Indexology^® Blog

At the beginning of this year, we suggested that 2013 might well have been a another tough year for active managers. Judging from the response received at the time, this expectation was somewhat controversial: the more common refrain was to point to falling correlations during 2013 and predict a return to “stock-pickers’ market.” In such an environment, the reasoning goes, it pays to be more active with your investments.

Our regular SPIVA® scorecard regularly reports on the relative performance of active managers, and the full-year 2013 results are in. Last year, roughly 45% of U.S. large-cap funds achieved the distinction of outperforming the S&P 500® – a touch up from the previous year, but still a strong validation for passive investors.

Source: S&P Dow Jones Indices Data for 2007 are to March end; all other years are full calendar years. Charts are provided for illustrative purposes. Past performance is no guarantee of future results.

Moreover, it seems our forecasts regarding 2013 were correct in a second respect. Based on our research on dispersion, we expected to see a relatively narrow spread between the best and the worst managers (again, despite falling correlations). The data show that for large-cap core U.S. equity funds (the subject of our original research), 2013’s interquartile range between the best and worst performers was indeed fairly low, and continues to be well-paralleled by dispersion.

Source: S&P Dow Jones Indices Data for 2007 are to March end; all other years are full calendar years. Charts are provided for illustrative purposes. Past performance is no guarantee of future results.

While it remains unclear whether the choppy markets of 2014 will provide a more conducive environment for active managers, those who wish to leaven their analysis with the latest values of dispersion may be interested in reading our ongoing commentary.

Types And Sources

In the U.S., there are two main types of income: as reported and operating. As reported income, sometimes called Generally Accepted Accounting Principal (GAAP), is income from continuing operations and it excludes discontinued and extraordinary income. Both of these terms are defined by the Financial Accounting Standards Board (FASB) under GAAP. As reported earnings represent the longest-monitored earnings series available today.

Operating income, by contrast, excludes unusual items from that value, and companies began reporting it in 1988. The intent for operating earnings is to show how much companies make from their operations (making widgets), excluding corporate expenses and unusual items. Operating income is not defined under GAAP by the FASB; however, companies are required to reconcile how they get from their operating income figures to their as reported income figures. This permits individual companies to interpret what is (and what is not) unusual. The result is a varied interpretation of items and charges, in which the same specific type of item may be included in operating earnings for one company and omitted from operating earnings for another company. Additionally, during difficult times, the term ‘unusual’ appears to be used more liberally.

S&P uses methodology to ensure items included (or excluded) from operating earnings are consistent across sector lines, in order to permit issue comparison. In general, as reported earnings are less than operating earnings, since they exclude corporate expense and write-offs. However, on occasion, the situation occurs where there are unusual income items, which reverses the normal trend.

Things get a bit more complicated for index-level estimates because there are two methodologies used for calculating the S&P 500 index level estimate: bottom-up and top-down. Bottom-up estimates come from the covering equity analyst for their specific issue. We then build up the index level estimate by combining all 500 issue level estimates, after each issue’s estimate is adjusted for its index weight. These are the more commonly used estimates on the street. On an issue level, bottom-up estimates are typically the ones used to determine if a company met expectations or not.

Top-down index-level estimates are usually supplied by economists and strategists on an index and (sometimes) sector level. They use a broad array of indicators and matrices based on economic and market history to project the index level earnings estimate. The economists or strategists never come down to the issue level and say how much a company will make, but instead make their estimates from the top down. They may adjust the index, sector, or group estimate based on overall economic beliefs, such as expected employment, tax rates, government costs, and expenditures. Economists will typically create estimates that project over many years, while strategists will generate them for just a few years (similar to equity analysts).

Expectation Versus Reality (Or Normalized Versus Methodology)

Operating earnings per share (EPS) is the dominant focus on the street. Equity analysts make their projections based on operating EPS, and most news reports cite them. In this case there are different versions of estimates. The two groups of estimates each have different functions and roles, similar to fundamental and technical analysis, and each group has its strengths. On an index level, a brokerage house may aggregate the S&P 500 earnings estimate based on the estimates supplied to it from their own covering analyst. Since estimates on issues differ, brokerage house index levels estimates differ as well (since their contributing analysts differ).

On a larger scale, several companies gather estimates and calculate a consensus estimate, which is widely reported in the press. S&P Capital IQ (CIQ) is one of the providers that gathers the estimates, so it can be used as an example. The CIQ numbers represent what the covering equity analysts are predicting at a certain point in time, meaning it is closely tied to the analysts’ current expectations and to the market. CIQ takes steps to ensure that when it calculates a consensus estimate for an issue, all of the analysts are predicting the same situation, meaning that if there is an item being excluded or included in the earnings, this is being done uniformly. For that reason, there may be 25 covering analysts but only 22 are used (typically the estimates are uniform).

The consensus number is the estimate which is used to determine a beat or miss. Generally, this estimate also shapes how the market initially reacts. Because of the nature of the market, analysts’ approach sometimes change their estimates, and an item in one industry may not be an item in another industry. Further, even within an industry there can be differences. Again, the strength and intent of the number is to show what analysts who cover that stock are currently thinking. Once the results are released, the number used for CIQ history is the one that matched up with the estimate. Therefore, if an item was excluded in the estimate, it will be excluded from the history. This process is known as ‘normalizing’

S&P Indices (which is separate from CIQ) uses a methodological approach to the S&P 500 earnings. In general, an item is included or excluded across all of the issues in the index. This permits comparisons of sectors and industries, and most of all, companies. Therefore, the result is also compatible with the index price, dividends, balance sheet items, etc. The strength of that number is its defined methodology, uniformity, and comparability–you know exactly what you are getting (there is no black box). Typically, the index level number is used on a higher level to analyze markets, sectors, and industries.

On an issue level, it permits comparison for screening and relative positions. However, many brokerage houses will note or modify certain S&P data on the lower-end (issue or group) so their specific approach to an issue can be incorporated (obviously, each house is slightly different). Since the index data are uniform and methodology-based, this adjustment can be done. The data can be thought of, in the context of building a house, as a series of 2’x8’ logs, each made with the same specifications. For most of the house, those uniform pieces would be exactly what one would want, but for parts of the house that log would need to be crafted. The good news is that the exact specifications of the log are known, so ‘crafting’ is possible.

DISCLAIMER
The analyses and projections discussed within are impersonal and are not tailored to the needs of any person, entity or group of persons. Nothing presented herein is intended to, or should be interpreted as investment advice or as a recommendation by Standard & Poor’s or its affiliates to buy, sell, or hold any security. This document does not constitute an offer of services in jurisdictions where Standard & Poor’s or its affiliates do not have the necessary licenses. Closing prices for S&P US benchmark indices are calculated by S&P Dow Jones Indices based on the closing price of the individual constituents of the Index as set by their primary exchange (i.e., NYSE, NASDAQ, NYSE AMEX). Closing prices are received by S&P Dow Jones Indices from one of its vendors and verified by comparing them with prices from an alternative vendor. The vendors receive the closing price from the primary exchanges. Real-time intraday prices are calculated similarly without a second verification. It is not possible to invest directly in an index. Exposure to an asset class is available through investable instruments based on an index. Standard & Poor’s and its affiliates do not sponsor, endorse, sell or promote any investment fund or other vehicle that is offered by third parties and that seeks to provide an investment return based on the returns of any S&P Index. There is no assurance that investment products based on the index will accurately track index performance or provide positive investment returns. Neither S&P, any of its affiliates, or Howard Silverblatt guarantee the accuracy, completeness, timeliness or availability of any of the content provided herein, and none of these parties are responsible for any errors or omissions, regardless of the cause, for the results obtained from the use of the content. All content is provided on an “as is” basis, and all parties disclaim any express or implied warranties associated with this information. The notes and topics discussed herein are intended to quickly inform and are only provided upon request. If you no longer wish to receive this information or if you feel that the information does not suit your needs, please send an email to Howard.silverblatt@spdji.com and you will be removed from the distribution list. A decision to invest in any such investment fund or other vehicle should not be made in reliance on any of the statements set forth in this document. Standard & Poor’s receives compensation in connection with licensing its indices to third parties. Any returns or performance provided within are for illustrative purposes only and do not demonstrate actual performance. Past performance is not a guarantee of future investment results. STANDARD & POOR’S, S&P, and S&P Dow Jones Indices are registered trademarks of Standard & Poor’s Financial Services LLC. – See more at: https://www.indexologyblog.com/2014/03/07/buybacks-and-the-sp-500-eps/#sthash.3aVDVSOX.dpuf

• Treasuries closed the week returning 1.32% as measured by the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index.  The index is now returning 0.18% for the month and 4.13% year-to-date.  Continued concerns over the Ukraine political situation may have led to a demand for Treasuries as a flight to safety trade.  The auctions of $64 billion of 3-, 10- and 30-year debt were successful in the current environment.

• The week ahead for economic numbers started today with March’s Empire Manufacturing which at 5.61 was lower than the expected 6.5.  Tomorrow’s CPI number is widely expected to be unchanged from its prior levels.  It still remains to be seen if any recent weakness in the economy has been due to the harsh winter and if the markets should have more confidence in the Fed’s view of underlying strength in the economy which led to the decision to continue taping its stimulus buying.  Wednesday’s FOMC Rate Decision along with Friday’s Philadelphia Feb Business Outlook (4.0 expected) and the Leading Index (0.2% expected) should provide more clarity.

• It’s too early in the month to tell how it will end but when compared to January and February, the S&P U.S. Issued Investment Grade Corporate Bond Indexis off to a negative start in return as the index is down -0.04% for the month.  The March 3rd, year-to-date high of 3.15% had eroded down to 2.09% but since then has been climbing back to its current 2.82%.  Investment Grade debt issuance has been active.  Timing the sale of debt before any significant rise in rates may be the underlying motivator of this trend.  The past week saw the pricing of numerous deals including names such as Coca-Cola, Citigroup, General Electric, Burlington Northern, Royal Bank of Canada and Viacom to name a few.

• The high yield market also saw its share of new issuance over the past few weeks as deals like Access Midstream, Pioneer Energy, Tenet Healthcare and many more came to market.  The S&P U.S. Issued High Yield Corporate Bond Index closed the week down -0.11%.  Like investment grade bonds, the high yield index’s year-to-date return peaked on March 5 at a 2.77% but has yet to recover, presently at a 2.4%.

• The S&P/LSTA U.S. Leveraged Loan 100 Indexis returning 0.19% for the month and 0.86% year-to-date.  The index has reached a year-to-date high for 2014 at 0.86%; the prior high was 0.74% on January 22.  The market held steady throughout the week as the recent outlook has improved with new deals such as Rite-Aid, Ellucian, Zuffa, and Spirit Aero.  Prior to 2008, the weighted average price of the S&P/LSTA U.S. Leveraged Loan 100 Indexaveraged 98 between 2001 and 2007.  Because of the financial crisis of 2008, the price dropped to a low of 59.20.  Since December 17 of 2008, the weighted average price of this index has risen 66% to its current level of 98.41.

Source: S&P Dow Jones Indices, Data as of 3/14/2014, Leveraged Loan data as March 16, 2014.

Thus far on the blog, we have written a few pieces about busts in the stock market. David Blitzer wrote, “Whenever this bull market ends, it is likely to be with a bang, not a whimper.” He also wrote about Deflation, Debt and Disaster where he pointed out we may be on the edge of deflation, which leads to stagnant economies and depression. I also pointed out the cycle of stock-to-commodity outperformance may be switching back in favor of commodities.

With the possibility of doom and gloom over the stock market, a natural question may be where to turn to protect your assets. Many consider gold a safe-haven, but is it really? My colleague, Reid Steadman, wrote about VIX – The Enforcer, where in a hockey analogy he pointed out that when other markets fail, VIX may be the last line of defense.  It is a decent argument that VIX may act as a strong safe-haven.

However, many might be hesitant to believe that VIX, a reflection of volatility, is a safe-haven since it’s not tangible. Despite the fact that not even the luckiest person can catch the leprechaun with the pot of gold at the end of the rainbow, at least everyone can dream that picture.  But what does a pot of VIX look like? Besides charts in a pot?

Although Reid does a good job of explaining what is VIX, as humans we possess irrational behaviors (besides believing we can catch a leprechaun with a pot of gold).  One of our behaviors is biased expectations or overconfidence that leads to misapprehensions about oneself and to the illusion of control.

In a published card game example, investors are more confident in the value of the cards they TOUCHED. The example is as follows:

• A game is played with two decks of cards, red and blue.  Players pay $1 and receive one card from one of the decks. The card is then returned to the deck, the dealer shuffles and draws one card. If the player’s card is drawn, the player wins $100.
• When the game is played with the blue deck, the dealer only shows the card to the player.
• When the game is played with the red deck, the player gets to touch the card and return it to the dealer.
• Players were asked to sell their cards prior to revealing the card chosen by the dealer.

The results show players valued the cards they touched more than they valued the cards they did not touch:

• Blue deck (no touching of cards): 19% were unwilling to sell their cards. Average asking price was $2
• Red deck (players were able to touch cards): 37% were unwilling to sell their cards. Average asking price was $9

Why does this matter?  It is since investors may value the tangible property of gold as a store of value, or currency, that it has been considered a safe-haven asset as throughout history. But the question is at what price? Is gold as a safe-haven really more valuable than VIX at protecting your portfolio in hard stock market times?

That all depends on how we measure time frames and what we consider protection, but from the look of it, we put much too high of a value on the tangibility of gold.

Let’s take a look at the overall cumulative return chart of S&P GSCI Gold, VIX, S&P GSCI and S&P 500.  Gold looks pretty attractive relative to VIX but we need to dig deeper to see which does a better job as a safe-haven.

Using monthly data in the time period from Jan 1990, the only negative years for the S&P 500 were 2000, 2001, 2002 and 2008.  The results of protection are mixed. In 2000 and 2008, VIX returned higher than the S&P GSCI Gold, but the opposite was true in 2001 and 2002.

However, the results become more clear when evaluating other metrics. VIX has the lowest correlation to the S&P 500 of -0.63, compared to -0.01 of S&P GSCI Gold with the S&P 500 and 0.18 of the S&P GSCI with the S&P 500.  This implies VIX has stronger diversification properties that could potentially lead to greater capital preservation when mixed with stocks.

Further, on average of 287 months measured, 103 months were negative for the S&P 500 and 27 of those lost more than 5% in the month. While gold protected, VIX seems to have done a better job. An average monthly loss for the S&P 500 was 3.6% with a 15% gain from VIX and only 56 basis points from gold.

VIX also has the best record of positive months when the S&P 500 lost. In 79% of down months for the S&P 500, VIX was positive.  The S&P GSCI Gold and S&P GSCI didn’t do a bad job but came up short again versus VIX.

Finally, maybe when it counts most, we measure two crisis periods during this time: the tech bubble burst and the global financial crisis.  Once again both gold and VIX protect but VIX wins.

As investors, and humans, we really might price the value of the golden touch too highly.