Market & Economic Commentary

Global Technology: still outperforming, but is it expensive?

Much of the attention in equity markets has been focused on the Technology sector, many of whose constituents are reporting Q2 earnings now. The Technology sector has outperformed dramatically both in the US and globally in recent years as well as for the year-to-date. This has raised questions about whether the sector is “overowned” and overvalued, particularly given its unusually high weighting in the S&P 500 index now.

While it may seem almost a foregone conclusion that after extraordinary outperformance the sector must be overvalued, our data suggest this is not necessarily the case. We review a couple of interesting charts below, focusing on relative returns and valuations (not absolute valuations).

Global Technology Relative Return

Tech stocks have indeed outperformed globally, extending a long-term trend in place for seven years and counting now. The chart above shows the relative return of global Technology stocks in our stock universe relative to the return of the entire global universe (~6000 stocks currently). The returns are calculated on an equal-weighted basis (to avoid the potential distortions of a few mega-cap stocks), though the trends using cap-weighted returns look similar.

Global Technology Relative Valuation

Based on the relative forward earnings yields¹ in Technology versus the global average, the typical Tech stock is not currently very far out of line with historical norms on a relative basis in our work. And Tech stocks are actually cheaper on a relative basis now than they were at the start of the year.
The chart above shows the relative forward earnings yield for the median² stock in the global Tech sector relative to the median stock in the global universe. The solid horizontal line is the long-run average, and the dashed lines are +/- 1 standard deviation from the average.
The current reading of -1.4% reflects the Tech sector’s current median forward earnings yield of 3.5% (equal to a forward P/E of 28.5) being 1.4% lower than the global median forward earnings yield of 4.9% (equal to a forward P/E of 20.4).
Technology is a growth sector, so it almost always trades at a lower forward earnings yield (higher P/E) than the overall market. Historically, the earnings yield differential has averaged about -1.2%, so the current valuation spread (-1.4%) is actually quite close to the long-run average.
Even though Technology has outperformed this year, the sector’s relative valuation has actually improved since the start of the year (from -1.6% to -1.4%). This is because expected earnings for Technology have also outperformed the global average by a substantial margin this year.
Confirming the global figures, the chart below shows the same calculation for the US Technology sector, where it may come as a surprise to some to see that the median US Technology stock is actually slightly cheaper than average on a relative basis now, and significantly cheaper than at the start of this year.

US Technology Relative Valuation

Using valuation alone as a timing tool can be quite challenging, but our data suggest that Tech stocks are not especially overvalued on a relative basis (i.e., putting aside whether the entire equity market is fairly valued or not on an absolute basis). So long as earnings in Technology continue to outpace the average, valuation does not appear to be a major headwind to the sector’s relative performance at this point, either globally or in the US.

¹ We use earnings yields (earnings/price ratios) instead of price/earnings ratios in aggregate calculations to properly account for the presence of companies with negative earnings. Consequently, higher numbers are more favorable. The forward earnings are based on rolling 12-month forward consensus estimates.

² Using the median stock avoids potential distortions that can occur in cap-weighted calculations, where unusual movements in a few mega-cap components can skew the sector’s valuation figures at times.

Relative volatility risk in US small-caps remains high

Among the various asset allocation decisions for which we provide guidance to clients is whether to favor small-caps or large-caps (i.e., the “size” factor) within the US equity market. In our view, small-caps do not reliably outperform large-caps consistently over time (as some models and studies might suggest), and instead view the “size premium” (outperformance of small-caps) more as a cyclical phenomenon that tends to show up under certain macroeconomic and market conditions.

While there are many potential conditions that might affect small-cap/large-cap relative performance, much of our work is oriented around the idea that small-caps give the best “bang for the buck” in the periods just before and through the early stages of a new economic or market cycle. That is, recessionary troughs in the economy and equity market set up the conditions for future small-cap outperformance, as smaller companies tend to benefit most from the re-acceleration of economic growth that typically occurs after recessions. This is also when monetary and fiscal stimulus tend to be strongest. In these scenarios, small-caps have typically underperformed before and during the preceding recession/bear market and become out of favor and potentially undervalued. Conversely, the later stages of an economic cycle and the early stages of a recession or bear market tend to be unfavorable for the riskier and more economically sensitive small-caps.

Looking at conditions now, there is certainly evidence that a recessionary trough has occurred or is in process, and both monetary and fiscal stimulus have been very aggressive. This would potentially argue for favoring small-caps over large-caps, and indeed small-cap relative returns have stabilized after a sustained period of significant outperformance by large-caps since mid-2018 (and arguably longer). However, it may be worth an extra dose of caution before making heavy overweight allocations to small-caps on an intermediate-term (6-12 month) basis. This is not only due to the unusual nature of the current cycle, but also more specifically to the extremely elevated relative risk still apparent in the volatility of small-caps versus large-caps.

Using the Russell 2000 Index to measure returns for US small-caps and the Russell 1000 Index for large-caps, the chart below shows the rolling three-month annualized volatility of daily returns for both indices over the last 20 years (small-caps in blue, large-caps in red) in the top section, and the difference between them in the bottom section.

US Small Large Cap Relative Volatility

A few things jump out: first, volatility for all equities surged to extreme levels earlier this year, matched only by the Great Financial Crisis in the last 20 years, and has been declining rapidly thanks to the Federal Reserve’s extraordinary interventions. And second, the difference between small-cap and large-cap volatility has remained near historic extremes even as volatility has declined for both size categories.

As shown in the bottom section of the chart, small-caps are almost always more volatile than large-caps (i.e., the volatility spread is usually above zero), with a historical average of about 4.5%. However, the latest readings on the volatility spread of over 14% are the highest in the last 20 years. That is, while large-cap volatility has dropped to a (still elevated) level of just under 24% (equal to average daily index movements of about 1.5%), the small-cap index volatility has only managed to decline to 38% so far (equal to average daily movements of about 2.4%). This is still far above the normal level of volatility for small-caps historically of about 22%.

The bottom line is quite straightforward: even after sharp rallies in equities and lower market volatility in general, owning small-caps remains much riskier on a price volatility basis than owning large-caps. So if expected returns must be commensurate with expected risk, then a decision to allocate heavily to small-caps requires either 1) an unusually high excess return expectation, or 2) an expectation of drastically lower small-cap volatility soon.

Given the economic backdrop and the reliance on government stimulus as well as the relative fundamentals of small-caps versus large-caps (a possible topic for another post), it may take a little while longer to have confidence that small-cap excess returns will be sufficient to compensate for their unusually high extra risk relative to large-caps.

In case you need a refresher course, it’s all stimulus these days

*with apologies to Irwin M. Fletcher

Much has been made about the divergence between the path of the US (and global) economy and that of the stock and corporate bond markets. Even while economic and earnings growth is historically weak and remains under severe pressure from a rapidly spreading virus, major stock market indices have rallied and are at or near all-time highs. Market valuations based on forecasted earnings over the next 12 months have clearly risen sharply.

While the divergence between financial asset prices and the “real economy” as experienced by many Americans is striking, the reason is not hard to see: enormous levels of stimulus by both fiscal and monetary authorities.

Essentially, the US Congress has voted (in four separate pieces of legislation so far) to drastically increase deficit spending to support individuals and businesses as well as the costs of health care and virus abatement. The trailing 12-month US federal deficit has jumped to about $3 trillion, easily a new record in nominal terms and the largest deficit as a percentage of US GDP since World War II.

As shown in the bottom section of the chart below, the current 12-month deficit is now nearly 14% of nominal GDP, significantly more than the peak following the Great Financial Crisis, and up from the deficit levels of 4-5% of GDP in 2018-19, i.e,. adding roughly 10% of GDP to spending. This has helped fill a huge gap in personal incomes caused by lockdowns associated with COVID-19.

US Monetary and Fiscal Stimulus

And crucially, at the same time, the Federal Reserve has also engaged in an unprecedented level of money creation (“quantitative easing”, or QE) to essentially monetize the increase in Treasury debt. After immediately cutting its fed funds policy target back to zero (0 – 0.25%), the Fed has expanded its balance sheet from around 20% of GDP before COVID-19 hit to over 30% of GDP currently, i.e., adding roughly 10% of GDP to the money supply. This is also far bigger than its balance sheet was after the three previous rounds of QE between 2008 and 2014.

While the Fed has a number of different programs in place to support financial markets and the economy, most of what it is doing is buying up Treasury bonds, mortgage backed securities, and more recently corporate bonds and bond ETFs. It does this with newly created money that can then circulate in the economy. A key effect is to essentially offset the absorption of money caused by the Treasury issuing huge amounts of new bonds, and has drastically expanded the US money supply. And by using newly-granted powers (under the recent CARES Act) to buy corporate debt (including some high-yield or “junk” debt), it has also compressed the credit spreads in the corporate bond market and made it cheaper for companies to borrow than it otherwise would be.

So an extreme oversimplification would be that the Treasury engaged in new spending of something on the order of 10% of GDP, and the Fed printed roughly a similar amount of new money to “pay” for it (a liquidity conversion of the Treasury bonds to cash), with some of that Treasury money being used to allow the Fed to take on corporate credit risk for the first time. That extra ~10% of the economy that has been conjured up by Congress and the Fed was meant to fill some of the hole left by the meteor that hit the global economy in the form of COVID-19.

The key question now is to what degree is additional stimulus needed, and will policy makers provide it to the appropriate degree? Current virus trends, structural economic damage COVID-19 has already caused, and rising debt levels suggest significant further stimulus will be required to bridge the gap until the economic effects of the virus have passed, though that remains a point of debate.

Investors who take the view that the policy response will be sufficient (or possibly even excessive) are likely those who are content to pay the same (or higher) prices for stocks and some bonds than they did in 2019, and assume that earnings will fully recover and stocks will be worth more in the future due to the lack of any competition from near-zero interest rates on safe debt (Fed policy rates are expected to remain near zero for several years at least).

Investors who worry that the policy response will falter may be more cautious, given the potential further weakness in corporate earnings that would also result. And one outcome in particular bears consideration: what if the fiscal response falters (due to Congress being unable to agree on sufficient stimulus legislation), but the Fed continues to intervene heavily in financial markets with quantitative easing and corporate credit spread compression (i.e., printing more money than can readily be spent)? Then financial assets, and unprofitable companies, might continue to hold up and inflation could eventually rise, even while the underlying economy weakens (with implications for income and wealth inequality).

That is arguably not far from what is happening now, as the Fed has adopted a “whatever it takes” approach and has few limits to the amount of monetary support it can provide. The question of further fiscal stimulus is the key question right now, as there reportedly remains a wide gap between Democrats and Republicans in Congress (and the White House) about the size and scope of any additional stimulus. With much of the original stimulus plans now fully utilized or expiring soon, there is a clear danger of a de facto sharp contraction in fiscal policy relative to the current extreme levels of support (the so-called “fiscal cliff”). Congress is scheduled to be in session for only a couple of weeks before going on August recess, and the key $600/week of extra unemployment benefits are due to expire on July 25^th. The path of the economy and financial markets may depend on decisions made by Congress in the next few weeks.

Global risk appetite measures slipping recently

July 14, 2020

Stock prices globally have remained unusually buoyant in the face of well-known health and financial risks. Thanks largely to aggressive global monetary and fiscal stimulus starting in March and still going on (though arguably fading), risk appetite jumped dramatically following the severe but relatively brief sell-off from late February to late March.

Most recently, however, several metrics of global risk appetite that we track have either plateaued or weakened. This coincides with a reduction in the pace of central bank activity and growing uncertainty about further fiscal stimulus programs, especially in the US. It also coincides with the recent turn higher in the growth of COVID-19 cases in the US and globally.

The complete explanation of the chart below follows and makes this post somewhat longer, but the key point is that multiple metrics show at least a pause if not an incipient downturn in risk appetite that is worth watching, particularly given that it occurs with the Fed and other central banks still actively pursuing asset purchase programs, even if at a less frantic pace recently.

Global Risk Appetite Measures

The chart above plots four price-based measures of investor risk appetite. Three are based on equity prices, and the bottom section shows US high yield credit spreads from the bond market. In all four, the preference for higher-risk assets has either lost its earlier momentum or is weakening.

The top section plots the relative return of the MSCI All-Country World Index (ACWI), one of the broadest measures of global equity returns. It includes both developed and emerging markets and has approximately 3000 constituents. Like most equity indices, it is capitalization-weighted, so the largest global companies get the most weight in the index. The US currently makes up about 57% of the weight in the index. We plot its total return relative to that of the ICE/BofA Merrill Lynch 10+ Year Treasury total return index. As its name indicates, it tracks the returns of all US Treasury bonds with 10 or more years to maturity, and thus better aligns with the long-term nature of equities as an asset class but is still considered a “risk-free” asset from the standpoint of return of principal. US Treasury bonds are a widely used global benchmark and the largest and most liquid bond market.

The relative returns of global stocks versus bonds captures the severe drop in stock prices starting in late February of this year, and the subsequent rebound. It bears noting, however, that even with the sharp rebound in stock prices, long-term US Treasury bonds have still outperformed global equities since the pandemic began (i.e., the stock/bond relative return series is lower than it was at the start of this year). The relative return series is also still below its own one-year average, which is itself declining. We also see that global stocks had struggled to outperform long-term Treasuries over a longer period even before COVID-19 became a factor earlier this year, reflecting the general weakness in the global economy developing in 2019. High total returns in bonds are potentially harder to generate now that interest rates are so low (though long-term bond prices can be quite volatile), so if stocks begin to lag bonds again on a sustained basis, it would reflect a clear shift in preference for “return of capital” rather than “return on capital”.

The second section of the chart plots our own index of high-volatility stocks globally. On a quarterly basis, we screen the global stock universe for all stocks with at least USD$200 million market cap (and at least $1 million/day average trading value) and identify those ranking in the top 10% (top decile) based on their trailing two-year price volatility (price risk). We track the daily returns of those top-decile volatility stocks as a proxy for global equity risk appetite. The index thus shows risk appetite in absolute terms, and confirms the stock/bond relative return pattern, though more dramatically. From its initial peak on January 16th 2020, the index plunged -49% to its trough on March 18th. From there it posted an extraordinary rise up to a new recovery high, gaining 123% from the low to its peak on June 8th, putting it higher for the year-to-date at that point. After a short-term sell-off from the peak, the index has been moving sideways recently, off about 10% from the June peak. It remains above its one-year average, and in line with levels seen in late 2019. The positive trend is thus arguably still intact, but has lost momentum.

The third section is somewhat similar but plots the relative returns of the S&P 500 High Beta index versus the S&P 500 Low Volatility index. These indices are constructed based on the 100 stocks within the S&P 500 with the highest market beta (sensitivity to market movements) and the 100 index stocks with the lowest historical volatility (rebalanced quarterly). The relative return series thus shows relative preferences for risk within the US equity market. It has followed a similar pattern to the global volatility index above it, but we can see a notable recent difference. The relative returns of high beta stocks versus low volatility stocks has turned down more distinctly recently, and is now back to about its one-year average. A drop below the average would potentially mark a reversal of investor risk preferences to at least neutral if not outright risk aversion, at least temporarily. We will be watching this series closely.

The final section of the chart plots the average credit spread (the option-adjusted spread, which accounts for call features on corporate bonds) for bonds in the Bloomberg Barclays US High Yield Index. Thus it measures the yield premium on high yield (“junk”) debt (rated BB/Ba or lower by Moody’s or S&P) over US Treasuries of the same maturity. A higher spread (rising line) indicates greater risk aversion and expectations of higher default risk on high yield bonds, while a lower spread indicates lower perceived credit risk. Within the fixed income market, high yield debt is closest to equity in risk, making this another useful proxy for investor risk perceptions.

This series is arguably slightly more difficult to interpret right now than it would have been historically, due to the Fed’s new direct influence on corporate debt, including high yield debt¹. Nonetheless, the message is similar. After surging as COVID-19 and the associated lockdowns halted much economic activity and the corresponding ability for companies to service debt, yield spreads have come back down sharply thanks to Fed support. But most recently, the narrowing of credit spreads has stopped and may be starting to reverse. It also still remains above (worse than) its own one-year average (which would be expected given the severity of the economic weakness). The underlying fundamentals for many junk-rated companies have not improved substantially and face continued risk from the virus, but monetary and fiscal support (along with the historically low yields on “safe” debt) have increased investors’ willingness to bear credit risk recently. If that risk tolerance recedes (due to policy changes, or worsening fundamentals), both the high yield debt market and the stock market would potentially come under renewed pressure.

Overall, investor sentiment is arguably quite positive (high equity valuations, low recent demand for put options, high proportions of bullish advisors represented in surveys, etc.), and this has been reflected in returns. But the most recent price action has shown some early warning signs of stalling or reversing that risk appetite, which could lead to renewed volatility in equities.

¹ While historically the Fed has been prevented from owning anything other than government-guaranteed debt, the recent legislation (CARES Act) passed in the wake of the economic and market distress allowed the Fed to act in concert with the Treasury to buy corporate and municipal debt, as well as backstopping direct loans to companies. This has directly impacted the credit spreads seen in debt markets, as intended, though at the potential cost of reducing the ability to see investors’ true risk preferences.

Earnings uncertainty still extremely high going into Q2 reporting season

July 10, 2020

As Q2 earnings season gets underway, the level of uncertainty about future earnings among analysts remains extremely high. Despite somewhat calmer equity market activity recently, our data shows that the level of disagreement among analysts regarding earnings over the next 12 months (NTM) is still well above the highest levels reached in the Great Financial Crisis (2008-09) period (chart below).

US Estimate Disperson

The chart plots monthly (and latest) readings for the average dispersion of analyst forecasts around the mean for US stocks (standard deviation of estimates as a percentage of the mean estimate for each stock, averaged across all stocks in our 2300-stock US universe*). A higher dispersion number indicates a wider range of estimates (more disagreement about the level of future earnings) for the average stock. The solid horizontal line is the long-run average, and the dashed lines are +/- 1 standard deviation from the average.

One reason for the extreme level of disagreement among analysts is that a record number of companies have withdrawn their usual earnings guidance in light of the uncertainty surrounding the impact of COVID-19 and related government responses.

And equity analysts, like many other workers, have also been forced to work from home and unable to travel to visit companies, attend conferences, and gather information as they normally would. So with less scope to do their own legwork and less input from company management, analysts have far less information to work with now than usual.

These limitations on information access, alongside the obvious difficulty of predicting economic activity and earnings in an unprecedented global health crisis, no doubt help explain why there is little confidence about forecasting future earnings. We might therefore expect to see a greater number of earnings surprises when companies release their results.

And while theory suggests that higher earnings uncertainty would normally prompt investors to reduce the valuations given to equities, that has not been the case recently as aggressive stimulus from central banks and government spending have in fact pushed equity valuations much higher.

*Note: our US universe includes stocks with at least three analysts covering them, a minimum $200 million market cap, and at least $2 million/day average trading volume.