Q3 2005 In Review

October 06, 2005

Energy stocks prop up markets both in the U.S. and globally. Market commentary.


 

The year 2005 is three-quarters over and thus far the U.S. stock market has disappointed investors with single-digit returns, earning about 4%. But we would have been even more disappointed had it not been for energy stocks, which have pumped up the entire market for the year to date. Energy stocks have returned 45% in the past 9 months while other sectors have struggled to break even. Since energy is about 9% of the market, the contribution of energy stocks to overall market performance is 4% (9% of 45%), so energy constitutes the entire market return to date, with the other sectors collectively breaking even. Energy has also led foreign markets, earning 50% for the year to date, but overall foreign markets have fared better than the U.S., earning 16%.

 

The following four graphs provide quick overviews of the third quarter 2005 U.S. and non-U.S. stock markets. The U.S. stock market appreciated 4.6% in the quarter while the non-U.S. market gained 12.7%. Energy stocks, spurred by the continuing increase in oil prices, led both markets, continuing the trend of the first two quarters of 2005. On the style front, small-to-mid growth companies fared best in the U.S., disrupting the 5-year winning streak for small value. By contrast, non-U.S. styles all returned about the same, but country allocations were key.

 

Here's how to read the next graph, depicting style performance in the U.S. for the third quarter of 2005. The floating bars in the graph are Portfolio Opportunity Distributions (PODs) for each of 9 styles and the total market. PODs are all of the possible portfolios that investors could have held, in this case holding 30-stock portfolios of stocks in the indicated style. Note the middles of the bars, which are the medians. The median return for large value is 4.6%, for large core it's 0.9%, and so on. The best performing medians are small and mid-cap growth, with 8.3% and 7.9% returns respectively, and the worst is large core. This was one of those unusual quarters where large core underperformed both large growth and large value. This typically happens when investor convictions are at opposite extremes, and may signal an inflection point in investor preferences. Also note the ranges of returns, representing the risk and opportunity in each style. As you would expect, the more volatile styles, like small growth, have a wider range.

 

Now turn your attention to the shaded area at the bottom of the graph, which shows the style profile of the S&P500. Here each stock in the S&P500 is classified into the 9 style groups and aggregate dollar allocations are shown. The S&P is currently 35.79% large value, 22.17% large core, etc. Also, the market's composition is shown as the red line running across the bottom of the exhibit. In aggregate the S&P is roughly 85% large/ 15% mid/ 0% small, representing a large company tilt relative to a broad market that is 65/25/10. This tilt hurt S&P performance in the quarter, since smaller companies, especially smaller growth companies, were in favor.

 

Lastly, the red dots in the exhibit show how the style sub-portfolios within the S&P fared against their respective style PODs. Note for example that the mid cap growth companies in the S&P, treated as a separate cap-weighted portfolio, performed above the median of the mid cap growth POD: the stocks selected by the S&P committee in this style outperformed in the quarter.

 

 

In summary, the S&P's large company orientation hurt performance so the S&P underperformed the broad market return. Yes, the S&P is a managed portfolio; it's just managed by committee. The net result is shown in the far right bar, where the S&P falls below the broad market. Sometimes the S&P outperforms the broad market and sometimes it underperforms; for purposes of evaluating investment performance it's extremely helpful to know when and why. 

 

Now let's look at a similar analysis for sector results, as shown in the following graph. As can be seen, Energy far outstripped the performance of all the other sectors.  Of particular interest is the S&P underperformance in the Energy sector, earning 18.8% versus the total sector's 23.5% return. More than half of the S&P's energy sector is comprised of two companies, Exxon and Chevron, which returned 11% and 17% respectively.

The next two graphs provide analyses for non-U.S. markets, using the MSCI Europe Australia Far East (EAFE) index as the sample fund. The following graph shows that, like U.S. markets, Energy was king in the quarter. And also like the S&P, the EAFE underperformed in Energy, and by a significant margin. This is due to two factors. More than half of the EAFE energy sector is comprised of two stocks, BP and Total Fina, which returned 15.2% and 16.5% respectively. But most importantly, EAFE is void of the better performing regions: Emerging Markets, Latin America and Canada.

 

 

The final graph shows that EAFE stock selection within countries was average, but that the better performing regions are not represented in EAFE.

These are important insights, but not when they're limited to just the S&P and EAFE. You'll want to know how your clients' portfolios stack up in these frameworks.

 

Ron Surz has held senior positions in the investment consulting and financial services industry since 1972 and is currently president of PPCA Inc., a firm that provides investment monitoring and performance attribution tools to the investment consulting industry. He is also a principal of Risk Controlled Growth (RCG) Capital Advisors LLC, manager of funds-of funds hedge fund portfolios. Surz was awarded an MBA in Finance from the
University of
Chicago
in 1974.

 

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