Elevated cross-asset volatility and shifting macro forces have created a more complex market environment in 2022. Sentiment has been impaired and risk-on attitudes have faded, following three consecutive years of gains and limited outsized moves in 2021.
As a result of the multiple dimensions of risks converging on top of one another, equities are down significantly this year — evidenced by 70% of global stocks trading in a bear market.1 But the equity drawdown has not greatly improved overall valuations. Broad-based valuations are now near long-term averages based on price-to-earnings ratios, but still well above historical averages based on price-to-sales and price-to-book metrics.2
The complexity of this current environment can also be quantified by comparing current implied volatility levels; the CBOE VIX Index has averaged 25.7 in 2022, versus its long-term average of 19.5.3 And the average percentile rank for measures of implied equity, as well as bond, currency, and oil volatility, are all above the 80th percentile — reinforcing how widespread risks have become.4
But with earnings sentiment waning, as evidenced by upgrade/downgrade trends, fundamental volatility has picked up — making firms’ cash flow strength extremely important for performance.
Adding fundamental risk to multiple macro risks, requires placing greater emphasis on attractively valued firms that exhibit lower relative fundamental volatility. These quality firms that offer more durable balance sheets with little leverage and low earnings growth variability may be well positioned for more consistent growth.
Realized volatility metrics further illustrate this complex risk regime. For example, the S&P 500 Index has posted a daily gain or loss of more than +/-1% 49 times so far this year.5 That averages at least nine moves a month — more than twice that of last year and the historical monthly average of four.
In another deviation from historical norms, 57% of these outsized moves were negative when typically there are more upside 1% moves in a year. And notably, the current 57% is greater than what we saw in 2020 at the start of the pandemic (41%), in 2018 when the S&P 500 Index last posted a yearly loss (50%), and during the Great Financial Crisis (56%). It also exceeds the historic yearly average of 47%.6
Moreover, the last time there was a higher percentage of downside 1% moves was 20 years ago in 2002 — a year when the market, reeling from the pop of the dot-com bubble and increased geopolitical risk from the 9/11 attacks, fell by 23%.7 While this does not forecast a dot-com 2.0, the performance of certain segments is similar, underscoring how the market is now trading more on fundamentals than narratives.
The handover from the narrative market where “stock stories” featuring grandiose proclamations of revolutionary growth took precedent over actual sales coincides with a reduction in liquidity8 and higher hurdle rates (e.g., increasing real rates). This is most apparent within unprofitable high tech.
Non-profitable high-tech growth stocks are down 40% on average this year.9 Meanwhile, profitable high tech is down 17%, in line with the return of the S&P 500 Index. The same trend emerges when analyzing the market, beyond high tech.
Overall, non-positive earnings-per-share firms are down 35% in 2022. Meanwhile, positive earnings firms are down just 14% —better than the overall market. In fact, positive earnings firms have now outperformed negative earnings firms every month since June 2021, as shown in the following chart. This trend is a strong sign of increasing fundamental volatility, as high cash flow firms are more in favor than high cash burn-rate firms.
Performance Trends of Positive Earnings-per-Share Firms versus Negative Earnings-per-Share Firms
This emphasis on the quality of growth, and not just profitability, is reinforced by a concentrated basket of quantitatively screened high quality firms outpacing low quality by nearly 5% this year.10 Similar to the prior analysis on profitability, concentrated long quality has outperformed concentrated short quality in nine out of the past 12 months.11
Performance, of course, is a byproduct of the fundamental backdrop. And the trends in analyst upgrades-to-downgrades provide another example of the market entering a more uneven fundamental environment. As shown in the following chart, the number of analysts upgrading 2022 earnings-per-share (EPS) estimates is essentially equivalent to the number of downgrades for US firms. And this ratio has been declining monotonically over the past five months. The US, however, is a beacon of strength compared to the rest of the world, as its ratio is the only major region above 1 — where it has been for some time.
2022 EPS Revision 3-Month Up-to-Downgrade Ratio
Lower than expected growth in those regions — +6% for developed ex-US stocks and +1.5% for emerging markets (EM) — compared to US firms’ +10% earnings-per-share growth12 make the US our favored market, followed by developed ex-US.
The case for EM is quite challenged right now, outside of it representing a value play. But sometimes things are cheap for a reason, and sluggish growth and weak sentiment, combined with heightened geopolitical risk, make EM a difficult overweight at the moment.
For those tempted to catch this falling knife, keep in mind that EM has been in bear market (a 20% decline) on 22% of the days over the past 10 years13 — leaving those who tempted fate empty-handed. And over the past decade, EM has underperformed developed markets in 85% of the rolling five-year periods.14
Analysts are not the only ones downgrading expectations. Firm guidance has been weaker as well. Following the most recent quarter results, more than 70% of S&P 500 firms have issued negative guidance.15 This is above the 60% historic average.16 As a result, earnings expectations for the second quarter have declined from 5.9% to 4.6%.17 Earnings surprises have also been lackluster, as firms have beat Q1 estimates by just 4.9%.18 This is below the historical 5-and-10-year averages of 8.9% and 6.5%, respectively.19
Revenue trends are better, with surprise rates above long-term averages. The same is true for growth.20 Yet, as a result of margin compression, earnings are being hit harder. Net margins have declined for three subsequent quarters and in the most recent quarter, 50% of firms in the S&P 500 had margins decline from one year ago.21 This margin weakness stems from higher input costs, reinforced by the fact that 85% of firms reporting in Q1 mention inflation — the most ever.22 This risk was most crystalized by severely weak earnings reports from consumer goods and large retail firms in late May.23
With weaker sentiment, firms that are unable to beat lowered estimates have been punished more than usual — falling 5.1% the day after releasing results compared to a five-year average one-day decline of 2.3%.24 This trend further reinforces the rise of more fundamental-led volatility and the need to mitigate this non-macro related risk moving markets.
With waning sentiment, having a bias toward firms with more fundamental durability may be additive. However, while valuations for quality stocks have re-rated amid the recent broader market turmoil, the premium for quality balance sheets still exists.
Based on a six-factor composite valuation metric, pure quality strategies have a current valuation that sits in their own historical 67th percentile.25 The premium for quality based on this composite metric is also five percentage points above its historical average. However, on a relative basis to the market, the average percentile rank of quality’s premium to the market is right at the median of 50%.26 As a result, across each of the metrics, the average relative premium to the market currently is actually four percentage points lower than the historical average premium for quality (23% versus 27%).27
With these results, it is clear that valuations for quality are neither supremely rich or cheap. Value, however, still screens as attractive — even after outperforming the market by more than 7% and growth stocks by 23% so far this year.28
If we use the same six-factor composite valuation metric, value stocks trade in the historical 18th percentile relative to their own history and 9% lower than their average rate.29 On a relative basis, value is equally as attractive. It sits in the 37th percentile with a discount to the market of -31%, greater than the historical average discount of -21%.30 In fact, four out of the six metrics are all trading at a discount relative to their own history. And on a relative basis, as shown in the following chart, every metric is in the bottom quartile.
Relative Valuation Metrics versus Historical Levels
The case for value can be expanded beyond the current relative fundamental ratios. There is also a macro case to be made. Over the past 30 years, growth stocks’ monthly excess returns to the broader market have had a negative correlation to changes in interest rates (-17%), whereas value excess returns have been positively correlated (+18%).31
With the prospect for higher rates resulting from tighter monetary policy, longer-duration growth exposures (cash payments further out in maturity like a long-duration bonds) could be further challenged on a total return basis.
Given these dynamics, blending these two exposures together could be additive from an earnings durability perspective (the quality side) while also tempering overall valuations (the value component). And as of right now, for a US blend, the combined current relative valuation level is a -4% discount to the market, a nine percentage point improvement compared to the historical average relative valuation premium of +5%.32
For high-quality value stock exposures, consider:
A multi-factor blend that includes quality and value
A dividend strategy that includes a rigorous screen on fundamental sustainability
A pure value exposure that holds only positive earnings-per-share firms
1 Bloomberg Finance, L.P. as of May 18, 2022 based on the MSCI ACWI IMI Index.
2 Bloomberg Finance, L.P. as of May 18, 2022 based on the S&P 500 Index for data from 1990 to 2022.
3 Bloomberg Finance, L.P. as of May 16, 2022.
4 Bloomberg Finance L.P. as of May 16, 2022 based on SPDR Americas Research calculations where Currency-implied volatility is measured by the J.P. Morgan Global FX Volatility Index. Rates-implied volatility is measured by the MOVE Index. Oil-implied volatility is derived from oil future contracts over the last three years.
5 Bloomberg Finance, L.P. as of May 18, 2022 based on SPDR Americas Research calculations of the daily returns for the S&P 500 Index.
6 Bloomberg Finance, L.P. as of May 18, 2022 based on SPDR Americas Research calculations based on SPDR Americas Research calculations of the daily returns for the S&P 500 Index.
7 Bloomberg Finance L.P. as of May 18, 2022 based on SPDR Americas Research calculations of the daily returns for the S&P 500 Index.
8 “Wall Steet Warns Stock-Bond Liquidity Is Getting as Bad as 2020”, Bloomberg May 17, 2022.
9 Based on the underlying holdings of funds classified by SPDR Americas Research as Broad Innovation funds within the thematic ETF marketplace as of May 18, 2022 per Bloomberg Finance L.P. data and SPDR Americas Research calculations.
10 Based on the Nomura US Quality Long and Short Basket Indexes as of May 18, 2022 per Bloomberg Finance L.P. data.
11 Based on the Nomura US Quality Long and Short Basket Indexes as of May 18, 2022 per Bloomberg Finance L.P. data.
12 Based on the earnings estimate for the S&P 500 Index, MSCI EAFE Index, and MSCI EM Index per FactSet data as of May 16, 2022.
13 Based on the performance of the MSCI EM Index per Bloomberg Finance L.P. data as of May 16, 2022.
14 Based on the performance of the MSCI EM Index relative to the MSCI World Index per Bloomberg Finance L.P. data as of May 16, 2022.
15 FactSet as of May 16, 2022.
16 FactSet as of May 16, 2022.
17 FactSet as of May 16, 2022.
18 FactSet as of May 16, 2022.
19 FactSet as of May 16, 2022.
20 FactSet as of May 16, 2022.
21 FactSet as of May 16, 2022.
22 FactSet as of May 16, 2022.
23 “Target Pummeled in Worst Rout Since Black Monday as Margins Sag”, Bloomberg May 18, 2022; “Dollar Tree, Costco, Dollar General Shares Decline After Retail Giants Reported Higher Costs in Earnings”, Bloomberg May 18, 2022
24 FactSet as of May 16, 2022.
25 Based on a composite of six metrics for the MSCI USA Quality Index using price-to-book, price-to-earnings, price-to-next-twelve-months earnings, price-to-cash-flow, enterprise value-to-sales, and price-to-sales ratios from 2013 to 2022.
26 Based on a composite of six metrics for the MSCI USA Quality Index and the S&P 500 Index using price-to-book, price-to-earnings, price-to-next-twelve-months earnings, price-to-cash-flow, enterprise value-to-sales, and price-to-sales ratios from 2013 to 2022.
27 Based on a composite of six metrics for the MSCI USA Quality Index and the S&P 500 Index using price-to-book, price-to-earnings, price-to-next-twelve-months earnings, price-to-cash-flow, enterprise value-to-sales, and price-to-sales ratios from 2013 to 2022.
28 Based on the return of the MSCI USA Value Weighted Index, the S&P 500 Growth Index, and the S&P 500 Index as of May 16, 2022 per Bloomberg Finance L.P. data.
29 Based on a composite of six metrics for the MSCI USA Value Weighted Index using price-to-book, price-to-earnings, price-to-next-twelve-months earnings, price-to-cash-flow, enterprise value-to-sales, and price-to-sales ratios from 2013 to 2022.
30 Based on a composite of six metrics for the MSCI USA Value Weighted Index and the S&P 500 Index using price-to-book, price-to-earnings, price-to-next-twelve-months earnings, price-to-cash-flow, enterprise value-to-sales, and price-to-sales ratios from 2013 to 2022.
31 Bloomberg Finance, L.P. as of May 16, 2022, based on the correlation of the monthly excess returns of the S&P 500 Growth Index to the S&P 500 Index to the changes in the US 10-year yield as well as the monthly excess returns of the S&P 500 Value Index to the S&P 500 Index to the changes in the US 10-year yield from 1991 to 2022 based on SPDR Americas Research calculations.
32 Based on a composite of six metrics for the MSCI USA Quality Index and the MSCI USA Value Weighted Index using price-to-book, price-to-earnings, price-to-next-twelve-months earnings, price-to-cash-flow, enterprise value-to-sales, and price-to-sales ratios from 2013 to 2022.
CBOE Volatility Index (VIX)
The index is a measure of the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.
The speculative stock-market run-up of the late 1990s that grew out of excitement about the potential of the Internet. While companies such as eBay and Amazon were born in this period, countless other start-ups with vague business plans and no profits were funded by investors dreaming of winning big. The fervor peaked on March 10, 2000, and a nearly three-year bear market followed.
A specific decline in the stock market during a specific time period that is measured in percentage terms as a peak-to-trough move.
Earnings per Share (EPS)
A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.
Emerging Markets (EM)
The economy of a developing nation that is becoming more engaged with global markets as it grows. Countries classified as emerging market economies are those with some, but not all, of the characteristics of a developed market. As an emerging market economy progresses it typically becomes more integrated with the global economy, as shown by increased liquidity in local debt and equity markets, increased trade volume and foreign direct investment, and the domestic development of modern financial and regulatory institutions.
A strategy that focuses on companies that have the potential to grow their earnings at a high rate.
The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets.
The ability to quickly buy or sell an investment in the market without impacting its price. Trading volume is a primary determinant of liquidity.
MSCI EAFE Index
An equities benchmark that captures large- and mid-cap representation across 22 developed market countries around the world, excluding the US and Canada.
MSCI Emerging Markets Index
The MSCI Emerging Markets Index captures large and mid-cap representation across 23 emerging markets countries. With 834 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Price-to-Book Ratio (P/B Ratio)
A valuation metric that compares a company’s current share price against its book value, or the value of all its assets minus intangible assets and liabilities. The P/B is a ratio of investor sentiment on the value of a stock to its actual value according to the Generally Accepted Accounting Principles (GAAP). A high P/B means either that investors have overvalued the company, or that its accountants have undervalued it.
Price-to-Earnings Ratio (P/E Ratio)
A valuation metric that uses the ratio of the company’s current stock price versus its earnings per share.
Characterized by firms with strong balance sheets and high profitablity
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
Characterized by lower price levels relative to fundamentals, such as earnings.
The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
The views expressed in this material are the views of Michael Arone and Matthew Bartolini through the period ended May 18, 2022 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.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
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Investing involves risk including the risk of loss of principal.
Diversification does not ensure a profit or guarantee against loss.
Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
Volatility management techniques may result in periods of loss and underperformance may limit the Fund's ability to participate in rising markets and may increase transaction costs.
The value style of investing that emphasizes undervalued companies with characteristics for improved valuations, which may never improve and may actually have lower returns than other styles of investing or the overall stock market.
Low volatility funds can exhibit relative low volatility and excess returns compared to the Index over the long term; both portfolio investments and returns may differ from those of the Index. The fund may not experience lower volatility or provide returns in excess of the Index and may provide lower returns in periods of a rapidly rising market. Active stock selection may lead to added risk in exchange for the potential outperformance relative to the Index.
A “quality” style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on “quality” equity securities are less than returns on other styles of investing or the overall stock market.
A non-diversified fund may invest in a relatively small number of issuers, a decline in the market value may affect its value more than if it invested in a larger number of issuers. While the Fund is expected to operate as a diversified fund, it may become non-diversified for periods of time solely as a result of changes in the composition of its benchmark index.
Passively managed funds hold a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions.
Derivative investments may involve risks such as potential illiquidity of the markets and additional risk of loss of principal.
Foreign (non-U.S.) securities may be subject to greater political, economic, environmental, credit and information risks. Foreign securities may be subject to higher volatility than U.S. securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.
Value stocks can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.
Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations.
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