Market & Economic Commentary

Semis vs Software trade now favors Semis

Within the broad Technology sector, there are often significant divergences among the various industries. A key intra-sector industry relationship that many investors use as a touchstone is the relative performance of Semiconductors versus Software.

These two industries capture different parts of the Technology ecosystem. Due to their widespread use in so many devices and products, the Semiconductors and Semiconductor Equipment industry reflects demand for hardware, both within Technology (servers, PCs, phones) and in other sectors (e.g. autos), and thus tends to be much more cyclical. Software tends to be much more stable, with more recurring revenue, and nowadays is closer to a service-type industry. There is much less chance of major “shortages” or “oversupply” of software of the kind that semiconductor makers must often deal with.

So even though software and semiconductors are complementary products (each requires the other), it is not hard to see that they can often have significantly different fundamentals and relative returns on an intermediate-term basis.

Our indicators currently show a growing shift in favor of Semiconductors over Software, both in fundamental earnings trends and relative returns. This is a reversal of the trend seen in the 2017-2019 period, when Semis lagged Software, and much of 2020 when relative performance was mixed.

The chart below shows the strong relationship between relative earnings estimate revisions activity in the two industries and their relative returns. The data are drawn from our broad US stock universe of about 2300 stocks (roughly, all US stocks with at least $200 million market cap and three analysts reporting estimates), and the constituents of each industry are equal-weighted in both the revisions and return series. The return series uses a five-day moving average to show the trends more clearly. Earnings estimate revisions breadth measures the average net proportion of analysts raising versus lowering estimates for each stock. Readings above zero mean more analysts raising estimates than lowering them on average.

US Semiconductors vs Software Revisions and Returns

We see that Semiconductor revisions breadth began losing its relative strength versus Software back in 2017, and continued through early 2019. At that point, Semiconductor revisions started to recover while Software continued a slow deterioration, allowing the relative revisions spread (middle section) to turn up from very negative (i.e., pro-Software) readings. That spread turned positive (favoring Semiconductors) in early 2020, just before COVID-19 hit, and then weakened again as many industries weakened simultaneously in the spring.  Both industries then had a simultaneous sharp rebound, along with most of the rest of the market, through the fall.

The last few months are where we again see a distinct divergence. Software revisions have clearly been losing momentum since September while those of Semis have held up and actually grown somewhat stronger. The spread is now quite wide and at multi-year highs in favor of Semis.

The bottom section of the chart shows the relative returns of the two industries, and we see the clear tendency for relative returns to follow the relative revisions. The relative return series has recently broken out of the range it inhabited for most of 2020, and looks set to follow the relative revisions higher. This suggests that Semiconductors should continue to outperform Software as long as the relative earnings indicators maintain their recent clear bias toward Semis.

US earnings estimate revisions trends remain strong amid Q4 earnings season

While certain heavily shorted stocks are getting much of the attention lately due to retail-driven price surges, the bigger picture news is Q4 earnings reports and analyst behavior.

We track earnings estimates for a broad universe of about 2300 US stocks (market cap of $200 million and up) and construct estimate revisions indicators using two key metrics: breadth and magnitude. Breadth is the net proportion of analysts raising versus lowering estimates for a stock, which is -100% if all analysts are cutting their earnings estimates and +100% if all are raising estimates (0 indicates a balance between positive and negative revisions, or no activity at all). We look at this proportion based on revisions that occurred over the last 100 calendar days (about one quarterly reporting cycle).

Magnitude is the size of the changes, measured as the percent change in consensus mean earnings (EPS) estimates over the past month. It will thus be more sensitive but also more volatile.

The first chart below shows the average daily readings of those two indicators for all US stocks. The red line is the average revisions breadth and the blue bars are the average revisions magnitude. We can see that revisions breadth is holding at very high levels (the long-run average is actually slightly negative because analysts tend to start off with high estimates and trim them as time goes on). This means that a solid majority of stocks have more analysts raising than cutting their estimates for earnings over the next 12 months, and this has been the case consistently since July.

United States_AbsERS_Daily_20210126

The blue bars are now starting to rise again, and we can clearly see the quarterly reporting cycle in the data. The earnings season for Q2 2020 earnings that started last July provoked a big upswing in revisions magnitudes (due to a high proportion of earnings reports beating consensus estimates), and then the reports for Q3 2020 earnings three months later also provoked a similar jump in estimates.

Right now, we see what looks like a third consecutive acceleration in estimate revisions developing as Q4 2020 earnings are now being reported, and are mostly coming in better than consensus expectations. So even after months of analysts raising estimates, they are still being surprised positively by the actual earnings reports.

Where are revisions strongest? The table below shows the average revisions breadth readings for the 11 GICS sectors in the US (using the same broad universe of stocks). We see that Financials is at the top, with a very high reading of over 50%. While Financials have had strong revisions for a while now, the latest jump is likely because Financials are among the first to report earnings in a given quarter and most have reported positive surprises so far: 30 of the 34 Financials in the S&P 500 which have reported so far have beaten consensus estimates for Q4. Analysts often then respond to “earnings beats” by raising estimates for future quarters.

US Sector Abs Rev Breadth tableBeyond Financials, it is still mostly cyclical areas that have the strongest revisions activity, including Industrials, Consumer Discretionary, Technology, and Materials. And while all sectors have net positive revisions breadth, the weakest by a considerable margin are Real Estate, Utilities, and Health Care.

So the message from analysts continues to be strongly favorable for future earnings expectations, even after two consecutive quarters when earnings beat expectations substantially. The macro influences of fiscal and monetary policy on corporate earnings are now well established and likely being embedded in analyst forecasts. This is clear from the relative strength in the cyclical sector revisions indicators.

While equity markets have jumped sharply over the last three months and potentially priced in a lot of good news, the positive trend in earnings estimates from analysts that has supported equity prices thus far looks to be intact for now.

Still a risk-on environment, but option traders remain nervous

Markets globally continue to show strong risk-seeking behavior, a continuation of the broader trend in place for much of the time since late March 2020. That was the point at which monetary and fiscal policy activity surged to produce enormous stimulus in the US and globally.

Recent US legislation that included a total of about $900 billion in new fiscal support is now starting to be felt, and recent political developments have increased the odds of further fiscal support this year. Alongside this persistent fiscal support to counteract the severe economic impacts of COVID-19, monetary policy remains extremely accommodative. Near-zero policy rates and heavy bond buying programs are expected to be maintained for many months if not years, putting both monetary and fiscal policy firmly in the “highly stimulative” category at the same time.

This backdrop has allowed the strong demand for risky assets to continue, as reflected in many measure of market prices. Our chart below shows four such measures:Global Risk Appetite Measures

Top section: The MSCI All-Country World Index (ACWI) is a broad global equity index, and it has been outperforming the total returns generated by the ICE/BofA Merrill Lynch (ML) 10+ Year Treasury Index (measuring returns to Treasury bonds with maturities of 10 years or more). This stock/bond relative return series has recently moved above its pre-COVID peak as bond returns have been weak and stock returns have been very strong.

Second section: Here we plot our own custom index of global high volatility stocks (top decile of global stocks above USD$200 million market cap, ranked by trailing two-year historical return volatility). This index of risky stocks is a useful measure of investor risk appetite. It has posted powerful gains since the March low in equity prices, and continues to make new highs.

Third section: This shows the relative returns of the S&P 500 High Beta index versus the S&P 500 Low Volatility index. The High Beta index reflects the 100 stocks in the S&P 500 with the highest market beta (sensitivity to stock market movements) and is a measure of high-risk stock activity among US large-cap stocks. The Low Volatility index captures the 100 stocks in the S&P 500 with the lowest historical return volatility (both indices are rebalanced quarterly). Their relative return is another measure of risk appetite among investors based on the relative riskiness of stocks within the major US benchmark index. It has been rising sharply again after a pause over the summer and is also making new cycle highs.

Fourth section: Turning to debt markets, this plots the average credit spread on high yield (junk) bonds in the US. The credit spread measures the additional yield investors require over and above the yield on a US Treasury bond of the same maturity to hold the debt of a high-risk borrower (i.e., companies with weaker financial conditions and thus higher default risk). That spread surged in the immediate aftermath of the COVID crisis in March/April of last year, and then has been steadily declining thanks to the Fed’s aggressive support of the corporate bond market. Recently it has continued to make new lows (reflecting greater risk appetite among investors), and is now back to pre-COVID levels despite the ongoing economic turbulence.

So we can confidently say that investors are content to take on greater risk than usual with the expectation that government support for markets and the economy will continue. We also note that the volatility of stock prices recently has dropped back down to very low levels, another condition typically found when risk appetite is high and a bullish trend is well established.

Under these conditions, we would normally expect options traders to react to the low market volatility and favorable backdrop by reducing their expectations of short-term future volatility. This would typically be visible in the CBOE VIX index, which measures the expected level of market volatility over the next month embedded in S&P 500 index options prices.

But right now, we see that the VIX has held at relatively high readings, and allowed a wide gap to open up between implied future volatility and recent realized volatility. We can see in the chart below that normally the VIX and realized volatility move together and are closer than they are now.VIX vs Realized Vol

It appears that options traders do not expect the current stability in equity markets to continue, and are pricing in a significant rebound in volatility (which is typically associated with falling stock prices). Our analysis indicates that this tends to be a favorable contrarian sentiment indicator: when options traders are especially nervous about rising volatility (relative to actual volatility), it suggests that some investors remain unconvinced and underinvested, which can support further near-term gains.

So while some measures of market sentiment are clearly pointing to high optimism among investors (a worrisome sign from a contrarian sentiment standpoint), the VIX is currently providing a supportive sentiment reading in our view. With the market’s trend still strong and the policy backdrop supportive, risk assets could continue to rise at least a little while longer.

Inflation likely to remain moderate even with more fiscal support

The news of Joe Biden winning the US presidency in November has now been joined by news that the US Senate will very likely be under the most narrow control of the Democratic party, along with a narrow majority in the House of Representatives. These developments have led investors to expect more fiscal stimulus and other support than would have been expected under continued Republican control of the Executive branch and Senate.

One of the consensus views that has emerged is that the higher level of expected fiscal support along with the aggressive monetary support from the Federal Reserve (zero policy rates and ongoing bond buying programs, or QE) will provoke accelerating inflation. The view is amplified because the recent stimulus legislation, and expected future fiscal support, have included direct payments to individuals ($600 stimulus checks, possibly becoming larger in the future) along with resumption of enhanced federal unemployment benefits (though smaller than the initial CARES Act amounts), among other programs. The view is that these sorts of direct payments are more likely to be spent on consumer goods and services (to a greater degree than spending on things like health care, infrastructure, or defense), and thus that consumer prices will be forced up by the increased demand.

We are often asked about our view on inflation, particularly in light of these unusual policy conditions. So what is our take? We think the supply side of the equation needs to be considered along with the demand-oriented arguments. Our view is that the economy has a lot of slack still left in it, and thus has capacity to meet increased demand without broad-scale acceleration in inflation. We certainly expect an increase in demand due to the stimulus relative to what it would have been otherwise, but do not expect it to be so extreme that it will push the economy past its potential output limits and produce substantial sustained inflation as a result. This does not mean relative prices will not change, as indeed they already have, but there will continue to be offsetting impacts that keep the overall inflation rate from accelerating.

The chart below shows the historical and projected estimates from the US Congressional Budget Office (CBO) of the “output gap”, or difference between actual real economic output and the estimated potential output the economy could produce without causing accelerating inflation. The grey shaded area indicates forecasted future data from the CBO. At the end of 2020, the economy is operating more than 6% below its estimated capacity, and even after a sharp rebound that is expected in 2021, the economy is still expected to be more than 3% below its potential at the end of this year. The CBO’s projections do not anticipate that the economy will exceed its capacity over the 10-year forecasting horizon (i.e., until 2030 at least). All such long-run forecasts should be viewed with skepticism, but the broad message makes sense given the long-run secular trends in the economy and the lasting damage caused by COVID-19. The inflation data shown in the lower section (using the Fed’s preferred measure of the Personal Consumption Expenditures core price index, i.e., excluding food and energy) corroborate our view that accelerating inflation is very unlikely when the economy is operating below its potential, as has been the case for most of the last 40 years.

Output Gap and Core Inflation

To better understand some of the key drivers of the output gap that argue that there is plenty of spare capacity in the economy, we can review the chart below. It shows the unemployment rate as a measure of labor capacity and the capacity utilization rate as a measure of manufacturing capacity. The unemployment rate remains above the long-run average (dashed line), and far from the low points near 4% where inflation (wage pressure) is more likely to become a concern. The reported (U-3) unemployment rate is also likely a conservative estimate of labor market slack, as it does not measure people who have given up seeking work but would do so under better conditions.

Unemployment and Capacity Utilization

The capacity utilization rate reported monthly by the Federal Reserve also shows a wide gap between the current reading (73%) and the historical average (80%), much less the historical peak levels that would be associated with accelerating inflation. Indeed, the fact that capacity utilization has shown lower peaks and lower troughs over the last three decades helps explain why consumer inflation has also been declining and low for much of that time. If demand can be met by current capacity, broad-based inflation is much less likely.

Long-term structural trends in demographics, debt, and productivity in the US and much of the developed world are generally disinflationary. So it would take an unusually large and persistent effort by fiscal policy makers to generate high inflation in this environment. Naturally, that could happen, but history and current politics suggest it is unlikely, and in our view any increase in consumer demand from additional stimulus can be readily met without broad-based inflation given the slack in the economy.

“K”-shaped economy clearly visible in the labor market

The US labor market is showing mixed signals depending on the data and time period used. Here we review some data that can help identify the divergences and put current conditions in context.

There has been much discussion about the “K-shaped” recovery in the economy following the shock of the initial lockdowns in the second quarter of this year.  The “K” is meant to represent a sharp divergence between industries and workers who have been unaffected by or benefited from recent conditions (the top of the “K”), and those who have been hurt (the bottom of the “K”).

This contrasts with other “letter” descriptions tossed around that included a “V” (a rapid, broad-based rebound in activity after a sharp decline), “L” (economy weakens and remains depressed for a sustained period), or “W” (a sharp rebound followed by a second leg of weakness before a final recovery).

The data we show here highlight the “K” shaped tendencies in the labor market right now: workers who have remained employed have continued to see solid real wage gains on average, but many fewer people are working or even participating in the labor market at all. These data can help remind both investors and policy makers to look at the broad scope of data and not be distracted or misled by selected information that may make things look too rosy or excessively bleak.

The first chart below shows the median inflation-adjusted hourly wage growth as calculated by the Atlanta Federal Reserve. It avoids the issues of changing sample composition that plagues the widely-followed average hourly earnings data by tracking wages of specific people (in aggregate) who are employed over time. It shows real wages (hourly, or salaried converted to hourly) growing at about 2% year-on-year, which is near the higher end of the range over the last 20 years and corroborates the resilient data on consumer spending this year. This captures the top section of the “K” in which those with jobs, particularly in industries that have held up or benefited from the shifts in the economy, are still seeing solid wage gains after accounting for inflation (which remains low overall).

Real median wage growth K

The second chart below shows the long-term trends in employment growth, labor force growth, and the labor force participation rate. Employment growth (measured by monthly nonfarm payrolls) remains severely negative on a year-over-year basis, still worse than the trough in 2009 even after the recent rebound. Perhaps more distressingly, the labor force (the sum of all people working or looking for work) is shrinking at its fastest pace in decades, as people give up looking for work or are forced to by circumstances. This is essentially the bottom section of the “K”, where people in the most affected industries or who cannot work due to illness, caring for relatives, or closure of their business, are not only unemployed but not even really participating in the labor market at all right now.

Employment Labor Force Trends K

The bottom section of the chart shows the labor force participation ratio, which is the percentage of the entire US working-age population that is in the labor force (working or looking for work). It has been declining for 20 years, and after some slight pre-COVID gains has taken a big step lower this year. After an initial rebound from the lowest point earlier this year, it has been stuck around 61.5% since June. Thus a smaller percentage of people in the US are even participating in the labor market. While some of this can be explained by long-term demographic changes (more people reaching retirement age, etc.), it means that an increasingly narrow base of employed people are seeing wage gains and supporting aggregate consumer spending. The big longer-term economic policy question therefore becomes (or remains) how to broaden the labor force again and increase participation and employment, and not be misled by the apparent strength in aggregate consumer spending data that is being supported by fewer people.


Banking sector facing good news/bad news from macro trends

Given the rebound in the Financials sector’s relative returns recently, and the broader increase in investor interest in Value after a long period of underperformance, it’s worth a look at some of the macro trends in the US banking sector to help identify trends that affect profitability. The data show both good news and bad news for the banking sector.

We first dig into the quarterly data on the US banking sector released by the Federal Deposit Insurance Corporation (FDIC), currently as of the end of Q3 (Sept. 30th, 2020), shown in the chart below. The top section shows the total assets of all FDIC-insured institutions in the US (about 5000 institutions), currently about $21 trillion.

FDIC Banking Industry Data

The first key point here is good news for banks: assets have been growing steadily and showed a sharp jump this year as the Fed and Congress implemented massive stimulus programs, pushing lots of new money into the banking system. There is thus plenty of money that could be lent out and potentially produce income.

The next section in the chart shows the biggest piece of bad news: the net interest margin on bank lending has dropped dramatically to the lowest on record (data back to 1984). Record-low interest rates on Treasury benchmarks and narrow credit spreads (both driven by the Fed) have squeezed the spreads on bank lending, hurting profitability.

The third section of the chart shows the actual dollar level of two major categories of bank income: net interest income (the bigger category, grey line) and non-interest income (purple line). Net interest income is the difference between interest collected on loans and the amount paid on deposits or other bank borrowings that fund loans.  Non-interest income reflects all forms of fees and gains (mortgage and lending fees, asset management, trading gains, etc.) that banks collect that are not part of the interest charged on loans.

We see that growing assets have helped the dollar value of interest income grow over time, but recently the drop in net interest margin has pushed interest income lower. Non-interest income, by contrast, has been steady and reached a new high recently. Banks are likely to rely more heavily on non-interest income going forward as long as net interest margins remain depressed.

At the same time, quarterly loan loss provisions jumped in the first two quarters of the year but in Q3 they quickly reverted back to pre-COVID levels as stimulus measures hit.  The current COVID recession is not a banking system issue like the Great Financial Crisis in 2008-09, and banks are much stronger than they were in 2007, though there could be further credit losses if more stimulus is not forthcoming.

The good news/bad news is therefore that lending is much less profitable now, but growing assets and fees and trading gains have helped make up for it to some degree.

Beyond the question of the margins on lending, there is also the question of demand for loans, and the number of credit-worthy borrowers.

The chart below shows the ratio of assets held by US banks in the form of loans versus those held in securities. We see the dramatic shift in bank balance sheets toward holding securities (Treasury and mortgage-backed bonds, etc.) rather than loans, with the loans/securities ratio now at an all-time low (since 1973).

Bank Loans vs Securities

This is likely the result of higher assets but fewer credit-worthy borrowers to lend to, causing banks to park money in securities rather than making new loans. Credit standards have tightened sharply this year, which is not surprising under the circumstances, reducing the number of potential borrowers.

Owning securities rather than making loans is typically a damper on profitability for banks, since income from securities is typically lower than those on loans the banks originate themselves. This is likely one of the factors causing the net interest margin figures to decline.

Overall, banks have reasonably strong balance sheets and plenty of lending capacity, but face a reduced pool of potential borrowers. The macro environment and the Fed’s policies have sharply reduced the profitability of new loans, even if loan losses are not a major problem so far. These conditions are not likely to change near-term, given what the Fed has indicated about its likely future policy path. Fees and other gains could continue to grow along with total assets, but these factors may not be able to fully offset the lower profitability of traditional lending.

Energy sector has rallied, but optimism is already high on crude oil

The recent returns of the Energy sector have been dramatic: in just two weeks from its latest trough on November 6th (just before the Pfizer vaccine news hit), the S&P 500 Energy sector rose 37%, the biggest return of any of the major sectors by a wide margin. The overall S&P 500 index, meanwhile, returned only 3.6% in that period. Most recently, the gains in Energy have cooled somewhat, but the sector (as of Dec. 2nd) is still up 30% from its November 6th level, well ahead of all other S&P 500 sector returns over the period.

The magnitude of the outperformance by Energy over such a short period is by far the biggest such move since the S&P sector return data begins in 1989.

This extraordinary move needs to be considered in context however.

It follows a sustained period of massive underperformance by the Energy sector. Over the 12 months through November 6th, the Energy sector had a -51% return, while the overall S&P 500 returned +14%. And in fact, the Energy sector has been underperforming the broader market fairly steadily since December 2016.

So one could certainly argue that Energy stocks were heavily out of favor and due for a rebound, and the recent vaccine news, with its hopes for a return to more normal levels of travel (and thus fuel use), has provided the spark for that rebound.

But because of the math of compounded returns, the huge recent outperformance only makes up a fraction of the cumulative underperformance since the start of the year, as reflected in the top section of the chart below.

Energy Sector and Crude Oil

What about the price of crude oil that so heavily influences Energy stock prices? Interestingly, crude prices have risen recently but less dramatically than the Energy sector stocks have. The average price of crude reflected in the futures markets over the next 12 months (which avoids quirks related to any specific futures contract) is at the high end of the range it has been in since early summer, around $45/bbl but still well below levels seen at the start of the year (middle section of chart). Oil’s recent movements have also been related to the OPEC+ meeting going on now that will influence how much new supply will be put on the market next year, following sharp output cutbacks this year.

Energy stocks continued underperforming over the summer and fall even as crude prices were range-bound, so the recent outperformance of Energy stocks looks more like stock prices catching up with the level of oil prices (after lagging oil’s movements earlier) rather than a response to a new dramatic rise in oil.

Can Energy stocks keep going? While short-term momentum can of course persist, the recent move has been extreme and thus has pushed Energy stocks closer to overbought conditions on a near-term basis. The bigger question is whether crude oil prices will move materially higher and thus help drive another leg higher for Energy stocks.

The near-term outlook for crude does not appear especially favorable for a couple of reasons. First, the current trends in COVID-19 in the US and Europe have led to more concern about travel (and therefore fuel use), not less, at least for now. The vaccines that have been announced will no doubt help, but will not be widely distributed for several months. If OPEC increases production, as they are discussing, prices may not gain much even with better demand.

The other concern is that sentiment toward crude oil is already quite optimistic, according to the surveys of market strategists published weekly by Consensus Inc. The latest readings show 62% of strategists are bullish on crude oil (bottom section of chart), matching the highest readings in the last several years (and far from the historically low readings around 20% in March/April). It is somewhat surprising to see such elevated bullishness given the price action in crude oil – normally sentiment tracks the price trend in the underlying market more closely. This implies that the majority of traders are already positioned for the potential good news from a return to more normal crude demand next year. The risk is therefore the contrarian concern that if most people are already positioned for higher crude prices, the opposite becomes more likely (absent an external shock).

Once Energy stocks have finished catching up with the current level of crude prices, and the heavy pessimism the stocks have faced this year has fully eased, further gains may be harder to come by. High optimism towards crude oil, combined with the potential for increased oil supply if demand does improve, suggests that the longer-term trend of Energy underperformance will be difficult to decisively break on an intermediate-term basis.

Small-caps are gaining traction as light appears at the end of the COVID tunnel

After a long period of either underperformance or mixed relative returns, small-caps in the US are now finally gaining meaningful traction relative to large-caps.

As shown below, the relative return of the small-cap Russell 2000 index versus the large-cap Russell 1000 index has broken out of the range it has been in since June. The latest move started after the Pfizer vaccine news hit on November 9th, after making an initial move in early October.US Small-Cap Large-Cap Relative Return

Our view has long been that small-cap relative performance follows a cyclical pattern, with the best return/risk payoffs coming when the economic and market cycle have been weak and are starting to recover. The early stages of a new expansion or bull market are thus typically the best for small-caps, while the later stages of an expansion or the early phases of a bear market or recession tend to be better for large-caps, especially after accounting for risk.

The current economic cycle has been very unusual. After a record-long expansion, a very rare external shock (a virus) hit, causing far higher amplitude in the economic data (record-setting declines and recoveries), along with historically huge policy interventions (fiscal and monetary stimulus, etc.). The heavy uncertainty about how the current cycle will play out may explain why small-cap relative performance has only recently started to show the upturn we would expect as conditions start to improve after a recession. The recent signs of progress on a vaccine (or multiple vaccines) offer the prospect of “getting back to normal” next year, and may reduce some of the headwinds facing smaller companies relative to larger firms.

Several other indicators suggest the small-cap outperformance trend may be a better bet now than earlier this year.

First, US small-caps are outperforming across all sectors over the last month, indicating a broad-based trend. This includes the Technology sector, where large-cap Tech had outperformed small-cap Tech by 30% for the year through September 1st, but since then small-cap Tech has outperformed its larger brethren by 12%.

Second, as shown below, the “volatility penalty” for owning small-caps has declined and is now back to relatively low levels. The rolling three-month volatility of the Russell 2000 index has now fallen back to just a small differential over the volatility of large-caps (Russell 1000). That is, investors do not have to take on substantially more risk (volatility) in their portfolios by choosing small-caps over large-caps, as they would have done earlier in the year.US Small vs Large-cap Relative Volatility

And third, small-caps outside the US have been outperforming for some time now (as shown in the lower two sections of the chart below), and therefore US small-caps may have some catching up to do.Global Small-cap Relative Returns

With price activity looking better and the cyclical backdrop potentially becoming more favorable, there could be more room for the recent trend of small-cap outperformance to run over the coming months.

Vaccine news brought record style rotation in stocks

The headlines on Monday (Nov. 9th, 2020) from Pfizer announcing favorable early results in their COVID-19 vaccine trials, while certainly welcome, clearly caught investors off guard. While the major indices were either up or flat on the day, there was a historic level of divergence within the market among the various styles and sectors.

Such extreme rotations remind us that there is risk in the equity markets even when stocks overall do not fall. Investors focused on relative performance likely either had a huge win or huge loss on Monday.

The charts below give some perspective. We highlight returns to widely-used market-neutral factors (styles) that were most impacted yesterday: price momentum, value, and size (small-caps).

The first chart below shows how extreme the returns on Monday were in historical context. We use the daily returns of the Dow Jones Thematic Market Neutral indices for the three styles, data for which goes back to 2002. These indices assume equal dollar amounts invested in long and short portfolios (netting out to zero, or “market neutral”) based on the standard textbook definitions of price momentum (which favors stocks that have outperformed over the last 12 months), value (which favors stocks that have low multiples of price to book value, earnings and cash flow), and size (which favors stocks with lower market capitalizations). The indices are rebalanced quarterly.

Dow Jones Thematic Style Indices Daily Returns

The market-neutral Momentum style had the biggest move on Monday among these indices: a daily return of -14%, the largest daily movement (up or down) in the history since 2002. The next most negative day (April 9, 2009) was a -7% return, so Monday was twice the magnitude of the next-worst day. The biggest positive return historically (April 20, 2009) was +10%. The normal range for daily returns since 2002 (where 95% of observations have fallen) has been -1.3% to +1.3%. So Monday’s Momentum return was extraordinarily extreme.

The Value style was one of the big winners, showing a market-neutral return of +8% for the day on Monday. Before this week, the Value factor’s biggest gain was earlier this year (May 26th) at 4.4%, so Monday’s return was almost twice the next-largest move (the biggest decline was similar at -4.3%). The normal range for daily returns for Value since 2002 has been -0.9% to +0.9%.

The Size style also had a big day, showing a +4.5% return, meaning small-cap stocks outperforming large-cap stocks by nearly 5%. This basically matches the previous maximum return of +4.7% from March of this year. The Size factor has had a similar typical daily range as Value (+/- 0.8%).

However, context is important here. These extreme moves in styles essentially constitute reversals of the general trend they’ve shown most of this year. Momentum had been one of the stronger styles until this week, while Value and Size had been performing poorly. The second chart below shows the indices themselves (rather than daily changes) over the last 12 months.

Dow Jones Thematic Style Indices

We see that market-neutral price Momentum had posted a return of +36% over the 12 months through November 6th, so Monday’s drop cuts into that gain but still leaves the strategy with a positive return for the last 12 months.

Value, by contrast, had been the reverse: it had shown a -37% return (market neutral) through November 6th, so Monday’s gain helped but leaves the style still significantly negative over the last 12 months.

Size (small-caps) had also underperformed coming into this week, showing a -16% return through November 6th. Thus the 4.5% gain reduces the 12-month loss, but still leaves small-caps lagging large-caps by a wide margin over the last year.

The question remains open as to whether Monday’s sharp reversals in relative performance within the major equity market styles (and related sectors) mark the beginning of a durable new trend, or a short-term positioning event that will reverse like a similar event in May/June of this year. Further developments in COVID-19 vaccines, fiscal stimulus plans, and corporate earnings will likely help answer that question, but the uncertainty surrounding these developments means that elevated internal volatility and rotation in stocks may well continue in the coming months.

Politics aside, earnings estimates are still improving

While the headlines and market reactions are dominated by the US election results right now, it is worth keeping in mind the news on corporate earnings trends. More than 75% of companies have now reported Q3 earnings, and the results have been extremely strong relative to expectations. The results have not, however, been immediately greeted with positive price responses. Market action being attributed to the election may also be influenced by a lagged response to earnings reports.

According to Factset, within the broad S&P 1500 index universe (large, mid, and small-caps), 84% of companies have reported positive surprises (earnings ahead of consensus estimates) for Q3 so far, and the average “beat” has been quite large in percentage terms. Whereas the consensus forecasts expected S&P 1500 earnings to be down about -25% from a year prior in Q3 when the quarter started (July 1st), the actual results look like they will be around -8%: still down, but far less than expected.

However, Factset’s calculations indicate that only 48% of stocks had a positive stock price impact immediately after their report. Worries about the election and the prospects for further fiscal stimulus in recent weeks may have dampened investor responses to what would otherwise be favorable corporate earnings news. With some of the political uncertainty in the process of being resolved now, investors may now be willing to reward positive earnings news.

So how are analysts responding to the corporate news flow with regard to their forward earnings estimates for the next 12 months?

Our data show that analysts continue to show significantly more estimate increases than decreases in the US, and increasingly that is true for the lagging developed ex-US (EAFE) universe.

The charts below show our indicators of analyst estimate revisions activity in the US and EAFE markets (Europe, Australasia and Far East, i.e., developed ex-North America markets). The red line is the average net proportion of analysts raising versus lowering earnings estimates (right scale), and the blue bars indicate the average percentage change in next-12-month (NTM) estimates over the last month (left scale).

United States_AbsERS_5Nov2020

EAFE Markets_AbsERS_5Nov2020

We see that the US estimate revisions indicators shifted dramatically from severely negative in the spring amid the initial COVID-19 lockdowns to positive over the summer (starting after Q2 earnings reports) and have recently accelerated further to their highest readings in many years. This reflects the impact of the massive stimulus programs started in April and continued through the summer, but which are now fading. It also reflects the heavily conservative estimates that analysts made amid the extreme uncertainty around the impact of COVID-19 and the lack of corporate earnings guidance: with much less information to go on and plenty of unprecedented events, they took a very cautious view on their earnings estimates. Thanks to stimulus and other measures (forbearance on debt repayments, evictions, etc.), earnings have been better than those pessimistic estimates.

A similar pattern has played out, to a somewhat lesser extent, outside the US, where growth was already somewhat weaker than in the US and stimulus efforts were more mixed. This is partly due to the issues in Europe where coordinated fiscal policy is more difficult to do, and the fact that interest rates were already zero or negative in most of the region and thus couldn’t be lowered much more. The same is true to some degree in Japan. And while the US election will be resolved one way or another in the coming days and weeks, the impact of Brexit on the UK and Europe remains an ongoing risk factor.

The recent trend in analyst estimate activity thus remains favorable, but faces risks from the current upswing in COVID-19 cases in the US and Europe as well as the timing and scope of any further fiscal support for economies. Thus choppy market action with an upward drift continues to look most likely, with significant rotation under the surface of the major indices.