The recent widening in earnings dispersion within the stock market has coincided with a more fruitful period for active managers. We explore some of the reasons for these trends, together with some of the implications for clients as we look into 2016.
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The opportunity set for investors waxes and wanes over time. This opportunity set is largely a function of how widely the performance of various asset classes, sub asset classes and single line securities differ. A recent reversal in post crisis trends towards ever narrower earnings dispersion has coincided with a more fruitful period for active managers. We explore below some of the reasons for these trends in dispersion, as well as some of the potential implications for clients as we look into 2016.
Narrowing performance dispersion
The difference in returns available from the worst and the best performing stock in the S&P 500 by mid 2014 was narrower than seen in at least three decades (Figure 1). Seeking explanations for this, Figures 1, 2 and 3 show that corporate sales, forecast earnings and valuations all display similar trends. The stock market became increasingly uniform as the economic cycle trundled unevenly forward. There are a number of potential explanations for this convergence.
First, even by the middle of 2014, the economic cycle was of around the average age for post war expansions. Intuitively it makes sense that the longer an economic expansion lasts, the more corporate revenues from all sectors are sucked towards the baseline of US GDP growth, with the US economy still by some distance the dominant capitalist economy. Meanwhile, those sectors with more revenues derived from outside of the US may increasingly provide a less distinctive edge as previously meteoric emerging markets growth continues to moderate.
Up to a point, the story of the ageing cycle may have helped drive this convergence further down the profit and loss statement too. Previous spikes in earnings divergence owed much to significant write-downs in certain sectors in the wake of various bursting bubbles down the years. Financials books were obviously the most severely affected in the most recent crisis, while the aftermath of the TMT bubble saw Technology, Media and Telecommunications companies suffering similarly dramatic write-downs. With many of the major write-downs (and write-backs) from the great financial crisis now in our rear view mirror, there has been less scope for significant distinction between sectors.
A final point is the fact that real interest rates now sit at the lowest level seen in contemporary economic history. Interest rates and inflation have been on a downward trajectory for the last three decades. In itself this may have helped to create a more level playing field for the corporate sector, helping to more durably narrow trends in earnings and performance dispersion.
Then came oil...
All of these trends were blown out of the water in mid 2014, as the various charts show, by the dramatic plunge in oil prices. The root cause was the performance of the energy and energy-related segments of the equity, but also credit markets. Credit and equity managers with the freedom to both steer clear of the worst afflicted areas of the energy and commodity complex, and cherry pick some of the fallen angels, received a notable boost.
However, with oil prices now significantly closer to their plausible floor (Oil: Will Saudi Arabia stay the course? Compass, Dec ‘14 / Jan ‘15) than their ceiling, and further downside for the rest of commodities looking significantly less possible, is the current spike in dispersion just a blip? Will
the end of this economic cycle, or some similar geopolitical/economic tectonic shift, be required for earnings dispersion to widen more sustainably?
Interest rates may have an important influence on this. Investors should not expect earnings or performance dispersion to spike as the corporate sector digests the first interest rate rise in the US. However, the pace of the rise in borrowing costs across the curve from that point will likely
have important implications for investors’ opportunity set. If, as we highlighted in this quarter’s strategy essay, inflation does return more forcefully than forecasters and markets currently expect, the gap between corporate winners and losers may widen meaningfully. Although corporate leverage in the developed world (excluding the financial sector) in aggregate sits at fairly benign levels, the range, as shown by Figure 4, is significant. As we have noted on many occasions, we welcome the approach of a normalisation of US (and UK) interest rates as a further step out of the long shadow for the world economy cast by the financial crisis. However, investor
looking to do more than track indices around the world will also have cause to celebrate if this does indeed herald a return to a sustainably wider opportunity set.