Q2 Summary


Amid a continued positive worldwide economic backdrop, global equity markets generated a small positive return in the second quarter as the S&P 500 returned +3.4% and the MSCI ACWI Net TR gained +0.5%. The equity growth was not without turbulence, as numerous political developments surprised markets and disrupted trends during this time. One of the most significant in our opinion was arguably the announcement of tariffs by the U.S., initially on steel and aluminum and then expanded to a variety of goods. Market participants seemed most concerned by the fact that the tariffs were declared not only on longstanding economic trading partners and allies such as Canada, Mexico, and the EU (all of whom were initially exempted), but also on China, the second-largest economy and largest exporter in the world. Equity markets appeared to hesitate on each of these announcements, but recovered and cautiously gained ground for the quarter.

U.S. fixed income markets continued to reflect pro-growth economic sentiment. U.S. treasury yields continued to rise, boosted by the U.S. Federal Reserve’s second rate hike of the year on June 13. U.S. 2-year treasuries rose by 29 basis points by quarter-end, to 2.53%, 10-year notes rose by 13 basis points to 2.85%, and 30-year bonds remained flat, ending at a 2.99% yield. With these intra-quarter moves the yield curve continued to flatten — the 10-year/2-year spread finished the quarter at 33 basis points, down from 48 basis points when the quarter began.

Miguel Sosa

Portfolio Strategist, Research and Investment Solutions

Market Analysis—An In-depth Look into Where We are Now
Equity Returns are Positive, But Narrow

Despite the political developments, the positive worldwide economic backdrop has seemingly been a supporting factor in the positive performance of U.S. equity markets. However, on taking a closer look at performance, one can see that the bull market has not been as broad as would be expected at this stage in the economic cycle. That is, the positive return is not based on multiple sectors performing positively, but is based on only a couple of sectors having outsized returns and carrying the entire index.

Only three of the S&P 500’s eleven sectors were meaningfully positive during the year. These three were information technology, consumer discretionary, and energy. Five other sectors were negative, and the remaining three were positive but minimal contributors. Furthermore, within information technology and consumer discretionary, there were only five stocks that drove over half of the positive performance of these subsectors (out of 157 stocks total in these two sectors combined). These stocks are commonly known as the FAANG stocks: Facebook, Amazon, Apple, Netflix, and Google (now Alphabet). Together they have contributed +1.9% of the S&P’s +1.7% year-to-date performance. Said differently, excluding these five stocks from the S&P would have resulted in this index being negative for the year. Having an index with over 500 stocks but having only a handful drive the performance is not typically a solid foundation for a broad bull market1 [Figure 1].

In addition, certain sectors of the S&P 500 that are the foundation of the U.S. economy, such as banks, automobiles, consumer services, food and beverage, and telecom are all down -5% to -10% since the beginning of the year.


Smaller Bite Without FAANGS
S&P 500 Performance Without FAANG STOCKS, Compared to FAANG Stock Performance

Cumulative Growth, December 31, 2016 =100


As of June 30, 2018. Source: Bloomberg. Past performance is not indicative of future results. Performance represents cumulative returns over specified time period.

Equity Valuations are Rich

The S&P 500 has experienced an epic, double-digit bull run in the last seven years and has reached record highs. Despite companies also posting record profits, the growth of earnings has not kept pace with the large increases in price. Thus, valuations on a price/earnings basis have ballooned since the financial crisis of 2008–2009 (especially since there were at substantial lows in the months following the recession).

The chart below [Figure 2] shows the cyclically adjusted price-earnings, or CAPE Ratio, over the last 130 years. The CAPE Ratio is a metric developed by Yale economist Robert Shiller that measures real earnings per share over a 10-year period2. The CAPE ratio is best known and used as a predictor for future long-term stock prices, as it historically has been a reasonably accurate indicator of whether the market is undervalued or overvalued.


Third Most Overvalued Stock Market in Over a Century
Cyclically Adjusted Price/Earnings (CAPE) Ratio for the S&P 500 | 1881 – 2017


As of July 2018. Source: Past performance is not indicative of future results. There is no guarantee that any investment will achieve its objectives, generate profits or avoid losses. An investor cannot invest directly in an index. Moreover, indices do not reflect commissions or fees that may be charged to an investment product based on the index, which may materially affect the performance data presented. Please see glossary at the end of this document for a definition of terms.

As you can observe in Figure 2, the S&P 500 is currently at the third-highest CAPE ratio valuation in 130 years, after the Tech Bubble of the 1990s and the years that preceded the Great Depression. The CAPE ratio value at July 2018 was 31.8, compared to the long-term average of 16.9.

Why is this important? Because high CAPE ratio valuations have historically preceded market underperformance. Figure 3 quantifies this historical underperformance, as it divides the market’s CAPE ratios into five groups, from lowest to highest CAPE ratio, and then averages and annualizes the following 5-year returns within each group.

The results are stark: higher CAPE ratios are associated with low or negative equity returns in the ensuing five years. The bar on the right represents historical periods where the CAPE ratio has been similar to the current level of 31.7, and the subsequent performance is not reassuring—subsequent S&P 500 returns averaged -2.5% per year.


Up and Down: Valuations and Returns
Average Forward S&P 500 5-year Annualized Returns based on CAPE Ratio Quintiles | January 1881 – June 2017


As of July 2018. Source: Past performance is not indicative of future results. There is no guarantee that any investment will achieve its objectives, generate profits or avoid losses. An investor cannot invest directly in an index. Moreover, indices do not reflect commissions or fees that may be charged to an investment product based on the index, which may materially affect the performance data presented. Please see glossary at the end of this document for a definition of terms.

In fact, the CAPE ratio is not the only indicator that is showing expensive valuations; Figure 4 shows a list of a variety of valuation metrics for the S&P 500 and how they compare to historical values going back almost 30 years. As you can see, a large majority of them are in the highest quartile, which, taken as a whole, show just how expensive the equity market has grown.


Various Valuation Metrics for the S&P 500

Current Valuation Current Percent Median Valuation Start Date of Data Valuation
Price/Earnings 21.1 84.5% 16.2 12/31/27 Extremely Overvalued
Price/Book 3.4 83.3% 2.8 03/31/90 Extremely Overvalued
Price/Sales 2.2 98.2% 1.5 03/31/90 Extremely Overvalued
Price/Cash Flow 14.2 82.4% 10.6 03/31/90 Extremely Overvalued
Price/EBITDA 11.8 100.0% 7.3 03/31/90 Extremely Overvalued
Enterprise Value/EBIT 19.2 77.1% 17.1 03/31/90 Moderately Overvalued
Dividend 12-month YTD: Gross 1.8 78.6% 2.8 12/31/70 Moderately Overvalued
As of July 2018. Source: Bloomberg. Past results are not indicative of future performance. There is no guarantee that any investment will achieve its objectives, generate profits or avoid losses. The referenced index is shown for general market comparisons and is not meant to represent any particular Fund. An index is unmanaged and not available for investment. Please see glossary at the end of this document for a definition of terms.

If historical trends prove correct in this environment, then equity investors may potentially be in for a rude awakening: after double digit returns from the S&P 500, capital losses may ensue for an extended period.

Yield Curve Inversion: The Historical Oracle

Much has been discussed about the yield curve and its current flattening trend. This is because the yield curve’s shape is critically important. U.S. treasury yields are much more influential in the economy than the stock market: they affect banks’ borrowing and lending rates, the rates at which companies, municipalities, and individuals can borrow, and thus the rates that debt investors will receive when investing in fixed income.

Figure 5 shows the current spread, or yield difference, between 10-year and 2-year treasuries. The spread is currently at 33 basis points at quarter-end, a level not seen since 2006. Market participants have speculated over whether this trend will continue to the point where the yield curve will “invert,” that is, when short-dated treasuries offer a higher yield than longer-dated treasuries. This inversion is crucial as it has predicted 100% of recessions in the last 40 years (recessionary periods are shaded).


Investing and Inverting
10-year Treasury Yield Minus 2-year Treasury Yield as Predictor of Economic Recessions (%) | 1976 – 2018


As of July 2018. Past performance is not indicative of future results. Source: U.S. Federal Reserve.

The track record for prediction is good, and thus many investors are paying close attention to the current spread. However an important caveat is the timing gap between the inversion and subsequent recession, as the most recent inversions occurred well before a recession started. For example, the last inversion occurred in December 2005, but the recession did not start until October 2007, almost two years later, and the stock market crash did not occur until the following year in September 2008, almost three years after the initial inversion. This time gap is a crucial aspect of the uncertainty of recessions, and makes timing the market for all practical purposes not possible. This gap makes it that much more important to instead focus on preparing one’s portfolio now, well before sudden market selloffs versus attempting to time the markets (which can be an exercise in frustration and futility).

Differentiated Alpha Sources Crucial in Current Equity and Fixed Income Environment

In summary, although equity returns have been strong for the last few years, they have more recently been propelled by just a handful of stocks. Valuations are at levels seen only two times in the previous 130 years—and both ended with ruthlessly large and sudden drawdowns. In fixed income, a historically effective predictor of impending recessions (the inversion of the yield curve) inches closer to sounding the alarm—but fails to reveal at what point a recession will strike.

It is important to understand these assessments for what they are: not specific predictions of what will occur next month, but broad warnings of a probable change in economic fundamentals and signs of more challenging times ahead. As such, it becomes even more important to find unique investment strategies that are independent and uncorrelated to broad equity market trends and have an ability to make long and short investments (and potentially profit from market corrections). Additionally, strategies that invest in securities with fewer market participants (and are thus less followed) have a greater tendency to be mispriced—and may be further potential opportunities for generating alpha.

Hedge funds meet all of these criteria. Equity index ETFs and mutual funds have broadly generated impressive returns in the last few years, but the drivers for these instruments that worked yesteryear (broad market upswings, attractive valuations) do not apply now. Although hedge funds have admittedly failed to keep pace during this bull run that we’ve seen, history has also shown that hedge funds outperform during periods of stress, when equity valuations are high and markets correct [Figure 6].


Three-year Rolling Return
Difference between HFRI Fund Weighted Composite Index and S&P 500 Total Return Index | 1991 – 2017


As of June 30, 2018. Source: Bloomberg, HFR. Past performance is not indicative of future results.

The future is not known, but the historical signs and the subsequent results are. We encourage you to contemplate alternative investment opportunities before it is too late.

1 As the famed investor Howard Marks said, “Things that are most hyped produce the most pain.”

2 A 10-year period is used in order to smooth out the effects of corporate profit variability that inherently occurs during a typical business cycle. A higher CAPE ratio typically means that stock prices are high relative to the underlying earnings, or that every dollar of a stock’s price buys a smaller share of the stock’s earnings.



This material is being provided for informational purposes only. The author’s assessments do not constitute investment research and the views expressed are not intended to be and should not be relied upon as investment advice. This document and the statements contained herein do not constitute an invitation, recommendation, solicitation or offer to subscribe for, sell or purchase any securities, investments, products or services. The opinions are based on market conditions as of the date of writing and are subject to change without notice. No obligation is undertaken to update any information, data or material contained herein. The reader should not assume that all securities or sectors identified and discussed were or will be profitable.

Past performance is not indicative of future results. There is no guarantee that any forecasts made will come to pass. Due to various risks and uncertainties, actual events, results or performance may differ materially from those reflected or contemplated in any forward-looking statements. There can be no assurance that any investment product or strategy will achieve its objectives, generate profits or avoid losses. Diversification does not ensure profit or protect against loss in a positive or declining market.

Hedge funds, commodity pools and other alternative investments involve a high degree of risk and can be illiquid due to restrictions on transfer and lack of a secondary trading market. They can be highly leveraged, speculative and volatile, and an investor could lose all or a substantial amount of an investment. Alternative investments may lack transparency as to share price, valuation and portfolio holdings. Complex tax structures often result in delayed tax reporting. Compared to mutual funds, hedge funds and commodity pools are subject to less regulation and often charge higher fees. Mutual funds involve risk including possible loss of principal. Alternative investment managers typically exercise broad investment discretion and may apply similar strategies across multiple investment vehicles, resulting in less diversification. Trading may occur outside the United States which may pose greater risks than trading on U.S. exchanges and in U.S. markets.

Index Descriptions

An investor cannot invest directly in an index. Moreover, indices do not reflect commissions or fees that may be charged to an investment product based on the index, which may materially affect the performance data presented.

HFRI Fund Weighted Composite Index. An equal-weighted return of all funds in the HFR Monthly Indices, excluding HFRI Fund of Funds Index.

MSCI ACWI Net Total Return. Captures large and mid-cap representation across 23 developed markets and 24 emerging markets countries. With more than 2,400 constituents, the index covers approximately 85% of the global investable equity opportunity set.

S&P 500 TR Index. The total return version of S&P 500 index. The S&P 500 index is unmanaged and is generally representative of certain portions of the U.S. equity markets. For the S&P 500 Total Return Index, dividends are reinvested on a daily basis and the base date for the index is January 4, 1988. All regular cash dividends are assumed reinvested in the S&P 500 index on the ex-date. Special cash dividends trigger a price adjustment in the price return index.


The following terms have been used in this article and the definitions below are for informational purposes only.

CAPE Ratio. The CAPE ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. The ratio is generally applied to broad equity indices to assess whether the market is undervalued or overvalued. While the CAPE ratio is a popular and widely-followed measure, several leading industry practitioners have called into question its utility as a predictor of future stock market returns. The CAPE ratio, an acronym for Cyclically Adjusted P/E (i.e. Price-Earnings) ratio, was popularized by Yale University professor Robert Shiller. It is also known as the Shiller P/E ratio.

Dividend 12-month Yield. A financial ratio that indicates how much a company pays out in dividends each year relative to its share price.

Enterprise Value/EBIT. EV/EBITDA equals a company's enterprise value divided by earnings before interest, tax, depreciation, and amortization. It measures the price (in the form of enterprise value) an investor pays for the benefit of the company's cash flow (in the form of EBITDA).

Price/Book. The Price to Book Ratio - P/B Ratio is used to compare a firm's market to book value and is calculated by dividing price per share by book value per share.

Price/Cash Flow. The price-to-cash-flow ratio is a stock valuation indicator that measures the value of a stock’s price to its cash flow per share.

Price/EBITDA. Price to EBITDA is the ratio of a company's stock price to its per-share Earnings Before Interest, Taxes, Depreciation and Amortization - EBITDA.

Price/Earnings. The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.

Price/Sales. The price-to-sales ratio is a valuation ratio that compares a company’s stock price to its revenues. The price-to-sales ratio is an indicator of the value placed on each dollar of a company’s sales or revenues.