Year-to-date Stock Market Review
Not intended to be investment advice. The exhibits and observations in this post are meant to help readers (and myself) identify areas to do more due diligence on, and should definitely not be taken as a specific recommendation to buy or sell.
It’s been quite a year so far. We’ve experienced a crash, a recovery, and now another micro-crash all since February.
I’ve been thinking about putting together a regular report on market trends, mixed with some analysis for a while now. So I’ve been writing up some code to automate this process at the same time as fleshing out the form and content of the report. If there’s anything you all would like to see, please don’t hesitate to let me know.
Asset Class Returns So Far
Let’s take a look at asset class returns so far this year. Given everything that’s happened in the world this year, and the way that certain stocks have soared, it’s surprising that for much of the year the best performing asset was long duration Treasury bonds. It’s also interesting that despite the mammoth rally in stocks the past few months, the S&P 500 is currently negative for the year, even after including dividends, thanks to the recent selloff.
Looking within equities, we see that more leveraged and economically sensitive parts of the market like small cap stocks and emerging markets (high commodity exposure) have underperformed. At least until two weeks ago (when markets began selling off), there was a strong preference for winners (tech stocks that can still grow in a COVID-19 challenged environment).
Factor Returns So Far
Equity factors are a helpful way of looking at the market. Factor indices are stock indices that tilt towards companies that exhibit more of a particular characteristic (or set of characteristics) than their peers. For example, the funds that focus on the dividend factor concentrate their holdings in stocks with above average dividend yields. Here is a quick explanation of all the factors that I like to look at:
- The growth factor tilts towards stocks with above average earnings and sales growth rates.
- The momentum factor tilts towards stocks with the best price performance over the past several months.
- The quality factor tilts towards companies with high profit margins, earnings stability (earnings that don’t fluctuate as much with the business cycle), and strong balance sheets.
- The value factor tilts towards companies with high earnings, sales, and book values (assets less liabilities) relative to their market caps. It’s an attempt to quantitatively weight the portfolio towards cheaper stocks.
- High beta tilts towards stocks with above-average betas. Beta is a measure of the riskiness of a stock and corresponds to how much a stock tends to move when the market moves. For example a stock with a beta of 2.0 would tend to decline by 10% if the overall stock market were to decline by 5%. Higher beta stocks are usually risker because they have more debt, higher fixed costs, or are more sensitive to the business cycle.
- The dividends factor tilts towards stocks that sport above-average dividend yields.
As we noted above, there is a strong preference for perceived winners (growth and momentum, which both include a heavy dose of technology firms). Working from home during COVID-19 has supposedly fast-tracked various technology trends massively, allowing companies to achieve in just a few months revenue levels that originally would have taken them several years to get to. I would advise caution however.
Current valuations for a lot of tech companies extrapolate forward for many years the significantly above average growth rates of the past few months. For the big winners, the shift to working from home and buying everything online has been like winning the lottery — but now valuations assume that these companies will be able to win the lottery again and again in the future (probably not realistic). If revenue growth rates for many of these companies drop from amazingly good to just very good as the health situation gradually improves or increased competition sets in, valuations (and returns) will suffer.
Looking at the underperforming factors in the previous plot, we can see that year-to-date the best performing factor (growth) has outperformed the worst one (dividends) by around 40%. This is actually a continuation of a long-term trend where rapidly growing companies have been beating by a wide margin their cheaper and slower-growing peers for many years now:
Over the past few years, growth and momentum have outperformed value and dividends by around 100% even after accounting for dividends paid! Part of this might have to do with the way the indexes are rebalanced. For example, Apple was part of some value factor indices a few years ago when it traded reasonably cheaply relative to its sales and earnings. But once it started performing well as a stock, its weight in the value factor declined relative to its weight in the growth and momentum indices. So the value factor probably suffers somewhat from “selling its winners too soon”.
Moreover, the value index is also heavily concentrated in energy, materials, and financial stocks, which have severely underperformed hot sectors like technology and consumer discretionary (Amazon) in recent years.
The value investor in me can’t help but wonder if and when this will reverse. For example, during the late 1990s Internet Bubble, small cap value could just not buy a bid — investors in small value actually lost money during one of the frothiest stock markets of all time. And then when the bubble finally popped, it came back in a big way, earning a positive return throughout the ensuing recession:
S&p 500 Growth Small Cap Value
1998 42% -6%
1999 28% -1%
2000. -22% 23%
2001. -12% 14%
2002. -23% -11%
2003. 26% 46%
Of course, we shouldn’t be contrarian just to be contrarian. History is helpful, but it should only be used as a rough guide because the current situation will always have its own unique characteristics and issues to be wary of.
But it is worth a look. At the minimum, I will need to set a reminder for myself to dig into the underlying constituents of the value and dividend factors to see whether there are any hidden opportunities there.
Cheers and good luck investing!