Over the past six years, August has been the worst performing month of the year for equities. Macro risk events loom large, including the uncertainty about the US Presidential election and the lack of specifics from the candidates about economic policies. And what about the Fed and the possibility of a rate increase? And the uncertainty caused by Brexit?
Over the past six years, August has been the worst performing month of the year for equities. Macro risk events loom large, including the uncertainty about the US Presidential election and the lack of specifics from the candidates about economic policies. And what about the Fed and the possibility of a rate increase? And the uncertainty caused by Brexit?
Over the past six years, August has been the worst performing month of the year for equities. Macro risk events loom large, including the uncertainty about the US Presidential election and the lack of specifics from the candidates about economic policies. And what about the Fed and the possibility of a rate increase? And the uncertainty caused by Brexit?
More importantly, just as we enter a historically dangerous month for the market, complacency has risen. The VIX (volatility index) has dropped -28% from its February 2016 high and currently sits at its lowest level of the year.All are reasons to be a bit cautious on the equity market in the near term.Ultimately, however, as we progress beyond the summer months, we believe the outcome for the market will be a result of earnings growth. Clearly, that’s what last year’s return reminded us: there is a strong correlation between the S&P 500 annual return and earnings growth. In other words, generally speaking, anaemic earnings growth equals anaemic returns. What’s more, as of 30 June, 2016, the S&P 500 2016 consensus earnings estimate was $118.79. That’s a weak increase of 1% over 2015 earnings. And with the US market, as represented by the S&P 500, already up over 7% for the year, it’s difficult to see the market making significant headway from here.But that’s exactly where we believe the opportunity arises. We believe the very sectors that caused the overall weak earnings growth last year may revert from a headwind for the S&P 500 to a tailwind. The “old economy sectors”, energy, industrials and materials have begun to turn up. The result, as the chart inset shows, is that the Citi Economic Surprise index has turned positive after being negative since early 2015. Is it coincidental that the market has been stagnant since this index went negative? We think not.What’s fascinating is that despite the opportunity set increasingly moving toward these cyclical value sectors, which will benefit if we get more economic acceleration, investors are loaded to the gills in low risk, low volatile economically insensitive stocks. According to the Wall Street Journal on 25 July, 2016, the top three low volatility strategies have experienced $12.5bn in inflows this year, resulting in huge outperformance of utilities, telecom and consumer staples YTD. That is classic investor behavior: chasing what has already worked. We believe reversion to the mean, arguably the most powerful concept in investing, suggests higher moves in the equity market for these value cyclical sectors and lower for these perceived “safe” sectors.To be clear, we are agnostic. We run unconstrained-style funds which simply try to take advantage of what the market offers, capitalising on reversion to the mean opportunities. The market and earnings have both been in stall mode for the past 18 months since the end of 2014, and the supposition that will remain has been bid up to high levels. However, we believe reversion to the mean is in the not too distant future, especially given the stronger economic data of late. Of course, we need to first get through the summer months.Andrew Slimmon is a senior portfolio manager at Morgan Stanley Investment Management
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