Indexology^® Blog

There is a Mexican saying about the weather, “Febrero loco, Marzo otro poco,” which means, “February is crazy and March is even more”.  I didn’t think about applying this to financial markets until now, with the European Central Bank (ECB) announcement, economic data in the U.S., inflation in Mexico, and last but not the least, the Fed’s monetary policy announcement.

Having announced that the ECB will stimulate its economy through additional purchases, bonds have seen increased demand recently.  Then, all eyes were on U.S. employment data, with the positive economic news that non-farm payrolls were up 25% more than expected (the estimate was for 235,000 jobs, and the actual level was 295,000).  One business day later, Mexico published its CPI for February that showed a 3.00% annual change, versus the 3.03% estimate; remember, the objective of the Mexican Central Bank (Banxico) is between 2% and 4%.  A few days ago, the Fed’s “patience” was over.  The question is: will Banxico take action before or after the Fed?  Looking at the CPI and level of the Mexican peso could point in that direction.

In March 2015, the Mexican 10-year reference bond has increased 25 bps to 5.88% from 5.63% (with a 19 bps average in the whole curve), with a closing high of 6.10% on March 10, 2015, with a 6.26% intraday level that day, causing the S&P/Valmer Mexico Government MBONOS Index to lose 0.97% (17.44% annualized).  Real rates also have moved significantly in March 2015, increasing 24 bps and causing the S&P/Valmer Mexico Government Inflation-Linked UDIBONOS Index to lose 1.59% (28.55% annualized).

The Mexican peso has depreciated by 2.13% since the start of the month, from 14.95 to the March 19, 2015, close of 15.27.  On March 20, 2015, the currency is down 1.52% (15.04).  Continued currency depreciation of the peso means that the strength of the U.S. dollar has helped the return of the S&P/Valmer Mexico Government International 1+ Year UMS Index to be less of a loss, at 17.05% annualized.

Of note, this week’s auction of government bonds had its highest bid-to-cover ratio since November 2014; it seems that depreciation of the currency hasn’t stopped the inflows.

With all that is happening, don’t forget to watch the movements and thoughts of the analysts in the Banamex Survey of Economists was published on March 20.

On Friday S&P Dow Jones Indices announced that Apple will be added to the Dow Jones Industrial Average after the market close on March 18^th.

What’s in it for Apple

Apple was certainly well-known last week before the announcement that it will join the DJIA.  However, its entry into an exclusive club defined by The Dow, the oldest and most followed market measure, still confers more recognition. One comment on Seeking Alpha said Apple is now an adult.  There may not be a universal definition of what a Blue Chip stock is, but no one will argue now that Apple doesn’t qualify.  Much the same could be said for the other companies in the DJIA – any company joining The Dow is already an established leader with a history of success.

One thing that Apple isn’t likely to get by joining the Dow is a pop in its stock.  At times in the past companies being added to one of a few key indices saw their stock gain as index funds and ETFs tracking the index bought shares.  The “index effect” or “index pop” has been widely studied in the S&P 500®.   In recent years some stocks joining the S&P 500 experienced a temporary gain of 3%-6% which was given back over the next few months.  The funds tracking the S&P 500 are orders of magnitude greater than the approximately $30 billion tracking The Dow.  Not enough buying is likely to be generated to even briefly move a stock as large as Apple.

While there is no price or index effect, there is a “list effect” for both The Dow and the S&P 500. Apple is now on the list of Blue Chips — when a journalist wants to talk to a leading company or try to interview a famous CEO she will look at the list. The same is probably true of a Congressman seeking a campaign stop that will get him on the evening news or in someone’s Twitter feed.  One advantage of The Dow list  compared to the S&P 500 list is that the former isn’t likely to be used as a hunting ground for takeover targets.  More than half the exits from the S&P 500 are caused by companies being taken over, often by another company in the same index.

What’s in it for The Dow

The market changes, the economy shifts and the Dow changes as well.  Only one company, GE, of the current 30 is an original member from 1896, and it is very different today from what it was 119 years ago.  Adding Apple to The Dow is another change in a long list off entries and exits that keep the DJIA representative of current Blue Chips.  As long as the economy grows and the markets change, there will be more changes to The Dow.

The addition of Apple was supported by more suggestions, arguments and advice that it belongs in The Dow than most previous changes.  At the same time, it would have been quite difficult to add Apple if it hadn’t split its stock seven for one in June 2014. Whether one reason for the split to make Dow membership possible is a question for Apple, not S&P Dow Jones Indices.   We don’t discuss possible index changes with the companies affected or with anyone outside of the committee overseeing the particular index.

What About AT&T

The Dow has 30 members and adding one means removing another.  The decision to add, or remove, a stock from the The Dow (or any other index) is not an investment opinion. No buy/hold/sell.  The decision is based on what can make the index a better market measure.  There were two telecommunication companies in The Dow – AT&T and Verizon – and the decision on which to remove was based AT&T’s lower stock price. Since The Dow is price weighted, the lower a stock price, the less impact on the index.

An analysis in Seeking Alpha noted that stocks exiting from The Dow often do well. Just as being added to an index gets a stock noticed, being removed can also generate some investor interest.  Some investors believe that by the time a stock joins an index; its price has already risen while those leaving may be ready to rebound.

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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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.