January 19, 2022
The Quarterly Statement: Q4 2021
Market Review: Fourth Quarter 2021
Opportunities for 2022 Following a Strong 2021
The S&P 500 index returned 11.0% in fourth-quarter 2021, finishing off a strong year and bringing the 2021 total return to 28.7%. The index posted an impressive total return of 119% since the COVID-19 sell-off lows on March 23, 2020, with 70 new all-time highs in 2021, the second highest behind the 77 highs in 1995. Small cap (Russell 2000 index) shifted to a positive return of 2.1% in the quarter. The index posted a 14.8% return for 2021 to close the year with its widest year-end underperformance relative to the large cap S&P 500 since 1998. Large cap growth continued to outperform large cap value for the third straight quarter in 2021, with the Russell 1000 Growth index posting an 11.6% gain and the Russell 1000 Value index gaining 7.8%, bringing 2021 total returns to 27.6% and 25.2%, respectively. In contrast, small cap growth (Russell 2000 Growth index) underperformed small cap value (Russell 2000 Value index) every quarter in 2021 to end the year at 2.8% versus 28.3% for value. International developed markets (MSCI EAFE Index) saw another positive quarter, finishing the year up 11.3%; international emerging markets (MSCI Emerging Markets Index) had a down quarter and finished the year in the red for the first time since 2018 with a return of -2.5%, its largest year-end underperformance since 2015.
Inflation, the Federal Reserve (Fed) taper and tightening timeline and COVID-19 variants were the dominant themes of the quarter. The U.S. consumer price index report for November was headlined by a 6.8% year-over-year inflation print, the highest annualized increase since June 1982. The Fed removed the word “transitory” from its inflation commentary, announcing a more aggressive taper timeline and more hawkish dot plot. Market expectations are for three to four rate hikes in 2022, potentially as early as March. While the delta variant was of some concern to the markets early in the quarter, the continued increase in vaccination and booster rates kept investor expectations positive. The World Health Organization announcement in November about the omicron variant generated some initial market volatility, but it was short lived when additional studies suggested the variant resulted in less severe cases.
We anticipate the positive economic momentum coming out of 2021’s stellar year of economic growth to ripple into 2022 in U.S. markets. Market concentration, particularly in large caps, likely remains a risk and could be more detrimental to passive products. The continued rotation from investing in a “good story” to investing in “good earnings” will likely continue in both large and small cap stocks, with value likely seeing some strength over growth this year. Key risks to the markets remain missteps by the Fed as it enters a quantitative tightening phase following an incredibly supportive environment in recent years. COVID-19 will likely remain in the headlines, but any new variants that shift this view substantially will likely be met with increased market volatility as the fiscal and monetary support potential will be in question. Overall, the economic backdrop looks positive for U.S. stocks, but the shift from a supportive fiscal and monetary environment will likely be met with some market volatility.
Following are three areas of the market that caught our attention in 2021, and where we believe there may be continued opportunity for 2022 — active small cap, active large cap and volatility strategies.
Small Cap: Negative Earners Could Create Positive Alpha for Active Strategies
Over the past 35 years, the small cap universe has had cyclical periods of negative earners outperforming positive earners. We define a negative earner as any company without earnings over the trailing 12 months. With the unprecedented monetary and fiscal support over the past few years, the Russell 2000 index component stocks have been in one of those cycles, with negative outperforming positive earnings. As of year-end 2021, ~35% of the Russell 2000 comprised negative earners, slightly off the all-time high of ~38% earlier in the year and well above the average of ~19.5% since August 1993 when sector data became available.
We believe this regime of negative earner out-performance may have peaked at the end of June. Second-half 2021 saw a notable shift in favor of positive earners, something we anticipate will continue into 2022. As seen in Exhibit 1, from 2016 to 2021 negative earners have outpaced positive earners with an annualized return of 13.6% for negative earners versus 9.7% for positive earners ($1.91 vs. $1.60, respectively, in total dollar growth during this time period). Specifically, from December 31, 2016 through June 30, 2021, negative earners outperformed positive earners by more than 2x (20.9% annualized return for positive earners versus 10.0% annualized returns for negative earners). In second-half 2021, negative earners declined 20% from midyear highs and positive earners increased 3.3%.
Historically, investing in positive-earning companies has proved more profitable than investing in negative-earning companies. Using the longest available history for which we have usable data for the Russell 2000 index (since December 31, 1986), positive earners have experienced almost 2.5x the annualized return with less than two-thirds the risk (annualized return for positive earners of 10.6% versus negative earners with 4.4% and standard deviation since of 19.4% versus 32.9%, respectively). A significant portion of this longer-term outperformance of positive earners is the avoidance of large drawdowns following market bubble bursts, like the internet bubble in the early 2000s and the global financial crisis in 2008.
During the internet bubble, negative earners saw 4x the annualized returns of positive earners from August 1998 to February 2000 (84% versus 21%, respectively), only to have those returns wiped out within 15 months and notable underperformance for the three-year period from February 2000 to February 2003 (-43% annualized versus 4%, respectively). While the financial crisis of 2008 did not see the same level of outperformance prior to the peak, negative earners experienced notable underperformance during the broader market drawdown.
We believe small cap stocks entered the correction phase of the negative earners’ outperformance in second-half 2021 and could continue to see relative weakness in these names throughout 2022. Given the concentration of negative earners in the Russell 2000, we continue to believe passive investors could experience notable underperformance during this cycle shift and therefore prefer actively managed strategies focused on higher quality, undervalued companies.
Large Cap: Concentration Risks to Passive Strategies
Over the past few years, there has been an increased concentration of a handful of names within the large cap indexes, with 2021 experiencing another increase from the prior year end. As seen in Exhibit 2, the top five weights in the S&P 500 (Apple, Microsoft, Amazon, Alphabet and Tesla) accounted for 23.0% of the index as of year-end 2021, up from 21.8% at year-end 2020. An all-time peak level of 23.9% was reached in August 2020, but in fourth-quarter 2021 that level was challenged, sitting at 23.7% at the end of November 2021.
While concentration of this magnitude (top five components with a weighting greater than 14% in the S&P 500) is rare, the dot-com period may be a reasonable proxy for how the index and the top five weighted stocks performed historically. For the three years prior to the March 2000 peak, the total weight of the top five components of the S&P 500 increased more than 50%, from 12.0% in March 1997 to 18.8% in March 2000. The top five weighted stocks outperformed the broader index by about 14.0% annualized over this period. After the peak in March 2000, these same top five underperformed the broader index by -6.1% annualized over the next three years. This compares to the average three-year return of the top five weighted stocks being about 80 basis points (annualized) below the broader index since 1993, regardless of the total weight of the top five. Of the top five weightings in 2000 (Microsoft, Cisco, General Electric, Intel and ExxonMobil), only Microsoft remains in the current top five.
While we may not have seen peak concentration for this cycle of the top five weighted companies, over the past three years the total weight of the top five has increased 54%, from 14.9% in December 2018 to 23.0% in December 2021. Since December 2018, the outperformance of the top five relative to the index has been an annualized excess return of 20.1%. If history were to repeat itself, the top five weighted stocks could experience underperformance relative to the index over the next several years.
A difference in the current environment versus the 2000s has been the substantial adoption of passive investment vehicles. As of November 2021, of the $26.9 trillion in managed U.S. funds, nearly 45% of these funds were passively managed (according to data collected by Bloomberg), and that number has been growing over the past 20 years. Of the passively managed strategies, about 44% have a large cap fund objective (according to Bloomberg data). While not all of these strategies may be indexed to the S&P 500, a reasonable assumption is that more money is invested in passive large cap strategies indexed to the S&P 500 than in the prior peak concentration in 2000. If this outperformance of the current five largest weighted stocks were to normalize, this could create an opportunity for outperformance by active funds with lower concentrations in these mega caps or large cap allocations that are more diversified versus strategies with high exposures to these five largest companies.
Volatility: Compensation for Short Volatility Remains Attractive
In oversimplified terms, implied market volatility tends to be driven by three factors: recent realized volatility, expectations for volatility around upcoming known events and the ever-present volatility of the “unknown.” Following a volatile year for markets in 2020, market-implied volatility for the S&P 500 as measured by the Cboe Volatility Index (VIX) remained elevated for much of 2021, with an average closing VIX price of 19.7 and a range of 15.0-37.2 (compared to the 31-year average closing VIX price of 19.5 and a range of 9.1-82.7). The average 1-month S&P 500 index realized volatility for 2021 was notably lower at 12.3% versus 2020’s level of 26.1% and the 31-year average of 15.0%, suggesting much of the elevated implied volatility for 2021 was driven by events both known and unknown rather than continued realized volatility experienced in 2020. Simply put, investor concerns were the driver of higher implied volatility instead of actual market volatility. Likely drivers of the increased implied volatility were the uncertainty of the Fed’s path, the dysfunction in Washington with both fiscal stimulus and the debt ceiling, ongoing concerns surrounding COVID-19, the impacts of higher inflation and the fears of potential economic slowdown driven by supply chain constraints.
Unlike 2020, when exposure to long volatility tended to be profitable, short volatility strategies likely had the more profitable outcomes for 2021 when measuring exposure through the volatility risk premium (VRP). VRP, defined as the market implied volatility (expected) minus market realized volatility (historical), is a risk premium that tends to be missing from most asset allocations. Exhibit 3 shows the increased levels of the VIX versus the overall lower realized volatility of the S&P 500, which resulted in VRP experiencing its second highest level in 31 years of 7.4%, behind 2009’s record of 7.8% and the 31-year average of 4.1%.
Like many other parts of the market, volatility also cycles through regimes. Using the VIX and the S&P 500 index 1-month realized volatility, Exhibit 3 shows periods over the past 31 years with lower and higher volatility. The lower volatility regime is defined as 1-month VIX average below 15 and 1-month realized volatility below 12% for prolonged periods of time, and the higher volatility regime as 1-month VIX average above 20 and 1-month realized volatility above 16%for prolonged periods of time. A more normal volatility period (VIX at 15-20 and 1-month realized volatility of 12%-16%) occurs within both higher and lower volatility regimes, so for illustrative purposes we distinguish between higher and lower volatility regimes only.
Since 1990, U.S. large cap stocks experienced lower volatility regimes through much of the early 1990s (1991-1996), mid-2000s (2003-2007) and the majority of the 2010s (2013-2019), and higher volatility regimes in the late 1990s/early 2000s (1997-2002) and post-financial crisis (2008-2012). The most recent higher volatility regime for the U.S. markets began during the pandemic in March 2020 and has remained above normal volatility since then. We expect this to continue through 2022, particularly as markets grapple with the transition from an accommodative to more hawkish Fed as well as U.S. midterm elections, both historically with periods of increased volatility. While the transition from a lower to higher volatility regime is typically more favorable for long volatility strategies, the transition from higher to lower volatility like the current environment tend to be more favorable for short volatility strategies. With the compensation for short volatility risk remaining elevated relative to history in this higher volatility regime, we continue to prefer strategies with short volatility exposure.
All data is as of 12/31/2021 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. For institutional adviser use only, not intended to be shared with retail clients.