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Equity markets exhaled on Thursday (7/8) from all-time highs; the S&P 500 (SPX), Nasdaq Composite (NASD), and Dow (DJIA) fell 0.92%, 0.76%, and 1.12%, respectively. Note these daily changes are higher than the intraday lows recorded, telling us that markets recouped some of their losses, as Dow futures were down over 500 points before the open. The pullback was, at least partially, attributed to concerns about the spreading Delta variant in other parts of the world along with the ongoing effects of a tight labor market and supply shortages pitted against high economic growth expectations from investors. Given the intraday drawdown, most of the major equity market indices reversed lower into a column of O’s on their intermediate-term Point & Figure charts; however, there were no material support violations. That said, the downtick (thus far) in equities appears to be an appropriate, expected, and healthy exhale after a breathless run to all-time highs. Domestic Equities retain the top rank in DALI and the US Equity Core remains dominant amongst all other groups, as we further examine in today’s Fund Score Overview, but we will see several reversals down across a variety of our bullish percent indicators, suggesting that underlying participation continues to narrow.

We also saw fixed income yields continue their descent on Thursday. The US Treasury 10YR Yield Index (TNX) ticked lower in a column of O’s to 1.275% on its default Point & Figure chart, now resting on its bullish support line. Should this trend violation occur, it would add further technical evidence of the shift in sentiment regarding potential rate hikes. Below in today’s (7/8) report we further unpack this unique fixed income environment.

In Thursday’s trading, the US Treasury 10YR Yield Index TNX reached 1.275% on its default chart after closing at around 1.48% last Thursday – a drop of around 20 basis points in a week’s time. Throughout all of May and June, TNX traded within a 25 basis point range between 1.45% and 1.7% on its chart, which offers some perspective on the magnitude of this move.  

A Bloomberg article from Tuesday, when TNX was around 1.35%, or 10 basis points higher than where it currently sits in its P&F chart, showed that its then-current level was three standard deviations below the level projected by JP Morgan’s “fair value model,” which is the largest deviation since fall of 2020. The model uses factors like inflation expectations, fed guidance, and recent economic data to predict an equilibrium level for the 10-year yield.

A number of explanations for the drop in yields have been offered including:

• A short-squeeze – when Treasury yields initially started to move down, against investors with who had taken short Treasury positions anticipating rising inflation and higher yields, they were forced to cover those positions, driving them down even further.
• Bond investors have lowered their expectations for economic growth and/or long-term inflation.
• Despite statements from FOMC members that tapering could begin in the fall, the market is predicting that the actual tapering will be slower than advertised.
• A flight to safety due to Increasing COVID-19 cases attributed to the delta variant, which has resulted in the resumption of lockdowns and social distancing measures in some countries, resulting in lower projections for the pace of global growth.
• Perceptions of how hot the Fed will let the economy (and inflation) run have shifted due to its recent more hawkish tone.

The reality is that are probably multiple factors driving the decline in yields. However, some of these explanations seem diametrically opposed – yields have declined because investors don’t believe the Fed will taper as fast as it has indicated vs. they’ve declined because of lower growth and inflation expectations due to the Fed’s more hawkish tone. The fact that we saw global equities decline Thursday in tandem with sovereign yields (in the US and elsewhere) runs counter to the idea that investors are doubting the Fed’s sincerity and believe the easy-money party will continue uninterrupted.

Whether due to tighter monetary policy or a resurgence of COVID-19, most of the other rationales that have been offered up have a common theme of investors adjusting their expectations for growth downward, which would be consistent with some of the other risk-off moves recently.

The sharp drop in Treasury yields merits our attention as it is a notable deviation from the norm and certainly has a risk-off undertone. That being said, at this point, there is no indication of weakness in the equities market. Even with Thursday’s decline the S&P 500 SPX and Nasdaq NASD both remain within 2% of their all-time highs, domestic equities remain atop the DALI asset class rankings, and US equity core percentile rank within the Asset Class Group Scores sits above 99%.

As we do each quarter, today we update our U.S. and International "Smart Beta Quilts" and Factor Studies for the second quarter of 2021. Before the term “factor investing” became commonplace within the financial community, there were two main "factors" that advisors were already using within client portfolios: growth and value. Advisors commonly used various market capitalization sizes or some form of style rotation, but beyond that, there was not a lot of access to many of the security selection processes that are available today. Over the past decade, the number of investable factors has increased significantly, thanks in large part to the proliferation of ETFs. The term "factor" is broad, and there is a healthy debate as to what exactly should fall into that category. Arguably, any indexing strategy in which securities are chosen systematically, based on measurable attributes, with a goal of producing superior returns over the asset class would qualify. Still, that covers a wide range and is a vague definition, but we can agree it goes well beyond "growth" and "value."

Other factors that are commonly accessible through ETFs today are momentum, low volatility, quality, dividend achiever, and buyback strategies. All of these factors are designed to pinpoint a certain investment theme within the marketplace, and systematically allocate to that theme. For instance, the “low volatility” factor is represented by the Invesco S&P 500 Low Volatility ETF (SPLV), a fund that seeks exposure to the 100 stocks with the lowest volatility in the S&P 500. Over time, most of the factors examined offer better performance than the benchmark, the SPDR S&P 500 ETF (SPY), however, no single factor ETF has been the best performer every year, or even most of the years...nor has any single factor ETF been the worst performing every year or most of the years.

Factor Return Observations (US Equities):

• Value has been the best performing factor throughout the first half of the year with a gain of 25.56%. This comes after value finished either last or second to last in each of the prior three years.
• Momentum went from the best performing factor for two consecutive years to the worst-performing factor year-to-date in 2021; momentum now shows a positive 2.14% return for the year after being in negative territory after the first quarter.
• After finishing in the bottom half of the factor rankings in 2021, buyback has been the second best performer in 2021, gaining just over 23%. 
• Growth is still the best performing factor from a cumulative perspective, though it ranks seventh year-to-date. 
• After a poor performance in 2020, the contrarian switching strategy has been the best performing "strategy" in 2021, while "return chasing" has been the worst performer. 

How do I use this information to build a portfolio around factors?

Our goal with the research above is both to illustrate the range of factors that are available and also the necessity of being disciplined in applying these factors over time as we want to promote "good behavior", as it relates to any investment process or product. This is perhaps the most important observation from the data above: We've illustrated the outcomes generated by a few common behaviors using the same investment universe, and the outcomes vary dramatically! There are the "buy and hold" outcomes, which show growth as the best performer, but we also know inherently what comes with a buy and hold commitment to only growth. While not visible above, 2000-2002 were tough years for that factor, tougher than many could endure in fact. Another approach that we illustrate is to simply equal weight all seven of the individual factors in a portfolio and rebalance that portfolio once a year. Additionally, we looked at the hypothetical behavior of buying the best performing factor from the previous year and holding that factor for the entire next calendar year. For our purposes, we label this “Return Chasing,” and while no portfolio manager markets themselves this way exactly, it is an emotional bias that creeps into many investors' psyches.

This "Return Chasing" portfolio tracks a hypothetical investor who sees that momentum was the best performing factor in 2020, and then just owns that factor for 2021. This strategy worked out well in 2020 and there have been a few other years where the return chasing worked out, such as when value was the best performer in back-to-back years from 2012 to 2013. However, even though it has worked out well in a few instances, on a cumulative basis, return chasing has been the worst “strategy” and has massively underperformed the contrarian strategy and an equal-weighted basket of the factors. The factors themselves are not the problem, as most create substantial alpha relative to the market. However, bad behavior can create bad returns out of good products, and constantly chasing last year's best performing factor is an example of bad behavior. 

The opposite of return chasing is the contrarian approach, which hypothetically buys the worst-performing factor from the previous year and holds it for the subsequent calendar year. The “Contrarian Switching” portfolio illustrates what is missed when an investor dumps a factor for having a bad year, and this strategy outperformed both cap-weighted and equal-weighted benchmarks over the study period! A good stock can become a bad stock and may remain a bad stock for a long time. A good factor is much less likely to remain perennially out of favor. A good factor should have a process of systematically eliminating bad stocks at some point and should return to favor as a result. Each factor illustrated above is available through an ETF, or multiple ETFs because they have been vetted through research and real-life portfolio management applications, which provides some confidence that periods of underperformance should not become perpetual underperformance.

This tells us that lagging years for a good investment factor have commonly been better-than-average entry points. In 2016, momentum had a rough go of it, which was the first time during the lookback period that it was the worst-performing factor. In the following year, it was the second-best performing factor behind growth, and these were the only two factors to outperform the benchmark. 2017's worst-performing factor (shown above) was the "Dividend" factor, which we represent with a Dividend Achiever portfolio (PEY), which is weighted based upon yield. The long-term returns for this fund are heavily weighted toward dividends and so the price return of the fund is perhaps less representative of the outcome than with other factor-based products. In 2018, we did not see much of a "mean reversion" as PEY was near the bottom of the pack again. Value also had a rough go of it during 2018, which was followed by underperformance in both 2019 and 2020. As a result, the "Contrarian Switching" approach lagged in those years. However, through the first six months of 2021 we have seen somewhat of a return to form for the Contrarian Switching strategy, as value went from the lowest-ranked factor in 2020 to the best so far this year.

These strategies can also be applied to factor representatives from international equities, which, as we can see below, demonstrate similar tendencies to their domestic counterparts.

Factor Return Observations (International Developed Equities):

• Buyback was the best performing international equity factor through the first six months of the year; if it finishes the year in first place, it would be the first time since 2017. Despite its lack of "wins" over the last few years, buyback remains the top international factor on a cumulative basis. 
• While momentum has lagged domestically, it has performed well in international markets this year, ranking third behind dividend achievers
• After being the worst performing factor during the first quarter of 2021, growth moved out of the basement in Q2; low vol is now the worst performing factor year-to-date after also lagging all other factors in 2020. 
• Unlike the US, the contrarian switching strategy has lagged internationally in 2021, while return chasing has been the best performing "strategy" thanks to momentum's stronger relative performance outside the US. 

The past week of market action saw the US Equity Core Percentile Rank (CorePR) continue to push higher to a recent reading of 99.30% through trading on Wednesday (7/7). As a refresher, the CorePR tracks the relative position of the S&P 500 Index Funds group, our core market representative, when compared against the rest of the groups found on the Asset Class Group Scores (ACGS) page. This recent reading came as the core moved into the second-ranked position, sitting behind MLPs with a recent group score of 4.39. While this is not the highest average score the group has seen so far in 2021, it is one of the highest readings we have seen for the CorePR. This is only the third time the reading has gotten to the 99^th percentile, which last occurred in November 2019 and previously in early October 2018. Those two instances saw drastically different movements for the S&P 500 Index SPX in the months that followed. The end of 2018 saw a sharp market correction and enhanced volatility in the last few months of the year, while the market continued to push higher in late-2019 and continued to hit new all-time highs in 2020 prior to the pandemic-induced market decline.

As we covered in the Fund Score Overview last Friday, it is a good sign to see elevated positioning for the CorePR reading, as this points toward a favorable stance for the broader domestic equity space. However, extremely high levels for the CorePR can present the risk of a near-term pullback as this points towards a narrowing of market strength. The bullish nature of domestic equity markets makes it fairly normal to see high CorePR readings, but just how often have we seen levels north of 90%?

To help answer this question, we measured the percentage of days the CorePR reading sat in each decile from its origin on November 18, 2003, through market movement Wednesday. We also took the average return for SPX over a forward one, three, six, and twelve-month timeframe for each decile.

As shown by the above table, the CorePR reading has sat at 90% or higher for 21% of the trading days since late-2003. In fact, the reading has been north of 70% for the majority of its existence at 53% of the trading days. The average forward return data shows that the broader hypothesis of elevated positioning leading to strong domestic equity returns holds true, as the returns are generally higher when the indicator remains above 70%. However, we can also see that the average returns become more muted as the reading moves from 70% to 100%, highlighting the potential for a near-term reversion or normalization in the price action for the core market representative.

Out of the 976 trading days that have seen a CorePR reading at or above 90%, roughly 62% of the average returns one month out from those days were positive. If we go three months down the road from those elevated positioning days, we see that 72% of returns were positive. This continues to improve over the forward six-month and twelve-month average returns at respective positive return “batting averages” of 78% and 87%.

At the time of this writing on Thursday, the S&P 500 Index is posting an intraday loss of about 1%, which would mark its fourth-worst daily decline since the end of March. While we cannot know with certainty what the next few months hold, the historical CorePR data for positioning above the 90^th percentile does present the possibility of muted near-term movement over the next month, but that movement has shown historical improvement further along the timeline.

Daily Option Ideas for July 8, 2021