Indexology^® Blog

A recent academic paper (link here, full citation below) demonstrates that day-to-day stock market returns follow a regular bi-weekly cycle tied to the schedule of FOMC meetings, the Fed’s policy unit. A rolling five day return calculated as the excess return of stocks over T-bills peaks on the day the FOMC meets and then every other week quite consistently thereafter.  The pattern goes back to 1994 when the FOMC began regular announcements of its policy adjustments.  With a series of analyses, the paper argues that the return pattern is statistically significant and would be likely to generate economically significant returns.  The analysis builds on an earlier paper that found strong positive equity returns in the 24 hours just before the FOMC releases its meeting announcement.  Since the analysis was based on all stocks traded in the U.S. using data from Ken French’s web site, implementing a strategy based on the results might require a lot of trading. However, similar results might be possible using ETFs or index futures.

The puzzle is what is generating such strong returns before the FOMC announcements?  If the announcement contained important news about monetary policy and the economy, one would expect the market move to come immediately after the announcement.  The research shows that internal meetings at the Fed follow a regular two week cyclical pattern tied to the FOMC meeting schedule. Moreover, these internal meetings include bi-weekly discussions of the discount rates set by regional Fed banks and regular economic analyses by the Fed staff.  Could information from these meeting be seeping into the markets?  The timing of other economic data, such as weekly and monthly data releases can’t explain the pattern of stock market returns.  Moreover, the Fed through its own analyses and data it gathers to support its policy making has a wealth of economic information.  One likely source is comments made to journalists with the intention of influencing the markets.  The research gives examples of news articles the appear from time to time on the front page of the Wall Street Journal or New York Times citing “Fed insiders” or “staff forecast” or suggesting that “Fed officials would welcome…”

Paper: “StockReturns and the FOMC Cycle” by Anna Cieslak, Adair Morse and Annette Vissing-Jorgenson, June 25, 2014. Second related paper: “The Pre-FOMC Announcement Drift” by David O. Lucca and Emanuel Moench, July 2013

“Middle Child Syndrome” is a psychological label for the empirical observation that middle children often do not receive as much parental attention as first and last-born siblings. But within the ashes of (relative) neglect may lay the seeds of a strong sense of independence, according to Catherine Salmon and Katrin Schumann in their book, “The Secret Power of Middle Children”[1].

Mid-caps stocks are also relatively neglected and often overlooked – to the detriment of equity investors who may miss out on holding future leaders in their respective industries before becoming better known large-cap names. The relative obscurity may be partially due to the academic focus on the size factor as a structural driver of returns. “Small Minus Big (SMB)”, as the Fama/French size factor is known, leaves no thought of “mid” as a way to drive long-term performance. Another reason may be the popularity of large-cap and small-cap benchmarks like the S&P 500 and Russell 2000. But mid-caps stocks, as a group, have some interesting characteristics. In many ways, they have the potential to offer the best of both worlds – possibly greater dynamism than grown-up siblings and more maturity than little brothers and sisters.

As it turns out, mid-cap stocks have a unique fundamental profile in comparison with large-caps or small-caps. For example, see the bar chart below showing the median of total assets among constituents of the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600 indices:

Mid-cap stocks also have performed very differently than other market segments. This is a chart of the total return index levels for the same three benchmarks:

If you are interested in hearing more about mid-caps as a unique market segment and mid-cap indexing, join S&P Dow Jones Indices and guest panelists for a webinar on September 4, 2014.

[1] Hudson Street Press, 2011.

Preferred securities as measured by the S&P U.S. Preferred Stock Index have returned 12.08% year-to-date.  The performance of this index has outpaced both the S&P U.S. Issued Investment Grade Corporate Bond Index (6.49%YTD) and the S&P U.S. Issued High Yield Corporate Bond Index (5.5% YTD).

The recent development of three new sub-indices to the S&P U.S. Preferred Stock Index breaks out this index by credit rating.  Separating the index by the lowest of the three rating agencies creates the sub-indices of S&P U.S. Investment Grade Preferred Stock Index, S&P U.S. High Yield Preferred Stock Index and the S&P U.S. Not Rated Preferred Stock Index.  High yield represents 54% of the parent index while investment grade issuers are 38% and non-rated issuers are 8% by market weight.  Though all three sub-indices are performing well, the investment grade index is in the lead with a total return of 1.59% MTD and 13.83% YTD.

Source: S&P Dow Jones Indices, data as of 8/22/2014

Rotating between cyclical and defensive stocks across economic cycles is a common approach for investors to take advantage of different economic phases. Energy, materials, industrials, consumer discretionary, financials and information technology are traditionally considered cyclical sectors, as stocks in these sectors have tended to be highly correlated to economic cycles. In contrast, consumer staples, healthcare, telecom and utilities are generally thought to be defensive sectors, as their profits and prices have had very low correlation to economic activity.

In our study of Australian equity, we observed that Australian sectors demonstrated much stronger cyclical and defensive characteristics across the global economic cycles when compared with domestic economic cycles. Cyclical sectors broadly outperformed defensive sectors during global economic up cycles, and they underperformed defensive sectors when the global economy slowed. This suggests that the global economy could more strongly influence relative performance between these two types of sectors than the domestic Australian economy can.

Source: S&P Dow Jones Indices LLC. Sectors highlighted in teal and gray represent cyclical and defensive sectors, respectively. Data from December 1989 to June 2014. Data are based on the S&P/ASX 200 universe (between March 31, 2000, and June 2014) and the S&P Australia BMI universe (prior to March 31, 2000). Global economic up and down cycles are defined by monthly change of the OECD + Major Six NME CLI. Performance of cyclical sectors and defensive sectors is equal-weighted, and stocks within each sector are market cap-weighted. Performance is based on total return in AUD. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results.

In Australia, cyclical sectors represent 80% of the total market, based on the S&P/ASX 200. However, cyclical sectors underperformed defensive sectors on average over the entire period between December 1989 and June 2014. They only outperformed defensive sectors on average in seven of the past 24 years. These results suggest that mimicking benchmark sector weighting may not be the most optimal way to maximize portfolio returns.

To exploit the cyclical and defensive nature of Australian sectors, we examined a strategy that alternately invested in cyclical and defensive sectors during global economic up and down cycles, based on the monthly change of the OECD global leading economic indicator. Results showed this simple strategy was profitable over the past two decades with an absolute annualized return of almost 15%, outperforming the benchmark by 5.4% per annum. As 80% of the Australian equity market is dominated by cyclical sectors, outperformance of this rotation strategy was mainly driven by turning to defensive sectors during global economic downturn.

Source: S&P Dow Jones Indices LLC. Data are based on the S&P/ASX 200 universe (between March 31, 2000, and June 2014) and the S&P Australia BMI universe (prior to March 31, 2000). Global economic up and down cycles are defined by monthly change of the OECD + Major Six NME CLI. Performance of cyclical sectors and defensive sectors is equal-weighted, and stocks within each sector are market cap-weighted. Performance is based on total return in AUD. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results. These charts and graphs may reflect hypothetical historical performance.

The growing popularity of sukuk is reflected in the recent strong index performance.The Dow Jones Sukuk Index delivered a total return of 7.08% year-on-year (Y-o-Y) and 5.26% year-to-date (YTD), as of August 18, 2014. The index’s yield-to-maturity also tightened by 51bps YTD to 2.55%. Noticeably, the yield of the S&P MENA Sukuk Index dropped 55bps YTD to 2.33%, which is almost on par with the yield of Dow Jones Sukuk Higher Quality Investment Grade Index. Please see Exhibit 1 for the yield comparison.

Exhibit 1: The Yield-to-Maturity Comparison of the Dow Jones Sukuk Index 

According to the rating based and maturity based sub-indices of the Dow Jones Sukuk Index family, the sukuk with longer maturities and lower ratings outperformed the market. The Dow Jones Sukuk 7-10 Year Index rose 11.1% Y-o-Y and 9.60% YTD, while the Dow Jones Sukuk BBB Rated Index gained 9.44% Y-o-Y and 7.03% YTD. In search of higher yields, investors tend to go further out on the risk spectrum, see Exhibit 2.

Exhibit 2: The Rating Based Sub-Indices of the Dow Jones Sukuk Index 

The market size tracked by the Dow Jones Sukuk Index expanded 23% YTD to USD43 billion. The new names tapping into the market are Export-Import Bank of Malaysia and Emaar Malls from UAE, together with returning issuers such as Islamic Development Bank and Saudi Electricity. The continued growth is fueled by ongoing financing needs, solid investor demand and more importantly, the regulatory support.

The issuance pipeline remains robust; for example, Indonesia sovereign just released a preliminary OC on a USD Sukuk, which is rated “BB+” by S&P Ratings. The Malaysia Airports also announced a perpetual subordinated sukuk that is denominated in Malaysian Ringgit.