July 25, 2022
The Quarterly Statement: Q2 2022
Enter Bear Market, Stage Fed
Inflation continued to be the dominant topic of market focus in the second quarter, with the Federal Reserve’s rhetoric and rate-raising response shifting the market dynamics of the past decade. Over the past 10 years, broader indices have experienced less stock market volatility and strong returns, in part because of the omnipresent “Fed put,”1 low interest rates and liquidity
injections through the Fed’s bond buying program. This year has seen a notable increase in market volatility as the central bank attempts to tame inflation through raising rates and reducing liquidity in the system by beginning its balance sheet runoff. This shift resulted in a repricing of risk across the market, particularly in stock market valuations and increased volatility.
The S&P 500 Index finished the quarter in a bear market, declining 2 0.5% f rom all-time highs on January 3, 2022, with most of the drop reflecting a price-to-earnings multiple compression, given estimated earnings for 2022 have remained strong. The index experienced its worst quarterly return since the depths of COVID-19 in Q1 2020, with a drawdown in Q2 2022 of -16.1%, and marked its worst first-half performance since 1962. For the first time since Q1 2019, the S&P 500 did not close at a new all-time high this quarter, following 139 new all-time highs
over the past three years. The Cboe Volatility Index® (VIX®) closed at an average of 27.3% for the quarter, above the longer-term average of 19.5% since 1990 and reflective of the increased investor perceived risk and uncertainty in the market.
Large cap growth underperformed large cap value again this quarter, with the Russell 1000 Growth Index declining 20.9% compared to the Russell 1000 Value Index down 12.2%. The Russell 1000 Value Index has outperformed the Russell 1000 Growth Index by 15.2% year to date, the second highest outperformance in back-to-back quarters in almost 20 years, with Q4 2020 through Q1 2021 the highest since Q3 2002.
Small cap (Russell 2000 Index) had its worst quarterly performance since Q1 2020 with a drawdown of 17.2%, bringing the year-to-date decline to 23.5%, the worst first-half performance since the index’s inception in 1978. Small cap growth (Russell 2000 Growth Index) underperformed small cap value (Russell 2000 Value Index) for the seventh consecutive quarter to end the quarter down 19.3% for growth versus down 15.3% for value.
International markets saw weakness with a decline of 14.3% for Q2 2022 for developed international (MSCI EAFE Index) and -11.4% for international emerging markets (MSCI Emerging Markets Index). Concerns of the continued war in Ukraine, potential fuel shortages in Europe, China lockdowns related to a zero-COVID policy and persistent inflation contributed to the overall global equity weakness.
Fixed income failed to be a safe haven investment to offset the equity weakness as the Fed’s tightening cycle pushed yields higher and bond prices lower, resulting in another quarter of negative returns across many fixed income products. Following its lift-off rate raise of 25 bps in March, the Fed continued its tightening cycle with a 50 bps raise in May and 75 bps in June. The May headline CPI surprised to the upside with a 1.0% increase month-over-month and 8.6% year-over-year, the biggest annual increase since 1981. Fed Chairman Jerome Powell stated the
central bank’s plan of continuing to raise rates and reduce the Fed’s balance sheet to contain and control inflation, leading many economists to worry a misstep could result in a recession. The U.S. Treasury 2-year yield increased 62 bps to 2.95%, and the 10-year yield increased 68 bps to 3.01%. There were multiple periods of yield curve inversion this quarter across various tenors, historically a precursor to a recession.
West Texas Intermediate crude continued to show strength this quarter, even with some broader commodity weakness. After Q1 2022 record returns for Energy stocks, this quarter saw some giveback with a 5.3% decline, but Energy remains the only positive sector of the index year to date with a total return of 31.6%. Consumer Discretionary was the worst-performing sector for the quarter and year to date, with a decline of 26.2% for the quarter and year-to-date decline to 32.8%.
We began the year with expectations of higher market volatility given the unwinding of the past decade’s monetary support, although we expected the overall economy and earnings expectations to remain fairly robust through the year. The increased market volatility has been realized as the S&P 500 saw 63 of the 124 trading days in the first half of the year with daily moves of more than 2%, the most in the first half of the year since the depths of the financial crisis in 2009. Earnings have remained robust, with 77% of S&P 500 companies reporting positive earnings in Q1 2022 and 73% reporting positive revenue surprises. According to FactSet, the overall S&P 500 next-12-month (NTM) EPS estimates have risen over 7% since the start of the year, admittedly an unusual observation in bear markets, which has increased investor concern for potential downside earnings revisions to push the stock market lower. The latest U.S. real GDP estimate for Q1 2022 was -1.6% versus +6.9% for Q4 2021.
While economists are estimating a positive GDP print in Q2 2022 and real GDP growth of 1-3% for 2022, the Atlanta Fed GDPNow real GDP growth estimate for Q2 2022 is -1.2%. The “rule of thumb” definition of a recession is two consecutive quarters of decline in real GDP, which if the Atlanta Fed GDPNow real GDP estimate proves correct, would suggest the U.S. economy may already be in a recession.
Continuing our investment strategy themes for 2022 as noted in our Q4 2021 Statement and Q1 2022 Statement, we believe active small cap, active large cap and volatility strategies remain attractive. We provide updates to our thesis in the following sections.
Small Cap: Stocks Without Earnings Erase Prior Gains
Over the past several decades, there have been episodic periods of negative earner outperformance relative to positive earner outperformance in the small cap universe. This quarter appears to mark the end of the most recent cycle of negative earner outperformance that began at the end of 2016 and was fueled by unprecedented fiscal and monetary support during Q1 2020. (We define a negative earner as any company without earnings over the trailing 12 months, and therefore view these securities as more speculative.) In our Q4 2021 Quarterly Statement, we noted what we thought could be peak outperformance of small cap negative earners in mid-2021. As mentioned in previous quarterly statements, from December 31, 2016, through June 30, 2021, negative earners outperformed positive earners by 2x (roughly 20% annualized return for negative earners versus roughly 10% return for positive earners). From second-half 2021 through Q2 2022, negative earners declined 50.6% (not annualized) compared to a decline for positive earners of 17.3% (not annualized), erasing the outperformance of negative earners in the previous years.
As seen in Exhibit 1, since 2016 positive earners have experienced over 2x the annualized return with less than two-thirds the risk (annualized return for positive earners of 4.7% versus negative earners with 2.2% and standard deviation of 26.6% versus 40.5%, respectively). This is consistent with the longer-term usable data for the Russell 2000 (since December 31, 1986). From December 31, 1986, through June 30, 2022, positive earners have experienced over 3x the annualized return with less than two-thirds the risk (annualized return for positive earners of 9.8% versus negative earners with 3.0% and standard deviation since of 19.4% versus 33.2%, respectively).
For additional reading on the topic, please see Why Profitability Matters: Positive versus Negative Earners and Negative Earners Could Create Positive Alpha for Active Strategies.
While the Russell 2000 Index experienced its worst-ever start to the year, with increased growth slowdown concerns amidst the Fed’s tightening cycle, we believe many small cap stocks offer a compelling valuation risk/reward. We continue to believe positive earning companies will outperform negative earning companies in the long run. Additionally, we continue to believe the small cap universe could offer a more compelling valuation currently relative to large caps.
In comparison to the past 25 years (June 30, 1997-June 30, 2022), the latest month end price-to-book ratio of large cap stocks versus small cap stocks ranked in the 8th percentile, and the price-to-sales ratio sat in the 11th percentile. Both metrics are approaching levels not seen since the dot.com selloff (price-to-book 0.52 vs. 25-year average of 0.72 and low of 0.48 in October 1999 and November 2000, and price-to-sales 0.55 vs. 25-year average of 0.72 and low of 0.43 in November 2000).
While past performance does not guarantee future returns, during the dot.com selloff and the last time these ratios were at similar levels in late 2000-early 2001, small cap stocks outperformed large cap stocks over the next three years:
- In 2001-2003, the Russell 2000 posted an annualized return of 6.3% compared to the Russell 1000 return of -3.8%.
- Annualized returns from 1998-2000 were 12.4% for the Russell 1000 and 4.6% for the Russell 2000.
- Dividend yield is in the 19th percentile since 1993 but the 4th percentile over the past 20 years (0.37 vs. average since August 1993 of 0.65).
The one metric not screening cheap on a relative basis is free cash flow yield (includes dividends, excludes financial companies), which still favors large caps.
Large Cap: Concentrated Stock Outperformance Starting to Normalize
Throughout the past few years, we have voiced our concerns about the increased concentration in the large cap indices. Specifically, the top five weights in the S&P 500 (Apple, Microsoft, Amazon, Alphabet and Tesla) represented 21.2% of the index as of June 30, 2022, down slightly from the previous quarter of 23.4% and off the peak level of 23.9% in August 2020. Concentration of this magnitude is rare, with only the dot-com period and global financial crisis of 2008 experiencing peaks of greater than 14% since 1993, and neither hitting levels seen during the most recent cycle.
As seen in Exhibit 2, from the end of 2019 to the period of peak concentration (August 2020), the top five weights of the S&P 500 outperformed the average stock in the index by 47.2% (not annualized). This is similar to the dot.com period, where the outperformance was 50.1% for the top five weights versus the average stock from July 1999 through the peak in concentration in March 2000. Unlike the dot.com period, where the most concentrated stocks gave back the overperformance over the next nine months and eventually underperformed by over 22% in the 26 months after the peak (May 2022), this cycle’s outperformance of the top five weights has been much stickier. As of November 2021 (15 months after peak concentration), these top five weights still had an outperformance relative to the average stock in the S&P 500 of 43.4% (not annualized). As of June 30, 2022, the markets had started to give back some of this outperformance, with the top five weights returning 27% more than the average stock since end of 2019.
As noted in our Q1 2022 Quarterly Statement, during periods of peak concentration, markets also experience similar peaks of growth-to-value valuation extremes. We define growth-to-value valuation as price-to-book spreads of the most expensive quintile divided by the least expensive quintile of the Russell 3000 Index. Historically, the “correction” of the price-to-book spreads tends to be swifter than de-concentration of the index, with concentration remaining for years after valuation normalization. As noted in last quarter’s report, the markets have begun the normalization of growth-to-value outperformance. Value spreads have fallen from four to about two standard deviations away from the mean from 1993, while market concentration remains quite elevated near three standard deviations. Given the growth/value spread at extremes has historically normalized fairly quickly, and something that has been occurring in recent quarters, we believe concentration normalization will follow suit. While the timing of the normalization of this concentration is elongated relative to the dot.com period, as discussed above, we still believe the top five weighted stocks have more risk to the downside relative to the average stock, given the cycle of underperformance from concentration has likely begun. In other words, while the growth/value spread at extremes has historically normalized quickly, concentration risk remained for years, suggesting passive indices may have more risk than active strategies that underweight these stocks.
Volatility: Short Volatility Strategies Historically Outperform in Bear Markets
Our expectation for 2022 was, and continues to be, that the broader markets will remain in a higher volatility regime. Implied volatility, which is a proxy for investor expectations of the future price movements of the market, remained elevated again this quarter as noted by the VIX, closing at an average of 27.3% for the quarter, above the longer-term annual average of 19.5% since 1990. Realized volatility, which is the measure of actual price movements in the market, is also elevated: The year-to-date closing-price-to-closing-price realized volatility of the S&P 500 measures 25.1%, above the longer-term average since 1990 of 16.7%. The intraday volatility is also unusual with more than half of the trading days in the first half of the year in the S&P 500 experiencing 2%+ daily moves, almost 2x the yearly average since 1990 of approximately 38 days. Overall, both S&P 500 implied and realized volatility remained elevated through the quarter.
In past publications, we have discussed our belief that the current higher volatility regime is likely more favorable for short volatility strategies relative to long. However, in this quarter’s report we compare a short volatility strategy that has exposure to both volatility moves and equity returns. As with all compensations of risk, starting levels are an important driver of potential returns. The volatility risk premium (VRP), defined as the market-implied volatility (expected) minus market realized volatility (historical), is a risk premium that is currently above historical averages, as discussed above with the current VIX levels relative to history. (For more VRP information please see Expanding the Efficient Frontier by Capturing the Volatility Risk Premium.) While there are various strategies to capture the VRP, for this report we focus on a put-write strategy so that we can also have a strategy with equity risk.
The Cboe S&P 500 PutWrite IndexSM (PUT) “tracks the value of a hypothetical portfolio of securities (PUT portfolio) that yields a buffered exposure to S&P 500 stock returns. The PUT portfolio is composed of one-and three-month Treasury bills and of a short position in at-the-money put options on the S&P 500 index (SPX puts).”2 The strategy is a cash-secured put-write, meaning dollar-for-dollar put and cash exposure so that there is no leverage. The puts are rebalanced monthly, typically the third Friday of every month at options expiration. This strategy gives an investor exposure to both the VRP and the equity risk premium (ERP) because of the short put exposure. By selling a put, the seller agrees to be a buyer the underlying, in this case the S&P 500, if it declines, and in return is paid an option premium to take that risk. A strategy like the PUT Index has diversified exposures with roughly 50% to the VRP and about 50% to the ERP. We chose the PUT because of the available data back to June 1986.
Exhibit 3 compares the 12-month rolling returns of the S&P 500 versus the PUT from May 1987 through June 30, 2022. While past performance is not a guarantee of future returns, historically the PUT has outperformed the S&P 500 in all but the most bullish of the S&P 500 return periods. The options premium, or VRP, received through the put sale has historically offered a cushion in a declining market. In a market that is sideways to slightly trending, the cushion has historically been a positive contributor to returns relative to just index exposure. In the most bullish of markets, particularly those with the S&P 500 experiencing returns >20%+, the underexposure to the ERP relative to owning the index has been a drag on performance.
We expected and continue to expect this higher volatility regime to remain through 2022, particularly as markets grapple with the transition from an accommodative Fed to a more hawkish one, U.S. midterm elections, inflation and recession fears. With the compensation for short volatility risk remaining elevated relative to history in this higher volatility regime and the uncertainty in equity markets leading us to believe the most bullish of S&P 500 returns are unlikely, we continue to prefer strategies with short volatility exposure, particularly those with “cushioned” equity exposure.
1 The “Fed put” refers to a belief held by investors that the Federal Reserve will step into financial markets with accommodative monetary policy such as cutting rates to support financial markets should asset prices decline sharply.
All data is as of 6/30/2022 unless otherwise noted. Opinions represent those of Glenmede Investment Management LP (GIM) as of the date of this report and are for general informational purposes only. This document is intended for sophisticated, institutional investors only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIM’s opinions may change at any time without notice to you.
Any opinions, expectations or projections expressed herein are based on information available at the time of publication and may change thereafter, and actual future developments or outcomes (including performance) may differ materially from any opinions, expectations or projections expressed herein due to various risks and uncertainties. Information obtained from third parties, including any source identified herein, is assumed to be reliable, but accuracy cannot be assured. This paper represents the view of its authors as of the date it was produced, and may change without notice. There can be no assurance that the same factors would result in the same decisions being made in the future. In addition, the views are not intended as a recommendation of any security, sector or product. Returns reported represent past performance and are not indicative of future results. Actual performance may be lower or higher than the performance set forth above.