S&P 500: When The Best Defense, is Getting Defensive

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S&P 500: When The Best Defense, is Getting Defensive..

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Stock returns and football season are – bar nothing – my favorite parts of the Fall. However, this month’s equity pullback, coupled with my Detroit Lions being last place “sellers” in the NFC North – has me looking to the future on both fronts. Perspective matters, even with the most recent pullback the S&P 500 Total Return is still up almost 400% since the market bottom on 3/9/2009. Unfortunately, the Lions are as far as possible from the NFL equivalent of excellent performance history. That honor goes to the New England Patriots, an apt companion to the “Most Hated Bull Market in History” having posted an NFL best 119-35 (77.0%) record since the beginning of the 2009 season (20 games better than the 2ndbest Pittsburgh Steelers!). During periods of sustained success, a lot can be learned from the losses they do take – as infrequently as that may be lately.

In football, while time of possession is not in and of itself highly correlated to winning games, the book on beating the Patriots has been to keep the ball out of Tom Brady’s hands. In Patriots losses from 2009-2018 the Pats have possessed the ball 10% less in defeats vs victories. Essentially, the best defense against the Patriots, has been a good offense keeping them off the field. Bringing this back to the financial markets, what can we learn from historical periods of market pullbacks and the best way to weather them?  Below we will look at historical concentration and return data which suggests that the best defense during a major market pullback is not a great offense, but to “get defensive” through allocating away from the largest sectors that have pulled the market to record levels (and have most to lose) and into sectors that have been relatively overlooked (and have the most to gain).

Historical S&P 500 Sector Concentration

As the largest companies in the S&P 500 eclipse $1 Trillion in market cap, the cap weighted nature of that Index leads to concentration. This is especially true when the largest stocks, (particularly FAANG and Microsoft) have been responsible for generating a disproportionately large amount of the S&P 500’s recent return and are heavily Tech concentrated. In fact, Exhibit 1 shows below that prior to the S&P’s sector recategorization – the Information Technology Sector had reached the highest weight of any sector in the S&P 500 (25.9% as of 6/30/2018) since… Information Technology (29.2% as of 12/31/1999) just before the Dot Com Bubble.

Exhibit 1 – S&P 500 Sector Exposure Over Time (12/1996 – 6/2018)

To be clear – this is not to suggest that Tech today is as overvalued as Tech in 1999 – but based on Morningstar’s S&P 500 attribution figures (seen in Exhibit 2 below), 46.4% of the S&P 500’s total return from 1/1/2017-10/31/2018 was generated by the Info-Tech Sector – which was 2.7x the contribution of Healthcare, the next best performing sector.

Exhibit 2 – S&P Contribution By Sector (1/2017-10/2018)

 As the FAANG trade has recently faltered and led Tech lower, investors should pay attention to low cost and efficient ways to get alternative core diversified US Equity exposure with less concentration risk.

S&P 500 (SPX), S&P 500 Equal Weight (S&P EWI) and S&P 500 Reverse Cap Weight (Reverse)

As mentioned above, December of 1999 was the last time a single S&P sector had a higher concentration than Tech (pre-sector recategorization). As a Cap Weighted Index, Tech gained that size within SPX through a sustained period of massive outperformance. Then and now, this creates a live by the sword/die by the sword environment in which the market is buoyed up and ultimately pulled down, largely due to the performance of that one sector. Through comparing SPX, S&P EWI and Reverse (three unique weighting schemes using the same underlying 500 constituents), we can get a sense of the relative breadth (or narrowness) or a market run-up/pullback. For those less familiar with the Reverse Weighted concept, more information can be found here.

For example, if every stock in the S&P 500 was up (or down) the exact same amount, all three weighting schemes would have the exact same return. However, if the market was being primarily led higher by a small number of extremely large, well performing names; we would expect a Cap Weighted strategy like SPX to outperform S&P EWI and Reverse by a large margin (and vice-versa should a broader rally of smaller companies be top performers). Exhibit 3 below shows the calendar year returns of all 3 Indices from 1997-2018 (ending 10/31/2018).

Exhibit 3- Annual Performance for SPX, S&P EWI and Reverse (1997-2018)

Note: S&P EWI has an index launch date of 1/8/2003 and Reverse has an Index launch date of 10/23/2017. Both Indices are licensed and calculated by S&P Dow Jones Indices and all information for the Indices prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date. Standardized performance for S&P 500, S&P EWI, and REVERSE can be found by clicking the respective link.

1997,1998 and 1999 saw SPX consistently and robustly outperform the Equal and Reverse weighting schemes. This coincided with the rapid expansion of the Tech sector within the S&P 500 depicted in Exhibit 1. This was immediately followed by a 5-year period in which SPX was the worst performing of the three weighting schemes. The root cause in this instance was an overconcentration within Tech – while SPX benefited as the sector rose to unsustainable levels, ultimately Tech performance turned at the exact point where SPX also had the largest exposure to that sector (a symptom of all Cap Weighted Indices). S&P EWI would have kept a consistent exposure to Tech during the run up (and crash), while Reverse systematically would be taking profits from the winners and reallocating to the underexposed. This profit taking sacrificed the compounding effects of Tech’s sustained run higher, but also meant that Reverse has its smallest allocation to Tech, right before Tech tanked.  Exhibit 4 below shows the corresponding Sector weights of Reverse, while Exhibit 5 shows the differential in sector weights between Reverse (Exhibit 4) and SPX (Exhibit 1).

Exhibit 4 – Reverse Sector Exposure (12/1996 – 6/2018)

Reverse has an Index launch date of 10/23/2017. The index is licensed and calculated by S&P Dow Jones Indices and all information for the Index prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date.

In addition to having its lowest Tech exposure just before the crash, Reverse (a contrarian play to SPX), reached its maximum in Tech exposure in December of 2002, taking full advantage of the massive recovery that followed.

Exhibit 5 – Differential in sector weights of SPX and Reverse (12/1996 – 6/2018)

Reverse has an Index launch date of 10/23/2017. The index is licensed and calculated by S&P Dow Jones Indices and all information for the Index prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date.

Exhibit 5 depicts the differential in sector exposure between SPX and Reverse and how it moves over time. To dig deeper into the movement of Tech (the line with the most volatility) we look at Exhibit 6, showing the Tech industry before and after the Dot Com Bubble and how sector allocations affected performance outlined in Exhibit 3.

Exhibit 6 – Info-Tech Exposure Before and After Dot Com Bubble

Reverse has an Index launch date of 10/23/2017. The index is licensed and calculated by S&P Dow Jones Indices and all information for the Index prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date.

Just before the Dot Com market peak, SPX had 21% more exposure to Tech than the Reverse Weighted strategy. However, that Tech exposure turned into an albatross – as the next three years saw the XLK (Tech Sector ETF), decline from $43/share on 12/31/1999, to $11.81/share on 12/31/2002 – a price decline of -72.5%. Having a low exposure to Tech was a main contributor to Reverse’s massive outperformance vs SPX during the pullback. The Tech decline resulted in 12/31/2002 exposures where SPX weighting declined from 29% to 14%, while Reverse weighting increased from 8% to 21% – as  the Reverse systematically allocated to (the now much smaller) tech companies in the S&P 500. Twelve months later (12/31/2003), XLK had rebounded by 40% contributing to Reverse’s overperformance in the recovery period. The Yellow line in Exhibit 5 shows a similar (albeit lower magnitude) effect with Financials in the lead up to, and recovery from, the Great Financial Crisis in 2008.

While Reverse Cap Weighting is a newer Index in the market, it is ultimately just an expression of one of the oldest investment adages, “Buy Low, Sell High”.

Looking To The Future

Since 1997 (the earliest available data for S&P EWI and Reverse), Exhibit 7 shows that S&P EWI and Reverse have outperformed SPX, albeit with additional volatility.

Exhibit 7 – Cumulative Risk/Return of SPX, S&P EWI and Reverse (1/1997-10/2018)

Note: S&P EWI has an index launch date of 1/8/2003 and Reverse has an Index launch date of 10/23/2017. Both Indices are licensed and calculated by S&P Dow Jones Indices and all information for the Indices prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date. Standardized performance for S&P 500, S&P EWI, and REVERSE can be found by clicking the respective link.

The consistency and robustness of the outperformance can be seen in Exhibit 8 below, showing a 20 years of daily rolling 5 year returns of the respective Indices.

Exhibit 8 – Daily Rolling 5-year returns (12/2001 – 10/2018)

Note: S&P EWI has an index launch date of 1/8/2003 and Reverse has an Index launch date of 10/23/2017. Both Indices are licensed and calculated by S&P Dow Jones Indices and all information for the Indices prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date. Standardized performance for S&P 500, S&P EWI, and REVERSE can be found by clicking the respective link.

Each data point on this graph shows the respective return of the Index, had one invested in the underlying strategy 5 years earlier. There are two key takeaways from this graph. First, is the relationship between the three Indices. It is clear (and intuitive), that in environments in which S&P EWI outperforms SPX – Reverse outperforms them both and in environments where S&P EWI underperforms SPX, Reverse will be the lowest performing of the three. The second aspect to note from this graph is what takes place when all three lines converge and what is a historically “normal” depth and duration for a 5-year rolling period in which SPX is the top performing of the three. To more clearly take a closer look at this, Exhibit 9 focuses on just the spread between the 5-year rolling return of Reverse and SPX (I.e. the difference between the blue and red lines in Exhibit 8).

Exhibit 9 – 5 Year Rolling Return – Reverse Relative to SPX (12/2001 – 10/2018)

Note: S&P EWI has an index launch date of 1/8/2003 and Reverse has an Index launch date of 10/23/2017. Both Indices are licensed and calculated by S&P Dow Jones Indices and all information for the Indices prior to its Launch Date is back-tested by S&P DJI, based on the methodology that was in effect on the Launch Date. Standardized performance for S&P 500and REVERSE can be found by clicking the respective link.

Referring back to Exhibit 3 above, the 2008 Financial Crisis and the Dot Com bubble were both preceded by periods in which cap weighting had sustained outperformance on the back of a specific selection of high-flying companies (Financials/Housing and Tech, respectively). While our data does not go back far enough to show the 5-year rolling return in pre-Dot Com bubble, the red dip in the middle of Exhibit 9 covers the 2008 Financial Crisis period. What’s notable is the shape and duration of the current period as the directionality of the 5-year rolling spread appears to be trending back toward 0. There is nothing to say that this trend will continue uninterrupted, but the macro headwinds in the economy – rates rising, tariffs possibly impacting large international companies and some firm specific headwinds that FAANGS are facing – could set up a situation where the market will need to rely on other industries/companies to be the catalyst for its next leg higher.

Conclusion

Over the last 20 years, Equal Weighted and Reverse Weighted strategies have outperformed the Cap Weighted S&P 500 (with additional volatility). While there have been some subsets in which SPX posted sustained outperformance, these were usually smaller in terms of both depth and duration (when compared to the periods in which SPX underperformed S&P EWI and Reverse) and were historically followed by longer periods of SPX underperformance (see Exhibit 3). If you are of the opinion that FAANG – or others among the largest international companies – are facing a difficult equity environment, then the best defense may be to “Get Defensive” and allocate to sectors which may be overlooked/undervalued. A Reverse weighted strategy represents an efficient and effective way to gain that differentiated exposure within the highly benchmarked S&P 500 universe.

 

Disclosure: The Reverse Cap Weighted U.S. Large Cap Index (Reverse) is a rules-based reverse capitalization weighted index comprised of the 500 leading U.S.-listed companies as measured by their free-float market capitalization contained within the S&P 500 universe. The Index has an inception date of October 23, 2017, with a back tested time-series inception date of December 31, 1996. You cannot invest directly in an index.

The S&P 500 Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. You cannot invest directly in an index.

The S&P 500 Equal-Weight Index is the equal-weight version of the widely-used S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight – or 0.2% of the index total at each quarterly rebalance. You cannot invest directly in an index.

FAANG is a widely-used acronym for high-performing technology stocks in the market – Facebook, Apple, Amazon, Netflix and Google (now Alphabet, Inc.).

The Reverse Cap Weighted U.S. Large Cap Index (the “Index”) is the property of Exponential ETFs, which has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC) to calculate and maintain the Index. The Index is not sponsored by S&P Dow Jones Indices or its affiliates or its third-party licensors (collectively, “S&P Dow Jones Indices”). S&P Dow Jones Indices will not be liable for any errors or omissions in calculating the Index. “Calculated by S&P Dow Jones Indices” and the related stylized mark(s) are service marks of S&P Dow Jones Indices and have been licensed for use by Exponential ETFs. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”), and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”).

Past performance of an index is not a guarantee of future results, which may vary. The value of investments may go down as well as up and potential investors may not get back the amount originally invested. Performance figures contained herein contain both hypothetical and live returns; results, hypothetical or otherwise, are intended for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs, or expenses, which would reduce returns. Inclusion of a security within an index is not a recommendation by to buy, sell, or hold such security, nor is it considered to be investment advice. It is not possible to invest directly in an index.

The Index, strategy, and performance returns discussed are for informational purposes only and do not represent an offer to buy or sell a security and should not be construed as such.

Posted By: Josh Blechman 11/20/2018

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