“Can you imagine someone running an MSCI ACWI index and leaving Apple out? It isn’t going to happen”
–Rob Arnott

Any industry professional nowadays with a title that loosely fits the “analyst” or “research” category is constantly blocking and filtering what they see and hear as part of their routine. Sensory overload is more of a threat than ever to sound decision making, whatever that may mean at the individual level.

Rob Arnott’s papers or interviews always head right to the top of my to-do list. In my opinion, he always reveals valuable observations or tidbits that go against conventional wisdom and, frankly, his analysis consistently has a “hit you on the head” effect.

Among other things, Research Affiliates is well-known for its successful dismantling of capitalization-weighted index tracking. In a Barron’s Interview last week Arnott fired off a list of sobering facts gleaned from his firm’s long-term analysis of market darlings at any given point in time:

“History tells us that of the top 10 stocks in the world [at any given point in time], 8 will disappear over the next decade—if history is any guide Apple might be in the Top 10, but won’t be No. 1. That means it would underperform the market.”

The Quote of the Day comes from the same discussion where Arnott presents a data-driven argument for one simple way to beat a cap-weighted indexing strategy over the long-term: Never own the most heavily-weighted stock in the index. This is one of the factual tidbits that’ll hit you on the head even if it’s not a strategy they plan to implement. The analysis was revealed to make a behavioral point.

Back to the Global Macro Grind…

We find value in tracking the performance and structure of many popular factor portfolios to help us understand potential flows and market structure, particularly in popular rebalancing periods. There are also times when these strategies will contradict our in-house asset allocation views, and we want to understand the opposing position and its motivations.   

Although we use the “factor” buzzword regularly, our preferred factor exposures are identified through a returns-based framework born out of our GIP-Model set-up. The GIP-Model identifies the “growth” environment and return profiles fit that style whereas many of the traditional quant factor portfolios are agnostic to external factors like “business cycle positioning.” Factor-timing analysis is building momentum in that community from what I gather.

The two biggest themes in Rob Arnott’s interview last week were 1) Poor prospective returns for FAANG stocks and 2) Favorable prospective returns in deep-value emerging market stocks.

It’d be a simpleton’s argument to play the someone’s right, someone’s wrong game. It all depends on time horizon and total portfolio context at the individual level among other things. However, the performance spreads between “value” and factors like “growth” or “momentum” have been unprecedented this cycle and caused quite a bit of pain for some. Whether the explanation is a cyclical or structural one is the million dollar question…

The Chart of the Day is actually two charts and the topic is probably worth a lengthy slide deck because not all factor portfolios are created equal. We use the example of the longstanding “Value” and “Growth” indices constructed from the Russell 2000. Note that this cycle phenomenon is visible across capitalizations and many value factors across the global landscape. It’s for illustration of Arnott’s thematic call-out:

  • Chart 1: The rolling 5Yr cumulative total return performance between the Russell 2000 “Growth” over “Value” Index
  • Chart 2: The rolling 3Yr cumulative price return performance between the Russell 2000 “Growth” over “Value” Index

We don’t doubt the answer is cyclical and that there is a place for a piece of your asset allocation set aside to capture the long-term value premium. While you’d probably have to conclude it’s different this time to bet the next 10 years will be like the last, there are some real structural considerations with P/B type of Fama-French historical analysis (methodology for the popular Russell “value” factor indices). We’ll give OSAM credit for the most concise outline of this debate: Negative Equity, Veiled Value, and the Erosion of Price-to-Book. Due to the evolution of modern accounting practices, there is ~$4Trillion of Mkt. Cap that is disregarded by some of the most popular and longstanding factor benchmarks for active managers. Again, that’s another can of worms…

In more of a total return type of global macro framework, we’ve tried to build a robust process for flagging underappreciated potential inflection points coming down the pipe 6-12 months out.

This top-down rate-of-change process can clash with idea of scooping up cheap markets based on financial performance price multiples. Deep-Value Emerging Market Stocks have not been something we’ve pushed. It’s been quite the opposite all year. 

Below is an excerpt from our Daily Derivatives Market Research Piece from this morning. The most important thing to note is underappreciated risks priced into derivatives markets even once many of these markets were already crashing. Very strong and one-sided consensus views take time to unwind. We released a 20-page slide deck on this topic two weeks ago Friday in conjunction with the Early Look. It’s an important reference.   

“EM Equities (EWZ, EWW, EZA) – Many emerging market equity vehicles continue to get tagged. Outside of Turkey, three of the worst performing tickers across global equity market and FICC (based on the same universe we use to track volatility trends) are the following three emerging market ETFs:

I-Shares MSCI Brazil ETF (EWZ): -5.13% D/D & -19.13% YTD

I-Shares MSCI South Africa ETF (EZA): -3.48% D/D & -11.26% YTD

I-Shares MSCI Mexico ETF (EWW): -0.79% D/D & -11.02% YTD

Considering many of these same markets were hot out of the gate to start the year, the drawdown from the highs is more indicative of the crash we are seeing. Sorry to point you in another direction, but our  Early Look from two weeks ago provides important market color on this continued crash, because we concluded the first part of the move in some of these markets was greatly underappreciated as seen in the derivatives realm ("All-Time" Click Bait).

Here is the drawdown from YTD highs in those same three ETFs:

EWZ: -30.1% (01/26 YTD High)

EZA: -18.3% (01/26 YTD High)

EWW: -19.0% (04/17 YTD High)”

Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now: 

UST 10yr Yield 2.77-3.04% (bullish)
SPX 2 (bullish)
RUT 1 (bullish)
NASDAQ 7 (bullish)
Nikkei 22003-22891 (bullish)
DAX 125 (neutral)
VIX 11.22-17.11 (bearish)
USD 93.10-94.75 (bullish)
EUR/USD 1.15-1.18 (bearish)
Oil (WTI) 63.71-70.67 (bullish)
Nat Gas 2.85-3.02 (bullish)
Gold 1 (bearish)

Good Luck Out There Today, 

Ben Ryan
Macro analyst

Oh The Pain - 06.08.18 EL Chart