Indexology^® Blog

Three issues surround the debate over the Fed and raising interest rates: why should interest rates be increased? When should they be raised and how can the Fed do it.  All three need to be resolved.

Why

The traditional description of Fed policy is “removing the punchbowl when the party gets good.” The Fed’s dual mandate of employment and stable prices is a balancing act between competing goals.  With the economy growing, employment rising and unemployment under 6%, attention is shifting to prices.  With a more upbeat economy comes expectations of higher inflation and upward pressure on prices and wages.  Inflation depends on how aggressively business tries to raise prices. The objective in raising interest rates is lower expectations of future inflation to limit efforts to raise prices.  Neither the size nor the growth of the money supply completely determines inflation rates.  Those who believe that the money supply is the only factor behind inflation must explain why inflation is currently so low after five years of unusually high money supply growth.

The Fed funds rate affects the economy and financial markets, not just inflation expectations. The Fed’s three rounds of large scale asset purchases – popularly known as QE or quantitative easing – pushed the Fed funds rate to almost zero (see chart) and were a crucial factor in the economic recovery. QE worked by keeping interest rates artificially low and boosting prices of stocks, homes and other assets. However, zero interest rates distort prices and returns in financial markets.   With the economy doing better, the Fed wants to normalize interest rates and move the fed funds rate from almost zero to something a bit higher.

A “normal” level for the Fed funds rate depends on inflation, employment and the economy. One widely followed definition of a normal Fed funds rate is the Taylor rule based on analysis of Fed rate setting by John Taylor, a Stanford University economist.  The chart, based on calculations of the Taylor rule by the St Louis Federal Reserve Bank, compares the rule to the past and current Fed funds rate, suggesting the the Fed funds rate should be raised. However, the central bank is not in a rush, will probably take small steps of a quarter percentage point at a time.

How

The last time the Fed raised the Fed funds target was July 2006. Back then the level of excess reserves – funds banks have on deposit at the Fed that exceed the level of reserves mandated by law, was small.  The Fed funds rate is what banks pay when they borrow or lend reserves to one-another. Before QE, the central bank could sell securities to drain funds from the banking system, raising the cost of borrowing needed reserves. After three rounds of QE, excess reserves are close to $3 trillion, far too large for the Fed to nudge rates higher by selling securities.

With the advent of QE, some questioned whether the central bank would be able to control interest rates until QE was reversed and $3 trillion of reserves somehow vanished. Last fall the Fed announced new operating procedures for managing the Fed funds rate.  The ceiling on the Fed funds rate is set by the interest rate the Fed pays banks on excess reserves on deposit at the Fed.  With the Fed paying one-quarter percent on excess reserves, there is no reason for a bank to lend overnight to anyone else at a lower rate.  The floor is set by reverse repurchase agreements (RRP) where the Fed sells securities and agrees to buy them back at a slightly higher price, the difference determining the interest rate. The availability of RRPs encourages non-banks with funds to invest not to seek a return lower than the RRP rate.  Paying interest on reserves has been in place for a few years, the RRP process has been tested. The Fed can manage the Fed funds rate.

When

Friday’s Employment Report of 295,000 jobs added in February is merely the latest piece of strong economic news.  The unemployment at 5.5%, also reported in Friday’s Employment data, is in the range that the Fed terms as full employment – it would be nice to see it move lower, but the risk of inflation might move up from here.  At the same time, wages are still not rising much, if at all, so there is no immediate reason for the Fed to act.  Most forecasts look for the Fed to raise interest rates in the second half of 2015, a few suggest as early as June and some as far away as 2016.  Among those Fed members who have comments, the same wide range holds.

Friday also gave the markets a taste of things to come: the Employment Report spooked investors and sent major equity indices tumbling.   Zero interest rates can’t go on forever; something that can’t go on forever must, sooner or later, come to an end.  The Fed will raise interest rates, no one (not even Janet Yellen) knows when. And, until the Fed acts there will be moments like Friday when the fear of rising rates scares markets.

S&P Dow Jones Indices announced that Apple (AAPL) will be added to the Dow Jones Industrial Average, replacing AT&T (T), after the close of business on March 18, 2015; release attached.

All data is based on last night’s close, and will be finalized after the close of March 18, 2015. 

American Telephone & Telegraph was added to the Dow Jones Industrials on October 4, 1916.  It was rename AT&T on April 20, 1994, and deleted from the Dow on April 8, 2004.  On November 1, 1999, SBC Communications, which formerly was Southwestern Bell, one of the seven ‘baby bells’ spun-off by AT&T in 1982 (Ameritech, Bell Atlantic, BellSouth, NYNEX, Pacific Telesis, Southwestern Bell, and US West – all 7 were added to the S&P 500), was added to the Dow.  On November 21, 2005 AT&T merged into SBC Communications, with SBC Communications renaming itself AT&T, which is the issue being removed now. After the change, Verizon, which was also one of the original seven spun-off, Bell Atlantic, will be the only telecommunications issue left in the Dow.

The change in membership will occur as Visa does a 4-for-1 stock split, which will have an impact on the index since the Dow is price weighted.  Overall, the changes will reduce the weighting of information technology from 19.17%, down to 17.05%, since Visa’s 4-for-1 stock split outweighs Apple’s addition (even as the full market value weighting, such as the methodology used for the S&P 500, will change information technology’s market value to 30.92% of the Dow’s market weight, from the current 19.71%). Telecommunication’s index weight will be reduced to 1.80%, from the current 2.94%, as Verizon becomes the only issue representing the sector in the Dow.

As of last night’s close (3/5/15), the split, combined with the membership change, will reduce Visa’s position in the price-weighted index from #1, at their current $274.13 price, to #21, at $68.53, reducing its weighting percentage from 9.71% to 2.53%.  Goldman Sachs will be take over the #1 weighting position with 7.01% of the weighting, followed by 3M (6.18%), International Business Machines (5.95%), and Boeing (5.70%).  Apple will enter the index in the 5^th position, accounting for 4.66%, even as it is the largest publicly traded issue by market value in the world (all subject to change based on the March 18 close).

Visa has been the best performing issue in the Dow since the close of 2013, accounting for approximately 21% of the gain.  To some degree, the impact on the Dow of the split is similar to profit taking, since the gains were locked in and the issue reweighted; at the new weighting, Visa would need to decline 75% in price to negate the 21% gain it added to the Dow since 2013.

Splits in the Dow have been rare (as they have for the S&P 500 and the market in general), with the last stock split in the Dow being a 2-for-1 by Coca-Cola in August 2012, and the one before that being a 2-for-1 by Caterpillar in July 2005; I went back to 1980, but didn’t find a 4-for-1 in the Dow (S&P 5000 members salesforce.com and VF Group did a 4-for-1 in 2013).  Technically, Visa’s 4-for-1 stock split will not count as a Dow split, since it occurs before the addition.

Apple and AT&T, strangely, both pay a $0.47 quarterly dividend ($1.88 annual). However, Apple, at $126.41 yields 1.5%, while AT&T, at $34.00 yields 5.5%.  The change to the Dow will be a slight increase to yields (due to Visa, which yields 0.7%), as it goes from the current 2.29% to a proforma 2.33% (all 30 issues in the Dow pay a dividend).   Apple, which started paying a dividend in March 2012, increased its dividend rate in April 2013 and in April 2014 (see chart – just happen to have one hanging around).

Information technology and telecommunications weighting decline, as the other sectors split the gains

Proforma Dow as of last night: Apple added, AT&T deleted, Visa split 4-for-1

Apple’s dividend history – April 2015? 

Rumors and talk of Apple’s addition to the Dow have been prevalent on the Street for years, and have grown since its 7-for-1 stock split in June 2014
However, the Dow is price weighted, with Apple being 5^th in the Dow, as compared to 1^st in the S&P 500 (by market value) and twice that of #2 Exxon – bottom line is Apple has weight in the Dow, but it’s not the giant it is in the S&P 500, so don’t expect its impact to be the same, in either direction

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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.

Broadly speaking, stocks within the same sector are often exposed to similar risk factors.  Investors with large energy sector exposures have certainly been reminded of this over the last six months.  This is precisely why segregating the U.S. equity universe by sector has been so appealing to investors over the years.  Over the last 16 years, the average annual return differential between the best and worst performing sector has been nearly 40%.

At their core, factor-based equity portfolios are nothing more than groups of securities that share common characteristic(s).  For example, the S&P 500 Pure Value Index includes members of the S&P 500 with the most attractive valuations as measured by earnings per share, book value to price value ratio and sales to price ratio.

Putting these two observations together – stocks within a factor portfolio and stocks within a sector sharing risk factors – it should be no surprise that pure factor portfolios can have sector concentrations that differ substantially from market-cap weighted benchmarks.

Within our U.S. Factor Defensive Equity strategy, we consider five factors: momentum, value, dividend growth, low volatility and small-cap.  The table below presents the current sector weights for five S&P indices that represent these factors.  Along with the sector exposures, we calculate a “Sector Diversification Score” for each of the factors as well as the overall S&P 500.  A Sector Diversification Score of 0 would indicate 100% exposure to a single sector while a Sector Diversification Score of 100 would indicate equal exposure to each of the nine sectors.

Four of the five factor indices tilt significantly – greater than 10 percentage points – away from the individual sector weights of the S&P 500.  This should not be worrying in the least bit.  If a portfolio looks exactly like a market-cap benchmark, then we surely can’t expect it to do any better than a market-cap weighted benchmark in helping an investor achieve investment goals.

However, it does highlight the need to keep an eye on sector exposures as factor products are incorporated into investor portfolios.

Our U.S. Factor Defensive Equity strategy holds all five of the factors discussed in inverse proportion to their volatility.  The weights in our portfolio as of 1/31/15 are shown below.

By building a diversified factor portfolio we are able to increase sector diversification relative to the broad market.

One final point to keep in mind is that by definition factor-based portfolios and indices will rebalance more often than a market-cap weighted benchmark as the characteristics of the stocks in the overall universe change.  Naturally, these rebalances mean that the sector allocations will change over time.  The velocity of these changes will vary on a factor-by-factor basis.  More frequent changes will be seen in factors that have a price component, including value and momentum.

The oil price drop has precipitated a flurry of interest around enhanced oil indices since the benefits of enhancing rolls in energy are well understood from the obviously costly storage situations in oil. Below is a chart of the ten year cumulative return of the S&P GSCI Crude Oil Total Return versus the S&P GSCI Crude Oil Enhanced Total Return.

As investors have been interested in oil, questions have come up about the enhanced roll for agriculture since it can also be difficult to store. To shed some light on the return enhancement in agriculture, below is an analysis comparing the S&P GSCI Enhanced Agriculture Select and the S&P GSCI Agriculture Select.  The analysis in the “select” version is easier to understand given just four commodities: Chicago wheat (wheat), corn, soybeans and sugar.  The enhanced rolls are seasonal and are as follows:

• Wheat is rolled into the December contract annually during the November roll period
• Corn is rolled only to the July contract annually during the May roll period
• Soybeans follow the regular S&P GSCI roll schedule
• Sugar is rolled only to the March contract annually during the February roll period

The weights are based on world production and notice through time since 1995 that wheat has decreased while soybeans have increased but corn and sugar have been more cyclical. The chart below shows the daily historical weights of each commodity in the S&P GSCI Agriculture Enhanced Select. On average wheat was 33.2%, corn 32.9%, soybeans 19.2% and sugar 14.7%. Wheat is now 27.4%, less than its historical average. Sugar is currently at 13.0%, which is also less than its historical average. Corn and soybeans are currently weighted at 35.1% and 24.6%, both above their averages.

Next, the chart below shows the cumulative performance of daily index returns of the S&P GSCI Agriculture Enhanced Select and the S&P GSCI Agriculture Select.  There is an outperformance of 98.8% from the enhanced rolling strategy.

This is important since there is evidence the commodities “to be grown” have fallen in price through time. One study done by Bessler and Wolff in Aug., 2014, showed “while aggregate commodity indices, industrial and precious metals as well as energy improve the performance of a stock-bond-portfolio for most asset-allocation strategies, we hardly find any portfolio effects for agricultural and livestock commodities.” Further, according to this study by Jacks, real prices for “commodities to be grown” fell by roughly 33% in real terms from 1950.

However, when the rolling of agriculture futures contracts is employed strategically according to seasonal adjustments, it has been significantly positive.  The chart below shows the difference in monthly roll yield (excess return – spot) of the S&P GSCI Agriculture Enhanced Select less the S&P GSCI Agriculture Select. On average, the enhanced roll added 39 basis points per month.  Cumulatively, this has compounded to add 144.7% from Jan 1995 – Feb 2015.

If Jacks is correct in pointing out the transition from fixed capital accumulation to a consumption-based economy, and suburbanization is tentatively beginning, then it may be likely to see an increase in demand for goods “to be grown” and an inflection in long-run trend. The sub-trend pricing for goods “in the ground” could be the formation of a new cycle in the medium run. So if it is time for agriculture, an enhanced roll might make sense.

If there is one thing that the large stimulus programs enacted by central banks in the U.S., U.K. and Japan over the past few years have taught us, it is that they provide a whopping boost to equity markets in the short term.  Is that the only reason Europe is doing so well?

The European Central Bank announced its own €60bn per month bond purchasing program in January, and so far the S&P Europe 350 index of large-cap pan-European stocks has been having its best year ever.  Our end-of-month European dashboard shows a total return of 15% for the first two months of the year; it also shows that every sector and every country represented in the index has gained.

But – as we have seen in Japan – the problem with a rising tide lifting all boats is that the performance of those boats becomes highly dependent on the tide.  Otherwise said, if the stimulus program is all that is supporting the performance of European stocks, then as soon as it is priced in we return to a more volatile, uncomfortable market predicated on the ECB’s next move.

The good news is that this doesn’t seem to be the case.  There are plenty of other reasons to be optimistic about European equities that have nothing to do with Mario Draghi.  Lower energy prices should help the pockets of consumers and businesses, and most economists agree they should act to improve consumption.  Less commonly appreciated, it is actually good news that German workers are striking for higher pay, following a generous deal already completed with the single-largest union.  That’s seen as good news for two reasons: firstly because it helps to assuage fears of deflation, but also because the more expensive German workers are, the more competitive the rest of Europe’s labour force becomes.  Finally, it seems that Greece, her government and their counterparts across Europe will continue to muddle through in compromise.  The risks to markets of a “Grexit” are habitually overstated (Greek equities only account for about 0.2% of the market capitalization of the broad-based S&P Europe BMI), but the uncertainty has plagued markets for half a decade.  From the perspective of sentiment as well as the long-term future of the euro – the outlook is more optimistic than it has been for some time.

Yet, one can always find reasons to be cheerful, if you look hard enough.  So is any of this important?  Or do the ECB’s actions suffice to explain the performance of European stocks?  It’s obviously hard to say definitively, but one way to seek an answer is to look at correlations.  If, day-to-day, stocks have been moving up and down in concert and without respect to their individual circumstances, then it is reasonable to suppose that a shared theme was the dominant driver of performance.  On the other hand, if correlations are relatively low then we might conclude that a widespread combination of factors has been germane.

The results are intriguing.  Just before the turn of the year, the correlation figure for the S&P Europe 350 was recording three-year highs.  So, in advance of the ECB’s announcement it might to be fair to say it was all that mattered.   Since the announcement, however, correlations among European stocks have collapsed to their lowest levels on record.   So the evidence points to a range of factors supporting the performance of European equities, beyond and above the stimulus.  That might be another reason why so many investors are looking to Europe in 2015.