Equity markets were a tad schizophrenic last week, though not overly so. There were some decent intraday reversals, but ultimately strong performance on Monday and Thursday led to a weekly gain of nearly 1% in the S&P 500. Small Capitalization stocks (i.e. Russell 2000) and the tech-heavy Nasdaq Index performed even better, generating gains of 2.5% and 1.8% respectively. Internationally the picture was mixed as Japanese and emerging market equities rose, while European stocks declined by 0.6%, likely because of nervousness concerning the French election over the weekend.
As it turns out, the nerves were unwarranted (at least for now) as Emmanuel Macron (an advocate of the European Union) and Marine Le Pen (a euroskeptic and far-right politician) received enough votes to move into a runoff election on May 7th. As of right now, markets are relieved by the outcome and risk assets are in rally mode. European equities are up 3% – 4%, while U.S. equity market futures are implying gains of 1% or better in the U.S. It should be a good day for risk assets, which provides an interesting backdrop for the discussion below.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Pacific Market — The definition of the adjective “pacific” is peaceful in character or intent. By most accounts, equity markets since the Financial Crisis can be described as pacific, exhibiting relatively low volatility and outstanding returns like boating on the Pacific Ocean in the summer time…. smooth and easy sailing. Yet, is this eight-year period unusual in a historical context? The answer to that rather simple question has important, tangible implications for investors both in terms of future return expectations and their approach to asset allocation. This is especially true as the Fed begins to shift monetary policy from ultra-accommodative to normalization. This short missive summarizes the results of two broader research efforts to infer how the path forward may evolve for equity markets.
If you are in a rush, I’ll provide the conclusion up front to save you some time. Equity market behavior since the Financial Crisis has been highly unusual, if not unprecedented. As such, investors should expect comparatively lower returns and higher volatility going forward. To understand the basis for this conclusion, please see the information provided below.
Study 1 – S&P 500 Return and Risk
This analysis was completed internally at Covenant and compares market behavior in the 18-year pre-crisis period extending from January 1990 to December 2007 to the post-crisis period from March 2009 through March 2017.
Sources: Zephyr StyleAdvisor and Covenant Investment Research
It is immediately evident from the results shown in the table that the Pre-Crisis and Post-Crisis eras are very different with regard to investment performance. The S&P 500 has generated annualized returns in the Post-Crisis period that are nearly twice as high as the Pre-Crisis period. At the same time, overall volatility levels (represented by Annualized Standard Deviation of monthly returns) have moved lower.
Higher returns combined with lower volatility have caused the Sharpe Ratio (a measure of risk-adjusted returns) to move dramatically higher in the Post-Crisis period. Indeed, in the Post-Crisis era investors have been rewarded with 3x the return for every unit of risk as compared to the Pre-Crisis era. For comparative purposes, a hedge fund strategy with a long-term Sharpe Ratio greater than 1.0 is considered a resounding success and would make the strategy a top-decile performer. On the contrary, it is highly unusual for any equity index to generate a Sharpe Ratio of greater than 1.0, as the long-term track record of the S&P 500 confirms.
Study 2 – Positive vs. Negative Months
The second analysis was conducted by a well-known hedge fund firm. The firm reviewed monthly returns of the S&P 500 since 1928 and separated the data into two periods: January 1928 – February 2009 and March 2009 – March 2017. The firm then segregated monthly performance into the following categories:
· Large Negative (S&P monthly return below -2%)
· Moderate (S&P monthly return between (-2% and +2%)
· Large Positive (S&P monthly return above +2%)
The firm found that in the Post-Crisis era there have been 40% fewer Large Negative months than were found in the Pre-Crisis era. Moreover, there has been a spike in the number of Large Positive months vs. Moderate Months.
This shift in the composition of monthly performance has resulted in a materially higher ratio of Large Positive months to Large Negative months. In the Pre-Crisis era, Large Positive months occurred at a rate of 1.5:1 (1.5 Large Positive months for each Large Negative month), but in the Post-Crisis era, that ratio has jumped to nearly 3:1. To quote the manager, “…the recent low incidence of large negative months is unprecedented in the almost 100-year history of the S&P 500 that we looked at.”
Bottom Line: Per the data from these two analyses, Post-Crisis performance of the S&P 500 has been characterized by higher annualized returns, higher risk-adjusted returns, and far fewer large negative months as compared to the Pre-Crisis era. All of this has occurred while the Fed has pursued an ultra-accommodative monetary policy. The chart below compares the size of the Fed’s balance sheet and performance of the S&P 500 since 2006.
Sources: Bloomberg and Covenant Investment Research
While the evidence presented above may be regarded as circumstantial (as is often the case with drawing conclusions from financial data), the preponderance of the data is too strong to dismiss outright. If in fact, the Post-Crisis era represents an anomaly and not the “new normal” market environment, logic dictates that the return profile for the S&P 500 should revert to its longer-term average state now that the Fed is moving to normalize policy. To be clear, this conclusion does not imply the market will experience a “crash” (nor does it preclude one from occurring either), rather it simply suggests that investors should expect comparatively lower returns (than during the last eight years) with more volatility going forward. This may have already begun, or it may be calendar quarters away. We won’t know until after the fact, but there is compelling evidence that the sailing will not be as smooth going forward.