Topic Tags: U.S. Equity

Service Sector of U.S. Economy Strengthens

This weeks’ Chart of the Week looks at the state of the service sector in the U.S., as measured by the Institute for Supply Management (ISM) Non-Manufacturing Index. On August 5th, the ISM released July data for the ISM Non-Manufacturing Index, which posted a reading of 58.7 (a reading greater than 50 indicates expansion in the service sector while a reading below 50 indicates contraction).

This weeks’ Chart of the Week looks at the state of the service sector in the U.S., as measured by the Institute for Supply Management (ISM) Non-Manufacturing Index. On August 5th, the ISM released July data for the ISM Non-Manufacturing Index, which posted a reading of 58.7 (a reading greater than 50 indicates expansion in the service sector while a reading below 50 indicates contraction). This was the highest reading since December 2005 and is one of the highest on record for the index (which dates back to July 1997). This index is important because it serves as a gauge of the overall strength of the service sector of the U.S. economy, and considering that the service sector is the single largest component of U.S. GDP (representing 45.7% of GDP as of 2Q 2014), it has fairly significant implications for the broad economy.

A deeper look into the underlying constituents of the ISM Non-Manufacturing Index points to continuing strength in the service sector. The new orders component, which reflects the level of new orders from customers, posted a reading of 64.9 in July. This was the highest reading of the new orders index since August 2005 and is also one of the highest on record. The employment component of the Non-Manufacturing Index also showed strength in July, posting a reading of 56.0. This was higher than the 54.4 reading in June but it is still lagging the broad Non-Manufacturing index. Given that the new orders index has increased significantly from 50.4 in December 2013 to 64.9 in July, we could see significant growth in service sector employment during the second half of the year if companies start to hire additional employees in order to keep pace with the increased demand.

An Alternative to U.S. Small-Cap Equity

This week we examine the valuation of developed non-U.S. small-cap equity (MSCI EAFE small-cap) compared to U.S. small-caps (Russell 2000). The chart displays the relative price-to-earnings (P/E) and price-to-book (P/B) ratios for the two asset classes. A lower number indicates the U.S. is more expensive compared to non-U.S small-cap stocks.

This week we examine the valuation of developed non-U.S. small-cap equity (MSCI EAFE small-cap) compared to U.S. small-caps (Russell 2000). The chart displays the relative price-to-earnings (P/E) and price-to-book (P/B) ratios for the two asset classes. A lower number indicates the U.S. is more expensive compared to non-U.S small-cap stocks. Based on the historical averages for both P/E and P/B, non-U.S. equity looks relatively attractive.

Small-cap companies in the U.S. have performed well in this historically low interest rate environment. Now five years into the economic recovery, market participants expect a rate hike from the Fed to occur sometime mid next year. With U.S. small-cap stocks lacking extraordinary earnings growth, many investors are questioning their valuations. In the Eurozone and Japan, two areas that account for over 40% of the MSCI EAFE small-cap index, the economies are earlier in their respective recoveries and experts anticipate lower interest rates to persist in these regions, which should be accretive for equities in those markets. Investors looking to reduce their U.S. small-cap exposure should consider developed non-U.S. small-cap, given the accommodative central bank policies and relative valuations.

Favorable Relative Valuation for U.S. Large-Cap Stocks

This week’s Chart of the Week examines the historical valuation premium of U.S. small-cap stocks (as represented by the Russell 2000 index) relative to U.S. large-cap stocks (based on the Russell 1000 index). A line above 1.0 indicates a higher relative valuation for the Russell 2000 compared to the Russell 1000. As of June 30th, 2014, the small-cap index carried an 18.7% premium relative to the large-cap index

This week’s Chart of the Week examines the historical valuation premium of U.S. small-cap stocks (as represented by the Russell 2000 index) relative to U.S. large-cap stocks (based on the Russell 1000 index). A line above 1.0 indicates a higher relative valuation for the Russell 2000 compared to the Russell 1000. As of June 30th, 2014, the small-cap index carried an 18.7% premium relative to the large-cap index. Investors should typically expect small-caps to command a larger P/E multiple relative to large-caps given that small-cap stocks tend to have higher expected earnings growth rates assigned to them. Despite this, the chart above indicates that small-caps are currently at the upper end of their historical relative valuation premium. This suggests a more favorable entry point for large-cap stocks versus small-cap stocks.

With U.S. equity markets over 5-years into the current recovery and major indices trading near all time highs, small-cap stocks are facing a few headwinds. As the Fed winds down its asset purchasing program and as the market begins to anticipate a rise in interest rates, small-cap performance will be more linked to the health of the U.S. economy and face a greater sensitivity to a rise in interest rates versus large-caps. In addition, large-cap stocks derive a larger percentage of their revenues outside of the U.S. and would be poised to benefit to a greater extent over small-caps from higher expected growth rates outside of the U.S. With relative valuation levels between small-caps and large-caps currently at a high level, a better risk/reward trade-off exists for U.S. large-cap stocks.

A Stock Picker’s Market?

So far, 2014 has seen a number of things fall: unemployment, interest rates, the pace of QE3, and correlations among U.S. equities. It is conventional wisdom that in times of crisis, correlations move to one and all equities fall in unison. Since 2008 when the correlations between sectors in the S&P 500 did indeed approach one, active equity managers have bemoaned the lack of dispersion that is commonly present in the U.S. equity market.

So far, 2014 has seen a number of things fall: unemployment, interest rates, the pace of QE3, and correlations among U.S. equities. It is conventional wisdom that in times of crisis, correlations move to one and all equities fall in unison. Since 2008 when the correlations between sectors in the S&P 500 did indeed approach one, active equity managers have bemoaned the lack of dispersion that is commonly present in the U.S. equity market. When dispersion is low and correlations are high, it is difficult for active managers to outperform a benchmark. During periods of high correlation, the market reacts to macro-type factors, punishing or rewarding all equities at once with little regard to stock specific fundamentals.

In 2014 however, correlations have once again begun to exhibit a downward trend, allowing active managers more opportunities to separate themselves from a benchmark. As measured by rolling 21-trading day windows, average correlations between the 10 sectors of the S&P 500 and the index itself reached a low of 63% in May, a level not seen since late 2010. If the trend of lower correlations continues throughout the year, expect greater dispersion between individual equities to be closely followed by greater dispersion between active managers and their benchmarks.

Active Share: An Increasingly Relevant Measure

The popularity of passive or indexed investment strategies is as high as ever due to low costs, strong recent performance, and compelling research by the likes of Eugene Fama indicating active management is a losing endeavor in aggregate. Nevertheless, as more assets move to passive strategies from active, skillful active management becomes more attractive assuming market pricing is not perfectly efficient

The popularity of passive or indexed investment strategies is as high as ever due to low costs, strong recent performance, and compelling research by the likes of Eugene Fama indicating active management is a losing endeavor in aggregate. Nevertheless, as more assets move to passive strategies from active, skillful active management becomes more attractive assuming market pricing is not perfectly efficient.

While the average active manager underperforms the market after fees, there are both successful and unsuccessful managers within the herd. The above table includes a sample of the results from a research study titled “Active Share and Mutual Fund Performance” by former Yale and NYU professor Antti Petajisto. The results of the study indicate that a specific subset of active mutual fund managers, specifically those with high Active Share, have exhibited persistent relative outperformance on a net-of-fees basis.

Active Share is a measure of how different a portfolio’s positions are from those of the passive index. The results of Petajisto’s study suggest that, on average, managers with high Active Share (i.e., Concentrated or Stock Picker type) outperform active managers with low to moderate Active Share. In fact, managers with both high Active Share and lower portfolio turnover actually outperformed the passive index net-of-fees by an average of 1.26% per annum with only slightly higher than average tracking error. A reasonable interpretation is that managers can be successful if they take active positions in strong companies and maintain conviction over time in those investments, avoiding excessive turnover. Meanwhile, managers with the lowest Active Share, termed Closet Indexers, persistently underperformed despite having the lowest fees and greatest diversification. This is unsurprising because these managers act mostly like the index but still charge fees reflective of active management. It is notable that large-cap stock strategies are more commonly closet indexers than small-cap strategies, and funds with too many assets under management have operational inability to take high active share.

In summary, there is a place in many portfolios for both active and passive management. The data does not indicate that all managers with high Active Share will outperform. Nevertheless, evaluating a manager’s Active Share in combination with other qualitative and quantitative factors can be very useful. Through due diligence, an independent investment consultant can help investors distinguish active managers who are more likely to exhibit talent and conviction. More importantly, if investors in so-called closet index funds were to move 60% of their money to a high Active Share manager and 40% of their money to a passive strategy, they could achieve the same level of Active Share while decreasing fees and increasing expected alpha. Take caution though: only patient investors who are comfortable with short-term tracking error can expect to realize the benefits of Active Share strategies, a virtue not exhibited by all.

Economic Surprise Index Turns Negative

In this week’s chart we take a look at the CITI Economic Surprise Index. As a matter of background, the CITI Economic Surprise Index is a composition of various economic indicators that are released; anything above 0 indicates that economic reports are beating expectations and anything below 0 is underperforming estimates.

In this week’s chart, we take a look at the CITI Economic Surprise Index. As a matter of background, the CITI Economic Surprise Index is a composition of various economic indicators that are released; anything above 0 indicates that economic reports are beating expectations and anything below 0 is underperforming estimates. Since its peak in mid-January, the index has been on a steady decline and just reached its lowest point since June of last year.

The start of 2014 saw several key economic indicators fall short of expectations including retail sales, new jobs, manufacturing, and the consumer confidence index; such trends help explain the decline. On the bright side, many experts have blamed the historically dreadful weather conditions as key contributors to such pull-backs in economic activity, and expect a rebound once spring arrives. Indeed, the market appears to agree: after a negative January (-3.5%), the S&P 500 returned 4.6% in February, shrugging off much of the poor economic data. Given the optimistic outlook shared by most economists for 2014, it is expected that the Economic Surprise Index will swing back to positive territory as winter gives way to spring.

Is the Stock Market Overpriced?

Given the monumental run of the equity markets in 2013, we have frequently been asked if the stock market (as measured by the S&P 500 index) is overvalued heading into 2014. The answer unfortunately is not a simple yes or no, because it depends on the valuation method and measurement period.

Given the monumental run of the equity markets in 2013, we have frequently been asked if the stock market (as measured by the S&P 500 index) is overvalued heading into 2014. The answer unfortunately is not a simple yes or no, because it depends on the valuation method and measurement period. This week’s Chart of the Week looks at one valuation measure, the S&P 500 trailing 12-month price-to-earnings (P/E) ratio. We compare today’s P/E ratio with its 10, 20, 30, and 40-year averages.

As the chart shows, there is no clear cut answer when comparing these different averages to the current value — the analysis is very much contingent on the time period utilized when calculating the long-term average. Based on the 20- and 30-year averages one may conclude that the market is fairly priced, if not underpriced. However, the exaggerated P/E ratios as part of the tech bubble likely provide an upward bias to truly objective “long-term” averages. Fortunately, the 40-year average is sufficient to more effectively smooth out the spikes from the Tech Bubble valuations. Using this time period to determine the long-term average, it does indeed appear that the market is overvalued and expensive by historical means. However, this is far from a guarantee that the market will experience a correction in 2014, though we encourage our clients who experienced outsized gains in their equity portfolios in 2013 to consider rebalancing back to their target ranges. If nothing else, one thing is for sure: in order to sustain this current bull market run, the S&P 500 will need to produce strong earnings growth over the next year.

2014 Market Preview

January 2014

Similar to previous years, we present our annual market preview newsletter. Each year presents new challenges to our clients, and 2014 is no different: We are coming off a banner year for U.S. equities, low interest rates continue to stymie fixed income investors, and while developed market equities enjoyed a strong 2013, emerging market stocks sputtered. In the alternative space, real estate and hedge funds proved accretive to portfolio returns, while growing dry powder in the private equity space is starting to raise a few eyebrows.

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What’s Next for the S&P 500?

This week’s chart illustrates the distribution of returns for the S&P 500 in the year following a return greater than 25%. Since 1926, the S&P 500 has produced a calendar year total return greater than 25% on 23 separate occasions.

This week’s chart illustrates the distribution of returns for the S&P 500 in the year following a return greater than 25%. Since 1926, the S&P 500 has produced a calendar year total return greater than 25% on 23 separate occasions. In the 12 months following, 15 observations or 65% of the time, the returns were positive (average return of +21.3%). Conversely, 8 observations or 35% of the time the results were negative (average return of -8.8%). Interestingly, since 1950 there have been 15 calendar years of +25% returns, yet only 3 (20%) of the following calendar years were negative. Many investors are calling for a market correction in 2014; however, a majority of the time returns have been positive and have averaged 10.9% following a calendar year return greater than 25% for the S&P 500.

Bull Market to Continue?

The Conference Board Leading Economic Index (LEI), which consists of 10 economic variables, increased 0.7 percent from the previous month to 97.1 in September. The LEI attempts to predict future changes in the overall economy. Prior to the September release, economists estimated a median 0.6 percent increase according to a Bloomberg survey. The reported 97.1 September number represents the highest point since April 2008 (97.2).

The Conference Board Leading Economic Index (LEI), which consists of 10 economic variables, increased 0.7 percent from the previous month to 97.1 in September. The LEI attempts to predict future changes in the overall economy. Prior to the September release, economists estimated a median 0.6 percent increase according to a Bloomberg survey. The reported 97.1 September number represents the highest point since April 2008 (97.2).

Examining the historical data, two inflection points, which are circled in the chart, stand out the most. The first inflection point, the peak in April of 2000 (95.5), led to an additional 4.5% increase in the S&P 500 through August 2000. The second inflection point, March 2006 (107.9) led to the S&P 500 increasing by nearly 20% the following year ending in October of 2007. While past performance does not guarantee future results, the historical data from the LEI suggest that the market’s bull-run may continue as the economy continues its expansion, though at a modest rate.