Q3 2019 Market Commentary

Risk and Valuation: Red Flags for Cap Weight

• US Large Cap has strongest YTD since 1997
• VIX and S&P 500 both rise in Q2 and Q3 - suggests more volatility to come
• Tech sector sees a renewed focus on valuation
• Active Business Risk: Core products are heavily biased

US equities continued to rally in Q3 as economic data and earnings growth remained strong. However, the quarterly performance numbers mask a treacherous environment. As US equity markets rose, so too did the VIX (investors are becoming increasingly nervous). At the same time, both the IPO market and the public equity markets are hinting that valuation matters again and that momentum strategies may see further downside pressure. These themes make us worried about the heavy concentration cap-weighted indices have in high momentum, high valuation technology stocks.

Core Index Comparison: Cap Weight versus Stratified Weight

Record bull market, but volatility on the rise

The S&P 500 rose 1.7% and the Stratified LargeCap Index (which comprises the same stocks with different weights) performed in line (+1.5%). While political uncertainty and trade concerns still persist, the S&P 500 is in the longest bull market period in history, according to the Wall Street Journal, and through Q3 2019 the S&P 500 had risen 20.6%, its strongest YTD performance since 1997(1). Despite its more diversified weighting approach, the Stratified LargeCap Index performed in-line with its cap-weighted counterpart.

However, the picture is not as rosy under the surface. The US yield curve has inverted deep into its term structure and the IPO market is showing signs of weakness (especially for high valuation companies). Though the S&P 500 rose in Q2 and Q3, the VIX also rose, breaking its usual negative correlation.

Volatility Index and S&P 500: Last four quarters

This is very unusual - the two indices have a negative 70% correlation and there are only 7 other instances in 25 years of both indices rising in consecutive quarters.

‍Periods when S&P 500 and VIX both rose in consecutive quarters

For the seven similar periods, shown as the blue bars on the chart above, the average level of the VIX was 20.7 - similar to its level at the time of writing (20.3 on 10.8.2019). The following year, the VIX rose over 20% on average.

1. See Wall Street Journal, “U.S. Stocks Poised to Enter Longest-Ever Bull Market.” Aug 21 2019

Tech sector sees a renewed focus on valuation

The anti-trust investigations into big tech (see Q2 Insights), coupled with a softening in the IPO market has given investors a renewed focus on valuation for technology related companies. In Q3, the FAANG stocks with above market P/E multiples underperformed the market, whereas those with lower multiples outperformed. Four of the five FAANG stocks are in the Information sector and oversized exposure in many market cap-weighted indices has led to a bias in that sector. In contrast, by spreading weight more evenly, the Stratified LargeCap Index allocated only 0.8% to the FAANG stocks in Q3.

FAANG stocks: Valuation and performance in Q3

Core equity products remain heavily biased

The Syntax Active Business Risk Score enables us to more accurately measure the amount of sector and industry bias in a portfolio or index. It is a measure of industry weightings relative to a neutral (equal) business risk exposure (see “Active Business Risk” by Rory Riggs).

We find that key equity indices continue to take large positions in specific business areas and have above average Active Business Risk scores. For example the S&P 500 has a score consistent with that seen in Q4 1999.

Historically, when markets become over concentrated, economic shocks carry an exaggerated impact on overall performance and hence the portfolio underperforms its potential. We caution taking a cap-weighted approach to capture the equity risk premium at these Active Business Risk levels.

Sector Exposure and Bias (from neutral business risk)

Active Business Risk in the S&P 500

Sector and Composite Performance

US LargeCap (S&P 500 universe)

Europe & Asia Developed Markets (MSCI EAFE universe)

Disclaimers

Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only.

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