Indexology^® Blog

Yesterday’s close brought the S&P 500 to another new pinnacle – the seventh new high reached since June 30^th, when the market surpassed its previous peak from July 20, 2015. In the context of the market’s recent bullish run, a number of commentators have remarked on the surprising outperformance of defensive strategies and sectors.

But this should not come as a surprise. We only recognize a market peak in hindsight, after prices have gone through a period of decline.  Eventually a trough is reached (most recently on Feb. 11, 2016), prices begin to recover, and the old peak is surpassed (as on June 30^th).  But in the period between the old peak and the first close that surpasses it, the market’s total return is approximately zero.  In such an environment, it’s not surprising that defensive indices exploiting low volatility and dividend factors would do well.

Since the 2008 financial crisis, there have been two other episodes when the market lost more than 10 percent and subsequently recovered. In both of them, as in the most recent periods, the most consistent outperformers were defensive strategies such as the S&P 500 Low Volatility and S&P 500 Low Volatility High Dividend Indices, as well as defensive sectors such as Utilities and Consumer Staples.

We don’t know where the market will go from here.  What we do know is that there’s nothing particularly remarkable about its most recent recovery.

Most active managers fail most of the time, at least if we regard their underperformance of passive benchmarks as indicative of failure.   This fact is so well known and widely documented that even staunch advocates of active management acknowledge it.

What remains in dispute is what should be done to improve performance.  Some argue that active management fails because it is not active enough.  Active managers, it’s said, are reluctant to deviate too much from a passive benchmark, knowing that their performance will be compared to it.  The proposed remedy for such “overdiversified” portfolios is for managers “to invest with high conviction, concentrating capital in the ideas they think are most likely to deliver strong long-term returns.”

Suppose that the active management community takes this advice, so that portfolios become substantially more concentrated in each manager’s “best ideas.”  What might the result be?  We’ve recently identified four logical consequences of increased portfolio concentration.

First, risk is likely to increase.   Other things equal, more securities mean more diversification.  Between 1991 and May 2016, the average volatility of returns for the S&P 500 was 15%, while the average volatility of the index’s components was 28%.   The difference between one stock and 500 is an extreme case, but it serves to illustrate the obvious point: if the typical active manager owns 100 stocks now and converts to holding 20, the volatility of his portfolio will almost certainly increase.

In a world where all active managers concentrate their portfolios, fund owners who are not willing to accept an increase in active risk have two options.  The first is for asset owners to retain the same number of active managers as before, but reduce the proportion that is actively managed.  This is not in itself objectionable, although it may not be what the advocates of concentration intend, and it forces asset owners to reduce the proportion of their allocation that they hope will outperform.

Alternatively, asset owners must hire more active managers.  Instead of using 20 managers each with 100 stocks, for example, a fund might achieve the same risk profile with 100 concentrated managers, each holding 20 stocks.  As well as considerable additional time and expense for the asset owner,  this produces a major logical inconsistency.  In the name of conviction, managers who pick stocks are told to pick fewer stocks.  As a consequence, asset owners who pick managers may be required to pick more managers.

This morning’s CPI report for June looked like the last few reports showing inflation at about one percent in the last 12 months. However, beneath the surface things are shifting around and giving hints that a year from now prices could be noticeably higher than they are today. A modest rise in inflation over the next year or so shouldn’t be a surprise. Current economic conditions can support higher prices: the economy is expanding, unemployment is down and consumers are confident and spending money. The current low levels of inflation are due to the strong dollar, falling food prices and formerly falling energy prices.

The “core CPI,” the index excluding the volatile food and energy segments, is a good way to understand inflation. The first chart shows 20 years of the total CPI in red and the core CPI in blue, both series measured as the percentage change over the previous 12 months.  The overall CPI in red gyrates up and down, largely driven by the surges and collapses in oil prices in recent years while the blue line reveals more gentle movements. In recent months both are rising.

In the year ended in June 2016, the overall CPI rose 2.3%; the food component was up 0.3% and the energy component was down 9.4%. Today falling energy prices are keeping inflation down. However, falling energy and oil prices may be a thing of the past. Oil rebounded from its lows. Even if oil and energy prices stay where they are, overall inflation will rise. The second chart shows the overall CPI (blue bars) and WTI oil (red line). As seen there, after oil prices peaked in 2014, inflation reversed and began to climb in 2015. When oil rose earlier this year, inflation rose along with it.

No one expects a rapid return to double digit inflation. However, the days when everyone assumed inflation would be zero forever maybe ending.  In a growing economy when businesses and consumers are less resistant to attempts to raise prices, higher prices eventually stick.

As summer gets underway, there are some commodities that do seasonally well during this time of year.   The one that historically does best in the summer is unleaded gasoline with an average historical third quarter return of 8.2%.  This is not surprising from the increased demand from summer driving as people vacation.  However, the prices are now falling rather than rising which only happens every one of three years.  In fact, the S&P GSCI Unleaded Gasoline has now hit its lowest July levels since 2004 and the total return is having its second worst third quarter start in history since 1988, losing 5.9%, with only 2009 falling faster when it dropped 13.5% in the first nine trading days.

The stronger dollar and stagnant interest rates aren’t helping commodities but individual commodity fundamentals are more powerful.  Both the International Energy Agency (IEA) and Energy Information Agency (EIA) released reports yesterday that drove oil down on global supply (according to IEA) and US supply (according to EIA).  On June 24, after the Brexit vote oil dropped the most in one day -4.9% since Feb., and since then, there have been two other big down days with yesterday being the third. It certainly questions whether the modest demand deceleration globally as forecasted by the IEA may lengthen the oil rebalance.

On the flip side, cotton, nickel and aluminum are typically the worst in the summer and are having a great start to q3, up 15.2%, 9.6% and 1.6%, respectively. Nickel is increasing from environmental licenses potentially impacting supply. Cotton is rising from the drought impacting supplies in India, and according to their government, inventory could be cut by 1/3 bringing output to the lowest in six years.  Aluminum is up slightly from anticipated automobile growth in China, which could grow more if gasoline prices stay low.

After yesterday’s record close for the S&P 500, memories of last month’s Brexit panic seem far away.  (In fact the U.K. referendum to leave the European Union took place only 19 days ago as of this writing.)  In the immediate aftermath of the referendum, global markets fell sharply, while low volatility indices mitigated the impact of the decline.  The crisis, if we may call it that, was short-lived.  The U.K. referendum took place on a Thursday, markets fell for the next two trading days, and then bottomed on Monday June 27.

Low volatility indices attenuate the returns of their parents in both directions.  They typically decline less when the market goes down, but rise less when the market goes up.  Since June 27, in fact, they have lagged their cap-weighted counterparts, as illustrated below for the S&P 500:

From June 27 to July 11, the S&P 500’s total return was 6.9%, well ahead of S&P 500 Low Vol’s 5.5%.  Notice, though, that since the beginning of June, Low Vol has significantly outperformed the S&P 500.  Even though it lags on the upside, the cushion that Low Vol provides on the downside can make for attractive compound returns over time.

This effect is not limited to large-cap U.S. stocks:

Even with the market at all-time highs, low volatility’s performance continues to be attractive.

The primary determinant of the relative performance of low volatility is the return pattern of its parent index.  If the S&P 500 goes up 30% next year, S&P 500 Low Vol is highly likely to lag far behind, and the opposite is true if the market declines significantly.  In that sense, predicting the relative performance of Low Vol is tantamount to predicting the direction of the market as a whole.  Some fortunate souls may have the key to that puzzle, but we are not among them.

What we can say is that low volatility’s performance is typically characterized by protection from the worst of downside moves and participation in market rallies.  Neither the protection nor the participation are perfect — but for the investor who’s willing to forgo some upside in exchange for a smoother downside, low volatility can provide a congenial pattern of returns.