Target equities that may be impacted less by volatility
The double-digit gains for global equities so far this year combined with 2018’s negative 11% return represent the largest positive year-over-year return differential (+30%) since 2009, when the market was emerging from the financial crisis.1 For US equities alone, 2019 ranks 13th of all-time2 and is the greatest non-bear market bottom year-over-year rally since 1995 — another year that saw the Federal Reserve use rate cuts to calm fears of a slowdown.
Yet, although US equities continued to set new all-time highs throughout the year, investors have shunned the asset class. Investment in equity ETFs is currently 41% off 2018’s pace and at the lowest year-to-date total since 2016.3 It turns out that this tepid optimism has been a risk to portfolios, as the 60/40 portfolio has had its second-best year in a decade.4
As the fear of missing out on future gains creeps in, investors might consider altering their view on risk assets and then jump back in with both feet. However, blindly buying equities in 2020 could be a bigger risk than not owning them in 2019. Given the macro risks in today’s marketplace, seeking to harness the equity risk premium in 2020 requires working overtime to limit the impact of any volatility.
While the headlines celebrate all-time highs, the path to the top hasn’t been exactly linear. Microbursts of volatility have become more common over the past few years, as shown below, with drawdowns becoming more frequent and severe. This is a different volatility regime for investors than the one they endured during the earlier stages of this still lumbering bull market.
After the market spent just 10% of its days in a greater-than-3% drawdown from 2012 to 2014,5 2018 and 2019 have seen 65% and 47% of days in a 3%-or-greater drawdown, respectively.6 This trend would have started in 2016, when Brexit and the devaluation of the renminbi ignited macro volatility, if it weren’t for the anomalous 2017, when investors were gripped with the short-lived reflation euphoria and the expectation of a tax cuts sugar high.7
Source: Bloomberg Finance L.P. 11/7/2019, based on price returns and do not assume the reinvestment of dividends. Calculations by SPDR Americas Research. Past performance is not a guarantee of future results.
However, as evidenced by current all-time highs, any pain felt under this new regime has been short-lived. Violent selloffs have been followed by equally sharp rallies spurred by policy actions or the removal of macro risks that challenged investor sentiment. If we are at all-time highs though, why does it matter? Volatility drag is why. Lose 25%, and you need 33% to get back to even, but lose 10%, and you only need 11%.
The market’s highway is jammed with broken rallies on a last chance power drive. And as 2020 nears, there are still plenty of macro risks that leave investors little place to hide. Yet, despite policy uncertainty, murky global economic data and manufacturing weighing on growth, global earnings seem set to rebound in 2020. But given how profit margins have declined (as shown below), that uptick won’t be fueled by organic growth and looks strong only when compared with 2019’s weakness.
Source: Bloomberg Finance L.P. 11/7/2019. Past performance is not a guarantee of future results.
Broad-based data can obscure positivity beneath the surface sometimes, however. Unfortunately, that is not the case with margins today, as the sluggishness is not sector specific. Nine out of the 11 US sectors have witnessed a decrease in year-over-year profit margins.8 Outside the US, profit margins that hit a cyclical peak in 2019 have been falling for 10 straight months, as shown above. As a result, expect these lofty growth figures— 10.5%, 7.8%, and 13% for US, developed-ex US, and emerging market regions, respectively9 — to come down, consistent with historical trends. In fact, 2020 earnings-per-share growth for US, developed-ex US, and emerging market regions have already been revised down by 1.8, 1.7, and 1.1 percentage points over the past two months, respectively.10 And once again, weakness at the sector level persists. Ten out of the 11 US sectors have lower estimated 2020 growth today than they did three months ago.
All this uncertainty surrounding US growth and broad-based valuations plotting in the top 86th percentile relative to history11 mean that the fundamental safety net has a few holes in it. Positive growth, a yield curve in stasis, and overvalued portions of the market may set the stage for a revival for value strategies — a factor style that has been mired in below-market performance for six out of the past seven years. However, while the inkling of a value rally began in September after momentum sold off, downside growth revisions and the broad-based scarcity — and quality — of growth remain the key risks to a full-on value revival.
Constructive valuations outside the US continue to be a siren’s song tempting contrarian investors to look past the sizable geopolitical risk impairing fundamental and economic growth. Yet this risk premium may require investors to put up with some pain along the way, as uncertainty driven by protests, Brexit, and Middle East unrest continues to percolate with widespread effect. After all, on a relative basis, both developed ex-US and emerging market (EM) equities have looked cheap for the past few years, as the US has hit numerous all-time highs while those markets have yet to climb past their 2007 peaks. In EM, perhaps the pain may be worth the premium, given the region’s already small weight in the standard asset allocation mix. In developed ex-US, the pain should be soothed by seeking to smooth volatility.
Will these issues weigh on future US equity returns? Well, hindsight is 20/20. In 85% of the periods, returns on US equities were positive six months after hitting all-time highs. As shown below, there has been a positive skew to subsequent returns of prior all-time highs. But drawdowns can occur when idiosyncratic events come out of nowhere, with volatility acting as a “drag” on returns.
Until organic growth returns, investors are faced with balancing risk while attempting to not miss out on any future gains. Rather than rebalancing to cash or allocating just to beta, these strategies range the volatility spectrum and can help you limit the impact of volatility while you pursue returns:
1 ) Balance downside and upside with diversified multifactor strategies
SPDR MSCI USA StrategicFactorsSM ETF targets lower volatility than the broader US equity market while retaining upside potential by adding Quality and Value factor exposures; creates a low-volatility strategy that focuses on firms with healthy balance sheets that trade at inexpensive valuations.
2 ) Add capital discipline with dividend growth strategies
SPDR S&P Dividend ETF screens for companies that have consistentlyincreased their dividend for at least 20 consecutive years, potentially providing an exposure to value-oriented, high-quality stocks that add resilience to a portfolio in an environment of uneven growth.
3 ) Minimize risk with pure low volatility strategies
SPDR SSGA US Large Cap Low Volatility Index ETF seeks to deliver ahigh exposure to the low volatility factor while not having sizable sector biases. This is accomplished by selecting the least volatile stocks by sectorand then weighting all stocks from that selection universe by the inverse of their variance.
Consider these two approaches to position equity portfolios defensively:
Our analysis of business cycle behavior of sectors based on changes in the Conference Board Leading Economic Indicator Index year-over-year declining since September 2018 indicates an economic slowdown. We found sectors that had performed well, on average, during past economic slowdowns since 1960 were Health Care and Consumer Staples, followed by Industrials.
Based on a sizable amount of academic literature on sector-rotation strategies and alternative weighted approaches seeking to minimize volatility,12 a low volatility sector portfolio can be created by analyzing recent volatility and market sensitivity metrics. An ensemble of six volatilitymetrics (3-Year Beta to S&P 500 Index, 1-Year Beta to S&P 500 Index, 3-Year Standard Deviation of Returns, 1-Year Standard Deviation of Returns, and 1-Year Downside Deviation) results in Utilities, Consumer Staples, Real Estate, Insurance, and Health Care as the five market areas for defensive technical-based portfolio.
1 Bloomberg Finance L.P. as of 11/7/2019. Past performance is not a guarantee of future results.
2 Bloomberg Finance L.P. as of 11/7/2019, calculations by SPDR Americas Research. Data back to 1926.
3 Bloomberg Finance L.P. as of 11/7/2019, calculations by SPDR Americas Research.
4 Bloomberg Finance L.P. as of 11/7/2019 based on a 60% MSCI ACWI IMI Index/40% Bloomberg Barclays US Aggregate Bond Index mix. rebalanced annually. In 2019, the 60/40 mix is up 15.0%. Past performance is not a guarantee of future results.
5 Bloomberg Finance L.P. as of 11/7/2019, calculations by SPDR Americas Research.
6 Bloomberg Finance L.P. as of 11/7/2019, calculations by SPDR Americas Research.
7 On December 22, 2017, the most sweeping tax legislation since the Tax Reform Act of 1986 was signed into law. The Tax Cuts and Jobs Act of 2017 (TCJA).
8 Real Estate and Materials have had an increase per FactSet as of 10/31/2019
9 Source: FactSet as of 11/7/2019 for firms in the S&P 500, MSCI EAFE, and MSCI Emerging Market Indexes
10 Source: FactSet as of 11/7/2019 for firms in the S&P 500, MSCI EAFE, and MSCI Emerging Market Indexes
11 Source: Bloomberg Finance L.P. as of 11/7/2019 based on a five factor ensemble of Price-to-Earnings, Price-to-Next-Twelve-Month-Earnings, Enterprise Value-to-EBITDA, Price-to-Book, and Price-to-Sales for the S&P 500 Index using data since 1990
12 Frank Leclerc, CFA, Jean-François L’Her, CFA, Tammam Mouakhar, CFA, and Patrick Savaria, CFA. 2013. “Industry-Based Alternative Equity Indices” Financial Analysts Journal, vol. 69, no. 2.
A specific decline in the stock market during a specific time period that is measured in percentage terms as a peak-to-trough move.
S&P 500® Index
A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
A graph or line that plots the interest rates or yields of bonds with similar credit quality but different durations, typically from shortest to longest duration. When the yield curve is said to be “flat,” it means the difference in yields between bonds with shorter and longer durations is relatively narrow. When the yield curve is said to be “steep,” it means the difference in yields between bonds with shorter and longer durations is relatively wide.
The views expressed in this material are the views of Michael Arone and Matthew Bartolini through the period ended November 15, 2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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