Q4 2018 Market Commentary

Highlights

• Market performance in December worst since Great Depression
• The downturn in Q4 was market-wide. We expect Stratified Weight to outperform as Business Risk trends emerge in recovery
• FAANGs lose their bite
• SEADM outperforms EAFE by 2.6% in 2018
• Stratified LargeCap outperforms Equal Weight by 1.2% in 2018
• Stratified MidCap outperformed the S&P MidCap 400 by 3.6% in 2018‍

‍Market performance in December is worst since Great Depression

Summary: Though the volatility in October and November seemed to be driven by earnings season, the downturn in December was driven by broad market factors.

• Concerns about future US growth and US interest rate rises weighed heavily - the US yield curve briefly inverted (3s and 5s) in early December, suggesting that a recession looked likely in the near future.
• Political pressures added to the volatility. The US midterm elections saw Democrats win the House of Representatives and left Congress divided.
• The US-China trade dispute continued, with escalation only paused by a temporary truce struck in December.
• Markets had their worst quarter since Q3 2011 and their worst December since 1931. The S&P 500 fell 13.5% over the quarter, with the Syntax LargeCap Index outperforming by 30 bps (-13.2%).
• Weak results from several large cap tech companies, fears of a recession, coupled with rising interest rates and political turmoil saw markets sell off and volatility rise. The VIX doubled from 18 on December 1 to 36 by Christmas Day.

The downturn in Q4 was market-wide

Summary: The downturn in Q4 was market-wide. We expect Stratified Weight to outperform as Business Risk trends emerge in recovery.

• The decline was market-wide, with all eight Syntax sectors falling and seven out of eight sectors falling by a similarly extreme amount 13-15%. Sectors were negative in both the 500 and 400 indices.
• This is indicative of a market-wide sell off and is often followed by a market-wide recovery, where Stratified Indices outperform their cap-weighted counterparts (e.g. March 2003 or March 2009).

FAANGs lose their bite

Summary: Widely reported in the financial press, over-concentration in the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google/Alphabet) dragged the benchmark lower with a string of disappointing announcements.

• This theme continued into 2019 as Apple lowered Q1 guidance - its trillion dollar market value looks like a distant memory after Apple ended the quarter down 29.9%.
• In the cap-weighted benchmark these securities’ outsize weights, which previously lifted the S&P 500 higher, meant their downturn had a disproportionate impact. The FAANG companies had 12.8% weight in the benchmark at the start of the quarter, so that their poor performance alone accounted for the S&P 500 dropping 2.9%. In contrast, they were only 0.8% weight in the stratified 500, contributing just -0.2%.

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SEADM outperforms EAFE by 2.6% in 2018

Summary: While volatility in the US was market-wide in 2018, international market saw broad sector themes emerge. As a result the spread between sector performance was wider and Stratified Weight outperformed.

• Stratification reduced the business risk concentrations in Financials, Industrials, Consumer (autos) and hence SEADM outperformed by 2.6% (SEADM fell 10.6% versus 13.2% for MSCI EAFE).
• International headwinds look set to continue in 2019. Tensions build around Brexit on March 29th, and European Elections in May. Meanwhile protectionist trade measures continue to gain traction.
• Therefore, we believe that the business risk diversification offered by SEADM is the best approach to gain international exposure while avoiding potentially painful overexposure to particular sectors.

Stratified LargeCap outperforms Equal Weight by 1.2% in 2018

Summary: Stratified LargeCap outperforms Equal Weight by 1.2% in 2018 and the underperformance of Equal Weight in 2018 was largely due to poor diversification of business risk.

• While an equal weight methodology is seen by some as delivering adequate diversification, it still leaves the index exposed to specific sectors and Related Business Risks.
• In an equal weight index those sectors with the most stocks are given the most weight.
• These sectors are Industrials (16.8%), Financials (15.6%) and Information (16.0%). All three sectors were among the worst performing sectors in Q4.
• Furthermore, the S&P 500 Equal Weight Index missed out on less populous sectors such as Food and Information Tools, which were among the best performing.
• The RAFI US 1000 Index and DFA Core Equity 1 Portfolio had even lower performance than the S&P 500 Equal Weight Index, returning -8.3% and -8.7% in 2018.

Stratified MidCap outperformed the S&P MidCap 400 by 3.6% in 2018

Summary: Stratified MidCap fell 7.5% in 2018 versus the S&P MidCap 400 which fell 11.1%, outperforming by 3.6%. Similar to equal weight above, stratifying the mid cap universe is a business risk diversification story.

• In the large cap universe, stratification removes idiosyncratic/stock-specific concentrations (e.g. FAANGs) as well as company type concentrations. Whereas in the mid cap universe, because the weights are in a tighter band, cap weight lacks the mega cap company concentration problem seen in the S&P 500. However, equal weight still has sector biases that stratification removes.
• The S&P MidCap 400 has large overweights in Industrials (22.8%) and Financials (21.6%), both of which significantly underperformed (-15.2 and -14.3% respectively).
• The Stratified MidCap Index diversified these sectors more effectively and hence outperformed its cap-weighted counterpart.

Sector Takeaways

Energy splutters in Q4

• Concerns about growth, and easy supply conditions saw WTI fall from its year high of $76 in early October to finish the year at $45.
• At the end of Q3, energy stocks in the Stratified Weight and cap weight 500 had posted strong returns for the year (8.6% and 6.0% respectively).
• However, the fall in oil prices in Q4 saw these gains erased. Mid cap energy companies had an even tougher time in Q4: the stratified sector lost 16.8% and the cap-weighted sector dropped 23.2%.

Stratified Healthcare underperformed due to Merck and Pfizer

• In Q4, the stratified large cap Healthcare sector gave up its gains for 2018 (finishing down -1.4%), as the S&P 500 Healthcare sector rose 6.5%.
• The outperformance of the cap-weighted Healthcare sector was largely due to strong performance of Merck and Pfizer (+40.0% and 24.8%), two of the largest healthcare companies in the S&P 500 with market caps of almost $200b and $250b.
• Excluding Merck and Pfizer, the cap-weighted Healthcare sector returned only 3.5% in 2018.

Consumer sector hurt by Amazon headwind

• The Stratified Weight large cap Consumer sector fell 14.6% in Q4, underperforming the cap-weighted sector by 2.9%, due to falling US growth expectations and pricing pressures from Amazon.
• Supply pressures caused by the ongoing trade disputes were also a headwind.

Industrials fall on growth concern

• The growth concerns and trade disputes also strongly impacted Industrials.
• The only companies in the sector with positive returns in Q4 2018 were Rockwell Collins, which was acquired by United Technologies, Ball Corp., and Newmont Mining (3 out of 85 companies rose).
• Defense performed particularly badly, due in part to the White House’s softening foreign policy positions (announcing plans to withdraw troops from Syria and Afghanistan, and the departures of Mattis and Kelly).

Comfort Food

• As is usually the case when markets become stressed, defensive sectors such as Food perform well.
• Food was the best performing sector last quarter in both cap weight and Stratified Weight (-5.5% and -6.4%).
• The outperformance of the cap-weighted sector stemmed from particularly strong returns by the largest companies, namely Starbucks (+13.9%) and McDonald’s (+6.8%).
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Disclaimers
Past performance is no guarantee of future results. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The inception date of the Syntax Stratified LargeCap Index and Syntax Stratified Sector Indices was December 27, 2016. The inception date of the Syntax Stratified Europe & Asia Developed Markets Index was January 1, 2016. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back-tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index. Charts and graphs are provided for illustrative purposes only.

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