Equities

Special Report

Highlights Portfolio rebalancing is the process of realigning portfolio weights back to their strategic allocations. Frequent rebalancing is essentially a counter-cyclical, or value, strategy. In effect, investors buy low and sell high. Infrequent rebalancing is a momentum-factor investing strategy. Maximizing risk-adjusted return is the reason investors should rebalance, not maximizing return per se. We find that calendar, deviation, or a combination of both methods of rebalancing, can all improve risk-adjusted return compared to a non-rebalanced portfolio. Feature What Do We Mean By Rebalancing? The first step of portfolio construction is strategic asset allocation. Simply put, it is determining a set of asset weights that best suits the investor’s return target, risk appetite, capabilities, and other considerations. Once a portfolio is constructed, divergent returns among asset classes cause the weights of the portfolio to shift. Portfolio rebalancing is therefore, the process of realigning portfolio weights back to their strategic allocations. Chart 1Rebalancing Can Imply Style Rebalancing is a means of reducing portfolio risk rather than increasing returns, and is necessary to maintain the desired risk exposure over time. Frequent rebalancing can be viewed as value investing: a style in which investors “buy low and sell high” (Chart 1). Given the mean-reverting nature of asset performance, buying the undervalued asset and selling the overvalued should imply that future returns would be higher than past returns. Through this process, investors are hoping to obtain a “rebalancing premium”. It is crucial to recognize that rebalancing works best at inflection points. Hence, that premium is gained when the rebalancing frequency is similar to the frequency of the mean-reversion feature of assets. Rebalancing also allows a portfolio to be consistent with the investor’s risk appetite in order to avoid a particular asset class dominating. However, this is easier said than done. An investor’s intuition usually acts in the opposite direction, pushing him or her to follow momentum rather than cut back the weight of a “winning” asset. The question that this Special Report aims to answer is not whether investors should rebalance or not, but rather what kind of rebalancing they should do. We discuss three different conventional rebalancing methods that investors can use, illustrating the risk-return characteristics of a simple two-asset-class (60% equity/40% bonds) portfolio since 1973. In doing so, we rebalance the portfolio back to its 60/40 strategic weights. Rebalancing is a means of reducing portfolio risk rather than increasing returns, and is necessary to maintain the desired risk exposure over time. It is important to note that rebalancing is no free lunch. Costs vary depending on the method used. Costs include trading and transaction costs, operational costs (trade lags, labor, and time to monitor the portfolio), and tax costs (capital gains on appreciated assets). In this paper, we do not consider the operational and tax costs (as they differ from investor to investor). Rather, we examine portfolio returns given: (1) zero trading costs, and (2) a variable cost of 10 bps dependent on trade size. Additionally, frequent rebalancing can introduce “negative convexity”, a return profile in which large divergences in asset performance exceed the rebalancing premiums investors obtain.1 Throughout our explanations, we show two tables for each method: Table A illustrates the returns given zero costs, while Table B illustrates the returns given the variable costs. It is key to note however that there is no one-size-fits-all rebalancing method. The important thing to realize is that rebalancing, done correctly, must find an optimal balance between cost minimization and managing portfolio risk. As a benchmark, we examine how an unbalanced portfolio, which we will refer to as a “drift portfolio”, comprised of 60% equities and 40% bonds in 1973, would have evolved over the past 46 years. Given that equities outperform bonds over the long run due to their riskier nature, the drift portfolio ends with an 86% allocation to equities, and a maximum allocation of 87% over the period (Chart 2). Chart 3Broken Equity/Bond Correlation   Before describing how each methodology performed, we need to highlight a key point in understanding the results that follow: the equity/bond correlation underwent a step-change around 1998. Between 1975 and 1998, the correlation between equities and bonds averaged about 0.4. However, declining inflation expectations led to a reversal of this relationship. Since 1998, the equity/bond correlation averaged -0.3 (Chart 3, top panel). It is key to note however that there is no one-size-fits-all rebalancing method. The important thing to realize is that rebalancing, done correctly, must find an optimal balance between cost minimization and managing portfolio risk. How does this affect the results? A positive correlation between equities and bonds means that asset-class returns moved together, reducing the advantages of rebalancing. Therefore, between the start of our sample period, 1973, and 1998, rebalanced portfolios only slightly outperformed a non-rebalanced portfolio. It is crucial to recognize that rebalancing portfolios should continue to be most advantageous during times when asset returns exhibit negative correlation. Portfolio Rebalancing can take place in different ways2 (Table 1). Table 1Conventional Methods Of Rebalancing Rebalancing Methodologies Time-Only Rebalancing The most common rebalancing methodology used by investors is on a simple calendar basis. A survey conducted by the Financial Planning Association showed that 48%, 36%, and 14% of financial planners rebalance quarterly, annually, and monthly respectively; 1% of respondents said they rebalanced based on a client’s request.3 This form of rebalancing involves bringing the asset-class weights back to the agreed-upon benchmark at the end of a specified period. Periods can range from daily (which is rare) to multiple years. Several academic papers and practitioners call for investors to rebalance at least annually. For the purpose of this report, we look at monthly, quarterly, semi-annual, annual, and bi-annual rebalancing.4 Rebalancing not only increases return at the margin, but also reduces portfolio risk and hence improves risk-adjusted returns. The risk-adjusted return increases as the rebalancing frequency decreases. Bi-annual rebalancing had a risk-adjusted return of 1.016 versus 0.895 for a non-rebalanced portfolio and 0.985 for a monthly-rebalanced portfolio over our entire sample period (Tables 2A and 2B). All calendar-rebalancing dates outperformed a non-rebalanced portfolio on a risk-adjusted basis due to lower volatility. The same results persist even when costs are factored in. Rebalancing too frequently not only increased costs, but also limited upside potential. That is noticeable from the number of rebalancing events for a monthly-rebalanced portfolio versus an annually or a bi-annually rebalanced portfolio. Unsurprisingly, we found that all rebalanced portfolios on average underperformed the drift portfolio during equity bull markets, and outperformed in the period leading up to recessions and equity corrections (Chart 4). Given that stocks peak on average six to 12 months before a recession, the higher weighting in bonds at the start of a correction explains the outperformance of a frequently rebalanced portfolio versus a drift portfolio during recessions and equity market corrections. To put this into context, the drift portfolio’s equity weight at the time of the S&P 500’s peak in the dot-com bubble was 84%, versus an average of 61% across the rebalanced portfolios. Similarly, at the peak before the latest market selloff starting on October 3, 2018, the drift portfolio had an 87% equity allocation versus a 61% average allocation for the frequently rebalanced portfolios. Chart 5 shows that rebalancing reduces downside risk relative to a drift portfolio during downturns and recessions. Chart 4Calendar Rebalancing: Relative Performance Chart 5Calendar Rebalancing: Lower Drawdown Threshold-Only Rebalancing Threshold rebalancing allows asset-class weights to be readjusted back to their target weights once they deviate away by a certain percentage. This can be set in terms of either a percentage-point or a percent deviation. Given that, in this paper, we illustrate our findings using just a two-asset class portfolio with relatively large weights in each asset, percentage-point deviations are more appropriate. However, percent deviations should be used when a certain asset class has only a small weight within a portfolio, for example, a 20% deviation away from the 5% target weight of an asset class. A key benefit of threshold-only rebalancing over calendar rebalancing in a multi-asset portfolio is lower transaction costs. Unlike calendar-only rebalancing where all asset classes are brought back to target weights, only the assets that have moved away from benchmark by the set deviation have to be bought and sold. For example, in a five-asset class portfolio, it could be the case that only the best and worst performers have hit their thresholds and have to be adjusted, whereas the other asset classes do not. Tables 3A and 3B show the risk-return characteristics of rebalanced portfolios based on 1, 5, 10, and 20 percentage-point deviations. Similarly to calendar rebalancing, the wider the threshold, the better the risk-adjusted return. The rebalanced portfolio with a 20-percentage point threshold outperforms all other deviations on both a return and risk-adjusted basis. All rebalanced portfolios led to better risk-adjusted returns than the drift portfolio, even after costs are factored in. Also similar to calendar rebalancing, threshold deviation rebalancing also outperforms during recessions and market corrections (Charts 6 & 7). Chart 6Threshold Rebalancing: Relative Performance Chart 7Threshold Rebalancing: Lower Drawdown The table also illustrates that picking the right threshold is crucial. A threshold set too wide will miss all turning-points and hence turn into a drift portfolio. Whereas, thresholds set too narrow will produce only a small improvement in return at the expense of more rebalancing events, and therefore higher costs. Time-And-Threshold Rebalancing A time-and-threshold rebalancing combines the merits of both strategies. The portfolio is rebalanced only when an asset class has deviated from its target allocation by a set threshold on the date of rebalancing. Assuming, for example, monthly rebalancing with a 10% deviation, a portfolio would be rebalanced on the next monthly date only if it had deviated by more than 10 percentage points. Otherwise, the portfolio would not be rebalanced. This implies that two decisions have to be made: a threshold band and a rebalancing frequency. We present the results of this method in a slightly different way. In this case, we show each metric (annualized return (Tables 4A & 5A), annualized volatility (Tables 4B & 5B) and risk-adjusted return (Tables 4C & 5C)) separately under assumptions of both zero costs and variable costs.   The highest risk-adjusted return of 1.023 was achieved with quarterly rebalancing and a 20 percentage point deviation. This resulted in only three rebalancing events throughout the 46-year period. However, this was not as good as simply relying on a 20 percentage point threshold deviation. Investors wanting to keep a tighter control over their portfolio could use a tighter band with a more frequent rebalancing. As noted earlier, rebalancing is a way to maximize risk-adjusted return rather than maximize return. To simply maximize return, annual rebalancing with a 10-percentage point threshold, which had an annualized return of 9.80%, would be the best combination. However, that came at the expense of high volatility and a higher average equity allocation. Having fewer rebalancing events does not necessarily mean lower costs. In fact, we noted that the fewer the rebalancing events, the higher the annualized cost per trade5 (Tables 6 and 7). Given that our variable cost was dependent on trade size, a rebalancing method that relied on wider bands would incur higher costs per trade relative to narrower bands. Table 6Time-And-Threshold Rebalancing: Rebalancing Events Table 7Time-And-Threshold Rebalancing: Cost Per Trade (Bps) Beyond The Conventional Methods New rebalancing strategies have evolved that rely on different metrics. These include timing rebalancing events using tracking error or risk deviation, absolute momentum, or analyzing the stage of the economic cycle. A recent paper published by Northern Trust discussed the merits of risk-based tracking-error rebalancing as a superior method to traditional strategies. The paper concluded that risk-based tracking had outperformed most other rebalancing strategies while requiring fewer rebalancing events. Within the core strategies mentioned, several adjustments could be made to obtain better results from rebalancing events. Some argue that rebalancing back to a tolerance band, rather than to the precise allocation target, could improve risk-adjusted returns. That band is usually set at half of the deviation threshold band, but can vary at the investor’s discretion. Given costs that vary based on trade size, it might be cheaper for an investor to use tolerance bands. However, relying on such a method can easily rack up costs if the investor is going against momentum prior to its end, since relying on tolerance bands would require more frequent rebalancing. Bottom Line Rebalancing is a means of maximizing risk-adjusted return, rather than increasing absolute return. Rebalancing is no free lunch. Investors must take various associated costs into account before considering how and when to rebalance. The added benefit of rebalancing might seem small in annualized returns. However, on average, rebalancing led to an annualized decrease in volatility in excess of 1% over the 46-year period. It might be best for investors to use a time-and-threshold rebalancing to find a balance between cost minimization and maximizing risk-adjusted returns. Amr Hanafy, Research Associate amrh@bcaresearch.com   1 Nick Granger, Douglas Greenig, Campbell Harvey, Sandy Rattray, David Zou, "The Unexpected Costs of Rebalancing And How To Address Them," AHL Partners LLP, July 2014. 2 Colleen Janconetti, Francis Kinniry Jr., Yan Zilbering, "Best Practices For Portfolio Rebalancing," Vanguard, July 2010. 3 Financial Planning Association, Longboard, and Journal Of Financial Planning, “2017 Trends In Investing,” www.onefpa.org. 4 We assumed that monthly rebalancing occurs on the first trading day of every month, quarterly rebalancing occurs on the first trading day of January, April, July, afn_4nd October, semiannual rebalancing on the first trading day of January and July, and annual rebalancing on the first trading day of the year. 5 Calculated as the difference in annualized return between 10 bps cost assumptions and 0 cost assumption multiplied by the number of years within the sample period divided by the number of trades.  

Overweight A little over a year ago we moved to the sidelines in the S&P managed health care index, crystalizing significant relative profits of 28% for our U.S. equity portfolio.  Now the time has come anew to explore this niche health care index from the long side and yesterday we moved to an overweight position. Leading indicators of health care insurance profit margins are currently flashing green. Not only are medical costs melting including drug price inflation (second & bottom panels), but also industry cost structures are kept at bay with wages climbing below a 2%/annum rate growth and trailing overall wage inflation (third panel). On the demand front, as the economy is running at full employment, with unemployment insurance claims probing 60-year lows and with wages representing a headache for small and medium business owners, enrollment should stay healthy. Most importantly, the combination of decreasing medical cost inflation and a healthy overall labor market heralds a steep decline in the industry’s medical loss ratio. While risks of a potential “Medicare For All” plan remain nebulous and have clearly weighed on industry stock prices, melting medical cost inflation, BCA’s rising interest rate expectations along with an economy running at full steam, all suggest that managed health care margins and profits will overwhelm in the coming quarters. Bottom Line: We boosted the S&P managed health care index to overweight yesterday; please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, ANTH, HUM, CNC, WCG.    

Highlights Portfolio Strategy Yield curve dynamics, higher oil prices, recovering balance sheets, and compelling valuations and technicals all suggest that energy stocks will burst higher in the coming months.  Melting medical cost inflation, BCA’s rising interest rate expectations along with an economy running at full steam, all suggest that managed health care margins and profits will overwhelm in the coming quarters. Recent Changes Upgrade the S&P managed health care index to overweight today. Add the S&P energy index to the high-conviction overweight list today. Table 1 Feature On the eve of earnings season, the SPX ended last week higher as bank profits delivered and allayed fears of recession. All-time absolute highs in the S&P tech sector and in the Philly SOX index suggest that global growth will likely reaccelerate in the back half of the year, vaulting the broad market to new highs. In addition, the suppressed Treasury term premium1 signals that the path of least resistance for equities is higher on a cyclical time horizon (term premium shown inverted, Chart 1). Chart 1All Clear... Nevertheless, some caution is still warranted from a tactical perspective. Since March 4 when we first turned short-term cautious on the broad equity market,2 the SPX has moved roughly 100 points both ways. Internal market moves, financial conditions, fund flows, complacency and the current economic backdrop all signal that stocks are not out of the woods yet. Namely, the S&P high beta versus the S&P low volatility tilt has failed to confirm the slingshot in the SPX (Chart 2). Similar to the small cap underperformance, mega cap tech is trouncing small cap tech stocks (Chart 3). Not only do large cap technology stocks have pristine balance sheets, but they also have earnings. In contrast, from the 89 S&P 600 tech constituents 54 have no forward profits. The weak over strong balance sheet underperformance is emitting the same signal (top panel, Chart 3). Chart 2...But Some... Chart 3...Caution... The bond market is also sending a warning shot. High yield corporate bonds are underperforming long-dated Treasurys (middle panel, Chart 2). And, the junk bond option adjusted spread has not fallen to the 2018 lows, let alone all-time lows (not shown). While a lot has been said on easier financial conditions, they have yet to return to the early-2018 lows. In fact, similar to the non-confirmation of the all-time SPX highs in late-September, the GS financial conditions index (FCI) is tracing a higher low, warning that equities have room to fall (FCI shown inverted, bottom panel, Chart 2). Mutual fund flows on all equity related products are contracting on a net sales basis. Historically, fund flows and equity returns are joined at the hip and the current divergence suggests that equity prices will likely succumb to deficient demand (top panel, Chart 4). Chart 4...Is Warranted On the economic front, last Wednesday we highlighted in an Insight Report, that lumber – a hyper sensitive economic indicator – failed to corroborate the recent equity market euphoria. The weak Citi Economic Surprise Index, also warns that the economic data has yet to turn the corner and should weigh on equities (bottom panel, Chart 4). What ties everything together is SPX profits. The news on this front is mixed, at least for the next little while: EPS will most likely contract in the first half of the year, but equity investors are looking through this earnings recession. Last year’s U.S. dollar appreciation will dent both revenues and EPS, and Q1/2019 is the first quarter where such greenback strength will subtract from corporate P&Ls (Chart 5). Chart 5Dollar Trouble? What worries us most is the sectorial concentration of 2019 profit growth in one sector, financials. Another source of concern is the heavyweight tech sector’s negative profit path for calendar 2019. Such sudden internal profit moves both in magnitude and in a short time frame are far from reassuring, especially given that overall profit estimates are still trimmed. Chart 6A depicts the current sector profit contribution to 2019 growth, and compares it with the January 22nd iteration (Chart 6B). What a difference three months make. In sum, internal equity and bond market dynamics, financial conditions, the economic soft-patch and the looming profit recession all signal that short-term equity market caution is still warranted. This week we upgrade a health care subsector and reiterate our bullish stance on a deep cyclical sector. Catch Up Phase Looms For Energy Stocks Last week we broadened out our research on the yield curve (YC) inversion beyond the S&P 500 to the GICS1 sectors.3 As a reminder, the SPX peaks following the yield curve inversion and on average the S&P energy sector performs the best from the time the YC inverts until the S&P 500 peters out (please refer to Table 3 from the April 8, Special Report). While every cycle is different, if history at least rhymes, deep cyclical energy stocks will likely outperform as the SPX eventually breaks out to fresh all-time highs. Already, year-to-date the S&P energy sector is the third best performing sector, besting the SPX by over 200bps. More gains are in store, especially given the big dichotomy between the oil price recovery and the relative share price ratio (Chart 7). What is perplexing is the ingrained sell-side analyst pessimism (Chart 6A) and lack of belief that oil prices will remain near current levels or even continue their ascent as our sister Commodity & Energy Strategy (CES) service publication predicts. Not only are EPS forecast to contract in every quarter this year, or 10% year-over-year according to IBES, but also revenues are slated to fall in every quarter in 2019. We would lean against this extreme analyst bearishness. While the $3.5/bbl backwardation in WTI oil futures prices one year out, and more than twice that 24-months out, underpins Wall Street’s gloomy energy sector outlook, U.S. oil extraction productivity reinforces sector profits. As U.S. crude oil production hits new all-time highs this is extracted by fewer oil rigs (bottom panel, Chart 7). If BCA’s CES constructive oil price expectation pans out, then energy stocks will easily surpass the profit and revenue bar that analysts have set extremely low for the sector. Delivering on the profit front will likely serve as a catalyst to rerate these deep cyclical stocks higher (Chart 8) and thus a catch up phase looms for energy stocks, at least up to the current level of WTI crude oil prices (top panel, Chart 7). Chart 7Catch Up Chart 8Bombed Out Valuation Granted, the U.S. dollar is a key determinant of oil prices and if BCA’s view proves accurate that global growth will return in the back half of the year (second panel, Chart 9), that is synonymous with a depreciating greenback, which in turn is bullish the broad commodity complex in general and oil prices (and thus energy stocks) in particular (middle panel, Chart 7). As a reminder, oil prices are an excellent global growth barometer, similar to their sibling Dr. Copper. Recovering global growth will boost energy stocks in an additional way: via a favorable supply/demand crude oil balance. Not only is OPEC rebalancing the global oil market through a reduction on the supply front, but a trio of potential supply shocks from Iranian sanctions, Venezuelan infrastructure and Libyan conflict are providing price support. Further, global growth has historically been tightly correlated with rising non-OECD oil demand (Chart 10). Chart 9Global Growth Beneficiary Chart 10Favorable Supply/Demand Dynamics Meanwhile, the broad energy sector is still licking its wounds from the late-2015/early-2016 manufacturing recession and is stabilizing debt and increasing EBITDA (fifth panel, Chart 11), thus the net debt/EBITDA ratio for the index has collapsed from over 11 to around 2, a level similar to the broad market (second panel, Chart 11). Interest coverage (EBIT/interest expense) is also renormalizing higher and is no longer sending a default warning for the energy space as a whole (third panel, Chart 11). The junk energy bond market corroborates/reflects this balance sheet improvement and is no longer flashing red (bottom panel, Chart 9). Finally, bombed out technical conditions are contrarily positive, and such extreme negative readings have marked the start of playable and sizable relative outperformance periods (Chart 12). Chart 11No Red Flags Chart 12Contrary Alert: Depressed Technicals Netting it all out, YC dynamics, higher oil prices on the back of rising global growth and a favorable supply/demand crude oil backdrop, recovering balance sheets, and compelling valuations and technicals suggest that energy stocks will burst higher in the coming months. Bottom Line: We reiterate our above benchmark recommendation in the S&P energy sector and today we are adding it to our high-conviction overweight list. Buy Into Managed Health Care Weakness A little over a year ago we moved to the sidelines in the S&P managed health care index, crystalizing significant relative profits of 28% for our U.S. equity portfolio.4 Now the time has come anew to explore this niche health care index from the long side. While we left some money on the table since our late-May 2018 move, relative share prices have come full circle, valuations have fallen roughly 18% from the late-2018 peak and analysts’ euphoria has been reined in (Chart 13). Chart 13Reset The inter- and intra-industry M&A fever has died down from mid-2018 and the rising momentum of a “Medicare For All” bill has weighed negatively on HMO sentiment. With regard to the latter, our geopolitical strategists believe that passage is possible. If the Democrats can unseat an incumbent president in 2020, they will also likely take the Senate and keep the House. This means they will be in the position to pass a major piece of legislation. While Trump is favored to win, barring a recession, the risk of both a Democratic sweep and a push for “Medicare for All” could be as high as 27%, and this would have a dramatic impact on the health care sector.5 Tack on the near 90bps drop in the 10-year U.S. Treasury yield since the November 2018 peak, and factors have fallen into place for a bearish raid in this pure play health insurance index. Thin managed health care margins and profits move in close lockstep with interest rates as roughly 10% of the industry’s operating income is tied to “investment income”. In other words, as insurers receive the premia they typically invest it in Treasurys and that explains the high EPS and margin sensitivity on interest rate moves (Chart 14). While at first sight, the outlook for profits appears grim, BCA’s bond strategists expect a selloff in the bond market to materialize in the back half of the year simultaneously with a pick-up in global growth which will prove a tonic to both margins and EPS. In addition, leading indicators of heath care insurance profit margins are flashing green. Not only are medical costs melting including drug price inflation (second & bottom panels, Chart 15), but also industry cost structures are kept at bay with wages climbing below a 2%/annum rate growth and trailing overall wage inflation (third panel, Chart 15). Chart 14Overdone Chart 15Melting Cost Inflation On the demand front, as the economy is running at full employment, with unemployment insurance claims probing 60-year lows and with wages representing a headache for small and medium business owners, enrollment should stay healthy (Chart 16). Most importantly, the combination of decreasing medical cost inflation and a healthy overall labor market herald a steep decline in the industry’s medical loss ratio. All of this is unambiguously bullish for margins and profits. Finally, relative valuations and technicals have both corrected from previously stretched levels and offer a compelling entry point for fresh capital (Chart 17). Chart 16Full Employment Is Bullish Chart 17Unloved And Under-Owned Netting it all out, despite the risks that “Medicare For All” pose, melting medical cost inflation, BCA’s rising interest rate expectations along with an economy running at full steam, all suggest that managed health care margins and profits will overwhelm in the coming quarters. Bottom Line: Boost the S&P managed health care index to overweight today. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, ANTH, HUM, CNC, WCG.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1      According to the NY Fed: “Treasury yields can be decomposed into two components: expectations of the future path of short-term Treasury yields and the Treasury term premium. The term premium is the compensation that investors require for bearing the risk that short-term Treasury yields do not evolve as they expected.” https://libertystreeteconomics.newyorkfed.org/2014/05/treasury-term-premia-1961-present.html 2      Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly” dated March 4, 2019, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Special Report, “10 Most FAQs From The Road” dated April 8, 2019, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Report, “Seeing The Light” dated May 29, 2018, available at uses.bcaresearch.com. 5      If there is a 60% chance the Democrats nominate a left-wing candidate, and a 45% chance they win the election, then there is a 27% chance that they are in a position to push for “Medicare for All” with fair odds of passage. Everything will depend on the specific outcomes of the Democratic primary, presidential campaign, general election, post-election government policy priorities, and congressional passage. Stay tuned as in the coming months we will be publishing a Special Report on “Medicare For All” and health care sector implications co-authored with our sister Geopolitical Strategy service. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

We noted in our December 5 Weekly Report that a tactical overweight stance towards Chinese stocks (either the domestic or investable market) within a global equity portfolio was probably warranted over the following few months, but that the conditions for a cyclical overweight stance (6-12 months) were not yet present.1 More recently, we noted that an improvement in several economic indicators suggested that a strong March credit number could create these conditions, and tip the scales in favor of an upgrade recommendation for Chinese stocks over the coming year.2 Chart 1Leading Indicators Are Now Convincingly Bullish For Chinese Stocks Chart 1 shows that today’s credit release has caused a meaningful improvement in the credit component of our leading indicator for the Chinese economy. Overall growth in the money supply remains weak, but monetary conditions are easy and have clearly helped support a rebound in credit growth. All told, today’s data has made us sufficiently confident in the Chinese macroeconomic outlook to recommend a cyclical (6-12 month) overweight towards Chinese stocks (both investable and domestic) versus the global benchmark. Several questions concerning both the outlook for the economy and for Chinese stocks remain, and we will review these issues at length in next week’s report. In particular, we will discuss how much relative equity upside investors can expect over the coming year, whether the recent pace of credit growth significantly increases the chance of another credit overshoot, and when investors should expect to see a pickup in actual economic activity. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     1 Please see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report “China Macro And Market Review”, dated April 3, 2019, available at cis.bcaresearch.com.

Special Report

Dear Client, I hosted a Webcast on Thursday, April 4th, during which I discussed the major investment themes and views I see playing out for the rest of the year and beyond. A replay can be accessed from this link. Best regards, Peter Berezin, Chief Global Strategist Highlights The exodus of baby boomers from the labor market is likely to lower income growth, which will reduce sales growth among publicly-listed companies over the coming years. After-tax profit margins may also come under pressure, while both the risk-free interest rate and the equity risk premium could rise. While it is difficult to estimate the magnitude of these effects, our best guess is that aging will have a moderately negative, though far from catastrophic, effect on equity prices. Even if the headwinds to equities from population aging turn out to be minimal, long-term investors are still likely to earn subpar returns given that valuations are fairly stretched today. In such an environment, a nimble investment approach, which focuses on the state of the business cycle among other things, will be necessary for generating alpha. Investors should maintain a cyclically bullish stance towards global equities for the time being, but begin paring back exposure late next year in advance of a recession in 2021. Feature Will Grandpa Sink The Stock Market? About 55% of U.S. stock market wealth is held by the baby boom generation – those born between 1946 and 1964 (Chart 1). As baby boomers increasingly exit the labor force and draw down their accumulated savings, there is a growing concern that equity prices will come under pressure.  Financial pundit Robert Kiyosaki published a book more than a decade ago arguing, in his usual hyperbolic style, that retiring boomers would trigger “the biggest stock market crash in history.”1 Conveniently, he even gave a date for the crash: 2016, the year when the first baby boomers would celebrate their 70th birthdays. Kiyosaki’s prophesized crash never happened. But does he still have a point? Will aging populations torpedo stocks? A Framework For Thinking About The Value Of The Stock Market Conceptually, the value of the stock market should equal the present value of the cash flows which shareholders can expect to receive. As Appendix 1 explains, this means that today’s dividend yield should equal the difference between the rate that investors use to discount those cash flows and the expected growth rate of cash flows. The discount rate is the sum of the risk-free rate and an equity risk premium. Cash flow growth tends to track earnings growth. The latter can be broken down into sales growth and margin growth. Thus, one can express the dividend yield ( D/P )  as the sum of four variables: The formula shows that an increase in either sales growth or profit margins will reduce the dividend yield (thus implying an increase in equity prices), while an increase in either the risk-free rate (rf) or the equity risk premium (rp) will raise the dividend yield. As we discuss below, demographic trends are likely to shift all four variables in the direction of lower equity prices. As baby boomers increasingly exit the labor force and draw down their accumulated savings, there is a growing concern that equity prices will come under pressure. 1. Aging And Sales Growth At the economy-wide level, business sales closely track GDP growth (Chart 2). GDP growth, in turn, is simply the sum of employment growth and productivity growth. Chart 2Business Sales Closely Track GDP Growth As baby boomers continue to age, more and more of them will leave the labor force. This will result in slower labor force growth. While this development will weigh on GDP growth, it is important to recognize that most of the decline in labor force growth in developed economies has already occurred (Chart 3). Chart 3ADM Labor Force Growth: Most Of The Decline Has Already Taken Place (I) Chart 3BDM Labor Force Growth: Most Of The Decline Has Already Taken Place (II) The annual growth rate of the labor force in the G7 peaked at 1.7% in 1980, but has averaged only 0.3% over the past decade. The UN estimates that the number of people in G7 economies between the ages of 15 and 64 – a crude proxy for the potential size of the labor force – will contract by 0.1% per year over the next twenty years, a modest step down from positive growth of 0.1% over the past decade. Productivity growth has been quite weak in developed economies since the mid-2000s (Chart 4). Whether this trend persists remains to be seen. On the positive side, robotics, AI, and genetic engineering could all boost productivity growth. On the negative side, cognitive test scores in developed economies have peaked and are now trending lower. Consistent with this observation, Heckman and LaFontaine have shown that properly measured, the U.S. high school graduation rate has been falling since the early 1970s.2 This makes baby boomers arguably the best educated generation in history. An open question concerns the extent to which slower economy-wide GDP growth filters down to sales growth among listed companies. While it is highly likely that S&P 500 sales growth will decline in an environment of weaker growth, the impact of falling GDP growth on sales may be blunted by at least three factors. First, developed economy firms will still be able to benefit from rising sales to emerging markets, even if they are suffering from sluggish sales growth at home. Second, domestic consumption will decelerate more slowly than income growth as older workers deplete their savings. Third, lower productivity growth will coincide with less “creative destruction,” which will benefit incumbent firms. In fact, this is already happening. Chart 5 shows that net firm formation has fallen dramatically since the 1970s. Chart 4In Developed Markets, Productivity Growth Has Been Falling For Over A Decade Chart 5A Sharp Drop In New Firm Formation   2. Aging And Profit Margins Population aging can affect profit margins in two ways: First, it can shift spending across sectors. For example, if age-related spending migrates from sectors with high margins to those with low margins, aggregate profit margins will decline. Second, aging can affect margins within sectors. Looking across sectors, health care spending is likely to rise in response to population aging. According to the Congressional Budget Office, health care expenditures are set to increase from 5.2% of GDP to 9.2% of GDP by 2048 (Chart 6). There once was a time when health care margins were double the S&P 500 average (Chart 7). During the past two decades, however, health care margins have fallen, and are now slightly below the S&P average. Chart 7AS&P 500 Margins By Sector (I) Chart 7BS&P 500 Margins By Sector (II) Looking out, it is likely that health care margins will continue to contract, as cash-strapped governments look for ways to cut health care costs. Presidential hopefuls Bernie Sanders, Elizabeth Warren, and Kamala Harris have all championed “Medicare for all.” If implemented, such a policy prescription would decimate health care sector profits by reducing demand for private insurance while giving the federal government more bargaining power to negotiate lower drug prices. Most of the decline in labor force growth in developed economies has already occurred. The only silver lining, pardon the pun, for margins is that older people tend to display greater brand loyalty (Chart 8). Whether this is because of experience, habit, or nostalgia is not clear, but older consumers switch products less often, preferring to stick with “what they know.”3 Perhaps reflecting a general tendency for self-reported happiness to increase in old age, elderly consumers also tend to express greater satisfaction with their purchases. Nevertheless, on balance, we expect aging to make a slightly negative contribution to profit margins. 3. Aging And The Risk-Free Rate Proponents of the secular stagnation thesis posit that demographic trends have led to a decline in the neutral rate of interest. As Chart 9 shows, aging could depress the neutral rate if an older population causes the aggregate investment schedule to shift inwards or the aggregate savings schedule to shift outwards. Chart 9Two Ways For Real Rates To Fall According to the standard “accelerator” model, the optimal level of investment spending is determined by the growth rate of aggregate demand.4 To the extent that slower population growth discourages firms from expanding capacity, this will lead to a lower neutral rate of interest. That said, as noted above, most of the decline in labor force growth in developed economies has already occurred. This implies that investment spending may not fall much further from current levels. What about savings? At the outset, aging will increase savings as more people move into their prime saving years (ages 30-to-50). Declining fertility rates will also tend to reduce spending on children, while allowing more women to join the labor force. Aging could morph from a force that has dragged down the neutral rate of interest to one that will start slowly pushing it back up. Over time, however, aging is likely to reduce the savings rate, as more workers retire, leaving fewer workers in the labor force. Once health care spending is included, consumption actually increases in old age, especially in the last few years of life (Chart 10). Globally, the ratio of workers-to-consumers increased from the early 1970s to the middle of this decade, but has now begun to decline (Chart 11). This suggests that aging could morph from a force that has dragged down the neutral rate of interest to one that will start slowly pushing it back up. Chart 10Savings Over The Life Cycle Chart 11The Worker-To-Consumer Ratio Has Peaked Globally   Instead of running larger deficits to finance pension and health care spending, governments could raise taxes. This would reduce private consumption, thus generating additional savings for the economy. While such a step could prevent the risk-free interest rate from rising, some of the tax burden would likely end up falling on the owners of capital in the form of higher taxes on dividends, capital gains, and business profits. This would lead to lower after-tax profit margins and slower sales growth. The end result would still be the same: weaker equity prices. 4. Aging And The Equity Risk Premium When people discuss the impact that aging baby boomers will have on the stock market, they are usually – whether they realize it or not – talking about the equity risk premium. By definition, for every seller of stock there must be a buyer of stock. If baby boomers start selling shares to finance their retirement spending, someone will need to buy their shares, provided the price is low enough. The question is by how much do share prices need to fall to clear the market? In theory, households should accumulate assets over their working years and then deplete their savings in retirement. In practice, uncertainty about the timing of death, the desire to pass on wealth to future generations, and the need to maintain enough assets to finance unforeseen health care expenses all tend to induce households to run down wealth at only a modest pace during retirement. A study by John Ameriks and Stephen Zeldes using a random sample of 16,000 accounts from a major retirement fund found no evidence that households gradually decrease equity allocations as they age.5 Looking out, it is possible that baby boomers will run down their equity holdings more quickly than prior generations. For instance, the decline in family size over the past fifty years and evolving societal norms may end up causing boomers to bequeath smaller estates than in the past. The increasing popularity of annuities may also reduce the likelihood of unintended bequests. In addition, the proliferation of target-date funds may produce a more rapid shift out of equities than would occur if investors had to consciously decide to reduce exposure to the stock market. Nevertheless, we suspect that any additional selling by baby boomers will only put modest downward pressure on equity prices. This is because the wealthiest 10% of U.S. households hold 84% of all stock market wealth, while the bottom 50% hold less than 1% (Chart 12). Households in the top one percent of the wealth distribution hold close to half of all stocks. These ultra-wealthy households tend to consume a fairly small share of their assets during retirement. As a result, most of their assets end up being bequeathed to family members and/or charities when they pass away. Chart 12The Wealthiest 10% In The U.S. Own The Bulk Of Equities Chart 13Foreign Ownership Of U.S. Stocks Has Grown Foreign purchases of U.S. stocks should also blunt the impact of any selling by retiring baby boomers. Foreigners now hold 27% of U.S. stock market wealth, up from 5% in the mid-1970s (Chart 13). If foreign demand for U.S. equities increases in line with global ex-U.S. real GDP, this will add about $250 billion in demand for U.S. stocks (in constant dollars) over the next twenty years. This is five times greater than the roughly $50 billion in annual net selling that would occur if all investors followed the popular rule of thumb which instructs them to take their age and subtract it from 100 in order to determine how much of their financial wealth to allocate to equities. Investment Implications The discussion above suggests that aging is likely to have a moderately negative, though far from catastrophic, effect on equity prices by: 1) reducing sales growth among listed companies; 2) putting downward pressure on after-tax profit margins; 3) increasing the risk-free rate of interest; and 4) raising the equity risk premium. It is difficult to be precise about how large these effects will turn out to be. Three factors cloud any potential calculation. First, as the equation presented at the outset of this report illustrates, small shifts in any one variable can lead to big changes in the fair value of the stock market. To see this point, let us take the current S&P 500 dividend yield of 2.0% and add 1.5% to account for net share buybacks (gross buybacks less share issuance). This gives a “cash flow to shareholders” yield of 3.5%. Now consider a one percentage-point increase in the equity risk premium. An increase in the equity risk premium of this magnitude would require the cash flow yield to rise to 4.5%. This, in turn, would necessitate that equity prices fall by 22%. That’s a lot. The second factor that makes it difficult to be precise about the extent to which demographic changes will affect stock prices is that there are likely to be interaction effects among the variables in the equation above. For instance, rising labor shortages stemming from the withdrawal of baby boomers from the labor market could put downward pressure on profit margins. The resulting increase in labor’s share of income would likely boost aggregate demand, thereby contributing to a higher neutral rate of interest. Chart 14Japan’s Population Bust Was Largely Foreseen At this point, one of two things could happen. On the one hand, if central banks failed to raise rates, this would cause the economy to overheat, leading to higher inflation. Higher inflation could push up the equity risk premium, as was the case in the 1970s. On the other hand, if central banks did raise interest rates, this could cause debt burdens to become unsustainable. That could also push up the equity risk premium. The third factor that makes it challenging to estimate the impact of demographics on stocks is that it is difficult to know the proper baseline for computing the effects of aging on stock market valuations. To the extent that the variables in the equation are all forward-looking, they should incorporate the market’s views on how the retirement of baby boomers will affect the relevant drivers of equity returns. This implies that shifts in equity valuations must stem from forecast revisions rather than from anticipated trends. Thus, as an example, any change to the “sales growth” term should be properly viewed as expressing not how future sales growth will differ from past sales growth, but by how much future sales growth will differ from what investors are currently projecting. It is tempting to assume that the market has already priced in the impact of population aging.  After all, the fact that baby boomers are exiting the labor force is not exactly breaking news. Yet, in the past, markets have proven to be surprisingly oblivious to easy-to-predict demographic developments. For example, Japanese investors were keen to buy stocks and real estate in the late 1980s, despite the fact that published projections at the time showed that the country’s working-age population would decline at an accelerating pace over the subsequent decade (Chart 14). Academic work supports the view that investors tend to understate the importance of demographic forces. Stefano Della Vigna and Joshua Pollet have shown that a trading strategy that exploits predictable age-related changes in spending on such items as toys, bicycles, beer, and life insurance would have earned an annualized risk-adjusted return of approximately six percent.6 Chart 15Poor Long-Term Returns In Store For U.S. Stocks The fact that equity valuations today are stretched in the U.S., and no better than middling in the rest of the world, should add to investor concerns. Chart 15 shows that the ratio of household equity holdings-to-total financial assets has been an extremely reliable predictor of 10-year equity returns in the post-war era. Today, this indicator is pointing to low single-digit returns for U.S. stocks over the next decade. This suggests that even if the headwinds to equities from population aging turn out to be minimal, long-term investors will still earn subpar returns from stocks relative to recent history. In such an environment, a nimble investment approach, which focuses on the state of the business cycle among other things, will be necessary for generating alpha. As discussed in our recently published Strategy Outlook, investors should maintain a cyclically bullish stance towards stocks for the time being, but begin paring back exposure late next year in advance of a recession in 2021.7   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Robert T. Kiyosaki, and Sharon L. Lechter, “Rich Dad's Prophecy: Why the Biggest Stock Market Crash in History Is Still Coming...And How You Can Prepare Yourself and Profit from It!” Time Warner, 2003. 2      James Heckman and Paul LaFontaine, "The American High School Graduation Rate: Trends and Levels," The Review of Economics and Statistics 92:2, (May 2010): 244–262. 3      Please see Rajesh Iyer, Timothy H. Reisenwitz, and Jacqueline K. Eastman, “The Impact Of Cognitive Age On Seniors’ Lifestyles,” Marketing Management Journal, 18:2, (Fall 2008); and Komal Gyani Karani, and Katherine A. Fraccastoro, “Resistance To Brand Switching: The Elderly Consumer,“ Journal of Business & Economics Research, 8:12, (December 2010). 4      In most economic models, the capital-to-output ratio is assumed to converge towards a stable level over time. By definition, the capital stock in Year t is determined by the capital stock in Year t-1 plus whatever net investment (gross investment minus depreciation) takes place in Year t. In general, the optimal net investment-to-GDP ratio will equal the product of the capital-to-output ratio and the growth rate of GDP. For example, suppose that the capital-to-output ratio is three (meaning that the capital stock is three times as large as GDP). If output does not change from one year to the next, no additional net investment would be necessary to maintain a stable capital-to-output ratio. However, if output is growing at 2%, net investment of 3X2%=6% of GDP would be required. 5      John Ameriks and Stephen P. Zeldes, “How Do Household Portfolio Shares Vary with Age?” Working Paper, 2004. 6      Stefano Della Vigna, and Joshua M. Pollet, “Demographics and Industry Returns,” American Economic Review, 97:5 (2007). 7      Please see Global Investment Strategy, “Second Quarter 2019 Strategy Outlook: From Dead Zone To End Zone,” dated March 29, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades