the high end of the spectrum that we saw during the tech bubble.

This does not necessarily mean there will not be a crash sometime soon since many factors other than valuations can affect the market. In the second half of 2007 leading up to the recession, valuations were within the mean bar of 16x–18x, yet the index collapsed due to earnings falling dramatically after the housing crash. Though the potential for a pullback is ever-present, a significant correction based solely on valuations seems unlikely.

Relative Yields for REITs and MLPs Trending Up?

Given the prolonged low rate environment in the aftermath of the credit crisis, investors have been on a continual search for yield. Historically, REITs and Master Limited Partnerships (“MLPs”) have been among the highest yielding asset classes, which led to strong performance in the years following the 2008 financial crisis.

Given the prolonged low rate environment in the aftermath of the credit crisis, investors have been on a continual search for yield. Historically, REITs and Master Limited Partnerships (“MLPs”) have been among the highest yielding asset classes, which led to strong performance in the years following the 2008 financial crisis. However, since the taper tantrum in May of 2013 MLPs and REITs have underperformed the S&P 500 by 1,136 and 648 bps, respectively.1 Currently, REITs2  and MLPs3  are yielding 3.8% and 6.0% compared to the S&P 500 yield of 1.9% as of May 2015.

This week’s chart looks at the historical relative yields of REITS (red lines) and MLPs (blue lines) compared to the S&P 500. The chart shows that if you owned MLPs or REITs since June 2006, on average, you were receiving 3x and 2x yield over the S&P 500 respectively. However, by early 2013 both MLPs and REITs looked expensive based on their yields relative to the S&P.4 Of course, given the underperformance of both MLPs and REITs over the last few years, the relative yields of both asset classes are again starting to look more attractive. REITs still seem a little expensive as yields remain relatively low (compared to history) but MLP yields (relative to the S&P) are now above their long-term average and look relatively attractive, and may present an opportunity for investors to boost portfolio returns.

1 As of May 29, 2015
2 REITs are represented by the FTSE NAREIT All Equity REITs Index
3 MLPs are represented by the Alerian MLP Index
4 Prices are inversely related to yields: if the yield is below the average it is more expensive

Which Equity Sectors are Most Sensitive to Rising Interest Rates?

Over the past few years there has been much discussion on the low interest rate environment and what will happen once interest rates begin to rise. Though the Fed has delayed raising its overnight lending rate for far longer than many people initially expected, it seems likely that it will finally begin to raise rates later this year. Coupled with the fact that the 10 yr Treasury yield is once again below 2% and approaching its historical low, an increase in interest rates seems very likely.

Over the past few years, there has been much discussion on the low interest rate environment and what will happen once interest rates begin to rise. Though the Fed has delayed raising its overnight lending rate for far longer than many people initially expected, it seems likely that it will finally begin to raise rates later this year. Coupled with the fact that the 10 yr Treasury yield is once again below 2% and approaching its historical low, an increase in interest rates seems very likely.

This Chart of the Week examines what has happened historically to the sectors of the S&P 500 index when rates on the 10 yr Treasury rise substantially. The chart compares the average monthly returns during seven rising rate periods to the average monthly returns during this entire timeframe. As a whole, the S&P 500 has generally outperformed during these time periods, along with most sectors. Industries that tend to be more cyclical, such as information technology, consumer discretionary, and materials featured the largest outperformance. On the other hand, more conservative sectors failed to beat their averages, with utilities and telecom delivering negative monthly returns. Though it is important to remember that historical results may not always persist in the future, the largely positive returns shown in the chart should help ease the fears of an equity market correction when rates begin to rise.

Is the U.S. Equity Market Overvalued?

As U.S. equity indices again touched record highs during the first quarter, the appropriate valuation level for the market continues to be a popular topic in the financial press. Complicating the issue for investors is the tendency of the financial press to use different valuation methods interchangeably (trailing price to earnings, forward price to earnings, cyclically adjusted price to earnings, enterprise value to pre-tax income, etc.).

As U.S. equity indices again touched record highs during the first quarter, the appropriate valuation level for the market continues to be a popular topic in the financial press. Complicating the issue for investors is the tendency of the financial press to use different valuation methods interchangeably (trailing price to earnings, forward price to earnings, cyclically adjusted price to earnings, enterprise value to pre-tax income, etc.). Oftentimes different valuation methods will flash different signals and there is no single method generally accepted as the “correct” indicator. When confusion arises, it is natural to have Warren Buffett weigh in on the issue with his trademark simplicity. In a 2001 article appearing in Fortune Magazine, Mr. Buffett commented that at any given point in the market cycle, market-cap to GDP is likely the best long-term valuation indicator of the market.

In this week’s chart, we plot the market-cap to GDP ratio for the U.S. by dividing the average quarterly market-cap of the Wilshire 5000 index by the quarterly nominal GDP of the U.S. economy. At the end of 2014, this ratio stood at 122%, the highest level seen since the late 1990s and almost 2 standard deviations away from the 43-year average. Although revered by Mr. Buffett, this indicator should not be relied upon for its predictive power. Instead, it should serve as another data point that urges caution to investors considering outsized allocations to U.S. equity.

Nasdaq: Then and Now

The NASDAQ Composite recently reached 5,000 for this first time since the days of the “tech bubble” back in March 2000. Given that IPO activity has picked up substantially over the last few years, and Silicon Valley is booming again, investors have begun to wonder whether we are witnessing a “tech bubble 2.0”.

The NASDAQ Composite recently reached 5,000 for the first time since the days of the “Tech Bubble” back in March 2000. Given that IPO activity has picked up substantially over the last few years and Silicon Valley is booming again, investors have begun to wonder whether we are witnessing a “Tech Bubble 2.0”. This week’s chart attempts to answer that question by looking at how the NASDAQ in 2000 compares to the NASDAQ today.

Back in 2000, the NASDAQ Composite included over 4,500 listed companies compared to roughly 2,500 companies today. At the beginning of the millennium, companies were commonly going public with no real business plan and often with no revenue and little cash on the balance sheet. As a result, back in 2000, the NASDAQ index as a whole actually had negative earnings.1  Contrast that market environment with today, when the NASDAQ trades around 30x earnings and most new public companies have both revenue and profits. All in all, we aren’t saying there is no bubble, but this time around the fundamentals look much more sustainable.

1The gap in the P/E ratio line on the chart is due to the negative earnings during this time frame.

Is the Bull Market in U.S. Equities Running Out of Steam?

Since the current bull market began in March 2009, the S&P 500 has posted an annualized return of 19.5%. During that time period, the trailing 12 month price to earnings ratio (P/E ratio) of the S&P 500 has increased from 14.2 to 18.1 (an increase of 27%). Over that same period, the trailing 12 month price to sales ratio (P/S ratio) has increased from 0.8 to 1.8 (an increase of 118%).

Since the current bull market began in March 2009, the S&P 500 has posted an annualized return of 19.5%. During that time period, the trailing 12-month price to earnings ratio (P/E ratio) of the S&P 500 has increased from 14.2 to 18.1 (an increase of 27%). Over that same period, the trailing 12-month price to sales ratio (P/S ratio) has increased from 0.8 to 1.8 (an increase of 118%). The current P/E ratio of 18.1 is below the 20-year average P/E ratio of 19.2 but above the longer-term average P/E ratio of 16.7. The current P/S ratio of 1.8 is greater than the 20-year average P/S ratio of 1.5 and is higher than it has been at any point since 2000.

As seen in the chart, the P/S ratio has grown at a much steeper rate than the P/E ratio during the past few years. Over this period, the growth in earnings per share of the S&P 500 has significantly outpaced the growth in sales per share. This tells us that cuts to bottom line expenses — not growth in top line revenues — have been the primary driver of earnings growth. It is fairly typical for this scenario to occur, especially in the early stages of a bull market, as companies tend to cut expenses in order to remain profitable following downturns in the economy. However, in order for earnings growth to be sustained over longer periods of time, there needs to be a pickup in sales growth, as there are limits to expenditure cuts. This is especially concerning because current forecasts indicate that the market expects negative sales growth for both the first and second quarters of 2015. To be sure, this may just be a statistical quirk caused by the significant drop in oil prices in recent months, but it bears monitoring nonetheless.