Saturday, July 31, 2010

Equal Weighting Stocks In Ones Portfolio Might Lead To Higher Returns

In January 2003 Standard and Poor's began tracking an equal weighted S&P 500 Index versus the traditional market cap weighted S&P 500 Index. In the short seven year period, the equal weighted index (EWI) has outperformed the market cap weighted S&P 500 Index.

From HORAN Capital Advisors
To market research theorist, this seems like an odd outcome as it does not conform to the capital asset pricing model (CAPM) or Efficient Market Hypothesis (EMH). So what does CAPM and EMH imply?

According to a recent S&P report that evaluated the performance of the equal weighted and market cap weighted indices, they provide the following summary of EMH and CAPM.
The theoretical underpinnings for market capitalization weighted indices as a basis for investment lie in the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis.

According to the CAPM model, the expected return implicit in the price of a stock should be commensurate with the risk of that stock. However, stocks are subject to two types of risk – systematic risk, resulting from potential movements in market factors; and unsystematic risks, resulting from factors associated with individual assets. Since unsystematic risk can be diversified away, stocks should be priced solely based on systematic risk. This also implies that it is optimal to hold a well diversified portfolio in order to minimize unsystematic risk for a given level of expected return.

According to the efficient market hypothesis, it is impossible to beat the market because prices already incorporate all relevant information. Based on this, the most efficient portfolio would be the entire market and a broad market capitalization index would represent the optimal investment. However, there is much debate as to how efficient the market is in practice. Thus, there are countless different strategies being used in an attempt to beat the market. This has led to indices created based on alternative factors that measure different strategies.
In addition to the question with EMH, there are questions surrounding Modern Portfolio Theory as well. I discussed issues with MPT in an earlier post titled, Modern Portfolio Theory: Is It Over Relied On?

Recent S&P research suggests the EWI outperformance is attributable to a couple of factors. The two prominent ones are size and style. As the below graphic shows, the EWI tends to have more exposure to the mid size companies in the S&P index as well as being more tilted towards value style companies. If one reviews Ibbotson data, the best performing asset class over the long run has been midcap value. As the performance table above shows, the larger sized S&P 100 Index has underperformed the cap weighted and equal weighted S&P 500 Index.

From HORAN Capital Advisors
In conclusion, the equal weighting in the indices has provided an investor with superior returns compared to the market cap weighted indices. Investors should read the entire S&P report as it shows this higher return comes with higher volatility. Additionally, the equal weighted indices have much higher turnover (rebalanced quarterly) in order to maintain the equal weighting of the underlying holdings. This higher turnover level is likely to lead to higher capital gains being realized. And lastly, given the higher volatility in the market today and likely into the foreseeable future, an investment portfolio that has more funds allocated to larger, generally higher quality companies, should hold up better in down market environments.


Equal Weight Indexing
Standard & Poor's
July 2010

Earnings Better Than Expectations and Revenues In Line

As the below graphic details, earnings have certainly improved compared to the end of the first quarter (first third of chart).

From HORAN Capital Advisors
According to Thomson Reuters, of the 336 S&P 500 companies that have reported earnings through the end of July, 75% have reported earnings above expectations. In a typical quarter since 1994, 62% of companies have beat expectations.

The market seems focused not only on earnings but on revenues as well. It is true revenues do drive earnings so long as sales are not generated by steep discounting resulting in slim or no gross margins. Again, according to Thomson Reuters, of these 336 companies, 64% reported revenues above analyst expectations, 0% reported revenues in line with analyst expectations, and 36% reported revenues below analyst expectations. Over the past four quarters, 61% of companies beat the estimates, 0% matched and 39% missed estimates. In the aggregate, companies are reporting revenues that are equal to estimates.

One factor to keep an eye on is the preannouncement ratio. For Q3 2010, 46 companies have provided negative earnings guidance while 15 have provided positive guidance. This equates to a negative/positive preannouncement ratio of 3.1. The N/P ratio for Q3 is above the long term N/P ratio of 2.1 for the S&P 500 Index.

From HORAN Capital Advisors

Tuesday, July 27, 2010

Norfolk Southern's Earnings Support Improving Economic Picture

After the market close today, Norfolk Southern (NSC) reported earnings (PDF) that increased 58.7%. The earnings of $1.04 per share bettered year ago results of 66 cents per share. Additionally, the results were 5 cents higher than analyst expectations of 99 cents per share.

Revenue increased 30.9% to $2.4 billion. During the company's conference call tonight, NSC noted, "effectively, all T&E employees have been returned from furlough status and we've started hiring in areas where traffic levels dictate and based upon expected attrition." Lastly, NSC announced a 6% increase in the company's third quarter dividend to 36 cents per share versus 34 cents per share in the same quarter last year.

From HORAN Capital Advisors

Both FedEx (FDX) yesterday and United Parcel Service (UPS) last week, cited an improving business environment as reasons to raise their outlooks. Other rail companies have reported this earnings season that their business conditions are improving.

These reports are certainly positive signs for the economy. Worries still remain with high unemployment and government and municipal debt issues though. In the end, all the news is not bad and investors can selectively find attractive investments in the current market.

Disclosure: Our firm is long NSC

Indexing Concerns And The Second Derivative Make This A Stock Pickers Market

One issue confronting investors at this point in the market cycle is the fact the growth rate of earnings on the S&P 500 Index are anticipated to slow going into 2011. Although operating earnings for the S&P 500 Index are projected to reach $92.19 per share, this level of earnings represents a lower rate of increase (the second derivative) than the earnings growth achieved in 2010.

From The Blog of HORAN Capital Advisors

For 2010 it is estimated that earnings will go from a -5% rate of growth in 2009 to a 22% growth rate in 2010. This represents a 27 percentage point positive swing in the rate of change in the increase in earnings on a year over year basis. It could be said the market's strong return in 2009 was forecasting this positive earnings change. The market does tend to be a good predictor of the future. As we now sit at mid year 2010, what are the estimated earnings for the S&P 500 Index in 2011 and what can be inferred from these estimates?

Although estimates show near record earnings of $92.19 for 2011 and a 16% increase over 2010 earnings of $79.53, this rate of growth is 6 percentage points lower than the estimated change in the growth rate of 27% in 2010. In other words, the second derivative of the earnings increase for 2011, or rate of change, is a negative 6%. Therefore, what investment strategy should investors pursue at this point in the market's cycle?

At HORAN Capital Advisors, we believe indexed large cap stock investors could be caught in this trading range cycle due to the negative second derivative of earnings, i.e. a negative rate of change in the growth rate. As a result, investors will likely achieve better returns, with less volatility, if they focus on individual high quality companies that exhibit a stable or consistent rate of growth in earnings when looking at earnings estimates for 2011 compared to the growth in earning for 2010. Those companies that can consistently growth earnings 10-15% over time are likely to provide investors with a more consistent return while assuming less downside risk as well. A couple of companies we own for our clients that satisfy this consistent or increasing growth criteria are Waste Management (WM) and Genuine Parts (GPC). As one can see by reviewing the below earnings charts, a steady or rising earnings per share growth rate is estimated for 2011. The 2011 EPS growth is near or better than the growth rate achieved in 2010. This represents just one of a number of variables we analyze, but it is certainly an important one.

From The Blog of HORAN Capital Advisors

One unpredictable variable is the market's potential reaction to the results of the midterm elections in November. What ever the election outcome, it could have a significant impact on sentiment for consumers and business.

Disclosure: Long GPC and WM

Thursday, July 22, 2010

Sentiment Swings From Bullish To Bearish

In this week's investor sentiment survey reported by the American Association of Individual Investors, bullish sentiment fell 7.2 percentage points to 32.16%. Bearish sentiment rose by a like amount to 45.03%. The 8-period moving average was reported at 33.2% and is still off of the YTD high reported earlier this year in the low 40% range. The bullish sentiment reading remains below the long term average of 39%.

From The Blog of HORAN Capital Advisors

Wednesday, July 21, 2010

Anxious Index

The Anxious Index is published by the Federal Reserve Bank of Philadelphia and refers to the probability of a decline in real GDP, as reported in the Survey of Professional Forecasters. The survey asks panelists to estimate the probability that real GDP will decline in the quarter in which the survey is taken and in each of the following four quarters. According to the Philly Fed the Anxious Index is the probability of a decline in real GDP in the quarter after a survey is taken. For example, in the survey taken in the second quarter of 2010, the anxious index is 9.81 percent, which means that forecasters believe there is a 9.81% chance that real GDP will decline in the third quarter of 2010.

From The Blog of HORAN Capital Advisors

In looking at the index over time beginning in the fourth quarter of 1968, the index often goes up just before recessions begin. For example, the first quarter survey of 2001 (taken in February) reported a 32% anxious index; the National Bureau of Economic Research subsequently declared the start of a recession in March 2001. The anxious index peaks during recessions, then declines when recovery seems near. For example, the index fell to 14 percent in the second quarter of 2002, when economic indicators began improving.

Monday, July 19, 2010

Is The Economy Rolling Over?

The economic data seems to be signaling a slowing of the economy; however, this slowing does not mean a double dip recession yet. Lackshman Achuthan of the Economic Cycle Research Institute noted in a recent Yahoo interview that we are experiencing a "sharp drop" in the weekly leading indicators. On the other hand the coincident indicator continues to show a sharp rise in economic activity.
One variable not included in the coincident measure and a part of the leading indicators is the direction of stock prices and stock prices have trended lower over the last three months; thus one component that is pulling down the leading indicator. Mark Thoma, a professor of economics at the University of Oregon, notes the relationship between capacity utilization and unemployment. In his article on his Economist's View website, he notes,
"In the past, there was a fairly close contemporaneous relationship between capacity utilization and unemployment. However, much like the relationship between output and unemployment, a lag in the relationship has developed in the last two recessions (see graph). That is, in past recessions an upturn in capacity utilization was matched by an upturn in employment, there was no delay in the relationship, but in recent recessions there has been about a half year delay before unemployment reacts to changes in capacity utilization (or perhaps even a bit longer)."
Thoma goes on to point out two favorable aspects of the above graph.
"First, the "V" in capacity utilization seems steeper than it was in the last two recessions. If the steep recovery of capacity utilization continues and employment follows, the recovery could be a bit faster than I've been anticipating (though the recovery of capacity utilization could certainly flatten out, and that possibility has to be factored into any policy response -- in the past two recessions the initial change in capacity utilization was also steep for the first few months, but it didn't last). Second, the lag between changes in capacity utilization and the change in employment appears to be shorter than the last two recessions. If so, then employment will recover faster. But the word "appears" here is important. Looking at the response of unemployment in the last (2001) recession, there were initial encouraging signs for unemployment just like this time, but then the recovery of unemployment stalled and actually increased a bit more before finally beginning to decline consistently. It's certainly possible that will happen again. Thus, while there are some encouraging signs here -- the steepness of the recovery for capacity utilization and the apparently shorter lag between improvements in capacity usage and improvements in employment -- but neither of these are unqualified, the steepness could change and the shorter lag isn't yet certain..."
The economic recovery we are experiencing is certainly fragile. Much of the support has been provided by the public sector and we need to see the private sector be more of a stimulus. Social, economic and tax policies coming out of Washington are creating potential headwinds. We continue to expect positive economic growth, although the growth is slowing at this time.

Sunday, July 18, 2010

Positioning For Higher Interest Rates

In a recent WealthTrack interview, conducted by Consuelo Mack, she talks with Loomis Sayles Bond Fund manager Dan Fuss. Dan Fuss is a two time winner of Morningstar’s Fixed Income Fund Manager of the Year award and has beaten the markets and its peers since the Loomis Sayles Bond Fund’s inception in 1991.

In the below interview, Dan Fuss provides insight into where he is finding value in the bond market. He also describes why he has recently shortened the average maturity of the bonds in the Loomis Sayles Bond Fund. Additionally, he talks about where he is finding value in the bond universe, which includes some global bond investments.

The lead in to the interview contains a performance comparison for treasury STRIPs and equity investments. The treasury investments have outperformed stocks for a very extended period of time. I do not believe the history of outperformance that is shown in the lead-in will repeat itself.

Saturday, July 17, 2010

Earnings In Second Quarter 2010 Better Than Expected

Earnings for the 2nd quarter of 2010 are coming in better than expected. A few facts noted by Thomson Reuters:
  • Through July 16, 48 companies in the S&P 500 Index have reported earnings for Q2 2010. Of these 48 companies, 75% reported earnings above analyst expectations, 13% reported earnings in line with analyst expectations and 13% reported earnings below analyst expectations. In a typical quarter (since 1994), 62% of companies beat estimates, 18% match and 20% miss estimates.
  • Over the past eight quarters, 69% of companies beat the estimates, 9% matched and 22% missed estimates. In the aggregate, companies are reporting earnings that are 16% above the estimates, which is above the 2% long-term (since 1994) average surprise factor and above the -1% surprise factor recorded over the past eight quarters.
From The Blog of HORAN Capital Advisors

Waning Consumer Confidence Hits The Market

One factor that contributed to the market's decline on Friday was the decline in the University of Michigan's Sentiment Index. The preliminary results came in at 66.5 versus expectations of 74.5. In prior posts I have noted how this index tends to lag the market's return by about 2-3 months. The recent market correction began in April and the consumer confidence index peaked in June.

(click for larger image)

From The Blog of HORAN Capital Advisors

Negative sentiment can translate into a negative impact on consumer spending as well.

From The Blog of HORAN Capital Advisors

It's not that the government can create jobs, but it can create an environment that translates into more confidence by consumers. The uncertainty created by the recent passage of a number of new policies and regulations is certainly negatively impacting consumer and business confidence. If the mid term elections result in a change in the party that has power in Congress, the market may view this as a positive and begin advancing prior to November. This is one factor that could lead to a more confident consumer.

Thursday, July 15, 2010

Second Quarter Investor Insight Letter

The second quarter of this year certainly presented noteworthy headlines, most of which led to downward market pressure. The S&P 500 Index ended down 11.43% and the 10-Year Treasury note rallied sharply as yields fell from 3.83% and settled below 3%, demonstrating a desire for less risky assets. Looking forward, if earnings expectations are met in Q3 and Q4 we believe the market has strong upside potential. Our letter this month will review Q2 and discuss market positioning and thoughts for the remainder of the year.

Read the complete Quarterly Investor Letter.

Thursday, July 08, 2010

Bear Attack

Today's individual investor sentiment survey released by the American Association of Individual Investors noted a 15 point increase in investor bearish sentiment. This survey measures investors' six month forward expectations for the market. Additionally, the bullish sentiment fell to 20.9% and is two points above the bullish sentiment reached in the week of March 5, 2009. Since this is a contrarian indicator, the low bullishness level is one technical measure that would be a positive sign for a future move higher in the market. This week's current gain of 4+% is certainly confirmation of this potential outcome.

From The Blog of HORAN Capital Advisors

Wednesday, July 07, 2010

Signs Are Not Pointing To A Double Dip Recession Yet

Since 1950 every US recession has been preceded by
  • A rise in interest rates
  • An inverting yield curve
  • Increasing oil prices, and
  • Falling unit profits for US nonfinancial companies
None of these factors have occurred as of today as the below charts detail.

No Rise In Rates:

From The Blog of HORAN Capital Advisors

Yield Curve Not Inverted:

From The Blog of HORAN Capital Advisors

Oil Prices Stable Last 12-Months:

From The Blog of HORAN Capital Advisors

Nonfinancial Corporate Profits Moving Significantly Higher:

From The Blog of HORAN Capital Advisors

So at the moment, a double dip recession does not seem to be the most probable outcome for the economy. We do not see the Fed tightening monetary policy at this point in time. The economic recovery is a fragile one so investors should not throw caution to the wind. We will be evaluating corporate earnings announcement and more importantly corporate earnings guidance for signs that an economic slowdown might be on the horizon.

Sunday, July 04, 2010

Dividend Payers Outperforming

For the month of June and the first six months of 2010, the dividend payers in the S&P 500 Index are outperforming the non-paying stocks. For the month, the payers' return of -5.91% was better than the non-payers' return of -7.30%. Additionally, this year the payers have declined 2.90% versus the non-payers decline of 4.41%.

On a year over year basis as of June, dividend payments were up 5.7%, for the quarter up 2.6% and down 3.2% on a year to date basis. In a further sign that companies view future prospects as improving, ten companies initiated dividends versus 65 that either decreased or suspended payments in the first six months of 2009.

dividend actions as of June 2010The two negative actions this year fell in the energy sector. Valero (VLO) decreased its dividend by 67% in January and Tesoro (TSO) suspended its 20 cent dividend in February.

Cash Likely To Reduce Overall Investment Returns

The past ten years have been difficult for investors given the extent of the market's volatility. During this time period it may seem that holding onto cash has been the proper investment decision. The question then becomes cash versus what other alternative. As the below chart notes though, on a calendar year basis, not once during the past ten years did cash outperform both stocks (S&P 500 Index) and bonds (BC Aggregate Index).

From The Blog of HORAN Capital Advisors

As a result there was a better investment alternative than sitting on cash if that cash was targeted for longer term investments. Holding some cash is perfectly logical if the cash is needed for short term needs. Since 1926 cash has outperformed equities and bonds in 12% of the calendar years covered.

From The Blog of HORAN Capital Advisors

Holding some cash can serve as a useful purpose in reducing ones overall investment volatility. However, holding too much cash can be a drag on an investor's overall returns.

Thursday, July 01, 2010

Individual Investors Certainly Not Bullish

Individual investor bullish sentiment declined over nine percentage points this week to 24.7%. This is the lowest bullishness level since November 5, 2009 when the bullish percentage was 22.2%. The 8-period moving average of the bullishness level fell for the sixth consecutive week to 35.1%. The 35.1% reading is the lowest bullishness average since the end of July last year when the 8-period average fell to 35%. The bull/bear spread for the week was reported at -17.3%.

From The Blog of HORAN Capital Advisors