This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.
With the first half of the year behind us, it’s time to take a look back at investment performance during the first six months of 2015. So far, momentum and growth have been the best-performing investment style factors, while active, large-cap, low volatility, value and dividend strategies have lagged. Eight factors were able to beat the S&P 500 Index, and three factors outperformed the S&P 500, S&P MidCap 400 and S&P SmallCap 600 indices. Small- and mid-cap stocks outpaced large-cap shares, aided by a strong dollar and reversions back to the mean in performance from 2014.
First half 2015 returns by investment factor
The first half: A bifurcated earnings backdrop creates performance dispersion
Momentum stocks tend to perform well during what quantitative analysts refer to as “periods of dispersion.” These are periods when the market can clearly focus on stocks with strong and weak performance, and discriminate between winners and losers. Dispersion contrasts with periods where stocks are moving up and down together in high correlation. This type of environment is sometimes referred to as “risk-on/risk-off.” The lagged impact of a rally in the US dollar, a sharp drop in energy prices and a mixed trend in sector earnings have contributed to the dispersion we’ve witnessed. One indication of dispersion rests in declining correlation between stocks and the overall market. The 63-day correlation of S&P 500 stocks to the S&P 500 Index eased through the first half of 2015, falling from 0.6174 on Dec. 31, 2014, to 0.5445 as of June 30, 2015.1
The dispersion in earnings was exacerbated by a mixed corporate earnings outlook. For example, the strong dollar has weighed on earnings in the export-heavy materials, energy, and consumer staples sectors – with shares in the energy and materials sectors further hampered by weak commodity prices. At the same time, consumers are benefiting from cheaper import prices and lower energy costs brought about by a strong dollar. These trends cut both ways for industrial companies, which typically benefit from lower energy prices, but see their exports hurt by the strong US dollar. The following table illustrates this dispersion in the earnings outlook:
S&P 500 earnings by sector
Notice that second quarter earnings are projected to contract on a year-over-year basis in the consumer staples, energy and financial sectors, and display minimal growth in telecommunication services. By contrast, health care and information technology (IT) companies are projected to have double-digit profit gains. Over the past six months, growth investors have largely benefited from the growth of health care and IT. Indexes have also rebalanced accordingly: The Dynamic Large Cap Growth Intellidex Index, used as a proxy for the growth factor, had an average exposure of 41% to health care and IT, with a 22.4% weight in consumer discretionary shares.
Low-volatility performance was benign
Volatility was generally benign in the first half of 2015, despite periods of disappointing economic growth and the threat of higher interest rates. The CBOE Volatility Index (VIX) – a barometer of near-term market volatility – fell from 19.2 at the end of 2014 to a low of 11.9 on June 23 just before the Greek exit crisis began to flare. A low-volatility environment tends to weigh on the performance of the low-volatility and quality factors. Conversely, these same factors can outperform during periods of market stress and rising volatility. Active strategies, as measured by the S&P 500 Dynamic VEQTOR Index, were also pressured by the decline in volatility and the term structure of VIX futures.
Interest rates increased during the first half of the year, with the 10-year Treasury yield hitting a monthly low of 1.64% on Jan. 30 and rising to 2.47% by June 26. This jump in interest rates depressed the real estate investment trust (REIT) industry and utility sector, while also hurting large-cap low volatility and dividend strategy performance. Value, as defined by the Dynamic Large Cap Value Intellidex Index, was weighed down by inventory concerns in the technology and consumer staples sectors. This was driven part by weak demand for personal computers in the first half of 2015.
Outlook for the second half of 2015
The second half outlook for equities is constructive, but the road is likely to be bumpy in my view. Already, market participants are looking ahead to 2016 earnings. Profit margins for companies within the S&P 500 Index are expected to rise more than 14% on a year-over-year basis in 2016, and increase across all sectors. Given the low level of interest rates, I believe stocks look attractive, with a few obvious alternatives. After all, a 10-year Treasury yield in the neighborhood of 2.50% is barely above the S&P 500’s dividend yield of 2.04%, and well below the expected 2016 earnings yield of 6.39%.2
Nonetheless, investors will likely have to navigate obstacles, including high manufacturer inventory levels, the lagged impact of a strong dollar and, quite possibly, the first Federal Reserve rate hike since 2006. Higher wage costs could also weigh on earnings, given the trend of companies raising their minimum wages. Conversely, higher rates could benefit financial companies by improving net interest margins (the difference between interest income that financial institutions generate and the interest they pay to lenders), while a healthy labor market and lower fuel costs should boost consumer shares, in my view.
Factor performance is likely to be driven by emerging macroeconomic themes. Dusting off the crystal ball, here are a few potential drivers of factor performance:
- I believe we’re likely to see improved low-volatility investment performance in the second half of the year. Given its recent rebalance, I believe the S&P 500 Low Volatility Index is better positioned for rising interest rates with materially lower exposure to utilities and REITs. At the same time, it has exposure to banks, insurance companies, and diversified financials. Moreover, volatility has already fallen toward the lower end of its longer term trading range after moving under 12 in June. Mean reversion argues for trends to be flat to higher.
- The stock market sell-off in China could generate uncertainty over the pace of global economic growth and provide support to the low-volatility, quality, and the active strategy (S&P 500 Dynamic VEQTOR) factors.
- If the market can get beyond Greece, a healthy consumer sector and the potential for dispersion in corporate earnings growth into year-end could keep the momentum factor strong, in my view. Momentum, as defined by the Dorsey Wright Technical Leaders Index, has over 30% exposure to consumer discretionary shares, and the dispersion in earnings is expected to remain high into the first quarter of 2016 before easing somewhat.
- Higher interest rates could help financial stocks, which often trade at a low valuations and can have value characteristics. This may lend some support to the value factor. However, investors may also want to give attention to growth as a factor, given the outlook for vibrant growth in 2016 corporate earnings.
- With the US dollar still strong and American consumers ramping up spending, small-cap stocks may once again find interest, as they continue their recovery from weak relative performance in 2014.
- Buyback was a middle-of-the-pack factor in the first half of 2015, but I believe de-leveraged corporate balance sheets and a continued focus on returning value to shareholders could support this factor. This may especially be the case internationally. Outside the US, companies are benefiting from the strength in the US dollar, which has boosted the profit growth of overseas exporters.
1 Source: Ned Davis Research, June 30, 2015
2 Standard & Poor’s, Bloomberg, LP, July 2, 2015