Market Capitalization: Large / Small

Highlights BCA still sees green shoots: Our latest view meeting reinforced BCA strategists’ optimistic global outlook, and we are methodically adding international and cyclical exposures to reflect it. Relatively modest M&A activity is not a sign of a top, … : Last Monday was the busiest Merger Monday of the year, but relative merger volumes are not anywhere near the peaks that coincided with the end of the last two expansions. … and neither is small-cap equity underperformance: There is no empirical basis for concluding that small-cap underperformance heralds economic weakness, stock market weakness or heightened risk aversion. Feature Onward. At our latest editorial view meeting, held last week, we completed the step we first began discussing in the spring, upgrading Eurozone equities to overweight in global equity portfolios. BCA continues to recommend investors remain underweight sovereign bonds in balanced and dedicated fixed income portfolios, and we expect that a top in the dollar versus the more cyclical major currencies is coming soon. We downgraded US equities to underweight to make room for the Eurozone overweight, along with new overweights in British and Japanese equities. The move reflects the BCA consensus that global growth has bottomed and is poised to accelerate. Against an improved growth backdrop, the dollar should cede leadership to more cyclically sensitive currencies, providing non-US equities with a relative tailwind.1 The narrowing of the growth differential between the US and the rest of the world should give international equities an additional boost. A revived growth outlook, and a cooling of trade tensions signaled by a signed Phase 1 China-US agreement, would ease some of the safe-haven demand for sovereign bonds, and help interest rates unwind some of the downward pull that dragged them lower across the first eight months of the year. The US equity downgrade is only a relative call, however; US Investment Strategy remains constructive on the absolute return outlook for US stocks. Other economies with a greater reliance on trade will benefit more from a global upswing than the US, which suffered less from the global slowdown than its peers. The S&P 500 has much more exposure to the rest of the world than the US economy, though, and its earnings would get a boost from accelerating global growth and a weaker dollar. At the same time that the fundamental picture is poised to improve, the wall of worry continues to renew itself, and this week we discuss concerns about M&A activity and small-cap stocks’ underperformance, which have come to the fore as Sino-American tensions have relaxed their grip on the collective investor psyche. Mergers And Animal Spirits Mergers and acquisitions (M&A) generated some attention-getting headlines last month. Just last Monday, nearly $60 billion of deals were struck: Charles Schwab purchased TD Ameritrade for $26 billion, LVMH bought jewelry icon Tiffany for $18 billion, Novartis paid nearly $10 billion for drugmaker Medicines Company, and Ebay sold StubHub for $4 billion. Earlier last month, Xerox launched a hostile bid for HP ($32 billion), and KKR reportedly discussed an acquisition of Walgreens that could top $70 billion. A Walgreens transaction is a long shot, as it would potentially be the largest leveraged buyout of all time, but it has set tongues wagging in investment banking and private equity circles and fingers wagging among observers with an inclination to be scolds. M&A overtures cannot be viewed as a pure proxy for animal spirits, but M&A activity has aligned closely with the business cycle over the past two full cycles. The value of completed transactions as a share of equity values and GDP has troughed soon after the recession ends and peaked just before the recession begins, both here and abroad (Chart 1). In early 2016, proportional M&A volumes approached the levels that marked a top in 2000 and 2007, but the signal turned out to be a head fake, at least in terms of the US business cycle. Today’s volumes do not appear to be a concern, especially when compared to equity market value, which has consistently outpaced M&A activity since the 2016 peaks. Chart 1Peaks In M&A Activity Coincide With Business Cycle Peaks, ... It makes intuitive sense that peaks and troughs, or surges and slowdowns, in M&A might provide some insight into corporate confidence. Insight into confidence might in turn offer a preview of capex and hiring activity. Chart 2... But M&A Isn't Predictive Otherwise The empirical record does not support the intuition, however, as non-residential fixed investment growth has not shown much of a relationship with M&A volume as a share of GDP (Chart 2, top panel). Since the crisis, M&A volume has oscillated around the steady climb in hiring intentions (Chart 2, middle panel) and job openings (Chart 2, bottom panel) without exhibiting a clear relationship. What Is Small-Cap Performance Saying? The S&P 500 has made thirteen new all-time highs, or about one every other day, since the last week of October. The S&P SmallCap 600, on the other hand, just narrowly topped its year-to-date high, and remains more than 9% from its all-time high, set at the end of August 2018. Small-caps are more volatile than large-caps and many investors treat relative small-cap performance as a proxy for overall risk aversion. When small-caps are outperforming, investors are presumed to be more willing to embrace risk; when they’re underperforming, investors are supposedly more prone to shun it, with implications for all equities. Small-cap indices are simply too jumpy to predict large-cap equity moves. The empirical record does not support the view that relative small-cap underperformance leads broader market downturns. Because small-cap market cycles tend to be more compressed than large-cap market cycles, there are many more of them. There have been seven complete S&P 500 market cycles since 1970 (Table 1), versus fifteen complete market cycles for the equal-weighted all-cap Value Line Index2 (Table 2). Simple logic holds that all fifteen small-cap events can’t be portents of seven large-cap events, and the S&P 500 has been largely indifferent to small-cap outperformance and underperformance over time (Chart 3). Table 1The S&P 500 Is On Its Eighth Bull Market Since 1970 … Table 2… While The Value Line Index Is On Its Sixteenth Chart 3Independent Events We do not believe that small-cap relative performance is a reliable indicator of investor risk tolerance/aversion, or a proxy for animal spirits. We have found that relative performance is best explained by more prosaic elements like sector composition, valuation and earnings discrepancies, domestic/global performance shifts and cyclical/defensive performance shifts. These elements have sent mixed signals as group so far this year, but sector composition is likely to support small-caps going forward if our constructive economic view pans out. Relative small-cap performance doesn't tell us anything about the S&P 500's future direction. Compositional Factors: The S&P SmallCap 600 Index is not just a mini-me version of the S&P 500 because the benchmarks’ sector composition often varies considerably. The SmallCap 600 currently has much heavier weightings than the S&P 500 in Industrials, Financials, Consumer Discretionaries and Real Estate, and much lighter weightings in Technology, Communication Services and Consumer Staples stocks (Table 3). The small-cap index has a greater share of early cyclicals than the S&P 500, and an equivalently smaller share of defensives, but that hasn’t mattered this year, as small-caps have underperformed large-caps in every sector but Health Care (Table 4). Small-cap underperformance in Energy, Communication Services, Staples, and Financials has been especially stark. Table 3Not Quite Apples To Apples Table 4Year-To-Date Sector Performance Valuation/Earnings Discrepancies: Disparities in index valuation may bear on small- and large-cap performance without revealing anything about underlying business or economic trends, or without providing much insight into investors’ broader appetites for risk. Relative valuation does not appear to have been much of a factor for small- and mid-cap stocks’ relative performance this year, as standardized relative multiples have stayed close to the mean (Chart 4). Both of the SMID indexes have experienced relative de-rating this year, but their underperformance is better explained by lagging earnings growth. According to Refinitiv/I/B/E/S, MidCap 400 and SmallCap 600 earnings are expected to decline by 7% and 19%, respectively, versus the S&P 500’s modest 1% contraction. Chart 4Relative Valuations Are In Line Domestic/Global Discrepancies: Smaller companies are less likely to derive significant portions of earnings and revenues from overseas, and multinationals tend to be mega-caps. The formerly decent correlation between small-cap relative performance and domestic-versus-global industry group performance has unraveled since the 2016 presidential election (Chart 5, bottom panel). It’s possible that investors bid too eagerly for small-caps on expected policy changes after the election and in early 2018, following the cut in the top marginal corporate income tax rate that stood to disproportionately benefit small-caps with effective tax rates equivalent to the top marginal rate.3 It is much easier to buy a small-cap index ETF than it is to assemble portfolios of domestically- and globally-exposed industry groups, which may explain why small-caps decoupled from domestic-versus-global industry groups in two pronounced spikes. A continued small-cap slide would be consistent with BCA’s sanguine global view. Small-caps' relative performance has decoupled from global-facing stocks' relative performance. Could tariffs be hurting them more than expected? Chart 5Small Caps May Not Be Immune To Global Pressures After All Cyclical/Defensive Discrepancies: Differences in exposure to cyclical and defensive sectors offer another perspective on differences in sector composition. The SmallCap 600 Index has just 60% of the S&P 500’s exposure to defensive sectors. Absolute small-cap performance has moved with cyclical-to-defensive performance this year (Chart 6, top panel), but the relative breakdown in small-cap performance that began when defensives took the lead failed to reverse when cyclicals recently revived (Chart 6, bottom panel). We expect cyclicals to outperform defensives in line with our constructive view on global growth, which should translate to a boost for relative small-cap performance. Chart 6Cyclicals Investment Implications The conventional wisdom that small-cap underperformance signals a broader equity downturn does not hold up to examination. Small- and mid-cap earnings have contracted considerably more than S&P 500 earnings, and SMID stocks have de-rated versus large-caps since the fourth quarter of last year, but it is not clear why either of those trends will continue this year. We suspect that SMID underperformance largely reflects a downward revision in expectations that ran a little too high in the wake of the tax cut and the assumption that small-caps would emerge relatively unscathed from new tariff barriers. Large-caps are more globally-oriented, but it’s possible that overweights in Industrials and Discretionaries render small-caps more vulnerable to increased tariff-related input costs. M&A volumes as a share of market cap or GDP have served as a much more reliable proxy for overheated animal spirits. Peaks and troughs in M&A have aligned closely with peaks and troughs in the last two completed business cycles. M&A headlines have revved up in the last month, but the volume of completed deals is not yet at worrisome levels. Our main takeaway from last week’s internal view meeting is that 2019’s worldwide easing of monetary conditions will manifest itself in a pickup in global activity in the first half of 2020. Our bond strategists expect that the Fed’s primary concern is getting inflation expectations up to a level consistent with its inflation target, and that it will strive to maintain policy settings that are perceived as accommodative until it gets the inflation expectations response it seeks. Unless signs of financial instability compel it to tighten policy to contain bubble-like excesses, they expect the Fed to remain on hold for nearly all of 2020. We concur, and therefore expect the monetary backdrop to remain conducive for risk asset outperformance at least into 2021. Investors should maintain risk-friendly positioning against that backdrop.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 All of BCA’s global recommendations are made from a common-currency perspective. 2 A complete market cycle encompasses a completed bull market (at least 20% closing trough to closing peak gain) and a completed bear market (at least 20% closing peak to closing trough decline). We use the Value Line Index as a small-cap proxy here because it has a 50-year history, unlike the Russell 2000 or SmallCap 600. 3 Multinationals’ effective tax rates are often reduced by their ability to shift income among tax jurisdictions.

The latest NFIB job openings data nosedived, warning that small cap troubles are even deeper than previously assumed. Worrisomely, when compared with non-farm payrolls (gauging the large cap labor market) our proxy is sending an unambiguously negative signal that relative earnings growth will remain downbeat in the coming quarters (middle panel). Already, forward profit estimates are sinking like a stone for small cap indexes, but large caps have remained resilient (bottom panel). Tack on the relative indebtedness of small versus large caps (not shown) and we continue to recommend a large cap size bias.  

The latest NFIB survey made for grim reading. Following up from this Monday’s profit margin report, the forward margin relevant survey subcomponents signal that small business profit margins will suffer a squeeze. Worryingly, both planned price hikes took a turn for the worse and labor compensation remains a thorny issue for small & medium enterprises (SMEs). In fact, this SME margin gauge has fallen below the GFC trough and has only been lower in 1998 (middle panel). This is a warning shot that economically hypersensitive small caps are sending to their large cap brethren and suggests that the wide margin gap is clearly unsustainable. Moreover, recently updated financial statement data revealed that the small cap debt binge continues unabated at a time when cash flow growth has ground to a halt (bottom panel). This is another red flag we are closely monitoring as it will likely infiltrate the extremely depressed corporate default rate. Bottom Line: Adding it all up, we continue to prefer large caps to small caps on a cyclical time horizon, but from a portfolio management perspective, we will obey our trailing stop at the 10% return mark since inception.  

Special Report

Investors should pay particular attention to definition and methodology when evaluating value versus growth strategies, both academically and in practice. Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap universe. Small-cap investors should focus on value. Large- and mid-cap investors should not be making bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels.  GAA remains neutral on value versus growth, but prefers to use sector positioning (cyclicals versus defensives, financials versus tech and health care) and country positioning (euro area versus U.S.) to implement style tilts. Investing by way of style is as old as investing itself. Value versus growth has been one of the most frequently asked questions among our clients of late, particularly given the sharp style reversal in recent weeks. In this report, we attempt to answer some of the most often-asked questions on value versus growth. We have arranged these questions into five separate sections: First, we look at 93 years of history of the Fama-French value and growth portfolios to see how value, growth, and size have interacted over time, because academics have mostly used the Fama-French framework. Second, we look at how comparable U.S. style indices are, including the S&P, the Russell and the MSCI, since practitioners mostly use these commercial indices as their benchmarks. Third, we investigate if international markets share the same value-growth performance cycles as the U.S., using the MSCI suite of value-growth indices (since MSCI is the only index provider that produces value-growth indices for each market under its global coverage). Fourth, we investigate if pure exposure to value and growth can actually improve the value-growth performance spread by comparing the pure style indices from the S&P and the Russell to their standard counterparts. Finally, we present the GAA approach to style tilts in a section on our investment conclusions. 1. Is It True That Value Outperforms Growth In The Long Run? There has been overwhelming academic evidence supporting the existence of the value premium.1 Academically, the “value premium”, also known as the HML (high minus low) factor premium, or the value outperformance, is defined as the return differential between the cheapest stocks and the most expensive. Even though Fama and French used book-to-price as the sole valuation criterion,2 many researchers have combined book-to-price with other valuation measures such as earnings-to-price, sales-to-price, dividend yield,3 and so on.  There is also academic evidence suggesting that “value outperformance is almost non-existent among large-cap stocks.”4 What is more, in 2014 Fama and French caused a huge stir by publishing “A Five-Factor Asset Pricing Model” working paper demonstrating that “HML is a redundant factor” because “the average HML return is captured by the exposure of the HML to other factors” (such as size, profitability, and investment pattern) based on U.S. data from 1963 to 2013.5 Asset owners and allocators should pay special attention when selecting benchmarks for value and growth. For non-quant practitioners, especially the long-only investors, value and growth are two separate investment styles, even though the style classification shares the same principle as the academic “value factor.” Their definitions vary, as evidenced by how S&P Dow Jones, FTSE Russell, and MSCI define their value and growth indexes (see next section on page 7). In general, value stocks are cheap, with lower-than-average earnings growth potential, while growth stocks have higher-than-average earnings growth potential but are very expensive. The indices published by commercial index providers do not have very long histories, however. Fortunately, Fama and French also provide value-growth-size portfolios on their publicly available website.6 Table II-1 shows that for 93 years, from July 1926 to June 2019, U.S. value portfolios in both large-cap and small-cap buckets based on the well-known Fama-French approach have returned more than their growth counterparts, no matter whether the portfolios are equal-weighted or market-cap-weighted. Most strikingly, equal-weighted small-cap value outperformed its growth counterpart by over 10% a year in absolute terms, and has more than doubled the risk-adjusted return compared to its growth counterpart. Table II-1Fama-French Value-Growth-Size Portfolio Performance* Some media reports have claimed that value stocks are “less volatile” because they are on average “larger and better-established companies.”7 This may be true for some specific time periods. For the 93 years covered by Fama and French, however, this common belief is not supported. In fact, value portfolios in both the large- and small-cap universes have consistently had higher volatility than growth portfolios, no matter how the components are weighted. The excess returns, however, have more than offset the higher volatilities in three out of four pairs, with the exception being market cap-weighted large-cap growth, which has a slightly higher risk-adjusted return due to much lower volatility than its value counterpart. From a very long-term perspective, the value outperformance does come from taking higher risk. Further investigation shows that the superior long-run outperformance of value relative to growth came mostly in the first 80 years of Fama and French’s 93-year sample. In more recent years since 2007, however, value has underperformed growth significantly in three out of the four Fama-French value-growth pairs, with the equal-weighted small-cap value-growth pair being the sole exception, as shown in Table II-2. Even though the equal-weighted small-cap value has still outperformed its growth counterpart in the most recent period, the hit ratio drops to 54% compared to 76% in the first 80 years, while the magnitude of average calendar-year outperformance drops to a meager 1.3%, compared to 12.5% in the first 80 years. Table II-2The Fight Between Value And Growth* Statistical analysis is sensitive to the time period chosen. How have value and growth been performing over time? Chart II-1 shows the long-term dynamics among value, growth, and size. The following conclusions are clear: Chart II-1Fama-French Value-Growth-Size Peformance Dynamics* Value investors should favor small caps over large caps, while growth investors should do the opposite, favoring large caps over small caps, albeit with much less potential success (Chart II-1, panel 1). Small-cap investors should favor value stocks over growth stocks (panel 2). Value outperformance in the large-cap space (panel 3) is much weaker than in the small-cap space (panel 2). Fama and French define small and large caps based on the median market cap of all NYSE stocks on CRSP (Center for Research In Security Prices), then use the NYSE median size to split NYSE, AMEX and NASDAQ (after 1972) into a small-cap group and a large-cap group. The value and growth split is based on book-to-price, with stocks in the lowest 30% classified as growth, and the highest 30% as value. Interestingly, small-cap value and small-cap growth account for only a very small portion of the entire universe, as shown in Charts II-2A and II-2B. Value stocks’ average market cap is about half of that of growth stocks, in both the large- and small-cap universes (panel 3 in Charts II-2A and II-2B). Again, this does not support some media claims that value stocks are larger and better-established companies. However, it does add further support to the claim that all investors should favor small-cap value stocks. Unfortunately, “small-cap value” is a very small universe. As of June 2019, the CRSP total U.S. equity market cap was $26.2 trillion, with small-cap value accounting for only 1.5% (about $383 billion); even large-cap value comprises only a relatively small weight, 13% (US$3.5 trillion). Chart II-2ASmall-Cap Value-Growth Portfolios* Chart II-2BLarge-Cap Value-Growth Portfolios*   The U.S. market is dominated by large-cap growth stocks with a heavy weight of 56% (US$14.7 trillion, as of June 2019). This is encouraging because academic research does show that the value premium among large caps is weak. But the large-cap value weakness mostly started from 2007, after 80 years of strength relative to large-cap growth (Chart II-1, panel 3). The Fama-French approach is widely used in academic research, partly due to its long history from 1926. For non-quant practitioners, especially long-only investors, however, commercial indexes from FTSE Russell, S&P Dow Jones, and MSCI are more often used as performance benchmarks. In this report, we study a series of commercial value-growth indexes in the U.S. and globally to shed light on value-growth dynamics, and how asset allocators can incorporate them into their decision-making processes. 2. Not All U.S. Style Indexes Are Created Equal Three major index providers have style indices. They are FTSE Russell (which launched the industry’s first set of value-growth indexes in 1987), S&P Dow Jones, and MSCI. MSCI is the only provider that has a full suite of value-growth indices for all individual markets under coverage. While all three provide “standard” style indices that include the full component of the parent index, the FTSE Russell and the S&P Dow Jones also provide “pure” style indices. There are two major differences between “standard” and “pure” style indices: 1) the standard indices are market-cap weighted, while the “pure” indices are weighted based on style score. 2) Standard value and standard growth have overlapping components, while pure value and pure growth do not share any common components. We prefer to use sector and country positioning to implement style tilts tactically. Other than book-to-price, the value variable used by the Fama-French approach, the three providers have added different variables in the determination of value and growth, as shown in Table II-3. This also reflects the evolution of the industry’s understanding on value and growth. For example, when MSCI first launched its style index in 1997, it used only book-to-price, but changed its approach in May 2003 to the current “multi-factor two-dimension” framework. Table II-3Value-Growth Index Criteria Because of the differences in index construction methodology, value-growth indices for the U.S. have behaved differently. The S&P 500, the Russell 1000, and the MSCI standard (large and mid-cap) indices are widely followed institutional benchmarks, with back-tested history dating to the 1970s. Chart II-3 shows the relative value/growth performance dynamics from the three index providers, together with that from Fama and French (market value-weighted, to be consistent with the approach from the index providers). One can observe the following: Chart II-3Which Value/Growth? None of the three pairs looks exactly like Fama-French’s market-cap value-weighted value/growth. This raises the question of how historical analysis based on the long history of Fama-French value/growth portfolios can be applied to the commercial indices. In the first cycle from 1975 to February 2000, all three index pairs made a round trip, with flat performance between value and growth. Also, even though the S&P 500 and Russell 1000 were more closely correlated with one another than with the MSCI, the three were quite similar. In the current cycle that began in February 2000, however, Russell value/growth has rebounded much more strongly than the other two. But in the down period that started in 2007, the three indices performed in line with each other, as shown in Table II-4. Table II-4U.S. Style Index Performance* In addition, the difference between S&P and Russell does not just lie between the S&P 500 and the Russell 1000. It actually exists in every market-cap segment, as shown in Chart II-4. Unfortunately, MSCI does not provide history from 1975 for the detailed cap segments. In the current cycle since February 2000, S&P value rebounded the least between 2000 and 2006. Why? Chart II-4Know Your Benchmark Chart II-5Value/Growth: Russell Vs. S&P Further investigation reveals some interesting observations, as shown in Chart II-5. At the aggregate level, the S&P 1500, the Russell 3000 and their respective style indices have performed largely in line with one another in the most recent cycle starting from February 2000 (Chart II-5, panel 4), reflecting the industry trend of index convergence. In different market cap segments, however, the divergence is still prominent, especially in the small-cap space (panel 1). The S&P 600 has consistently outperformed the Russell 2000 in both the value and growth categories. In addition to different style factors, this consistency also reflects different universes, size distribution, and sector exposure, as explained in an earlier GAA Special Report on small caps.8 Managers with Russell 2000 as their performance benchmark could simply beat it by doing a total-return-performance swap between the Russell 2000 and the S&P 600. Bottom Line: Asset owners and allocators should pay special attention when selecting benchmarks for value and growth.  3. How Have Value And Growth Performed Globally? MSCI is the only index provider that also produces value-growth indices for each equity market under its global coverage, using the same methodology. Unfortunately, only the “standard” (i.e., large- and mid-cap) universe has a long history, dating from December 1974. Charts II-6A and II-6B show the value/growth dynamics in major DM and EM markets. The relative performance of MSCI DM value versus growth shares a similar pattern to that of the U.S. in the latest cycle since 2000, but looks very different in the period before 2000 (Chart II-6A). The ratio of EM large- and mid-cap value versus growth did not peak until February 2012, about five years after the peak of its DM peer (Chart II-6B, panel 1). On the other hand, EM small-cap value has resumed its outperformance versus growth since early 2016 after having peaked around the same time as its large-cap counterpart. Chart II-6AIs Value Dead In DM? Chart II-6BIs Value Dead In EM?   The global value/growth dynamics also show that the “value outperforming growth” effect is more prominent in the small-cap space. But why has small value also underperformed small growth in most DM markets? Our explanation is that the EM universe is much less efficient than the DM universe because there are not many quant funds dedicated to the EM small-cap space – in addition to the fact that, in general, EM small caps are much smaller than those in DM markets. This is also in line with our finding that, in general, factor premia are more prominent in the EM universe.9 Bottom Line: Value premium is more prominent in non-U.S. markets, especially the EM small-cap universe. 4. Do Pure Style Indices Improve Performance? Both S&P Dow Jones and FTSE Russell provide pure-value and pure-growth indices. Unlike the standard value-growth indices, which target about 50% of the parent market cap, the pure-style indices include only stocks with the strongest value and growth characteristics. There is no overlap between the two. In theory, the pure-style indices should outperform the standard-style indices because of their concentrated exposure to style factors. How do they do in reality? Table II-5 shows that in terms of absolute return, this is indeed the case for 14 out of the 18 pairs of indices from S&P and Russell for the period between 1998 and 2019. However, the higher returns from greater exposure to style factors have largely come from much higher volatility in 17 out of the 18 pairs. Pure style has higher volatility than standard style in general, the only exception being the Russell mid-cap value space. As such, on a risk-adjusted basis, pure style is not necessarily better. Table II-5Purer Is Not Necessarily Better Charts II-7A and II-7B show the different performance dynamics for the S&P and Russell families of style indices. For the S&P indices, pure growth has outperformed standard growth for the entire period in all three market-cap segments, but only the S&P 500 pure value outperformed its standard counterpart. Therefore, more concentrated exposure to style characteristics has improved the value-growth spread only in the large-cap space, but it has actually worsened the value-growth spread in the mid- and small-cap universes (Chart II-7A). Chart II-7AS&P Pure Styles* Chart II-7BRussell Pure Styles*   For the Russell indices, it’s clear that there were a lot more tech stocks in its pure-growth indices leading up to the 2000 tech bubble, because pure growth shot up significantly more than the standard growth before the bubble burst, and also crashed more severely following it. Overall, only in the small-cap space did the value-growth spread improve by the more concentrated exposure to style factors. However, this improvement was not because of the outperformance of the pure-style relative to the standard indices. In fact, both pure value and pure growth in the small-cap universe underperformed their standard counterparts, but pure growth performed even worse (Chart II-7B and Table II-5). 5. Investment Conclusions Value and growth can mean very different things and behave very differently. Investors should pay special attention to the definitions and methodologies when evaluating style indices or strategies, both academically and in practice. Depending on an investor’s mandate, the following is recommended: Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap space. Small-cap investors should focus on value. Large-and mid-cap investors should not make bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels. Price-to-book is the only common variable used in the determination of value and growth by academics and practitioners. Its track record as a systematic return predictor has been poor, as shown in panel 2 of Charts II-8A and II-8B. Another factor we have a long history for is dividend yield. Its predictive power is even worse than that of price-to-book (panel 3). Chart II-8AValuation Is A Poor Timing Tool In The U.S. Chart II-8BValuation Is A Poor Timing Tool Globally   Many factors have been used in conjunction with price-to-book by both academics and practitioners to time the rotation between value and growth. However, the results have been mixed. Regression models that correctly predicted in the past may not work in the future. For example, a regression model based on valuation spread and earnings-growth spread using data from January 1982 to October 1999 successfully predicted the rebound of value outperformance starting in early 2000,10 but the universal suffering of value funds over the past several years implies that this model may have given many false signals. Chart II-9 demonstrates how difficult it is to use regression models as a timing tool for value and growth rotation. A simple regression is conducted between value and growth return differentials (subsequent 60-month returns) and relative price-to-book. For data from December 1974 to July 2019, the r-squared for the MSCI world is 0.38 and for the U.S. it is 0.09. In hindsight, both models predicted the value outperformance starting in early 2000. However, the gaps between actual value and fitted value started to open, long before 2000. By late 1998, the gaps were already wider than the previous cycle lows, yet they continued to widen as value continued to underperform growth until February 2000. Chart II-9How Good Is The Fit? What should investors currently do, based on these models? The gaps are large, but not as large as in early 2000. At which point should investors start to shift into value given its more than 12 years of underperformance? We have often written that we prefer to use sector and country positioning to implement style tilts.11, 12  This preference has not changed. Value and growth indices have sector tilts that change over time. Currently, the S&P Dow Jones large- and mid-cap value indices have a clear overweight in financials but an underweight in tech and health care compared to their growth counterparts (Table II-6). Table II-6Sector Bets In Value And Growth Indices* Chart II-10Prefer Sector And Country Positioning To Style We have been neutral on value and growth, but would likely change this view if we change our country equity allocation between the U.S. and the euro area, and our equity sector allocation between cyclicals and defensives as well as between financials and information technology (Chart II-10). Xiaoli Tang Associate Vice President​​​​​​​ Global Asset Allocation   Footnotes 1     Antti Ilmanen, Ronen Israel, Tobias J. Moskowitz, Ashwin Thapar, Franklin Wang, “Factor Premia and Factor Timing: A Century of Evidence,” AQR Working Paper, July 2, 2019. 2     Eugene F. Fama and Kenneth R. French, “Common risk factors in the return on stocks and bonds,” Journal of Financial Economics, 33 (1993). 3     Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, “Fact, Fiction, and Value Investing,” The Journal of Portfolio Management, Vol. 42 No.1, Fall 2015. 4     Ronen Israel and Tobias J. Moskowitz, “The Role of Shorting, Firm Size and Time on Market Anomalies,” Journal of Financial Economics, Vol 108, Issue 2, May 2013 5      Eugene F. Fama and Kenneth R. French, “A Five-Factor Asset Pricing Model,” Working Paper, University of Chicago, September 2014. 6             Fama-French value-growth-size portfolios. 7     Mark P. Cussen, “Value or growth Stocks: Which are Better?” Investopedia, Jun 25, 2019. 8     Please see Global Asset Allocation Special Report titled “Small Cap Outperformance: Fact or Myth?” dated April 7, 2017, available at gaa.bcaresearch.com. 9     Please see Global Asset Allocation Special Report titled, “Is Smart Beta A Useful Tool In Global Asset Allocation?” dated July 8, 2016, available at gaa.bcaresearch.com. 10    Clifford S. Asness, Jacques A Friedman, Robert J. Krail and John M Liew, “Style Timing: Value versus Growth,” The Journal of Portfolio Management, Spring 2000. 11     Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - March 2016,” dated March 31, 2016, and available at gaa. bcaresearch.com. 12     Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - April 2019,” dated April 1, 2019 available at gaa.bcaresearch.com.

Special Report

Highlights Investors should pay particular attention to definition and methodology when evaluating value versus growth strategies, both academically and in practice. Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap universe. Small-cap investors should focus on value. Large- and mid-cap investors should not be making bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels.  GAA remains neutral on value versus growth, but prefers to use sector positioning (cyclicals versus defensives, financials versus tech and health care) and country positioning (euro area versus U.S.) to implement style tilts. Feature Investing by way of style is as old as investing itself. Value versus growth has been one of the most frequently asked questions among our clients of late, particularly given the sharp style reversal in recent weeks. In this report, we attempt to answer some of the most often-asked questions on value versus growth. We have arranged these questions into five separate sections: First, we look at 93 years of history of the Fama-French value and growth portfolios to see how value, growth, and size have interacted over time, because academics have mostly used the Fama-French framework. Second, we look at how comparable U.S. style indices are, including the S&P, the Russell and the MSCI, since practitioners mostly use these commercial indices as their benchmarks. Third, we investigate if international markets share the same value-growth performance cycles as the U.S., using the MSCI suite of value-growth indices (since MSCI is the only index provider that produces value-growth indices for each market under its global coverage). Fourth, we investigate if pure exposure to value and growth can actually improve the value-growth performance spread by comparing the pure style indices from the S&P and the Russell to their standard counterparts. Finally, we present the GAA approach to style tilts in a section on our investment conclusions. 1. Is It True That Value Outperforms Growth In The Long Run? There has been overwhelming academic evidence supporting the existence of the value premium.1 Academically, the “value premium”, also known as the HML (high minus low) factor premium, or the value outperformance, is defined as the return differential between the cheapest stocks and the most expensive. Even though Fama and French used book-to-price as the sole valuation criterion,2 many researchers have combined book-to-price with other valuation measures such as earnings-to-price, sales-to-price, dividend yield,3 and so on.  There is also academic evidence suggesting that “value outperformance is almost non-existent among large-cap stocks.”4 What is more, in 2014 Fama and French caused a huge stir by publishing “A Five-Factor Asset Pricing Model” working paper demonstrating that “HML is a redundant factor” because “the average HML return is captured by the exposure of the HML to other factors” (such as size, profitability, and investment pattern) based on U.S. data from 1963 to 2013.5 For non-quant practitioners, especially the long-only investors, value and growth are two separate investment styles, even though the style classification shares the same principle as the academic “value factor.” Their definitions vary, as evidenced by how S&P Dow Jones, FTSE Russell, and MSCI define their value and growth indexes (see next section on page 7). In general, value stocks are cheap, with lower-than-average earnings growth potential, while growth stocks have higher-than-average earnings growth potential but are very expensive. The indices published by commercial index providers do not have very long histories, however. Fortunately, Fama and French also provide value-growth-size portfolios on their publicly available website.6  Table 1 shows that for 93 years, from July 1926 to June 2019, U.S. value portfolios in both large-cap and small-cap buckets based on the well-known Fama-French approach have returned more than their growth counterparts, no matter whether the portfolios are equal-weighted or market-cap-weighted. Most strikingly, equal-weighted small-cap value outperformed its growth counterpart by over 10% a year in absolute terms, and has more than doubled the risk-adjusted return compared to its growth counterpart. Table 1Fama-French Value-Growth-Size Portfolio Performance* Some media reports have claimed that value stocks are “less volatile” because they are on average “larger and better-established companies.”7 This may be true for some specific time periods. For the 93 years covered by Fama and French, however, this common belief is not supported. In fact, value portfolios in both the large- and small-cap universes have consistently had higher volatility than growth portfolios, no matter how the components are weighted. The excess returns, however, have more than offset the higher volatilities in three out of four pairs, with the exception being market cap-weighted large-cap growth, which has a slightly higher risk-adjusted return due to much lower volatility than its value counterpart. From a very long-term perspective, the value outperformance does come from taking higher risk. Further investigation shows that the superior long-run outperformance of value relative to growth came mostly in the first 80 years of Fama and French’s 93-year sample. In more recent years since 2007, however, value has underperformed growth significantly in three out of the four Fama-French value-growth pairs, with the equal-weighted small-cap value-growth pair being the sole exception, as shown in Table 2. Even though the equal-weighted small-cap value has still outperformed its growth counterpart in the most recent period, the hit ratio drops to 54% compared to 76% in the first 80 years, while the magnitude of average calendar-year outperformance drops to a meager 1.3%, compared to 12.5% in the first 80 years. Table 2The Fight Between Value And Growth* Statistical analysis is sensitive to the time period chosen. How have value and growth been performing over time? Chart 1 shows the long-term dynamics among value, growth, and size. The following conclusions are clear: Value investors should favor small caps over large caps, while growth investors should do the opposite, favoring large caps over small caps, albeit with much less potential success (Chart 1, panel 1). Small-cap investors should favor value stocks over growth stocks (panel 2). Value outperformance in the large-cap space (panel 3) is much weaker than in the small-cap space (panel 2). Chart 1Fama-French Value-Growth-Size Peformance Dynamics* Asset owners and allocators should pay special attention when selecting benchmarks for value and growth. Fama and French define small and large caps based on the median market cap of all NYSE stocks on CRSP (Center for Research In Security Prices), then use the NYSE median size to split NYSE, AMEX and NASDAQ (after 1972) into a small-cap group and a large-cap group. The value and growth split is based on book-to-price, with stocks in the lowest 30% classified as growth, and the highest 30% as value. Interestingly, small-cap value and small-cap growth account for only a very small portion of the entire universe, as shown in Charts 2A and 2B. Chart 2ASmall-Cap Value-Growth Portfolios* Chart 2BLarge-Cap Value-Growth Portfolios* Value stocks’ average market cap is about half of that of growth stocks, in both the large- and small-cap universes (panel 3 in Charts 2A and 2B). Again, this does not support some media claims that value stocks are larger and better-established companies. However, it does add further support to the claim that all investors should favor small-cap value stocks. Unfortunately, “small-cap value” is a very small universe. As of June 2019, the CRSP total U.S. equity market cap was $26.2 trillion, with small-cap value accounting for only 1.5% (about $383 billion); even large-cap value comprises only a relatively small weight, 13% (US$3.5 trillion). The U.S. market is dominated by large-cap growth stocks with a heavy weight of 56% (US$14.7 trillion, as of June 2019). This is encouraging because academic research does show that the value premium among large caps is weak. But the large-cap value weakness mostly started from 2007, after 80 years of strength relative to large-cap growth (Chart 1, panel 3). The Fama-French approach is widely used in academic research, partly due to its long history from 1926. For non-quant practitioners, especially long-only investors, however, commercial indexes from FTSE Russell, S&P Dow Jones, and MSCI are more often used as performance benchmarks. In this report, we study a series of commercial value-growth indexes in the U.S. and globally to shed light on value-growth dynamics, and how asset allocators can incorporate them into their decision-making processes. 2. Not All U.S. Style Indexes Are Created Equal Three major index providers have style indices. They are FTSE Russell (which launched the industry’s first set of value-growth indexes in 1987), S&P Dow Jones, and MSCI. MSCI is the only provider that has a full suite of value-growth indices for all individual markets under coverage. While all three provide “standard” style indices that include the full component of the parent index, the FTSE Russell and the S&P Dow Jones also provide “pure” style indices. There are two major differences between “standard” and “pure” style indices: 1) the standard indices are market-cap weighted, while the “pure” indices are weighted based on style score. 2) Standard value and standard growth have overlapping components, while pure value and pure growth do not share any common components. Other than book-to-price, the value variable used by the Fama-French approach, the three providers have added different variables in the determination of value and growth, as shown in Table 3. This also reflects the evolution of the industry’s understanding on value and growth. For example, when MSCI first launched its style index in 1997, it used only book-to-price, but changed its approach in May 2003 to the current “multi-factor two-dimension” framework. Table 3Value-Growth Index Criteria Because of the differences in index construction methodology, value-growth indices for the U.S. have behaved differently. The S&P 500, the Russell 1000, and the MSCI standard (large and mid-cap) indices are widely followed institutional benchmarks, with back-tested history dating to the 1970s. Chart 3 shows the relative value/growth performance dynamics from the three index providers, together with that from Fama and French (market value-weighted, to be consistent with the approach from the index providers). One can observe the following: Chart 3Which Value/Growth? None of the three pairs looks exactly like Fama-French’s market-cap value-weighted value/growth. This raises the question of how historical analysis based on the long history of Fama-French value/growth portfolios can be applied to the commercial indices. In the first cycle from 1975 to February 2000, all three index pairs made a round trip, with flat performance between value and growth. Also, even though the S&P 500 and Russell 1000 were more closely correlated with one another than with the MSCI, the three were quite similar. In the current cycle that began in February 2000, however, Russell value/growth has rebounded much more strongly than the other two. But in the down period that started in 2007, the three indices performed in line with each other, as shown in Table 4. Table 4U.S. Style Index Performance* In addition, the difference between S&P and Russell does not just lie between the S&P 500 and the Russell 1000. It actually exists in every market-cap segment, as shown in Chart 4. Unfortunately, MSCI does not provide history from 1975 for the detailed cap segments. In the current cycle since February 2000, S&P value rebounded the least between 2000 and 2006. Why? Chart 4Know Your Benchmark Further investigation reveals some interesting observations, as shown in Chart 5. Chart 5Value/Growth: Russell Vs. S&P At the aggregate level, the S&P 1500, the Russell 3000 and their respective style indices have performed largely in line with one another in the most recent cycle starting from February 2000 (Chart 5, panel 4), reflecting the industry trend of index convergence. In different market cap segments, however, the divergence is still prominent, especially in the small-cap space (panel 1). The S&P 600 has consistently outperformed the Russell 2000 in both the value and growth categories. In addition to different style factors, this consistency also reflects different universes, size distribution, and sector exposure, as explained in an earlier GAA Special Report on small caps.8 Managers with Russell 2000 as their performance benchmark could simply beat it by doing a total-return-performance swap between the Russell 2000 and the S&P 600. Bottom Line:  Asset owners and allocators should pay special attention when selecting benchmarks for value and growth.  3. How Have Value And Growth Performed Globally? MSCI is the only index provider that also produces value-growth indices for each equity market under its global coverage, using the same methodology. Unfortunately, only the “standard” (i.e., large- and mid-cap) universe has a long history, dating from December 1974. Charts 6A and 6B show the value/growth dynamics in major DM and EM markets. The relative performance of MSCI DM value versus growth shares a similar pattern to that of the U.S. in the latest cycle since 2000, but looks very different in the period before 2000 (Chart 6A). The ratio of EM large- and mid-cap value versus growth did not peak until February 2012, about five years after the peak of its DM peer (Chart 6B, panel 1). On the other hand, EM small-cap value has resumed its outperformance versus growth since early 2016 after having peaked around the same time as its large-cap counterpart. Chart 6AIs Value Dead In DM? Chart 6BIs Value Dead In EM? The global value/growth dynamics also show that the “value outperforming growth” effect is more prominent in the small-cap space. But why has small value also underperformed small growth in most DM markets? Our explanation is that the EM universe is much less efficient than the DM universe because there are not many quant funds dedicated to the EM small-cap space –  in addition to the fact that, in general, EM small caps are much smaller than those in DM markets. This is also in line with our finding that, in general, factor premia are more prominent in the EM universe.9 Bottom Line: Value premium is more prominent in non-U.S. markets, especially the EM small-cap universe. 4. Do Pure Style Indices Improve Performance? Both S&P Dow Jones and FTSE Russell provide pure-value and pure-growth indices. Unlike the standard value-growth indices, which target about 50% of the parent market cap, the pure-style indices include only stocks with the strongest value and growth characteristics. There is no overlap between the two. We prefer to use sector and country positioning to implement style tilts tactically. In theory, the pure-style indices should outperform the standard-style indices because of their concentrated exposure to style factors. How do they do in reality? Table 5 shows that in terms of absolute return, this is indeed the case for 14 out of the 18 pairs of indices from S&P and Russell for the period between 1998 and 2019. However, the higher returns from greater exposure to style factors have largely come from much higher volatility in 17 out of the 18 pairs. Pure style has higher volatility than standard style in general, the only exception being the Russell mid-cap value space. As such, on a risk-adjusted basis, pure style is not necessarily better. Table 5Purer Is Not Necessarily Better Charts 7A and 7B show the different performance dynamics for the S&P and Russell families of style indices. For the S&P indices, pure growth has outperformed standard growth for the entire period in all three market-cap segments, but only the S&P 500 pure value outperformed its standard counterpart. Therefore, more concentrated exposure to style characteristics has improved the value-growth spread only in the large-cap space, but it has actually worsened the value-growth spread in the mid- and small-cap universes (Chart 7A). Chart 7AS&P Pure Styles* Chart 7BRussell Pure Styles* For the Russell indices, it’s clear that there were a lot more tech stocks in its pure-growth indices leading up to the 2000 tech bubble, because pure growth shot up significantly more than the standard growth before the bubble burst, and also crashed more severely following it. Overall, only in the small-cap space did the value-growth spread improve by the more concentrated exposure to style factors. However, this improvement was not because of the outperformance of the pure-style relative to the standard indices. In fact, both pure value and pure growth in the small-cap universe underperformed their standard counterparts, but pure growth performed even worse (Chart 7B and Table 5). 5. Investment Conclusions Value and growth can mean very different things and behave very differently. Investors should pay special attention to the definitions and methodologies when evaluating style indices or strategies, both academically and in practice.  Depending on an investor’s mandate, the following is recommended: Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap space. Small-cap investors should focus on value. Large-and mid-cap investors should not make bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels. Price-to-book is the only common variable used in the determination of value and growth by academics and practitioners. Its track record as a systematic return predictor has been poor, as shown in panel 2 of Charts 8A and 8B. Another factor we have a long history for is dividend yield. Its predictive power is even worse than that of price-to-book (panel 3). Chart 8AValuation Is A Poor Timing Tool In The U.S. Chart 8BValuation Is A Poor Timing Tool Globally Many factors have been used in conjunction with price-to-book by both academics and practitioners to time the rotation between value and growth. However, the results have been mixed. Regression models that correctly predicted in the past may not work in the future. For example, a regression model based on valuation spread and earnings-growth spread using data from January 1982 to October 1999 successfully predicted the rebound of value outperformance starting in early 2000,10 but the universal suffering of value funds over the past several years implies that this model may have given many false signals. Chart 9 demonstrates how difficult it is to use regression models as a timing tool for value and growth rotation. A simple regression is conducted between value and growth return differentials (subsequent 60-month returns) and relative price-to-book. For data from December 1974 to July 2019, the r-squared for the MSCI world is 0.38 and for the U.S. it is 0.09. In hindsight, both models predicted the value outperformance starting in early 2000. However, the gaps between actual value and fitted value started to open, long before 2000. By late 1998, the gaps were already wider than the previous cycle lows, yet they continued to widen as value continued to underperform growth until February 2000.  Chart 9How Good Is The Fit? What should investors currently do, based on these models? The gaps are large, but not as large as in early 2000. At which point should investors start to shift into value given its more than 12 years of underperformance? We have often written that we prefer to use sector and country positioning to implement style tilts.11, 12 This preference has not changed. Value and growth indices have sector tilts that change over time. Currently, the S&P Dow Jones large- and mid-cap value indices have a clear overweight in financials but an underweight in tech and health care compared to their growth counterparts (Table 6). Table 6Sector Bets In Value And Growth Indices* Chart 10Prefer Sector And Country Positioning To Style Tilts We have been neutral on value and growth, but would likely change this view if we change our country equity allocation between the U.S. and the euro area, and our equity sector allocation between cyclicals and defensives as well as between financials and information technology (Chart 10).     Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Footnotes 1Antti Ilmanen, Ronen Israel, Tobias J. Moskowitz, Ashwin Thapar, Franklin Wang, “Factor Premia and Factor Timing: A Century of Evidence,” AQR Working Paper, July 2, 2019. 2Eugene F. Fama and Kenneth R. French, “Common risk factors in the return on stocks and bonds,” Journal of Financial Economics, 33 (1993). 3Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, “Fact, Fiction, and Value Investing,” The Journal of Portfolio Management, Vol. 42 No.1, Fall 2015.  4Ronen Israel and Tobias J. Moskowitz, “The Role of Shorting, Firm Size and Time on Market Anomalies,”Journal of Financial Economics, Vol 108, Issue 2, May 2013 5Eugene F. Fama and Kenneth R. French, “A Five-Factor Asset Pricing Model,” Working Paper, University of Chicago, September 2014. 6Fama-French value-growth-size portfolios. 7Mark P. Cussen, “Value or growth Stocks: Which are Better?” Investopedia, Jun 25, 2019. 8Please see Global Asset Allocation Special Report titled “Small Cap Outperformance: Fact or Myth?” dated April 7, 2017, available at gaa.bcaresearch.com. 9Please see Global Asset Allocation Special Report titled, “Is Smart Beta A Useful Tool In Global Asset Allocation?” dated July 8, 2016, available at gaa.bcaresearch.com 10Clifford S. Asness, Jacques A Friedman, Robert J. Krail and John M Liew, “Style Timing: Value versus Growth,” The Journal of Portfolio Management, Spring 2000. 11Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - March 2016,” dated March 31, 2016, and available at gaa. bcaresearch.com. 12Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - April 2019,” dated April 1, 2019 available at gaa.bcaresearch.com.  

We are removing the large cap bias we have had on a tactical basis since our December 2018 High-Conviction Call report and booking gains of 9% (top panel). We are also setting a stop near the 10% return mark to protect cyclical profits since the May 7, 2018 inception of the large cap bias. Rising interest rates along with diminishing odds of an ultra-easy Fed in the upcoming September FOMC meeting have kept the dollar upbeat with some trade-weighted Fed indexes vaulting to all-time highs. Large caps have significant foreign sourced sales exposure and an appreciating currency will eat into profits, a headache that small caps do not have to sweat over. In addition, there are early signs that investors are beginning to treat small caps as trade war insulated companies anew, given their domestic focus. Bottom Line: While we are not ready to book cyclical profits in our large over small cap preference (please see this Weekly Report for more details),1 in the near term our confidence in additional large cap gains has decreased and we recommend removing the large cap bias from the high-conviction call list for a gain of 9% since inception.   1      Please see U.S. Equity Strategy Weekly Report, “Cracks Forming” dated June 24, 2019, available at uses.bcaresearch.com

Bearishness toward small vs. large caps has been pervasive over the past year, raising the question: Does it still pay to prefer large caps to small caps? The short answer is yes. Five key reasons underpin our large/mega cap preference in the size bias: First, a small cap margin squeeze has been underway since the 2012 cyclical peak. Simply put, small business labor costs are rising at a faster clip than overall wage inflation, warning that small cap profit margins have further to fall compared with large caps margins (middle panel). Second, relative indebtedness has been widening. Debt saddled small caps have been issuing debt at an accelerating pace at a time when cash flow growth has not been forthcoming. Small cap net debt-to-EBITDA is now almost three times as high as large cap net debt-to-EBITDA. Investors have finally realized that rising indebtedness is worrisome, especially at the late stages of the business cycle (bottom panel). Bottom Line: Small cap underperformance has staying power. Continue to prefer large/mega caps to their small cap brethren. Please see our most recent Weekly Report for the other three reasons why we believe small caps will underperform large caps.

Highlights Portfolio Strategy Melting inflation expectations, widening relative indebtedness, expensive adjusted relative valuations, high odds of a further drop in relative profit margins and the high-octane small cap status all signal that large caps continue to have the upper hand versus small caps. Modest deterioration in credit quality, weakening prospects for loan growth and falling inflation expectations, compel us to put the S&P bank index on downgrade alert. Recent Changes We got stopped out on the long S&P managed health care/short S&P semis trade on June 10 for a gain of 10% since inception. We got stopped out on the long S&P homebuilders/short S&P home improvement retailers trade on June 14 for a gain of 10% since inception. Table 1 Feature Equities surged to all-time highs last week, as investors cheered the Fed’s dovish stance and increasing likelihood of a late-July interest rate cut. The addiction to low interest rates and global dependence on QE are evident and simultaneously very worrisome signs. We are nervous that the U.S. economy is in a soft-patch, thus vulnerable to a shock (maybe sustained trade hawkishness is the negative catalyst) that can tilt the economy in recession. The risk/reward tradeoff on the overall equity market remains to the downside on a cyclical (3-12 month) time horizon as we first posited two weeks ago (this is U.S. Equity Strategy’s view and is going against BCA’s cyclically constructive equity market House View). In fact, using the NY Fed’s probability of a recession in the coming 12 months data series signals that there’s ample downside for stocks from current levels (recession probability shown inverted, Chart 1).1 We heed this message and reiterate our cautious equity market stance. Chart 1Watch Out Down Below Importantly, drilling deeper with regard to the excesses we are witnessing this cycle, Chart 2 is instructive and an unintended consequence of QE and zero interest rate policy. In previous research we highlighted the cumulative equity buybacks corporations have completed this cycle near the $5tn mark. Chart 2Financial Engineering What is worrying is that this “accomplishment” has come about at a great cost: a massive change in the capital structure of the firm. In other words, all of the buybacks are reflected in debt origination from the non-financial business sector (using the Fed’s flow of funds data), confirming our claim that the excesses this cycle are not in the financial or household sectors, but rather in the non-financial business sector (please refer to Chart 4A from the June 10 Weekly Report). One likely trigger of a jumpstart to a default cycle, other than a U.S./China trade dispute re-escalation, is dwindling demand. On that front, we are bemused on how much weight market participants place on the Fed’s shoulders bailing out the economy and the stock market. Chart 3 is a vivid reminder of this narrative. On the one side of the seesaw is the mighty Fed with its forecast interest rate cuts and on the other a slew of slipping indicators. Our sense is that these eighteen indicators will more than offset the Fed’s about-to-commence easing cycle and eventually tilt the U.S. economy in recession, especially if the Sino-American trade talks falter. S&P 500 quarterly earnings are contracting on a year-over-year basis and the semi down-cycle points to additional profit pain for the rest of the year (top panel, Chart 4). On the trade front, exports are below the zero line and imports are flirting with the boom/bust line (second panel, Chart 4). Overall rail freight, including intermodal (retail segment) freight is plunging and so is the CASS freight shipments index at a time when the broad commodity complex is also deflating (third & bottom panels, Chart 4). The latest Q2 update of CEO confidence was disconcerting, weighing on the broad equity market’s prospects (top panel, Chart 5). Non-residential capital outlays have petered out and private construction is sinking like a stone. In fact, the latter have never contracted at such a steep rate during expansions over the past five decades (second panel, Chart 5). Real residential investment has clocked its fifth consecutive quarter of negative growth during an expansion, for the first time since the mid-1950s. Single family housing starts and permits are contracting (third panel, Chart 5). Chart 4Cracks… Chart 5…Are… Light vehicle sales are ailing (bottom panel, Chart 5) and the latest senior loan officer survey continued to show that there is feeble demand for credit across nearly all the categories the Fed tracks (bottom panel, Chart 6). Non-farm payrolls fell to 75K on a month-over-month basis last month and layoff announcements are gaining steam signaling that the labor market, a notoriously lagging indicator, is also showing some signs of strain (layoffs shown inverted, third panel, Chart 6). The latest update of the U.S. Equity Strategy’s corporate pricing power gauge is contracting (please look forward to reading a more in-depth analysis on our quarterly update on July 2) following down the path of the market’s dwindling inflation expectations. Finally, the yield curve remains inverted (top and second panels, Chart 6). Chart 6…Forming Chart 7The “Hope" RallyAdding it all up, we deem that the equity market remains divorced from the economic reality and too much faith is placed on the Fed’s shoulders to save the day. Thus, we refrain from positioning the portfolio on “three hopes”: first that the Fed will engineer a soft landing, second that the U.S./China trade tussle will get resolved swiftly, and finally that the Chinese authorities will inject massive amounts of liquidity and reflate their economy (Chart 7). This week we are putting a key financials sub-sector on downgrade alert and update our view on the size bias. Large Cap Refuge While small caps shielded investors from the U.S./China trade dispute that heated up in 2018 (owing to their domestic focus), this year small caps have failed to live up to their trade war-proof expectations and have lagged their large cap brethren by the widest of margins. In fact, the relative share price ratio sits at multi-year lows giving back all the gains since the Trump election, and then some (Chart 8). Chart 8Stick With A Large Cap Bias As a reminder, our large cap preference has netted our portfolio 14% gains since the May 10 2018 cyclical inception and this size bias is also up 9% since our high-conviction call inclusion in early December 2018. Five key reasons underpin our large/mega cap preference in the size bias. Bearishness toward small vs. large caps has been pervasive raising the question: does it still pay to prefer large caps to small caps? The short answer is yes. Five key reasons underpin our large/mega cap preference in the size bias. First, melting inflation expectations have been positively correlated with the relative share price ratio, and the current message is to expect more downside (Chart 8). While the SPX has a higher energy weight than the S&P 600, financials and industrials dominate small cap indexes and likely explain the tight positive correlation with inflation expectations (Table 2). Table 2S&P 600/S&P 500 Sector Comparison Table Second, relative indebtedness has been widening. Debt saddled small caps have been issuing debt at an accelerating pace at a time when cash flow growth has not been forthcoming. Small cap net debt-to-EBITDA is now almost three times as high as large cap net debt-to-EBITDA. Investors have finally realized that rising indebtedness is worrisome, especially at the late stages of the business cycle, and that is why small caps have failed to insulate investors from the re-escalating trade dispute (top & middle panels, Chart 9). Third, a large number of small cap companies (100 in the S&P 600 and 600 in the Russell 2000) have no forward EPS. Very few S&P 500 companies have negative projected profits. Thus, while, relative valuations have been receding, the relative forward P/E trading at par is masking the relative value proposition of the indexes. Were the S&P or Russell to adjust for this, small caps would trade at a significant forward P/E premium to large caps (bottom panel, Chart 9). Chart 9Mind The Debt Gap Fourth, a small cap margin squeeze has been underway since the 2012 cyclical peak and the relative margin outlook is even grimmer. Simply put, small business labor costs are rising at a faster clip than overall wage inflation, warning that small cap profit margins have further to fall compared with large caps margins (Chart 10). Finally, small cap stocks are higher beta stocks and typically rise when volatility gets suppressed. As such, they also tend to outperform large caps when emerging markets outperform the SPX and vice versa. Tack on the recent yield curve inversion, and the odds are high that the size bias has entered a prolonged period of sustained small cap underperformance. Netting it all out, melting inflation expectations, widening relative indebtedness, expensive adjusted relative valuations, high odds of a further drop in relative profit margins and the high-octane small cap status all signal that large caps continue to have the upper hand versus small caps (Chart 11). Chart 10Relative Margin Trouble Chart 11Shay Away From Small Caps Bottom Line: Small cap underperformance has staying power. Continue to prefer large/mega caps to their small cap brethren. Put Banks On Downgrade Alert In the context of de-risking our portfolio we are taking the step and adding the S&P banks index on our downgrade watch list. The Fed’s signal of a cut in the upcoming July meeting steepened the yield curve last week. While the yield curve has put in higher lows in the past eight months, relative bank performance has been facing stiff resistance and has failed to follow the yield curve’s lead (Chart 12). One of the reasons for the Fed’s dovishness is melting inflation expectations. The latter are joined at the hip with relative bank performance and signal that downside risks are rising especially if the Fed fails to arrest the lower anchoring of inflation expectations (Chart 13). Chart 12Banks Are Not Participating Chart 13Melting Inflation Expectations Are Anchoring Banks With regard to credit demand, the latest Fed Senior Loan Officer survey remained subdued confirming the anemic reading from our Economic Impulse Indicator (a second derivative gauge of six parts of the U.S. economy, bottom panel, Chart 14). Lack of credit demand translates into lack of credit growth, despite the fact that bankers are, for the most part, willing extenders of credit. U.S. Equity Strategy’s overall loans & leases growth model has crested (second panel, Chart 15). Chart 14Anemic Loan Demand… Chart 15…Will Weigh On Loan Origination Similarly, the recent softness in a number of manufacturing surveys signal that C&I loan growth in particular – the largest credit category in bank loan books – is at risk of flirting with the contraction zone (third panel, Chart 15). Worrisomely, not only is the overall U.S. credit impulse contracting, but also U.S. Equity Strategy’s bank credit diffusion index is collapsing (second panel, Chart 16). Such broad breadth of loan growth deterioration warns that loan growth and thus bank earnings are at risk of underwhelming still optimistic sell-side analysts’ expectations (not shown). On the credit quality front there are now two loan categories that are starting to show some modest signs of stress. Credit card net chargeoffs and non-current loans are spiking and now C&I delinquent loans have ticked up for the first time since the manufacturing recession (third & bottom panel, Chart 16). Our bank EPS growth model does an excellent job in capturing all these forces and signals that bank EPS euphoria is misplaced (bottom panel, Chart 15). Nevertheless, despite these softening bank sector drivers there are four significant offsets. First the drubbing in the 10-year yield has been reflected nearly one-to-one on the 30-year fixed mortgage rate and the recent surge in mortgage applications signals that residential real estate loans (second largest bank loan category) may reaccelerate in the back half of the year (top panel, Chart 17). Chart 16Deteriorating Credit Quality Chart 17Some Significant… Second, while there have been credit card and C&I loan credit quality issues, as a percentage of total loans they just ticked higher and remain near cyclical lows, at a time when banks have been putting more money aside to cover for these potential loan losses (bottom panel, Chart 17). Third, bank source of funding remains very cheap as depositors have not been enjoying higher short term interest rates, at least not at the big money center banks. In other words, banks have not been passing higher interest rates to depositors sustaining relatively high NIMs (not shown). Finally, banks are one of the few sectors with pent up equity buyback demand. The upcoming release of the Fed’s stress test will likely continue to allow banks to pursue shareholder friendly activities, that they have been deprived from for so long, and raise dividend payments and increase share buybacks (Chart 18). Chart 18…Offsets In sum, melting inflation expectations, modest deterioration in credit quality, and weakening prospects for loan growth compel us to put the S&P bank index on downgrade alert. Bottom Line: We remain overweight the S&P banks index, but have put it on downgrade alert and are looking for an opportunity to downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BaAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1      https://www.newyorkfed.org/research/capital_markets/ycfaq.html Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps