Decomposing The U.S. Equity Market
The objective of our strategy is to provide investors complete exposure to the beta of the equity markets at lower valuations. We measure overall market valuation with traditional methods such as the price-to-sales ratio, price-to-book ratio, and price-to-earnings ratio. Based on academic research, as well as our own research, we believe that using the price-to-sales ratio of a diversified portfolio of stocks provides guidance to potential forward-looking returns.
A simple regression analysis of the S&P 500 price-to-sales ratio over the past 32 years illustrates that as the price-to-sales ratio of the S&P 500 increases, the forward-looking 5 and 10-year returns decreases. Our regression analysis of the S&P 500 is consistent with “Are Some Stock Prices Destined to Fall,” a white paper written by professors Morris G. Danielson and Amy F. Lipton (Nov. 2012). Therefore, we believe a successful strategy of decomposing the S&P 500 into several known factors offers investors the flexibility to manage the price-to-sales ratio of the broader S&P 500 index. Why is managing your index important? Because a capitalization-weighted index may provide beta exposure but fails to manage the price-to-sales ratio. The price-to-sales ratio of the S&P 500 is currently 2.30, which puts it close to the all-time high only matched by the tech bubble of 1999. According to the data we present in this discussion, this places current investors allocated to a capitalization-weighted index with higher a probability of low, or even negative, returns going forward.
We have worked with S&P analysts to develop four single factor strategies based on the constituents of both the S&P 500 and S&P 600. These factor portfolios are based on value/quality, growth/momentum, low beta, and small/mid-capitalization. The value/quality, growth/momentum, and low beta are all members of the S&P 500 but the constituents are measured and segmented into the above three factors.