“For every complex problem there is an answer that is clear, simple, and wrong.”
― H.L. Mencken
For much of the past six years since the end of the global financial crisis, central bank actions have been the primary drivers of equity markets. Stocks seemed to move up and down (mostly up) together in response to every move – or failure to move – by global central banks.
The financial media and investors carefully scrutinized every public appearance and painstakingly parsed every statement by U.S. Federal Reserve (Fed) officials, as well as those by central bank policymakers in Europe, Japan and elsewhere. So called “Quantitative Easing” (QE), a novel approach to monetary policy, practically became a household term.
Don’t Fight the Fed
There is an old adage on Wall Street: “Don’t fight the Fed.” This rule of thumb posits that when the U.S. central bank is engaged in monetary easing, investors should buy stocks. Indeed, the first two periods of QE in 2009 and 2010 saw impressive gains in U.S. equity markets.
Since “Operation Twist” – the Fed’s program of buying long-term bonds and selling shorter-term bonds that began in late 2011 in an effort to drive interest rates even lower – the S&P 500 Index has roughly doubled. During this latter period the market was primarily driven by multiple expansion, as the price/earnings ratio for the S&P increased from 12x to about 21x recently (Exhibit 1).
As we discussed in a previous blog, Dividend Stocks: Fads, Factors, and Fundamentals, another significant shift happened after 2011. With interest rates near zero, investors searched for yield anywhere they could find it.
This hunt for yield, combined with an aversion to risk born out of the aftermath of the 2008 financial crisis, led to the rapid growth of so called “low volatility” and dividend investment strategies. Indeed, between the launch of Operation Twist in late 2011 and mid-2016, low volatility Exchange Traded Fund (ETF) assets grew from basically zero to almost $25 billion! And dividend-focused ETFs, which held about $20 billion in assets at the end of 2011, recently topped $100 billion.1
Missing in Action: A Focus on Fundamentals
As we watched these trends unfold over a period of years, we noticed that something was conspicuously missing: A focus on company fundamentals. Stocks moved up and down together more than they had historically.
The chart below shows correlation among large-cap stocks over the past 90 years (Exhibit 2).
After the financial crisis, we saw these correlations increase dramatically and settle in at levels significantly higher than the long-term track record. Indeed, the last time correlations remained elevated for this long was during the Great Depression.
Then, suddenly in mid-2016, these correlations dropped just as dramatically as they had risen. From Brexit in late June to the U.S. election in November, the world changed. Correlations among stocks fell back to levels below the long-term average. The world suddenly got more complicated, to put it mildly. The stock market is no longer primarily concerned with what the world’s central bankers will do next. Now, many other debates are front and center among market participants, including:
- Tax Reform – Who are the winners and losers if the U.S. reforms its corporate tax code? Will consumers spend or save if individual tax rates are lowered?
- Regulation – Will a Trump administration make good on its promises to lower the regulatory burden on business?
- Trade – Will protectionist rhetoric lead to trade wars?
- Immigration – Will developed nations try to close their borders?
- Currencies – Will policies (such as a border adjustable tax or Fed policy) have a meaningful impact on the dollar?
- Fiscal Stimulus – How much will be done and what form will it take?
- Energy Policy – Will the Trump administration reverse prior policies on issues such as drilling on federal lands and coal production?
Refocus on Fundamentals to Find Value
The world in early 2017 looks more complex, and with greater complexity comes greater uncertainty. The dramatic drop in correlations among equities demonstrates that the market is beginning to differentiate between companies based on their fundamental exposure to the potential outcomes of these ongoing debates.
For example, small-cap stocks have significantly outperformed large-cap stocks since the U.S. election due to the fact that they are much less exposed to international economies and would be better off, on a relative basis, if trade protectionism gained any momentum. Similarly, as we discussed in another blog, bank stocks outperformed in the fourth quarter due to the potential benefits of higher rates, decreased regulation, and corporate tax reform.
In a world of greater complexity, we believe stocks no longer rise and fall together based on their exposure to factors such as dividend yield and low volatility. The underlying fundamentals of each business, which over the long term will always determine value, reclaim their rightful place as the primary focus of investors. To borrow from Mencken, a simple solution based on passive equity strategies may not be appropriate in an uncertain environment with myriad variables.
In our view, this kind of environment should benefit fundamental, active investors who can differentiate between those companies where fundamentals are improving and those whose fortunes are deteriorating.
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1Source: Credit Suisse Trading Strategy, 11/29/16.