Do you have a research process that identifies the winners and losers in each macroeconomic environment? We do.
Our research process says sell bonds and buy U.S. equity sectors like Consumer Discretionary (XLY), Tech (XLK) and Financials (XLF). Here's why.
Beating the S&P 500 is hard. Over the last twenty years, only 19% of active fund managers have been able to do so, according to a recent study by J.B. Heaton et al. "The culprit for underperforming can almost solely be attributed to missing key sectors and large price moves in a small number of stocks," writes Hedgeye Director of Research Daryl Jones in today's Early Look.
On the other side of the performance spectrum, according to another recent study, roughly 70 percent of stocks will do worse than the Treasury bill. Not good.
Meanwhile, there are $2.8 trillion in assets under management (AUM) invested in all U.S.-listed ETFs, in which investors are simply buying an underlying index like the S&P 500. These diversified investors don't miss out on the indices' big winners and therefore aren't as crippled by the big losers.
Then again, blindly buying and holding passive ETFs has it's own issues. There's the -55% peak to trough drawdown in the S&P 500 SPDR to contend with during the market turmoil of the 2008 financial crisis.
Active or Passive Management?
There's a better way that mixes elements of both passive and active management. Our Growth, Inflation, Policy (GIP) model tracks the year-over-year rate of change in U.S. economic growth and inflation both of which are highly predictive of the proper asset allocation mix.
The goal is to capture the big picture then ask the fundamental question: Is growth and inflation heating up or cooling down? Our GDP predictive tracking algorithm, which inputs 30 economic data points per month, 90 for the quarter, spits out a forecast for U.S. economic growth and our proprietary inflation tracker suggests the future direction of inflation.
We get four possible outcomes, each of which is assigned a “quadrant” in our GIP model along with the typical fiscal/monetary policy response as a result (neutral, hawkish, in-a-box or dovish):
- QUAD 1: U.S. Growth accelerating, Inflation slowing
- QUAD 2: U.S. Growth accelerating, Inflation accelerating
- QUAD 3: U.S. Growth slowing, Inflation accelerating
- QUAD 4: U.S. Growth slowing, Inflation slowing
From there it's a matter of selecting the right mix of assets. For that, we have backtested data showing the asset classes that outperform in each quad.
Why We like Consumer Discretionary Right now... Not Energy
In the Chart of the Day, we've highlighted the difference between the top performing S&P 500 sector compared to the worst sector. The difference in performance between Consumer Discretionary (XLY), up +10.9% and Energy (XLE), down -10.6%, is more than 2,000 basis points. Obviously it is no coincidence that with consumer costs (energy) down, consumer spending is up.
The market has essentially been front-running the U.S. economy's move into QUAD 1, in which growth is accelerating and inflation has been slowing down.
On growth:
- Earnings Season is Red Hot: 305 of 497 companies in the S&P 500 have reported year-over-year sales and earnings per share growth of +7.7% and +15.6%
- US GDP decelerated modestly from 2% year-over-year growth in the fourthquarter to the first quarter’s +1.9% reported last week, versus -24 basis points below Hedgeye’s forecast of +2.14%. Our predictive tracking algorithm expects U.S. growth to pick up for the balance of 2017.
On inflation:
- ISM Manufacturing dropped -2.4 points to 54.8 (back to November levels) to start Q2. ISM sub-indices also saw notable declines. This is one reason to expect middling results in Energy, Basic Materials and Industrials sectors as we comp out of the industrial and commodity price recession.
- Consumer Price Index (CPI) slowed from a five-year high of 2.8%year-over-year in February to 2.4% in the March data reported a few weeks back.
Taken together, economic data suggests staying away from Energy stocks while buying sectors like Consumer Discretionary (XLY), Tech (XLK) and Financials (XLF).
Bottom Line
To beat the benchmark you need a process that aggregates all of the available economic and market-moving data, interprets it and suggests an agnostic investment decision. From there you can overlay fundamental research without falling prey to your own biases.
We say U.S. growth is accelerating. What say you?
