Topic Tags: U.S. Equity

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.

Can Consumer Confidence Continue to Boost the Stock Market?

This week’s Chart of the Week compares consumer confidence (based on the University of Michigan Index of Consumer Sentiment) to the performance of the S&P 500 over the past five years. As the chart illustrates, there has been a very strong correlation between consumer confidence and the performance of the S&P 500 over the past five years, as evidenced by a correlation coefficient of 0.72 over that time period.

This week’s Chart of the Week compares consumer confidence (based on the University of Michigan Index of Consumer Sentiment) to the performance of the S&P 500 over the past five years. As the chart illustrates, there has been a very strong correlation between consumer confidence and the performance of the S&P 500 over the past five years, as evidenced by a correlation coefficient of 0.72 over that time period.

In July, the University of Michigan Index of Consumer Sentiment came in at a level of 85.1, which was the highest level of the index since July of 2007. Given the recent combination of improving labor market conditions, a rebound in housing prices, and all time highs in the U.S. equity markets, it is not surprising that consumer confidence is on the rise. This recent rise in consumer confidence has been accompanied by a simultaneous increase of money flowing into equity mutual funds, which have seen inflows of more than $92 billion year to date in 2013, following five consecutive years of out flows from equity mutual funds (from 2008-2012 when a total of $535 billion flowed out of equity mutual funds)1. The flows into equity funds, along with relatively strong economic data as of late, have resulted in the S&P 500 reaching all time highs during the month of July.

It should be noted, though, that there are some potential risks to consumer confidence over the near term. The July consumer confidence survey indicated that a continuation of the recent rise in interest rates has the potential to be a drag on confidence. The renewed battle over the U.S. budget, which is set to expire at the end of September – including talks of a government shutdown and possible default due to a battle over lifting the debt ceiling – is eerily similar to what occurred in the summer of 2011. During the budget negotiations in summer of 2011, consumer confidence dropped from 74.3 to 55.7, and the S&P 500 from May to September dropped 17.9%. To be sure, there were factors other than the budget battle that contributed to the steep drops in consumer confidence and the equity markets (notably, the Euro crisis was in full swing during this time period).

It is important for investors to pay attention to these potential risks that are on the horizon. Considering the tight correlation between consumer confidence and equity market returns in recent years, any event that has the potential to erode consumer confidence could result in losses in the equity market as well.

1 According to the Investment Company Institute

Small-Caps Lead the Way

The chart above illustrates the year to date outperformance of small-cap stocks (Russell 2000) versus large-cap stocks (Russell 1000). Year to date, small-cap and large-cap stocks have returned 24.8% and 20.3%, respectively.  

The chart above illustrates the year to date outperformance of small-cap stocks (Russell 2000) versus large-cap stocks (Russell 1000). Year to date, small-cap and large-cap stocks have returned 24.8% and 20.3%, respectively. While both indices have largely been positive throughout the year, small-caps have outperformed substantially since June 24th as the stock market has come to grips with a higher interest rate environment, as an increase in Treasury yields has diminished the appeal of large-cap dividend paying stocks. Investors may be willing to take on additional risk and rotate into small-caps, in search of returns via capital appreciation rather than income growth. Additionally, with the prolonged difficulties in international markets, investors may also find small-caps attractive since a smaller portion of their sales are derived from overseas. As a percentage of total revenue, the Russell 1000 derives approximately 34% of their sales overseas, while the Russell 2000 only around 18%. Finally, as corporations sit on large piles of cash, debt is relatively cheap and organic growth remains difficult, we may see continued activity in the mergers and acquisitions markets that should benefit small-cap stocks. These factors may help explain the recent outperformance.