Could a Fed Rate Cut Be Bearish?

Bbg Rate Cut Prob

After the S&P 500 suffered one of its worst May’s in decades, stocks are rallying so far in June on expectations the Federal Reserve is about to cut interest rates. The next Federal Reserve Open Market Committee meeting is set for June 19, 2019. Based on the Bloomberg World Interest Rate Probability screen (WIRP), markets are pricing in a 20% chance for a rate cut next week, an 84% chance in July, and a more than 94% chance of a rate cut in September.

Beware the Fed Pause and Reverse.

Should investors expect a new equity bull market after a rate cut? We looked at past interest rate cycles most like the current environment, periods when the Federal Reserve began a series of interest rate increases over multiple quarters, paused for multiple quarters, then began a series of rate cuts. It turns out this kind of “pause and reverse” from the Fed is quite rare. Since 1972 there have only been two similar periods. The forward 3, 6 and 12 month returns for the S&P 500 were negative each time.

Fed Pause Reverse

Maybe It’s Different This Time. Maybe Not.

Markets have faced a similar environment only twice in the past 47 years, both resulting in recession and costly bear markets. Two examples are certainly not a large sample size, and of course it could be different this time. But investors expecting a Fed rate cut to automatically result in higher equity prices may be headed for disappointment. A Fed “pause and reverse” may indicate it’s time for advisors to be sure they have a solution for risk management in their asset allocation.

 

For more than twenty years, Anchor Capital has been at the forefront of risk-managed investment strategies designed to help advisors and their clients be more confident in reaching their goals. Anchor Capital is a SEC-registered investment adviser located in Aliso Viejo, CA with over $800M in assets under management. Our investment team has a combined 40 years of experience in the research and execution of quantitative trading disciplines, risk management, and alternative investment strategies.

 

A Roadmap for Defensive Investing

Winding Road

While the 2019 market rebound has undone much of the damage from 2018’s year-end drubbing, the brutal selloff offers a key reminder for investors about portfolio management, specifically the importance of having defensive exposures.

The selloff from October 3rd to December 24th dragged the S&P 500 Index down by 20% and the Russell Small-cap index more than 24% (Source: Bloomberg). This was driven primarily by fears of continued rate hikes by the Federal Reserve, valuation concerns and worries about a global growth slowdown.

These large draw-downs are a far cry from the relatively quiet markets seen in recent years, which drove investors to seek exposures to pro-cyclical market areas such as momentum stocks or high yield credit. As investors adjust to a lower growth paradigm, investors may want to consider exposures that either offer limited downside protection such as minimum volatility strategies or that move less in sync with equity and bonds such as in commodities

ETF Flows

Indeed, investors are taking notice of the importance of defensive positioning. Even with the rebound in stocks this year, our research shows that flows into defensive exchange traded products are outpacing flows into all products as a percentage of assets under management.  U.S. listed fixed income ETFs have garnered nearly twice as much as equity flows year to date. Minimum volatility strategies are attracting the biggest flows this year among factors, gaining $5.78 billion, while momentum has seen nearly $0.6 billion in outflows (Source of flow data: Markit, BlackRock as of March 14, 2019.)

Building a buffer

Here are a few ways investors can add targeted defensives exposures to their portfolios.

1. Equities

Minimum volatility strategies historically have reduced risk in down markets compared to the broader market and Q4 2018 was no exception. The MSCI USA Minimum Volatility Index outperformed the S&P 500 Index by more than 600 basis points (bps, or 6%) in the fourth quarter of 2018. Min vol also worked well in other regions: The MSCI Emerging Markets Minimum Volatility Index outperformed the MSCI Emerging Markets Index by more than 900 bps in 2018.[1]It is worth noting that minimum volatility strategies historically have tended to perform well both in growth slowdowns and in outright recessionary market conditions. Investors may also want to consider high quality dividend paying stocks, which can offer potential income as well as some resilience in down markets as well as adding so-called “safe haven” countries such as Switzerland and Japan.

2. Fixed Income

The Federal Reserve has raised interest rates nine times since the tightening cycle began 2015. Investors, who were looking to take advantage of those hikes added exposures to short-term fixed income assets. However, with the market expecting just one more rate hike 2019, investors concerned with slowing growth or geopolitical turmoil may want to consider longer duration Treasurys (ten years or longer). Historically, these have offered some buffer for portfolios in serious market downturns, as well as a chance to potentially pick up some extra yield.

3. Commodities

Historically, commodities have tended to provide meaningful diversification and inflation hedging benefits.

Correlations

For example, from April 1991 to March 2019, the annual returns of the S&P GSCI Index have had just a -0.13 correlation to the US Treasury 10 year benchmark index and a 0.25 correlation to the S&P 500 Index.[2]

In addition, many commodity assets, such as gold, are priced in dollars, and historically have performed in line with an increase in inflation expectations. Therefore, they may serve as an inflation hedge in a portfolio. In the current environment we don’t expect a major increase in inflation, but holding inflation hedges.

Some may question where cash fits into a defensive portfolio: While investors generally hold relatively high levels of cash, as the BlackRock Investor Pulse survey has shown, this buffer is increasingly being reallocated to other high quality fixed income options such as U.S. Treasuries as a way to earn incrementally higher yield.

Let’s be clear: Seeing your portfolio decline in value is never fun, and losing less money than the market at large offers little solace. But over the long term, creating a buffer from the downswings – known as “downside protection” can add value to a portfolio.

There’s an old saying, “You should fix your roof when the sun shines.” We don’t expect a recession in 2019, we still believe stocks will continue to climb and we prefer them over bonds. But the kind of volatility we saw in the fourth quarter could reappear, the result of any number of unforeseen events. When or if that occurs, it would be wise to ready.

 

Chris Dhanraj is the Head of the iShares Investment Strategy team and a regular contributor to The Blog.

 

[1] Source: Bloomberg, as of 12/31/18.

[2] Correlation measures how two securities move in relation to each other. Correlation ranges between +1 and -1. A correlation of +1 indicates returns moved in tandem, -1 indicates returns moved in opposite directions, and 0 indicates no correlation.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes than the general securities market. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

Investing in commodity-linked derivatives and commodity-related companies may increase volatility. Price movements are outside of the fund’s control and may be influenced by weather and climate conditions, livestock disease, war, terrorism, political conflicts and economic events, interest rates, currency and exchange rates, government regulation and taxation.

A fund’s use of derivatives may reduce a fund’s returns and/or increase volatility and subject the fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. A fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited.  There can be no assurance that any fund’s hedging transactions will be effective.

Diversification and asset allocation may not protect against market risk or loss of principal. The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.  The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by S&P Dow Jones Indices LLC, nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with S&P Dow Jones Indices LLC.

The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2019 BlackRock. iSHARES and BLACKROCK are registered trademarks of BlackRock. All other marks are the property of their respective owners.

Stocks are Cheap(ish)

Tags

With the exception of a few, hardy centenarian traders, nobody has ever witnessed a December like the one that just ended. A difficult year ended with a collapse in equities as investors began to discount a growing possibility of an economic slowdown. Globally stocks fell roughly 8%, leaving every major index in the red for the year. The silver lining, to the extent there was one, was that December’s rout left stocks the cheapest in years and early January saw stocks rise. That said, are stocks truly cheap? A few observations:

1. The big bargains are still outside the United States.

The broadest global equity index, the MSCI All Country Index, closed December at just under 15 times trailing earnings, the lowest valuation since mid-2012. However, the majority of that discount is coming from international markets. Looking at the ACWI-ex U.S. Index the valuation is less than 13 times earnings, a 32% discount to the 2017 peak. However, U.S. valuations are another story. While the trailing multiple on the S&P 500 is down more than 20% from last year’s peak, it has only reverted back to the post-crisis average.

2. Stocks look cheap versus bonds, less so after accounting for deteriorating financial conditions.

Stocks, including in the United States, look cheap if you adjust for interest rates. The Equity Risk Premium, the differential in expected yield on stocks versus bonds, is well above average, suggesting stocks look cheap relative to bonds. That said, stocks look less compelling if you believe that financial conditions will continue to tighten. Looking at U.S. valuations versus market volatility or broader financial conditions suggests lower valuations are consistent with dearer money and more volatile markets.

3. Cyclicals looks cheap, defensives less so.

Equity Valuation By Sector

Looking at valuations both on an absolute level and relative to history, the cheapest sectors are financials, energy, materials, industrials and consumer discretionary (see Chart 1). Real estate, consumer staples and healthcare show up as the most expensive. Interestingly, not only are the defensive sectors expensive on an absolute basis, but in the case of real estate and healthcare they are still trading slightly above their 10-year average. The takeaway: With evidence growing that the economy is slowing, investors have been willing to pay up for names perceived as less economically sensitive.

Given these nuances, how should investors position their equity portfolio? I would advocate a barbell approach, one that includes more cash while bottom-fishing in beaten-up cyclicals. My logic is that the last 12 months are best characterized as a rolling bear market. In other words, investors have successively punished various segments, starting earlier in the year with emerging markets. Interestingly, it was the most beaten up segments, notably emerging markets and Europe that outperformed during December’s carnage. As such, select EM equities or perhaps European energy companies look particularly cheap and interesting. At the same time, some of the segments investors have been flocking to, notably defensives, still look a long way from cheap.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog. 

 

Investing involves risks, including possible loss of principal.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 2019 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2019 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Technology “Bubble” Fears Don’t Hold Up

3D Rendering, old tv sets

Upon hearing of his obituary, Mark Twain famously quipped, “The reports of my death are greatly exaggerated.” A similar rebuke could be used for those claiming that technology stocks are back in bubble territory.

While technology stocks are having another stellar year in an otherwise languid market, their outperformance has been driven primarily through stellar earnings, not obscene multiple expansion. Since the start of 2010, the trailing price-to-earnings ratio (P/E) for the S&P 500 Technology Sector Index has risen approximately 20%, only slightly faster than the 14% for the S&P 500 Index. A quick look at top-line valuations confirms that 2018 is not the late ’90s redux.

1. Absolute sector valuation is below average.

At 23 times trailing earnings, the sector is trading at a discount to the long-term average of 28. To be fair, the long-term average is distorted by the bubble years, when the sector traded as high as 70 times earnings. Using the median, a statistical measure less influenced by outliers, suggests that today’s valuation is right in line with the long-term norm.

2. Relative value also looks reasonable.

SP500 Relative Valuation

The technology sector trades at an 11% premium to the broader market. While this is up from a couple of years ago when the sector traded at a small discount, the current premium appears very reasonable in light of recent history. Again, excluding the bubble years, the current relative valuation is actually a bit below the 15-year average (see Chart 1). Using cash-flow rather than earnings provides a similar picture: On a P/CF basis the sector is trading at about an 18% premium to the market, below the historical median of 30%.

3. The sector remains very profitable.

With a return-on-equity of 20%, the sector remains profitable relative to both its history as well as the broader market. The current return on equity is six percentage points above the broader marketThis compares favorably to the long-term median of around four percentage points.

Vulnerable to disruption

To be clear, every technology company remains vulnerable to being disrupted by a slightly more clever version of itself. A sobering reminder of this reality: On the eve of the financial crisis, Nokia’s smartphone market share was approximately 45%, the iPhone was less than one year old and Facebook was barely out of the dorm room. Pessimists will see this as a sign that the sector’s premium is unwarranted given the accelerating pace of innovation.

Although the pessimists have a point, the overall sector continues to be extraordinarily profitable, and, despite rumors to the contrary, reasonably valued. In an environment in which every company, in and outside tech, is vulnerable to being blindsided by an unheard of competitor or innovation, the tech sector is still delivering. It is worth a modest premium.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.  Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes and than the general securities market.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2018 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Money Is Still Cheap Enough to Support Stocks

Wooden economy and currency unit on a craft background; Shutterstock ID 121452739

Recently, U.S. interest rates hit multi-year highs and the dollar came back from the dead. From the February low to Monday’s high the DXY Dollar Index gained approximately 6.5%. At the same time, long-term U.S. interest rates are back to their early 2014 peak; two-year Treasury rates are at their highest level in roughly a decade. Together, higher rates and a dearer currency both represent a tightening of financial market conditions.

Still, despite these developments stocks have bounced, with the S&P 500 up 5% from the May low. How is it that stocks are rallying despite tighter financial conditions? Strong earnings are part of the answer. But apart from a stellar earnings season, the simple truth: Financial conditions have actually become easier in recent weeks.

According to two measures of financial conditions maintained by the Chicago and St. Louis Federal Reserve Banks, financial conditions have eased in recent weeks. There are three reasons financial conditions have actually gotten easier.

1. The dollar is still down year-over-year

While the dollar rally has been abrupt, it has also been short-lived. The dollar has advanced roughly 5% between mid-April and mid-May, but that rally only puts it back to where it was in mid-December. On a year-over-year basis the dollar is still down approximately 4% (see Chart).

Trade-Weighted Dollar

2. Credit conditions remain benign

Equity market volatility in February and March never did spread to credit markets. As a result, high yield spreads remain extraordinarily low, approximately 180 basis points below the 20-year average. Unlike during the growth scare in early 2016, credit markets have remained remarkably calm throughout the recent bouts of volatility.

3. Equity volatility has fallen

Although the February and March spikes in volatility were an “equities-only” affair, even that has calmed down. While volatility remains elevated relative to last year’s comatose levels, the VIX has “mean reverted,” or dropped back closer to average. Since the start of the month the VIX has averaged approximately 14. In comparison, implied equity volatility averaged 20 in February and March.

The resilience of equities

The fact that financial conditions have actually eased goes a long way towards explaining the resilience of equities. As I’ve discussed in previous blogs, the price investors are willing to pay for a dollar of earnings is in large part driven by the cost and availability of money, i.e. financial conditions.

Historically, easy financial conditions, particularly low volatility, have been associated with higher valuations. Depending on the exact measure used, in the post-crisis environment the level of financial conditions has explained between 25% and 35% of the variation in the S&P 500’s price-to-earnings multiple.

In other words, while U.S. stocks are still not cheap, a premium valuation is easier to maintain in a world of still cheap money and low volatility.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts.

There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2018 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Swimming With Dolphins

Pier

Markets lately have resembled a dolphin at sea, leaping and diving in spectacular fashion. Observers often don’t know where to look for the dolphin next. In recent weeks, the same can be said of markets, leaping up at night before crashing down the next morning.

So how should you play these non-directional markets? In my opinion, you shouldn’t. Leave that to short-term traders and computer algorithms. But if your intent as an investor is to seek solid returns over the long term in order to pay future college expenses or fund a comfortable retirement, you need to ask yourself the following questions:

  1. Do headlines from Washington or Wall Street really matter? The answer, after years of sifting through empirical data is no. Headlines matter to voters, but rarely to investors. And in my view, they aren’t correlated with returns.
  2. Then what is correlated with long-term returns? In my experience it’s free cash flow generation and free cash flow yield.
  3. What drives free cash flow? To my way of thinking, free cash flow is driven by economic growth, margins, proper stewardship of capital and sound management.
  4. What other valuation metrics bear watching? The price-to-free cash flow ratio matters a lot, but in my view, so do the price-to-book ratio and the cyclically adjusted price-to-earnings ratio (CAPE), which are both quite rich too.1

Some perspective

Today’s headlines are awash with talk of trade wars and tariffs. Yes, tariffs matter, but only to certain companies and industries and to farmers of particular crops. From an economic standpoint, they don’t impact the market as a whole and aren’t of such a magnitude that they’ll end the economic cycle. The recently passed tax cuts alone dwarf all the tariffs being discussed, making the latest trade-related moves out of Washington look small by comparison.

As far as free cash flow generation is concerned, it’s off its record high per dollar put into the market, but is it going higher? Maybe. But my work shows me that future free cash flow generation is under pressure from rising labor outlays, higher borrowing costs and increasing general and administrative expenses. Free cash flow yield looks less promising at this point than it did during the spectacular rise we witnessed earlier in this long business cycle.

While the economy continues to grow and assets are still being used productively, there are signs that global economic growth may have begun to slow. In my view, economic growth is necessary, but not sufficient, for improved profits and cash flow. In order to continue to grow, cash flow companies need a decline in the cost of capital, steady-to-falling wages or a sizable rise in productivity.

So despite the recent market pullback, the price of entry into the market is still historically high, in my opinion. Consequently, in balancing risk and reward, it doesn’t make sense to be fully invested until risk asset price levels recede further.

So rather than chasing the dolphin — or the headlines — follow the cash flow while remaining cautious. If you are looking for a place to ride out these choppy market waters while awaiting more compelling equity valuations, the short end of the US investment-grade corporate bond market looks to be a less risky part of the market. Short-term high grade corporates have become relatively more attractive lately due to a number of technical factors, chief among them a one-time shift out of short-maturity corporate bonds as companies bring home cash held outside of the United States as a result of the recent tax act.

Price/book ratio (P/B) is the ratio of a stock’s price to its book value per share. The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, is a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation.

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

 

The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.

The Case for Technology in 2018

Circuitboard

The performance of technology stocks over the recent past has been striking: In 2017, for example, the information technology sector of the S&P 500 posted a 38% return, while the broader S&P 500 Index gained 22% (Source: Bloomberg data). Perhaps even more impressive is the fact that technology is responsible for almost 30% of the total gains of the S&P 500 Index over the last five years (Source: Bloomberg, as of 2/28/18).

In investing, however, past is not prologue. So the question is: Can the good times roll on? We may not see another year like 2017, but there are three reasons why technology continues to be one of our top sector picks.

Strong earnings momentum

The BlackRock Investment Institute recently upgraded U.S. equities from neutral to overweight on the basis of significant earnings growth expectations driven by a supportive macroeconomic environment—and potentially boosted by fiscal stimulus. This thesis equally applies to technology.

This reporting season, 88% of IT companies in the S&P 500 Index posted positive earnings surprises—the highest proportion of all the sectors—while recording 22.5% aggregate year-on-year earnings growth compared to the broad Index’s 14.3% (Source: BlackRock, Bloomberg, as of 3/5/2018). This has translated into strong equity market performance year-to-date, as depicted below. Notably, the other high-flying sector—consumer discretionary—also includes two tech-powered giants: Amazon and Netflix.

Total Return Earnings Surprises

Significant cash balances

Many established technology companies are cash rich, commanding strong balance sheet positions and ample investment firepower. (Source: Bloomberg, as of 11/2/2018).

This offers a number of potential advantages. First, these companies potentially are insulated from the impact of rising interest rates, and may even benefit. As we recently noted, technology historically has been among the sectors the most insulated from yield curve shifts.

In addition, one of the consequences of the recent tax legislation is the prospect of companies repatriating cash back to the U.S. at favorable rates. This increases the potential for dividends, share buybacks or increased mergers and acquisition activity. At the same time, increasing capital expenditure or research and development (R&D) spending may be supportive of the sector in the longer term.

Investing in long-term trends

The impacts of technological disruption extend beyond the confines of old fashioned sector classifications. As we highlighted in October, investing in technology allows investors to tap into large scale, transformational shifts in the way entire industries operate—whether it be the growth of “big data,” cloud-based enterprise and infrastructure solutions, cyber security or the intrinsic importance of semiconductors. Additionally, the growth of online shopping is displacing traditional brick-and-mortar retail and could change the face of commercial real estate markets. These forces result in the tech sector exhibiting a strong secular growth profile and in our view, help justify a premium in the form of higher valuations.

Investors can choose from a wide range of tech exposures.  For example, exchange traded funds (ETFs) tracking broad technology indexes can include large cap technology stalwarts. Alternatively, ETFs tracking more focused sub-indexes allow investors to target companies with network and cyber security business lines or a software focus. Investors seeking a more economically sensitive exposure may consider a semiconductor ETF, providing access to the growth of companies that design, manufacture or distribute semiconductors—the vital components of many electronics and computer devices.

Bottom line

We believe earnings momentum, strong balance sheets and economy-wide transformational forces of innovation and disruption can help provide both cyclical and structural support for technology stocks in 2018. Investors seeking exposure to technological growth can consider taking a targeted approach to their sector definitions.

Chris Dhanraj is the Head of the ETF Investment Strategy team in iShares and a regular contributor to The Blog.

 

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Funds that concentrate investments in specific industries, sectors, markets or asset classes may under-perform or be more volatile than other industries, sectors, markets or asset classes and than the general securities market.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

This post contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

The iShares Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by The NASDAQ OMX Group, Inc., nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with The NASDAQ OMX Group, Inc.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2018 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

The Surprising Way the Bond Market Matters for Stocks

Neat rows of colored beads on an abacus with a single blue bead to the side

One of the reasons stocks have done as well as they have in 2017 is that earnings growth has rebounded. Unlike recent years, when stocks were driven largely or exclusively by multiple expansion—i.e. investors willing to pay more per dollar of earnings—this year’s gains have come from companies actually producing stronger earnings. This is supportive of the market.

What is less supportive is the cumulative effect of years of multiple expansion, a trend that has left U.S. equities expensive by most metrics. Whether or not stocks can continue to sustain current valuation is partly dependent on what happens in the bond market, but just not in the way many people think.

When comparing stocks to bonds, investors typically focus on the relationship between interest rates and equity multiples. This is both empirically evident and based on basic finance, i.e. a lower discount rate supports higher valuations. Unfortunately, this relationship has been less relevant in the post-crisis environment of already low rates. Instead, investors need to focus on two more nuanced measures: the term premium and bond market volatility.

Low or negative term premium

The term premium measures the marginal return to investing in a long-dated bond versus constantly rolling a series of shorter maturity instruments. While normally positive, it has been unusually low or negative in recent years.

Term Premium Equity Valuations

This is important. Since 2010 the term premium has explained roughly 40% of the variation in the S&P 500 earnings multiple (see the chart below). Price-earnings (P/E) ratios have averaged 18.5 in months when the term premium was below 0.5, roughly the post-crisis average; in all other periods multiples were below 15.

MOVE hasn’t moved

The other key measure to watch is bond market volatility. Using the MOVE Index, a proxy for U.S. bond market volatility, we see a similar relationship. Low bond volatility has been associated with higher multiples. In months in which volatility has been below the already repressed post-crisis average, multiples on the S&P 500 were roughly 18, versus 16 when volatility was above average. While you’d expect multiples to be higher when the bond market is calm, the relationship was not nearly as strong in the pre-crisis world.

Why does this matter? It matters because negative term premiums and repressed volatility are unique features of the post-crisis environment. They are also both related to the Federal Reserve’s (Fed’s) ultra-accommodative monetary policy. As the Fed removes monetary accommodation, it is unclear if these conditions are sustainable.

Common sense would suggest that just as building up the Fed’s balance sheet compressed the term premium and suppressed volatility, the reversal should have the opposite effect. What is less certain is the magnitude. For now, investors seem to believe that any rebound in the term premium or volatility will be modest and slow. If that proves wrong, expect lower multiples and a less benign environment for stocks.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

October 2017 Investment Newsletter

Glen Eagle Logo

As of Oct 19th, the Dow Jones hit its 66th high since the Nov 2016 election.  The market has been in a mode of complacent growth with historically low volatility.  The number one question I get asked is how high can the market rise?  Obviously, no one has a crystal ball that predicts the future.  At Glen Eagle our Investment Committee does meet regularly to review the trends based on both qualitative and quantitative data to help steer our efforts to best position our clients’ portfolios for what we believe are the most likely possibilities.  Interestingly, in general the data, ranging from unemployment rates to yield spreads, does not imply that the market is overvalued.  Most importantly, corporations are generally seeing increasing earnings.  There is also no indication of an imminent economic recession.

While the data is not signaling concerns, we do feel that it is prudent for investors to begin to become more conservative by both focusing on downside protection and increasing their exposure to fixed income, preferred stock and convertible instruments.  Unfortunately, market turns are often only seen after they happen and while it is likely that in the late stages of a bull market one gives up some return for becoming more conservative, we think it is worth protecting some of your assets from a potential significant stock market correction.

At this point in the market we are closely watching three areas: Tax Reform, the Federal Reserve and International Markets.

Tax Reform

The United States currently has the highest corporate tax rate among advanced economic countries. Both the President and many in Congress are actively pursuing tax reform including significant changes to the corporate tax rates.  This is an issue that business owners care about, as 52% of small and medium size businesses believe that tax changes will impact their operations more than any other issue.  The likelihood of a corporate tax cut is one issue that has been driving the market.  Failure to pass a tax cut could be the catalyst for a correction.  On the other hand, if there are real cuts to the corporate tax rates it is likely to drive the market higher as this will result in a direct benefit to most corporations’ bottom lines. ‌

One area that both parties in Congress seem to support is the idea of creating a tax incentive for corporations holding cash overseas to bring that cash back into the U.S.  If this idea becomes reality the largest technology and health-care companies should benefit.  Even without tax reform, we believe that the technology and healthcare sectors will continue to grow as a result of continued automation and an aging demographic, respectively.

Federal Reserve

The Federal Reserve has indicated that it plans to continue raising interest rates going forward.  It is likely that these increases will be relatively slow because the Fed does not want to repeat the mistake it made in the past when it raised rates too quickly and pushed the economy into a recession. Additionally, the recent string of natural disasters in the form of Hurricanes Harvey and Irma may lead the Fed to further slow the hikes as the economies and populaces of Florida, Texas, and Puerto Rico recover.  Further complicating the outlook is the fact that President Trump needs to decide whether he will keep or replace the current Federal Reserve Chairwoman, Janet Yellen, at the end of her term in four months.

As we have mentioned in previous commentaries, the rise in interest rates most directly benefits financial institutions, such as banks, that are able to earn more fees from the spread between what they pay for money (deposits) and what they earn on loans.As a side note, we also see some interesting opportunities in materials and construction, companies that will be at the forefront of the hurricane disaster-relief and rebuilding efforts.

International Markets

The economic expansion has officially taken hold internationally as 98% of the world’s economies are now participating in the growth.  Asia and Europe, in particular, look to have some positive momentum.  We expect this trend in the larger East Asian economies to continue as corporate earnings rise further and the uncertainty of China’s 19th National Congress, which is planned for the end of October, passes.  Similarly, Europe has benefited from the election of pro-European Union (EU) leaders, such as President Emmanuel Macron in France and Chancellor Angela Merkel in Germany.  Although there seems to always be another unanticipated cause of fear in the European Union, such as Catalonia’s current independence effort in Spain, we believe that the European economic zone is poised well to continue to grow.

Due to the United States’ stronger economic growth trajectory after the 2008 recession, many portfolios have become heavily weighted toward U.S. investments.  While we generally advocated an overweight position in the US market, we think that some allocation toward international markets is beneficial.  In particular, materials and semiconductor companies stand to benefit as China’s economy continues to grow.  This is because China consumes over 50% of some of the world’s raw materials such as aluminum and concrete, while at the same time having the largest demand for semiconductors as it continues relying on a manufacturing-based economy.

When people are complacent it is always prudent to stay vigilant.  If you have any concerns or would like to review your portfolio in detail, please do not hesitate to reach out to us.

I hope you have a great fall season with family and friends,

Susan McGlory Michel

CEO & Founder

 

Disclosure: This commentary is furnished for the use of Glen Eagle Advisors, LLC, Glen Eagle Wealth, LLC and their clients. It does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific objectives, financial situation or particular needs of any specific person. Investors reading this commentary should consult with their Glen Eagle representative regarding the appropriateness of investing in any securities or adapting any investment strategies discussed or recommended in this commentary.

Value: Dead or Just Slumbering?

The Pyramid complex at Giza, Egypt.

Despite stalling in recent weeks, U.S. equities remain at or near historical highs with many indexes enjoying double digit gains. But not all segments of the market have fared so well: Many of the reflation trades that dominated late 2016 have reversed. This has been most evident at the style level.

After a stellar second half of 2016, value stocks have largely sat out this year’s rally. The S&P 500 Value Index has gained roughly 3% year-to-date, a bit of an embarrassment compared to the 15% rally in the S&P 500 Growth Index.

Why has growth done so well while value has barely merited a look by investors? A couple of factors help explain the performance gap.

Mean reversion

While growth has crushed value year-to-date, the one-year performance numbers are more balanced: 9.6% for value and 14.5% for growth. Part of growth’s outperformance year-to-date simply reflects some “catchup” after value’s strong run in the back half of 2016.

Moderating expectations for economic growth

Although the U.S. economy is firm, we’re not seeing the pickup in U.S. growth and inflation that many had expected. Most measures of inflation have decelerated and expectations for economic growth have softened. Based on a Bloomberg survey of economists, 2017 U.S. growth expectations have fallen from 2.30% in February to 2.10% today. This is important as value tends to perform better when economic expectations are rising. In contrast, when economic growth is modest, investors are more likely to put a premium on companies that can generate organic earnings growth, regardless of the economic climate. This dynamic helps explain the strong year-to-date rally in technology stocks.

What could change this dynamic? Two things to watch, the first being events in Washington, D.C. Economic estimates have slipped in part because investors and economists have put a lower probability on tax reform and/or fiscal stimulus. If Congress started to evidence real progress on tax reform, economic expectations would likely rebound along with investor’s preference for value.

If Washington cannot rescue value, eventually investor excess will. When value outperformed in late 2016, it was the exception that proved the post-crisis rule: This has been a growth-led rally. Growth has trounced value since the market bottomed in early 2009. As a result, the relative value gap between the two styles is back to levels last seen at the peak of the late 90s tech bubble.

S&P Value to Growth P/E Ratio
S&P Value to Growth P/E Ratio

Since 1995 the average ratio between S&P Value and Growth price-earnings (P/E) ratios has been 0.45, i.e. value typically trades at a 55% discount to growth. Currently the ratio is 0.30, close to two standard deviations below the long-term average. Value has not been this cheap relative to growth since early 2000.

Relative value is a poor short-term timing mechanism, but at some point investor preferences will shift. After all, this is not the first time that value has been left for dead.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.