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President & CEO
Masood Vojdani began his career in the financial services industry in 1981. From the outset, he was driven by the vision of a firm that was different from the industry status quo. At the heart... Full Bio
“The market was up (or down) today,” says the financial news anchor. Almost invariably that comment will be followed by the daily performance numbers for the Dow Jones Industrial Average, and maybe also the S&P 500 and/or the NASDAQ Composite Index. Those three have become a kind of holy trinity of U.S. stock market benchmarks – a tangible shorthand for “the market”. In fact, though, these three benchmarks are very different from one another, with different performance dynamics. In reality, none of them constitute “the market” in its entirety, but rather each offers a partial view of that market. Consider the following chart:
Several Markets, Not One
This chart shows the relative performance of the NASDAQ Composite (green), the S&P 500 (blue), and the DJIA (red) from the beginning of July to the present. As you can see, performance has widely diverged between the three. The NASDAQ Composite appreciated by 14.9% over this period. The S&P 500 clocked in with a 9.2% price advance, while the Dow put up a significantly more modest 4.3% gain. We represent all three exposures by exchange traded funds that track the respective indexes.
This particular time period does not represent some kind of anomaly. Consider the following chart, which shows the relative performance of the S&P 500 and the Dow over the past three years. Again, both are represented by ETFs (IVV and DIA) that track the respective indexes. When the line is above the horizontal axis, it indicates outperformance by the Dow over the S&P 500, and vice versa when the line is below the horizontal axis.
The Dow is currently in a period of sharp underperformance versus the S&P 500, but back in late 2011 and early 2012 it was outperforming by roughly the same amount (about 6% on a one-year basis). When you think about it, this should really not come as a surprise. The Dow Jones Industrial Average is an index of 30 very large, blue-chip companies, and its components are weighted by price. The S&P 500 includes 500 large and large-to-mid cap companies, and is weighted by the market cap contribution of each member. That’s enough difference for us to expect that these performance differences should be the norm, not the exception.
The Limits of Benchmarks
The real message here, though, is that there are limits to the effectiveness of market benchmarks as a way to measure investment performance. Benchmarks can serve as a useful data point, by putting a context around performance in a given period. It is all too easy, though, to get hung up on a single benchmark as the ultimate performance arbiter. As these charts demonstrate, this is a flawed approach. If a manager of large cap U.S. stocks were to choose the Dow as a benchmark for the July-October 2013 period, she would have a much lower bar to clear than she would by using the S&P 500. Likewise a growth stock manager who invests in companies that tend to show up on the NASDAQ Composite would probably rather use the S&P 500 than the NASDAQ as a benchmark when the latter has performed so well. Benchmarking is by nature arbitrary and subject to misleading interpretation if relied on excessively.
Portfolio performance depends on a combination of factors, not just returns-based performance against one benchmark or another. Risk is a critically important factor – both absolute risk and risk relative to the market. Other factors include performance during drawdown periods, fidelity to a professed investment style, and correlations between different assets in a portfolio. In this multi-factor performance methodology, there is certainly a role for market benchmarks. But that should not be to the exclusion of other important factors.
What is a stock index? Essentially, nothing more than a relationship between the aggregate earnings of a group of companies and the price which investors are willing to pay to purchase those earnings. That relationship is expressed in the price-to-earnings (P/E) ratio. If XYZ Company’s net income for the last twelve months is $1 per share and the current stock price is $10, then investors are willing to pay $10 for every dollar of XYZ earnings – a P/E ratio of 10x. As new information comes into the public sphere, that new information will impact this relationship between price and earnings. Maybe XYZ Company is a biotech firm that just developed a revolutionary new therapy for a serious disease. So now investors are willing to pay $12 for every dollar of earnings, and the price of XYZ stock jumps 20% to $12. In theory, at least, that’s the way the stock market is supposed to work. It’s the basis of the efficient market hypothesis (EMH) taught to every aspiring financial professional.
Through the Looking Glass
The EMH, however useful it may be as a conceptual framework, breaks down in the messier, increasingly surreal world of day to day market trends and movements. Consider the following chart. This is the year-to-date stock price performance of JPMorgan, along with the LTM (last twelve months) P/E ratio:
The chart shows that, over the course of this year, JPMorgan stock trended upwards, with occasional pullbacks, while the P/E ratio fluctuated gradually as investors digested new information about earnings, litigation, the external economic context and other factors. Suddenly we see that, after the latest earnings release on October 11, the stock price rises sharply while the P/E ratio…well, the P/E goes through the roof. What’s this all about?
Bad News Is Bad, Except When It’s Good
Recall that for many months now, JPMorgan has been involved with the negative fallout from a rogue trader, known as the “London Whale”, whose perfidy in the derivatives market caused losses for the firm measuring in the hundreds of millions of dollars. Well, in their October 11 earnings statement, JPMorgan revealed a whale of an earnings surprise. The firm incurred a third quarter loss of $380 million as the accumulated litigation costs associated with the London Whale reached $9.2 billion – a much higher figure than had been anticipated. The market’s response to this decisively negative surprise was…to buy JPM stock like crazy! The P/E ratio went literally overnight from 45 to 56 because the numerator in the equation went way up and the denominator (the earnings) went way, way down. Investors essentially said this: “Yesterday I was willing to pay $45 dollars for every dollar of JPM earnings. Today, though, I found out that the company’s litigation mess is even worse than I had thought. So…today I’ll pay 56 dollars for each dollar of those earnings!”
Method in the Madness
Crazy, right? Well, there’s actually some method in the madness. We see this not just in counterintuitive responses to earnings surprises, but also in how asset prices react to all sorts of things; from the near-miss with the debt ceiling to parsing the monthly Fed minutes and so forth. The obvious outcome – a stock will go down if something bad happens – may not be so obvious after all. Maybe investors were relieved that the litigation wasn’t worse than $9.2 billion – a figure that while onerous doesn’t threaten to put the giant bank out of business. Maybe some giant high frequency trading algorithm was programmed to unleash a torrent of buy orders if the litigation came in anywhere less than $10 billion. Anything’s possible.
The important point is that this is the way markets work in this day and age. The fundamental relationship between price and value matters, but it’s far from the only thing that drives daily stock prices – contra the Efficient Market Hypothesis – and sometimes it doesn’t seem to matter at all. This knowledge is power. It facilitates the development of market strategies that allow for and anticipate spasms of irrationality as asset prices seek out and converge on value. Maybe markets aren’t supposed to work this way. But they do. If you’re in the business of managing money, you need to acknowledge and deal with that reality.
The depressing Washington sideshow is certainly not over. It appears that we have at least another six weeks of empty rhetoric and vainglorious posturing to endure while policymakers search for a clue about how to run the government and pay for things. But investors, weary of this unbecoming spectacle, are turning attention back to corporate earnings. We had our brief volatility flare-up this week, followed by an equally brief relief rally, and now it’s back to business. The 3Q earnings season is underway, and it will be an important gauge of where we are in the economic recovery.
The “Consensus Oracles”
To make sense of earnings season requires one to study that curious species of human known as the “consensus group”. These are professional analysts and economists who supply estimates about company revenues and earnings to media groups and market researchers. The watchword is “surprise”. If a company beats expectations, then it is a positive surprise. The company’s stock may then rally (but not necessarily, as we discuss below). Failing to exceed the estimates bar, conversely, can be a bad thing.
The Waltz of the Estimates
Looking at some data around recent quarters we are struck by how often a certain pattern repeats itself – a three-step estimates waltz, if you will:
Step 1: Early in the calendar year, the consensus group makes predictions about performance in each of the coming four quarters. The predictions are almost always rosier than the actual results turn out to be.
Step 2: As the reporting season approaches, the consensus estimate is revised downwards, often sharply.
Step 3: A majority of companies then wind up outperforming the downwardly revised estimates. “Positive surprises” abound, and everyone goes home happy…unless there are hints by company executives about some approaching bumps in the road. That’s known as “guidance” in earnings season parlance.
Reading the 3Q Tea Leaves
So earnings season is actually less a straightforward reporting of company performance and more a psychological puzzle about how the market will respond to this combination of evolving estimates, surprises and guidance. Take, for example, some of the current data as the 3Q season gets underway. The latest revision to consensus group EPS expectations for the quarter comes in at 3.4% below the estimate on July 1, according to FactSet. Bad, right? Maybe not. That 3.4% downward revision is actually less of a downward revision than the average going back to 4Q 2009. In other words, the consensus is less negative, in relation to its view three months ago, than it usually tends to be. Or something.
Earnings estimates are important, because they are the denominator of one of the most closely-watched valuation metrics – the forward P/E ratio. If forward estimates are too rosy then an attractive-looking P/E, i.e. where prices do not seem overvalued relative to earnings, can start to look less promising. We will be keeping a close eye on the tea leaves as they emerge from this earnings season.
In the past three years, event risk has become a dominant paradigm in market performance. We have seen the Eurozone crisis, political dysfunction in Washington, and the occasional geopolitical flare-up send markets into a brief, sometimes deep contraction. These events have then been followed by the other dominant paradigm of this day and age, the relief rally. The underlying problems never really get fixed, but enough is done to prevent the worst case scenario from happening. Oiling the wheels of the relief rally are the constant ministrations of the Federal Reserve through its monetary stimulus measures. With this context in mind, let’s look at the latest “event” to force itself upon us: the US government shutdown; and the latest incarnation of the policy folly otherwise known as the debt ceiling.
Not Your Usual Event Risk Cycle
In our Market Flash last week we talked about the volatility gap, an indicator of a relatively calm attitude by investors towards the shutdown. When the event actually happened this week we did see a rise in the VIX index – the market’s so-called “fear gauge” – but a muted one. Consider the following chart:
Here is the key thing to focus on with this chart (apart from the wry fact that the market rallied on the day the shutdown began). With two key events in the mix – the Fed’s non-taper decision and the shutdown / debt ceiling crisis – as of yet there is not one single day in which the S&P 500 dropped by1% or more. In the world of event risk that is quite rare. The cycle certainly has been negative: as of the market close on 10/3 the index ended in negative territory for eight of the last ten days (as we write this piece on 10/4 equities are rallying, though). But the absence of extreme one-day drawdowns distinguishes this cycle from others, including Bernanke’s initial use of the word “tapering” in May, the post-election fretting over the fiscal cliff last November, and the succession of Eurozone flashpoints stretching back into 2011 and 2010.
What Happens Next?
We believe it is likelier than not that the political stalemate will be resolved at some point before Uncle Sam goes into default, i.e. sometime between now and the 17th of this month. The votes are there – the shutdown could end tomorrow and the debt ceiling could be raised with votes that currently exist in both the House and the Senate. Procedural logjams are preventing the facilitating bills to come to the floor. Those CNN soundbites floating out of the television are certainly vicious and personal, but we do not see the congressional leadership letting this get to the point where we actually go off the default cliff. House Speaker Boehner, through whom any bill has to pass in order to be voted on, has said as much.
Will There Be a Relief Rally?
The rather muted reaction to the latest events at play may keep a lid on the usual burst of enthusiasm that sends share prices soaring when it becomes clear that Armageddon once more is not happening. The S&P 500 has already gained around 20% for the year to date- sizable for a year in which economic growth remains modest and company earnings less robust than forecast at the outset. More likely than a giant relief rally, in our opinion, would be a moderate continuation of recent market-driving trends, such as cyclicals, non-US names and mid-small caps. The fourth quarter is often a momentum quarter, as money managers try to get their portfolios in line with the assets that are performing best ahead of year-end.
Nothing is certain, of course. There may be other X-factors that emerge in this present event cycle, or other events that pop into existence before the end of the year. As always, we have to stay vigilant and positioned for whatever possibilities present themselves.
Last week we wrote about “taperphobia” in the wake of the Fed’s decision to back off from plans to start reducing the size of its QE3 monetary stimulus program. After that announcement on September 18, the S&P 500 jumped 1.2%, and then gave back all those gains and more over the course of the next five trading days. Yet the pullback has been relatively gentle as pullbacks go, at least so far. More interesting still is what we call the “volatility gap”. This gap is a measure of the relationship between stock market prices and risk, with the latter being represented by the CBOE VIX index. The larger the gap, the calmer the markets. Here’s how the volatility gap looks as of this writing (afternoon on Thursday 9/26):
The green vertical line indicates that the volatility gap is about as wide as it has been any time this year. Curiously, this comes at a time when a handful of uncertainties loom. In addition to ongoing confusion over the Fed’s non-decision last week, we have the specter of a possible government shutdown come Tuesday next week, and more brinksmanship over the debt ceiling to follow almost immediately thereafter. Is this collective yawn by investors a clever calling of the government’s bluff, or are we in for a nasty October?
Been There, Seen That
There is clearly a rational case to make for calling Washington’s bluff. When the debt ceiling theatrics bubbled up in the summer of 2011, it marked the first time that a normally routine decision involving the legislative and executive branches became an acrimonious political football. For a while it seemed genuinely, stunningly possible that the United States would default on its outstanding obligations. But now these dismal sideshows are a permanent part of the landscape. Sequestrations, fiscal cliffs and budget impasses haunt us at regular intervals. Each time some quick fix is applied so that the worst case scenario does not prevail. Viewed in this context, perhaps the volatility gap is not so curious after all. Investors expect that, regardless of how many Senators posture their way through the midnight hours on an oratory soapbox, and regardless of the slings and arrows of partisan vitriol, life and markets will go along more or less as normal.
Corporate Earnings: Trick or Treat?
If we do manage to jump through the hoops of Washington dysfunction, we still have to contend with the onset of corporate earnings season. Consensus 3Q earnings estimates for the S&P 500 are currently at 3.5%. That’s quite a bit lower than they were at the end of the first quarter. The 3Q consensus as of March 31 was 9.5%, reflecting a gradual souring of analysts’ views of the sales & profits landscape across most industry sectors over the ensuing time. It will be important to see early signs of companies at least able to meet, if not surpass, these lowered expectations.
Follow the Signals
The volatility gap is an important market signal. Continued tameness in this metric would indicate to us that a handful of present trends – including outperformance by cyclical industry sectors over defensives and non-US stocks over US names – may supply a tailwind to take us into year-end. However, as the above chart shows, the volatility gap can also reverse course very quickly. Our outlook remains oriented towards the optimistic. However there are enough potential tricks along the path to keep our attention fully engaged.