The Quarterly Statement: Q2 2018
MARKET COMMENTARY- SAFE AT HOME
Market participants consciously chose to stay close to home in Q2, sidestepping headlines and market exposure related to the U.S.-China tariff standoff, ongoing Brexit saga, and reversed fortunes of emerging markets. Returns demonstrated investors’ preference for domestic plays, particularly U.S. small-cap stocks, and the propensity for recent successful trends including growth over value, FANG stocks, and exposure to credit. Additionally, volatility as measured by the CBOE Volatility Index remained elevated and less stable compared to 2017, which had mixed results on equity returns (Exhibit 1). Whilethe S&P 500 ultimately trended up +3.4% for the quarter, the index finished 5.4% below its January high.
While investor anxiety centered on the long duration of the current economic expansion and geopolitical tensions, strong economic data abounded during the quarter. For example, year-over-year estimated earnings growth topped 20% for the quarter, U.S. unemployment fell to a level in May not seen since April 2000 (3.8%), and GDP growth estimates for the second quarter are tracking above 4%.
Despite the enacted tariffs’ limited economic impact so far—only 0.1% to GDP1-fear of escalation contributed significantly to continued global volatility relative to 2017’s smooth sailing. Moreover, strong earnings growth estimated for Q2 is expected to peak in the third quarter. As investors enter the second half of 2018, attention will turn to estimated earnings growth for calendar year 2019, currently projected at a comparatively low +10%.
Geopolitical risks and the expected peak in S&P 500 earnings growth in the next quarter had a limited impact on domestically-focused small-cap securities which fared well due to limited international exposure and a continued tailwind from tax reform. Year-to-date the Russell 2000 outpaced its large-cap counterpart by nearly +5%, and the relative outperformance of small-cap based on a rolling 3-month return sits at the 81 percentile, after peaking in May at the 94 percentile (Exhibit 2).
A large component of the underperformance in international equities, particularly emerging markets, was related to a stronger U.S. dollar. For example, the MSCI EM index was down -8.0% for the quarter, but only fell -3.5% in local currency terms. Rising U.S. interest rates and trade war concerns also contributed to both dollar strength and international equity underperformance.
Though the Federal Open Market Committee (FOMC) acted consistently by increasing its target federal funds rate in June, the Committee also acknowledged that continued curve flattening could lead to yield curve inversion. According to the San Francisco Fed, every recession in the past 60 years was preceded by an inverted yield curve. Given that guidance from the FOMC indicates an additional two rate hikes this year and the fact that the two and ten-year Treasury spread hovered near 35 bps at the end of the quarter, this concern may be valid. However, it’s important to note that the absolute yield of the 10-year U.S. Treasury sits significantly higher than other developed nations, with only severely debt-ridden emerging market economies having higher or comparable yields (Exhibit 3). This data suggests that the relationship between the slope of the yield curve and subsequent economic activity may have shifted given current global monetary policy dynamics.
The first half of 2018 left investors to grapple with an unpleasant mix of elevated valuations, supportive global “hard” data and aggressive trade rhetoric. Unsurprisingly, trade war tensions intensified volatility, lifted the U.S dollar, placed greater value on domestic revenues and flattened the yield curve. As we venture into the back half of 2018, the magnitude and effect of international tensions remains the largest unknown and absolute earnings growth for calendar year 2019 will take center stage.
Concentrating on Concentrations
In the third quarter of 2017, we highlighted the regularity with which the 10 largest capitalization stocks in the S&P 500 contribute to index returns each year. We found that since 1953, these 10 stocks represented an average 26.5% of the market’s return when the return of the index was positive.
This year, we’ve experienced even higher index return concentration than what we categorized as normal in our analysis from Q3 2017. For example, the top five securities in the S&P 500 contributed 50% of the index’s +3.4% quarterly return and over 80% of its +2.7% year-to-date return. So, instead of evaluating the contribution to returns, we take our research a step further and examine subsequent performance of the index and its top five securities when concentration rises above average.
At quarter end, the Russell 1000 Growth and S&P 500 indices were comprised of the same top five technology- and internet-related companies: Apple, Microsoft, Amazon, Google and Facebook. In both of these indices, security concentrations are at levels last seen during the height of the tech bubble. The top five constituted 26.9% of the Russell 1000 Growth index at quarter-end (Exhibit 4A), and from an even broader perspective, 15.2% of the S&P 500 (Exhibit 4B).
Let’s start with the Russell 1000 Growth index. In the past, when the top five securities in the Russell 1000 Growth have constituted more than 20% of the index, these stocks’ average forward return has lagged the index by 4% over the subsequent year, and by 2.7%, annualized, over the following three years (Exhibit 5). Perhaps more telling, the top five securities underperformed the index two-thirds of the time in the following year and over 81% over the subsequent three years.
In addition to the weak relative performance of its top five securities, Russell 1000 Growth index returns have been lackluster when concentrations become higher. When the top five combined market capitalization reached over 20% of the index, the Russell 1000 Growth returned a substandard 1.5% in the following year and was flat in the subsequent three years. The average stock in the index fared better over both of these time frames (Exhibit 6).
The S&P 500 experienced even more drastic results on both a relative and absolute basis. When the top five concentration breached 14%, these securities experienced returns 9.0% and 4.2%, annualized, behind the index’s return over the following one and three years (Exhibit 7). Underperformance frequency was also greater in magnitude, with the top five securities falling behind the index 95.4% and 100% of the time during these same time frames.
Once again, absolute index returns were muted when the top five rose above 14%, whereas the average stock maintained fairly consistent returns regardless of the index’s concentration (Exhibit 8).
This analysis suggests that as market indices become more concentrated, both the top five securities and the overall index may experience subpar returns over the following one and three year time frames, while the average stock fairs substantially better. Given this information, it may be time for investors to consider the potential benefits of being “average”.
THE QUARTERLY STATEMENT is a Glenmede Investment Management newsletter
written by Peter J. Zuleba, III, President of Glenmede Investment Management
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1 Tax Foundation, as of June 22, 2018
All data is as of 6/30/18 unless otherwise noted. Opinions represent those of Glenmede Investment Management, LP (GIM) as of the date of this report and are for general informational purposes only. This document is intended for sophisticated, institutional investors only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIM’s opinions may change at any time without notice to you.
This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. It may contain information which is not actionable or appropriate for every investor, and should only be used after consultation with professionals. References to risk controls do not imply that all risk is removed. All investments carry a certain degree of risk. Past performance of any strategy, area or security is not indicative of future performance. Information contained herein is gathered from third party sources, which GIM believes to be reliable, but is not guaranteed for accuracy or completeness.