Dollar Dictated Returns In April - Except This Time The Lowest Correlated Outperformed

With April in the rearview mirror, it's a good time to look back on which factors had the strongest relationship to market over the past month. USD correlation had the tightest relationship to the market. This isn't all that surprising given that USD correlation has had the third highest r-square value (0.94) over the past year. What is surprising (sort of) is that the stocks with the lowest correlation to the USD were the best performers in April. This is the exact opposite that has been the case over the past year.

MSCI World Index Factor Scoring Model


One way that we measure factor relationships is by putting all the stocks into 10 groups (deciles) from highest correlation (1) to lowest correlation (10). Stocks that were in the 9th and 10th (least correlated) deciles returned on average 6.1% in April. Stocks in the 1st decile (most correlated) returned just 1.5%. This is the exact opposite trend that has taken place over the past year. Stocks that are the most correlated to the USD are up 32$ while stocks with the lowest correlation are down -5% over the past year.

NYSE Margin Debt Charged To New All-Time Highs In March

After spending the past year somewhat ranged bound, margin debt increased by just under $11.5 billion in March to a new all-time high of $476 billion, taking out the previous high set in February 2014. The increase in margin debt over the past two months is the largest two-month increase since February 2013. Net margin debt (Debit balances minus credit balances) also increased to a new all-time high in March. However, the one-quarter moving average of margin debt as a % of total market capitalization remains 18 basis points below all-time highs.

The Step Down In Long-Term US Growth Rates Breaks Lower

From 1974 to 2007, the long-term US growth rate in real GDP generally fell between 3-3.5% on annualized basis (excluding the v-shaped bounce from 1982-1984).  We define long-term here by looking at the 10-year annualized percentage change. With the 1Q now in the books, this series just dropped to an all-time low of 1.46%.





Long-term nominal growth has been on the decline since peaking at nearly 11% in 1981. It has since steadily fallen to a new post-WW2 low of 3.29%.



High interest rates are not to be blamed for the slowdown in growth. The long-term nominal growth rate has remained above long-term interest rates almost without interruption since 2000.




Lastly, unlike the majority of the 1977-2011 period, consumers have (hopefully) been able to sock away some savings as the long-term growth rate in personal income has recently outpaced the long-term growth rate in personal consumption expenditures by 37 basis points.

Are Asset Prices In The Midst Of A Change In Trend Or Simply A Counter-Trend Rally?

Yesterday, we highlighted how equity trends have completely flip-flopped in April. Emerging market stocks have outperformed the developed market stocks, developed market energy is the best performer while developed market health care is the worst performer, etc.  There is a chance that we are in the midst of a major turning point but experienced market watchers are aware that picking out trend turning points in real-time is very difficult. With this in mind, as we look across a variety of asset classes, it seems that the market may just be taking a breather from the intense one way march that most assets have been on since last summer. As has been the the theme recently, it seems that the dollar may be driving market action across most asset classes.

Let's start with the dollar. The nominal trade-weighted dollar indexed topped out in mid-March. After increasing from about 76 to 93 from July to March, the index has slightly fallen back to 90. As of now, the dollar looks like it is simply in consolidation mode and not in a full scale trend change.





Yields in developed markets have slightly widened in April. German 30-year yields have backed up by about 20 basis points and the 10-year has backed up by about 8 basis points. However, this needs to be viewed with the steady march lower in yields of the past six months. With that in mind, German (and US) yields look like they too are could be in a consolidation phase.





Same story holds for commodities. Commodities, especially oil, have shown some signs of friskiness since mid-March. Is this a wholesale trend change? Or again just a consolidation phase? Only time will tell.





Lastly, let's look at some equity trends. As we said, developed market energy stocks been by far the best performer MTD. However, this group of stocks has vaulted from very oversold to overbought in the matter of a single month, at least on a 100-day basis. Meanwhile, breadth in health care continues to be strong even though it has been the worst performer MTD. Health care, on a 100-day basis, remains squarely in overbought territory and as of now shows no signs of relenting its bull market pole position . EM stocks have enjoyed its recent run, most sectors are powering towards overbought levels.

It seems that the dollar is (still) driving market action across most asset classes. If dollar breaks down from current levels, trends observed since mid-March most likely will persist. However, if the dollar is simply consolidating before a move higher than there is a good chance that 2015 will look very similar to the second half of 2014.

Knowledge Investments Continue To Become A Larger Share Of Total Investments In The US

The trend toward knowledge investments and away from traditional investments in fixed assets such as equipment and structures continued in the 1Q in the US. Investment in intangible property products now account 4.1% of GDP. This is the highest percentage on record for this series and a continuation of the upward trend that has been in place since WW2. Structure's share of GDP decline to 2.8% and equipment's share of GDP was flat at 5.9%.

On a SAAR, investments in intellectual property products increased by 7.99% year-over-year. This compares to a 5.6% YoY% change for investments in equipment. Investments in structures actually declined by nearly 1% over the past year. 

Intellectual property products contributed 30 basis to real GDP in the 1Q. IPP was the lone bright spot for real GDP from a nonresidential fixed investment standpoint . Structures dragged down real GDP by -75 basis points and equipment didn't contribute to real GDP. Overall, even with the positive contribution from IPP, nonresidential fixed investment subtracted 44 basis points from real GDP in the 1Q. 

The Smart Money Is Getting Long Treasury Bonds Again

Long-dated US Treasury bonds have been treading water of late, leaving many rate watchers wondering in what direction the next big move is going to be. One variable in the next move is of course trader positioning. The two charts below show how the "smart money" is betting. Each chart shows the net number of options and futures contracts held by commercial traders (blue line), overlaid on the 10 and 30-year treasury bonds, respectively.

We observe that the commercials have been adding to their long positioning in the 10-year for most of the year following a large reduction in net long contracts in January. Meanwhile in the 30-year, the commercials have flip flopped from being net short in November to net long today. Positioning for neither contract is at an extreme yet, but the move has been large enough for us to not rule out the possibility that rates go lower before to long.

Equity Performance Trends Have Completely Flip-Flopped In April

As the first month of the second quarter winds down, an interesting (momentary?) change in long-standing trends has taken place in the equity markets. What have mostly been the best performing sectors of the past four years have underperformed in April and what have been mostly the worst performing sectors over the past four years have outperformed. This is especially true for developed market equities but holds to a certain extent for emerging market equities as well. As always, this data is on equal-weighted, USD basis. 

The best performing sector in the developed markets has been the energy sector and its not even close. The energy sector is up nearly 11.5% MTD, while the second best performing sector is up only 5.7% (telecom). This surge in April has brought energy returns back into positive territory (barely) over the past four years. So what is the worst performing sector MTD? You guessed it, health care. Health care which is up a remarkable 155% over the past four years is only 2% higher in April. Consumer discretionary, information technology and consumer staples, are the three worst performing sectors MTD and they are the three best performing sectors over the past four years as well. 

In the emerging world, the energy sector again is the best performing sector as it has gained over 13% MTD.  However, breadth in the emerging markets is stronger as industrials, utilities, materials, and financials are all at least 10% higher MTD. These five sectors, however, are the worst performing sectors over the past four years. 

The question facing investors is are we at a significant turning point in equity leadership? Or is April just another example of every dog having its day? 

A Portfolio Framework For R&D Investments

After our recent call, we received an insightful question about how we view research and development (R&D) because surely not all R&D is productive and profitable? While there is always the chance that an individual R&D project may fail, we believe, based on the leading academic research on innovative accounting, that R&D should be viewed from a portfolio perspective and not on the basis of individual projects. Let us explain below but first let's briefly look at the historical accounting treatment of R&D to add context to the framework we use.

R&D activities are first mentioned in accounting literature in 1917 by the Federal Reserve Board in a Federal Reserve Bulletin. At this time, the Federal Reserve Board declared that R&D should be categorized as a deferred charged in published financial statements. This is another way of saying R&D expenses should be capitalized and recorded on the balance sheet. We follow this treatment of R&D in our intangible-adjusted financial statements. This capitalization view held for four decades and was supported by a wide variety of financial institutions such as the National Association of Cost Accountants, the Internal Revenue Service and again by the Federal Reserve Board. In the mid-1950s, the IRS modified its stance and allowed companies to, in effect, keep two sets of books. One book for internal purposes, wherein most companies capitalized R&D, and another for tax purposes, wherein most companies expensed R&D in order to lower their taxable income.  It is believed that the IRS took this approach in order to spur investment after WW2. This “dual book” system lasted for two decades and it wasn't until 1974 that the Financial Accounting Standards Board (FASB) enacted Statement of Financial Accounting Standards (SFAS) No. 2 which stated that a direct write-off of R&D expenses was mandated. At this point, companies could no longer choose how they wanted to treat R&D and had to expense all R&D expenses as they were incurred. The great irony here is this rule was put into effect just a few years after the start of the greatest technologically innovative period in the history of humankind. Corporations for the past four decades have undertaken more R&D than in any other period in human history, however, SFAS No. 2 completely obfuscated those corporate innovative activities from investors. This is one of the primary reasons why the Knowledge Effect exists. 

Before changing the rule in the 1974, FASB actually considered four different methods of accounting for R&D. They considered: 1) charging all costs when incurred 2) capitalizing all costs when incurred 3) capitalizing some costs when incurred if those costs met certain specified conditions, and 4) accumuling all costs in a special category until the future benefits could be determined. In the end, FASB took the most conservative approach and declared all R&D expenditures must be immediately expensed. This is where our view, as well as leading academic views, of R&D considerably differs from FASB. FASB took a very myopic view in determining whether or not the future benefits of R&D could be determined, and consequently, be capitalized as an asset on a company’s balance sheet. They were concerned with the riskiness of individual R&D projects and worried individual projects had a high rate of failure. However, they overlooked that a portfolio of R&D projects can have a much lower aggregate level of risk than an individual project has. On a collective basis, an individual R&D project can offset a portion of another R&D project’s risk because of the benefits of diversification and because knowledge creation creates many beneficial spillover effects. As professionals in the investment community, our readers are well versed on this interaction between risky endeavors as this is one of the bedrock principles of modern portfolio theory. Diversification produces a lower level of overall risk for a portfolio than individual assets can produce. This holds as much for a portfolio of stocks as it does for a portfolio of R&D projects.  Also large, modern corporations indeed view R&D from a portfolio perspective, not on an ad-hoc, individual basis. R&D for companies that follow an innovation strategy, such as those that we define as Knowledge Leaders, is part of an organizational strategy. As such, companies do not put all of their innovative eggs in one basket or one project. A portfolio perspective on R&D, accompanied with the capitalization of innovative investments, gives investors the clearest picture available of the unique capital stock that drives future profits for a corporation. 

Chinese Companies Keeping the Dream Alive with Leverage and Channel Stuffing

Last week we wrote that 2014 marked another year in which Chinese companies increased the leverage on their balance sheets. In fact 2014 marked the 10th consecutive annual increase in aggregate leverage as measured by total liabilities as a percent of equity. Meanwhile profit margins are down by more than half over the same period.

What we didn't mention in that post last week is that the amount of "channel stuffing" - the reciprocal increase of working capital accounts among companies - has also continued to explode. Think of "channel stuffing" as recording a sale by issuing the customer trade credit, which shows up as credit to accounts receivable for the seller and a debit to accounts payable to the customer. The customer can then issue its own downstream trade credit, and so on, such that sales for the entire "channel" are higher than they would otherwise be at the expense of greater working capital liabilities and assets (AKA leverage).

Identifying "channel stuffing" is actually quite easy. All one needs to do is measure the aggregate level of working capital accounts as a percent of sales through time. Lines 3 and 4 in the below table measure exactly that. What we find is that accounts receivable as a percent of sales increased from less than 6% to more than 11% between 2006-2013 and then absolutely exploded in 2014 to 13.2%, the largest single-year increase as far back as we have data. Meanwhile, accounts payable as a percent of sales increased from about 10% to almost 17% from 2006-2014.

But it doesn't stop there. Companies are also carrying almost 50% more inventory today as compared to 2006 (line 5 below), implying production activity has not yet adjusted down to the lower level of sales growth. Higher levels of inventories put pressure on prices as companies are incented to lower selling prices to reduce the inventory level. This may be one reason profit and cash flow margins have crumbled lower since 2009.



*The above data is based on the aggregate summation statistics for CSI 300 constituents excluding financial and utility companies

This post has been updated. An earlier version made an incorrect currency adjustment for the "AR % of Sales" line item in the table above. All other data was unaffected.

Divergent Trends in Market Breadth

A couple of weeks ago, we discussed the propensity for markets to go on runs or slumps in a manner not unlike what we can observe in baseball.  In that example, we looked at the percent of stocks in a particular region that are outperforming the MSCI World Index over the previous 65 trading days, noting that Europe and Asia-Pacific were the hottest markets around.

It can also be helpful to look at the evolution of the percent of companies outperforming over different slices of time, in order to get a better sense of the direction of the momentum in a market.  Overall, in the MSCI World, we note that the percent of companies outperforming over the 200, 100, and 50-day time periods has been relatively steady (50-55%)--however, that number dropped sharply over the last 20 days to as low as 45%.






In MSCI Europe, the proportion of companies outperforming over the long (200-day) run remains under 40%, indicating room for further expansion.  However, in the medium-term (100 and 50-day time horizons), the percent of companies outperforming recently touched on historically high levels (60% or so) and appears to be weakening somewhat.






Meanwhile, in North America, the percent of equities outperforming has slipped from recent highs of 65% over the last 200 trading days, to just 46% on a 100-day time horizon and only 38% when we look at the 50-day.






Last we look at MSCI Pacific, where the percent of stocks outperforming has expanded from 54% to 73% to 75% over the respective 200, 100, and 50-day time periods.  And, with more than half of the companies in the region outperforming in the near (20-day) term, we see once again how strong the move has been compared to the other regions (all in the 40 percent range).