EQUITY RESEARCH U.S. Portfolio Strategy | 9 March 2012 U.S. PORTFOLIO STRATEGY WEEKLY April showers OVERVIEW: The U.S. growth outlook is the most important driver of equity Barry Knapp +1 212 526 5313 markets; while the housing market is stabilizing, household deleveraging still has email@example.com room to go, and several near-term restraints on the macro outlook and equity BCI, New York market fundamentals remain. Major central bank easing into an improving economic outlook is winding down. It might take some time for momentum to Eric Slover, CFA dissipate, but we would be cutting risk. +1 212 526 6426 FOCUS (SMALL CAPS): The Russell 2000 has underperformed the S&P 500 by firstname.lastname@example.org roughly 4% since the beginning of February. We believe this is largely attributed BCI, New York to a pullback in monetary easing expectations. The performance has cleared much of this premium; we don’t recommend a short position to express a QE Michael Keller, CFA +1 212 526 2404 view. email@example.com FOCUS (DIVIDEND YIELD STRATEGIES): The positive performance of dividend BCI, New York yield strategies is consistent with a falling stock market, rising volatility, and a deteriorating macro outlook. Dividend yield strategies are trending toward Adam Sussi positive correlation with returns, a signpost for caution. Legging into dividend +1 212 526 9778 yield exposure seems attractive. firstname.lastname@example.org BCI, New York Dividend yield strategies are trending toward positive correlation with returns, consistent with underperformance of small caps and cyclical sector VIEWS ON A PAGE 2 Normalized slope coefficients, 20dma Index, 20dma OVERVIEW 3 0.20 1.0 SMALL CAPS 7 0.15 0.8 0.6 0.10 DIVIDENDS 11 0.4 0.05 0.2 MARKET SNAPSHOT 14 0.00 0.0 -0.05 -0.2 EARNINGS 15 -0.4 -0.10 -0.6 -0.15 -0.8 -0.20 -1.0 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Div Yld, Earnings Yld, Book/Mkt, Size, Sector (L) S&P 500 (R) Source: Barclays Capital. Note: twenty day moving average of daily returns Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 16. Barclays Capital | U.S. Portfolio Strategy Weekly VIEWS ON A PAGE While U.S. growth has proven resilient to confidence shocks, it remains constrained by policy uncertainty and household balance sheet deleveraging. In addition, the economy is vulnerable to a deteriorating inflation/growth tradeoff given rising gasoline prices. In our view, the upside for stocks in early 2012 is limited. Financial repression has limited the Fed’s effectiveness, rendering it counterproductive as inflation volatility rises (and multiples fall). We believe a period of significant equity market valuation improvement can’t begin until the Fed begins the exit strategy process. Our 2012 S&P 500 price target is 1,330 and our operating EPS forecast is $103 (6% y/y) Full-Year 2010a Full-Year 2011e Full-Year 2012e S&P 500 Level y/y Level y/y Level y/y Operating EPS* $84 48% $97 48% $103 6% P/E 15x 7% 13x –13% 12.9x -1% Index 1,258 23% 1,260 13% 1,330 6% *Trailing-four-quarter EPS. Source: Barclays Capital We believe the U.S. elections will be far more significant to domestic investors in 2012 than concerns about Europe. Once the GOP selects a candidate and the debate about debt, deficits and the 2013 ‘fiscal cliff’ moves to center stage, the recent bounce in confidence should fade. This negative theme should continue until investors begin to discount the outcome of the elections following conventions in August. The deceleration in earnings growth along with public sector deleveraging uncertainty in the U.S. and Europe and high levels of inflation volatility leave us expecting a roughly flat multiple of 12.9x and a price target of 1330 for 2012. We favor Technology, Energy and Healthcare Technology Energy ↓ Health Care ↑ Industrials ↓ Large-scale asset purchases are Discretionary a tailwind for cyclicals and a Telecom headwind for defensives Materials ↓ Financials ↓ Utilities ↑ Staples Underweight Marketweight- Marketweight Marketweight+ Overweight Note: ↑/↓ = increases/decreases on 12/02/11 to ratings in place since 10/20/11 or earlier. Source: Barclays Capital Overweight: The performance of the S&P 500 sector is expected to significantly outperform the performance of the S&P 500 index in the next 3–6 months. Marketweight Plus: The performance of the S&P 500 sector is expected to outperform the performance of the S&P 500 index in the next 3–6 months. Marketweight: The performance of the S&P 500 sector is expected to perform in line with the S&P 500 index in the next 3–6 months. Marketweight Minus: The performance of the S&P 500 sector is expected to underperform the performance of the S&P 500 index in the next 3–6 months. Underweight: The performance of the S&P 500 sector is expected to significantly underperform the performance of the S&P 500 index in the next 3–6 months. We have maintained a slight cyclical bias after scaling back to begin 2012; Technology, Energy, and Healthcare should outperform; Staples, Utilities, Financials and Materials should lag. 9 March 2012 2 Barclays Capital | U.S. Portfolio Strategy Weekly OVERVIEW April showers Barry Knapp The U.S. growth outlook is the most important driver of equity markets; while the +1 212 526 5313 housing market is stabilizing, household deleveraging still has progress to make, and email@example.com there are several remaining near-term restraints on both the macro and equity BCI, New York market fundamentals. Eric Slover, CFA The period of major central bank easing into an improving economic outlook is +1 212 526 6426 winding down. It might take some time for the momentum to completely dissipate, firstname.lastname@example.org but we would be cutting risk. BCI, New York We’re not gonna’ party like it’s 1995 The U.S. equity market is After an impressive start to 2012, the U.S. equity market is beginning to show signs of beginning to show signs of vulnerability. This supports what seemed intuitive; the ‘Great Deleveraging Cycle’ is not vulnerability. complete. Central banks can facilitate an orderly deleveraging process, but they cannot prevent the process itself. Rising energy prices, a deceleration in central bank easing, slowing earnings growth, political risk in the developed world and the Middle East, and overzealous financial sector regulatory policy all point to a 2012 unlike 1995, when the S&P 500 rose for eight months without more than a 2 ½% correction, on its way to a 34% gain for the year. Figure 1: The data surprise index has been falling, Figure 2: … however, relatively robust labor reports have, in highlighting constraints on domestic growth prospects … part, kept a positive bias to the market implied outlook Index 3m/3m % chg saar 0.20 10 0.15 8 6 0.10 4 0.05 2 0.00 0 -0.05 -2 -4 -0.10 -6 -0.15 -8 -0.20 -10 Jan-11 May-11 Sep-11 Jan-12 00 01 02 03 04 05 06 07 08 09 10 11 12 US Data Surprise Index (5d ma) Payroll Proxy 3mma 3m Source: Barclays Capital Source: Haver, BLS, Barclays Capital We believe the most important We’ve argued throughout the post-crisis period that the U.S. growth outlook is the most driver of equity markets is the important driver of equity markets, not domestic monetary strategy, public policy or U.S. growth outlook, which isn’t external factors. Even last fall, when the European experiment seemed to be crumbling, likely to soften much until April. improving data in the U.S., following a spike in market implied recession risk, pushed stocks erratically higher. While we see numerous constraints to continued improvement in domestic growth -- the U.S. data surprise has been falling and 1Q12 GDP forecasts are at risk -- the relatively robust labor, auto and chain store sales reports have kept a positive bias to the market implied outlook. An early Easter probably ensures at least another month of decent retail sales and, consistent with the last couple of years, the labor data have started 9 March 2012 3 Barclays Capital | U.S. Portfolio Strategy Weekly strong, but in 2010 and 2011 it began to soften in the 2nd quarter, implying the outlook isn’t likely to soften much until April. There are several near-term Longer term, we believe household balance sheet deleveraging and bottoming in the restraints on both macro and housing market, as evidenced by negative regional house price correlation, provide strong equity market fundamentals. underlying support for U.S. growth. However, while the housing market is stabilizing, household deleveraging still has progress to make, and there are several remaining near- term restraints on both macro and equity market fundamentals. In the interest of brevity, here is a list of looming issues with brief explanation. • Energy prices: The ongoing debate is which matters more; the price level or rate of change. While the rate of change’s effect on confidence is important, cash flow is king in a deleveraging cycle. The rise in prices is offsetting the improvement in the household financial obligations ratio, leaving the median consumer struggling. Nominal consumption has been stable throughout the recovery, but energy price spikes have led to drops in real PCE (i.e., 4Q09 and 2Q11). The stock market is pointing to a similar episode; the relative weakness in transports, industrials, small caps and the unexpected drop in ISM are leading indicators of a coming decline in real PCE, at least they were last year at this time. Figure 3: While the housing market is stabilizing, household Figure 4: Higher energy prices are offsetting the decline in deleveraging still has progress to go the household financial obligations ratio ,,,,, % % Gasoline & Motor Oil / Income Before Tax 80 75 16 14.6 Household Income Quintiles 14 70 64 12 10.2 60 57 10 8.5 50 8 6.8 6.0 6 4.8 5.2 40 44 3.6 4 2.9 2.1 30 2 20 0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Lo 2 3 4 Hi Mortgage Debt / Nominal GDP 2010: $2.60 avg price 2012e: $4.00 avg price Source: FRB, Haver, Barclays Capital Source: BLS, EIA, Haver, Barclays Capital • Public Policy: As long as the proportional delegate GOP primary drags on, we are in a political sweet spot. The four candidates continue to debate items such as cuts in corporate and individual taxes, the elimination of government agencies, the number of oil wells drilled on Federal land, and how quickly the budget can be balanced, all constructive commentary for equities. When the GOP settles on a candidate, the debate should be far less favorable for business and investor sentiment. Issues such as the 2013 ‘fiscal cliff’ and unsustainable entitlement programs will quickly come back into focus. • Earnings Season: The equity market powered through less-than-impressive 4Q11 earnings reports on the back of falling European contagion risk. We think 1Q12 earnings, beginning in mid-April, won’t be much better. The broad trend continues to be slowing earnings growth due to mid-cycle factors; our primary concern, however, is margins. Our margin diffusion index has fallen below the 9 March 2012 4 Barclays Capital | U.S. Portfolio Strategy Weekly boom/bust line because of deterioration in early stage sectors such as consumer discretionary and technology. The sector most vulnerable in 1Q12 is industrials. Our operating margin diffusion index is falling faster than net income margins, likely due to a loss of top line momentum from slowing emerging markets growth. At 1375 we believe the market is discounting 10% earnings growth in 2012, a level that seems unrealistic after investors see 1Q12 earnings reports. Figure 5: Our margin diffusion index has fallen slightly below Figure 6: Industrials look most at risk for 1Q12; net margins the boom/bust line haven’t fallen as fast as other margin measures %, 3mma %, 3mma 80 90 70 80 70 60 60 50 50 40 40 30 30 20 20 93 95 97 99 01 03 05 07 09 11 93 95 97 99 01 03 05 07 09 11 SPX: Net Mgn Diffusion Oper Mgn IND: Net Mgn Diffusion Oper Mgn Gross Mgn Source: FactSet, Barclays Capital Source: FactSet, Barclays Capital • Monetary Policy Tailwind: Complicating factors in the inflation outlook (e.g., gasoline prices) have the Fed effectively on hold until June—absent a serious near- term deterioration in the growth outlook—debating the merits of sterilized large scale asset purchases. The logic similar to that behind the original Operation Twist; a fear of a run on U.S. gold reserves during the Bretton Woods fixed exchange rate era precluded increasing the monetary base. The 2012 version of Operation Twist, in contrast to QE2, was not initially followed by a sharp drop in the dollar and broad rise in commodity prices. Sterilized QE would also avoid increasing the monetary base, thereby reducing the risk of a drop in the dollar. There are likely to be technical problems with sterilized QE. The banking system needs excess liquidity for regulatory purposes and it is no longer clear that purchasing agency MBS is plausible. There has been a tightening of the agency market since the decision last September, which we advocated, to reinvest MBS paydowns into MBS rather than Treasuries. We expect the Fed will struggle with near-term communication (next week’s meeting) as it probably needs to acknowledge improving current conditions, while maintaining concerns about the outlook, keeping QE3 on the table. The risk of the market focusing only on the current conditions assessment, reacting similarly to the Humphrey Hawkins testimony (sending stocks, gold and real treasury rates down and the dollar higher), seems elevated. With ECB President Draghi taking a step back from ECB accommodation at Thursday’s press conference, it seems the Fed, ECB and Bank of England are all on hold, at least in the near term. • Europe: The three year LTROs have likely pre-refunded ~18 months of unsecured debt maturities. However, this implies a greater percentage of banking system assets is encumbered, negative for the rest of the capital structure from senior 9 March 2012 5 Barclays Capital | U.S. Portfolio Strategy Weekly unsecured debt to equity. We expect to see additional evidence of deleveraging, including slow bank credit growth, particularly in countries with both current and now capital account deficits (Spain, Italy, Portugal and obviously Greece). February service sector PMI reports in Italy and Spain were weak, heightening this concern. The political environment seems likely to take a turn for the worse as well. Brussels is already under pressure from the right as Spain balks at sharp fiscal adjustments. In April, the pressure from the left could become extreme if the French election unfolds as the polls would currently imply and the new President doesn’t dramatically shift his positions. Figure 7: Large Fed purchases of agency MBS may not be Figure 8: The 3 yr LTROs likely pre-refunded ~18 months of plausible given a tightening of that market unsecured maturities , but a greater percentage of the …………………………. banking system is now encumbered 2012 Supply Forecast ($bn) % 450 350 400 300 350 300 250 250 200 200 150 150 100 100 50 0 50 -50 0 Pre Op Twist Post Op Twist Est LTRO borrowing / 2012 Sr unsec debt maturities Net Issuance Fed Paydowns Treasury Sales GSE Run-Offs Netherlands Germany France Italy Spain Source:, Barclays Capital Agency MBS Research Source: Barclays Capital Fundamental Credit Research It might take some time for the A common denominator in several of these broad areas of risk is the month of April. With momentum to completely the markets sending numerous signals that 2012 is not 1995—weakening relative dissipate, but we would be performance of small caps and cyclical sectors, gold falling, energy prices increasing and cutting risk real 10 year treasury rates rising—we believe the period of major central bank easing into an improving economic outlook is winding down. It might take some time for the momentum to completely dissipate, but we would be cutting risk. Our thoughts on how to approach small caps and dividends follow. 9 March 2012 6 Barclays Capital | U.S. Portfolio Strategy Weekly SMALL CAPS Small-cap performance & Fed policy expectations The Russell 2000 has underperformed the S&P 500 by roughly 4% since the beginning of February. We believe this is largely attributed to a pullback in monetary easing expectations. The performance has cleared much of this premium; we don’t recommend a short position to express a QE view. The recent underperformance in After outperforming the S&P 500 by 5% in January, the Russell 2000 has underperformed by small caps has coincided with an 4% since the beginning of February, only recently stabilizing. Small caps are more sensitive underperformance of cyclical to market volatility and economic cycle; their underperformance must be considered in the sectors context of broader risk reduction or a loss of economic momentum. The sharp underperformance of small caps led the selloff in the S&P by nearly a month. Figure 9: The sharp underperformance of small caps is often a precursor of things to come Ratio Index 1.60 1,400 1,350 1.55 1,300 1.50 1,250 ? 1,200 1.45 1,150 1,100 1.40 1,050 1.35 1,000 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Rel Performance: Smalll / Large Cap (L) S&P 500 (R) Source: FactSet, Barlcays Capital In January 2011, small caps had a similar period of underperformance, while the broad market moved higher, which we believe signalled a near-term top in the S&P 500 was approaching. Even so, on the back of a QE supportive statement from Chairman Bernanke, the Russell 2000 outperformed by more than 6% over the next two months despite a pullback in the S&P and stalling of the relative performance of cyclical to defensive sectors. On the surface the drivers of underperformance are not clear, but a deeper dive reduced some factors and reinforced others. We believe the underperformance can be largely attributed to a pullback in monetary easing expectations; the January payrolls report and Mr. Bernanke’s testimony marking the peak and rapid acceleration in underperformance, respectively. We are cautious on risk and small caps, but the recent relative performance suggests to us that much of the QE premium has cleared, and we don’t believe a short position in small caps is the appropriate way to express a QE view The January Effect Historically there is not a bias to Before we get to fundamentals, we’ll acknowledge technicals. The January effect, the well the downside in February and/or documented seasonal driver of relative small cap performance (see Blume and Stambaugh March Biases In Computed return: An Application to the Size Effect), is credited with providing a consistent boost to small cap stocks in January. Our analysis finds a very large, positive and 9 March 2012 7 Barclays Capital | U.S. Portfolio Strategy Weekly statistically significant coefficient for January (see table 10). The coefficient in February while positive, is insignificant; leaving us unable to conclude the sell-off was a reversal of the January Effect. Figure 10: The coefficient in February is insignificant, we’re unable to conclude the sell-off was a reversal of the January Effect Month Jan Feb Mar Apr May Jun Jul Aug Sep Nov Dec Coefficients 4.4 1.9 0.7 (0.2) 1.2 3.6 1.1 0.7 1.8 0.8 0.6 P-value % 0.2 17.9 64.3 88.3 39.0 1.0 43.1 59.8 19.8 55.7 69.4 Source: Fama-French, Barclays Capital Size or sectors? Sector bias is clearly not driving A rogue sector could explain underperformance particularly given the sector weight small cap underperformance differences across indices; however, this is not the case. All sectors and industry groups in the Russell 2000, both market and equal weighted, have recently underperformed their respective matches in the S&P 500. The technology sector was an outsized source of large cap outperformance; however, AAPL added 350bps to the sectors’ outperformance. Stripping out AAPL, the value weighted small cap tech sector still underperformed by ~500bps, but in-line with other sectors. Equal weighted performance is generally uniform. Figure 11: All sectors and industry groups in the Russell 2000 have recently underperformed. Equal weighted performance is generally uniform Relative returns Value Equal Value Equal R2000 weighted weighted weighted weighted Sector 12/31/12-2/2/12 2/2/12-3/7/12 Consumer Discretionary 4.4 4.4 (2.2) (3.4) Consumer Staples 7.7 5.4 (2.4) (2.1) Energy 5.0 4.2 (2.9) (2.8) Financials (0.2) (2.0) (4.2) (4.9) Health Care 6.8 8.0 (2.2) (2.9) Industrials 3.9 2.4 (2.8) (3.8) Information Technology 2.9 4.0 (8.0) (4.9) Materials 7.7 4.6 (3.0) (3.2) Telecommunication Services 11.6 9.8 (3.8) (3.8) Utilities 3.7 3.2 (2.2) (2.8) Total 4.8 4.4 (4.1) (3.9) Source: Barclays Capital Valuations Long-term relative valuations for small versus large cap equities are rich, but in our normalized valuation model, they did not hit one standard deviation from the mean, as was the case in 2011 (see USPSW: A small (cap) problem that might get big 4/29/11). Absolute valuations were higher as well, with forward PE multiples of 20x; following the recent small cap selloff, multiples sit at 18x (down from 19x), 9 March 2012 8 Barclays Capital | U.S. Portfolio Strategy Weekly Monetary policy The pattern of small cap Small caps are sensitive to monetary policy accommodation; in the 1980’s, 1990’s, and performance around these dates 2000’s small caps outperformed leading into Fed policy normalization thereafter follows that of other asset underperforming (see USPSW: It ain’t over till it’s over 3/11/11), In a normal cycle you classes that are highly would expect small caps to react to potential adjustments to the fed funds rate, but in the responsive to monetary easing, ZIRP (Zero Interest Rate Policy) era, instead they react to changes in the probability of such as precious metals further accommodation. Three instances highlight this point particularly well; recently the 2/3/12 January payrolls report and the 2/29/12 Humphrey Hawkins address, and in early 2011 the 1/26/11 FOMC statement. The near-term perception of Fed accommodation was altered—reduced in Feb 2011 and increased in Jan 2011—and small cap equities responded accordingly. The pattern of small cap performance around these dates follows other asset classes highly responsive to monetary easing, such as precious metals, metals & mining stocks and Treasuries. The extension of the decision timeframe, (probably until June) likely induced a reduction in risk. Figure 12: Small cap performance around these dates follows that of other asset classes highly responsive to monetary easing Relative Returns 2/3/2012 2/29/2012 1/26/2011 Probability of easing Lowered Lowered Raised Sectors -1wk +1wk -1wk +1wk -1wk +1wk S&P 500 (Operating Basis) 0.0 0.0 0.0 0.0 0.0 0.0 Russell 2000 2.0 (0.5) (0.7) (2.4) (3.1) 1.2 CBOE Market Volatility Index (3.7) 1.6 (2.0) 18.3 11.1 (1.0) SPDR S&P Metals & Mining ETF 0.7 (3.0) (1.7) (6.8) (4.2) 5.1 Gold (NYM $/ozt) 1.3 (3.0) 1.0 (4.4) (2.3) (0.7) US 10Y T-Note Yield (TPI)* 17.8 11.0 7.3 12.4 22.4 11.3 Source: FactSet, Barclays Capital. Note: Treasury performance is absolute, not relative A good time to get small? While we would suggest on If the indications of slowing market momentum, weakening macro data, public policy caution at current levels if a uncertainty around the general election or geo-political risks lead to a correction small caps growth scare unfolds, investors would typically underperform. Still, looking at the probabilities and up/downside payouts of should consider legging into retesting the lows and the recent highs, there is a case for an asymmetric payoff in favor of small caps small caps. So, while we would suggest caution at current levels, if a growth scare unfolds, and small caps continue to underperform, investors should consider adding small cap exposure. Figure 13: Looking at the probabilities and associated up/downside of relative performance retesting the lows and the recent highs there is an asymmetric payoff in favor of small caps Index Price 3/8/12 Recent Highs % chg 8/22 lows % chg Russell 2000 807 830 2.9 651 -19.3 S&P 500 1365 1370 0.4 1124 -17.7 Difference 2.5 -1.7 Source: Barclays Capital 9 March 2012 9 Barclays Capital | U.S. Portfolio Strategy Weekly DIVIDENDS Dissecting dividends: Signpost for a market drop? U.S. Portfolio Strategy The outperformance of dividend yield strategies is consistent with a falling stock Eric Slover, CFA market, rising volatility, and a deteriorating macro outlook. Dividend yield strategies +1 212 526 6426 are trending toward positive correlation with returns, a signpost for caution. We email@example.com recommend paring risk and legging into dividend yield exposure. BCI, New York Historically, periods of profitable dividend yield strategies (e.g., buying the top 20% of high U.S. Equity Product yielding stocks and selling the bottom 20%) are consistent with a falling stock market, rising Management volatility, and a deteriorating macro outlook. Despite the underperformance of dividend Gavin Smith indices and the highest yielding stocks, dividend yield strategies are trending toward +1 212 528 6139 positive correlation with returns, consistent with underperformance of other market firstname.lastname@example.org measures, such as small caps and cyclical sector. Along with the rising price of oil and BCI, New York gasoline, these signals in early 1Q11 and 2Q11 served as signposts for the deteriorating market conditions, which ultimately led to strong outperformance from dividend yield strategies. These signals served as signposts Figure 14: Dividend yield strategies are trending toward positive correlation with returns. in early 1Q11 and 2Q11, for the These strategies have performed with a falling stock market, rising volatility and a deteriorating market conditions, deteriorating macro outlook which ultimately led to strong outperformance from dividend Normalized slope coefficients, 20dma Index, 20dma yield strategies 0.20 1.0 0.15 0.8 0.6 0.10 0.4 0.05 0.2 0.00 0.0 -0.05 -0.2 -0.4 -0.10 -0.6 -0.15 -0.8 -0.20 -1.0 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Div Yld, Earnings Yld, Book/Mkt, Size, Sector (L) Div Yld (L) S&P 500 (R) Source: FactSet, Barclays Capital. Note: twenty day moving average of daily returns Following the outperformance of high yielding stocks and sectors such as utilities in the 3Q/4Q11 downturn, we’ve fielded a number of client questions on different dividend yield strategies. Against this backdrop, we thought it would be well founded to examine the value of investing in dividends. In this note we dissect dividend strategies and outline various implications for investors, including: Historical performance of various dividend yield strategies and the economic states in which they outperform; Examine the explanatory power of dividend yield and when this power is consumed by other effects such as size, value and sectors; 9 March 2012 10 Barclays Capital | U.S. Portfolio Strategy Weekly Evaluate the signal from the performance of dividend yield strategies and what it infers about the state of the markets and economy. Is this a precursor for a drop in the market? Performance of dividend strategies: Is it state dependent? Do dividend yield strategies consistently add value for investors? To answer this question, we focus on three basic strategies: 1) High Dividend Yield vs. Low Dividend Yield; 2) Dividend Payers vs. Non-Dividend Payers; 3) High Dividend Yield vs. Non Dividend Payers. The rolling 12 month averages of monthly returns are shown in Figure 15. Figure 15: Average Monthly Returns to Dividend Strategies Period Payer v Non Payer Hi v Lo Hi v No Pay Last 12 Months 1.22% 0.60% 1.50% Last 2 Years 0.44% 0.30% 0.56% Last 5 Years -0.06% 0.07% 0.05% Last 10 Years -0.12% 0.11% -0.07% Last 20 Years -0.08% 0.10% -0.06% Whole History -0.27% 0.06% -0.25% Source: Fama-French, Barclays Capital. While all three dividend yield While all three strategies have generated positive returns over the past two years, the strategies have generated longer-term effectiveness is not apparent. These strategies have had large swings of positive returns over the past positive and negative returns. This raises the question of whether performance is dependent two years, the longer-term on market or economic states. To explore this possibility, we identify five common variables effectiveness is not apparent. used to classify market or economic states: the return to the stock market, change in 10y Treasury yields, NBER recessions, VIX, and the ISM. Figure 16 paints a clear picture of when dividend yield strategies perform— falling markets, rising volatility and a deteriorating economic outlook. Figure 16: Dividend yield strategies average monthly returns in different states Payer v Non Payer Hi v Lo Hi v No Pay Stock Market Return > 0 -1.80% -0.90% -2.15% Stock Market Return <= 0 1.98% 1.47% 2.55% Change 10y Tsy > 0 -1.10% -1.21% -1.71% Change 10y Tsy <= 0 1.62% 1.80% 2.41% NBER Recession = 0 -0.37% -0.02% -0.38% NBER Recession = 1 0.14% 0.38% 0.14% VIX < 20 and Increasing 0.37% 0.15% 0.39% VIX >= 20 and Increasing 1.49% 1.02% 1.90% VIX >= 20 and Decreasing -1.49% -0.71% -1.83% VIX < 20 and Decreasing -0.42% -0.53% -0.70% ISM <= 50 and Increasing -1.03% -0.17% -1.10% ISM > 50 and Increasing -0.43% 0.07% -0.40% ISM > 50 and Decreasing 0.43% 0.08% 0.39% ISM <= 50 and Decreasing 0.68% -0.03% 0.59% Source: Fama-French, ISM, NBER, Haver, Barclays Capital. Note: Stock market from 1926, 10y Tsy from 1953, VIX from 1986, ISM from 1948 9 March 2012 11 Barclays Capital | U.S. Portfolio Strategy Weekly Is it really dividends? We question whether dividend Our previous analysis demonstrated that the performance of a basic dividend yield strategy yield is simply a proxy for other could be explained by macro variables that capture the state of the economy and the level common stock characteristics. of investor risk aversion. These state variables are associated with periods when we would also expect investors to have strong sector preferences (e.g., cyclicals vs. defensives) or perhaps risk preferences (e.g., small cap vs. large cap). With this in mind we question whether dividend yield is simply a proxy for other common stock characteristics. To disentangle these confounding effects, we run cross-sectional regressions to examine the ability of dividend yield to explain the cross-section of returns before and after controlling for other effects. Specifically, we run the following regressions: Returni ,t = α t + Dividend Yield i ,t + ε i ,t (1) N −1 Returni ,t = α t + Dividend Yield i ,t + Sizei ,t + Valuei ,t + ∑ Sector Dummy D =1 D i ,t + ε i ,t (2) where Return is the 1 month stock return; Size is the log of market capitalization; Value is the log of book-to-market; and Sector Dummy is equal to 1 if the stock belongs to sector D, otherwise 0. We define the ten sectors using the 2-digit GICS codes. Figure 17 charts the rolling 12-month average of the coefficient on dividend yield. We then re-run equations (1) and (2) on a daily basis, with a focus on the last year. Other factors such as size, value Figure 17 (Rolling 12-month average of the coefficient on dividend yield): A regression of and sectors can explain a good cross-sectional returns highlights returns explained by dividends and others factors deal of returns. A strategy controlling for these unintended Normalized slope coefficients, 12mma exposures reduces the dividend 2.0 2.0 strategy volatility 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 -0.5 -0.5 -1.0 -1.0 -1.5 -1.5 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Div Yld, Earnings Yld, Book/Mkt, Size, Sector (L) Div Yld (L) Difference (R) Source: Barclays Capital. Note: twelve month moving average of monthly returns As Figure 17 highlights (see the series labelled ‘Difference’), other factors at times explain a good deal of returns. A strategy controlling for these unintended exposures reduces the strategy volatility and outperforms a simple ‘uncleansed’ strategy in down markets. In the recent January rally, the explanatory power of other variables is particularly evident, with defensive sectors and larger cap stocks contributing to negative returns (see Figure 18 below). 9 March 2012 12 Barclays Capital | U.S. Portfolio Strategy Weekly What do dividend strategies tell us about the current state? We would be wary a pattern Dividend yield strategies are trending higher after weakness during the January rally. similar to early 2011 when Positive returns from these strategies are consistent with a falling stock market, rising dividend strategies quietly volatility and a deteriorating macro outlook. The S&P 500 is showing signs of pause, and outperformed as the S&P 500 while volatility remains subdued, short-term measures of correlation are rising and the ISM traded in a range for nearly two has shown signs of weakness. A continued sharp move higher in dividend yield strategy quarters performance should coincide with a selloff. However, we would be wary of a pattern similar to early 2011 when dividend strategies quietly outperformed as the S&P 500 traded in a range for nearly two quarters, failing to break the top-end of the range and ultimately falling to 1100 (Figure 18). With performance of dividend yield strategies added to the list of cautious signals from the We recommend paring back risk market, mixed macro data and a pause in monetary policy accommodation expectations, and legging into dividend yield we recommend paring risk, legging into dividend yield exposure seems attractive. Dividend exposure yielding strategies that limit unintended exposures to other factors such as beta, size, value and sector effects would reduce short-term volatility effects. Figure 18 (Rolling 20-day average of the coefficient on dividend yield): We would be wary of a pattern similar to early 2011 when dividend strategies quietly outperformed as the S&P 500 traded in a range for nearly two quarters Normalized slope coefficients, 20dma Index, 20dma 0.20 1.0 0.15 0.8 0.6 0.10 0.4 0.05 0.2 0.00 0.0 -0.05 -0.2 -0.4 -0.10 -0.6 -0.15 -0.8 -0.20 -1.0 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Div Yld, Earnings Yld, Book/Mkt, Size, Sector (L) Div Yld (L) S&P 500 (R) Source: FactSet, Barclays Capital. Note: twenty day moving average of daily returns 9 March 2012 13 Barclays Capital | U.S. Portfolio Strategy Weekly MARKET SNAPSHOT Figure 1: Price performance Figure 2: Relative performance, total return As of Ratio Ratio Index 03/08/12 1wk, % 3m, % 12m, % YTD, % 1.15 1.15 Discretionary 345 0.4 13.1 11.9 11.8 Staples 342 0.3 5.2 11.5 1.9 1.10 1.10 Energy 552 -0.8 7.8 -3.6 5.9 1.05 1.05 Financials 199 -0.6 15.4 -11.9 13.4 1.00 Health Care 419 0.0 9.0 9.8 4.3 1.00 Industrials 317 -0.5 11.3 -1.0 8.5 0.95 Technology 474 -0.3 14.3 11.5 15.5 0.90 0.95 Materials 231 -1.8 9.5 -4.1 9.3 0.85 0.90 Telecom 131 0.6 5.8 3.9 1.0 3/9/10 9/9/10 3/9/11 9/9/11 Utilities 177 0.0 1.6 7.9 -3.4 Rel Perf: Cyclical / Defensive Sectors (L) S&P 500 1,366 -0.3 10.7 3.3 8.6 Rel Perf: S&P 600 (small) / S&P 500 (large) (R) Russell 2000 2,004 0.5 11.6 -2.2 8.8 Note: S&P 500 sector indices. Source: FactSet, Barclays Capital Source: FactSet, Barclays Capital Figure 3: Valuation multiples Valuation Metrics (as of 03/08/12) P/Earnings P/Earnings Div Yield P/Sales EV/EBITDA EV/EBITDA Index LTM NTM Div Yield LTM NTM P/Book LTM P/Sales NTM LTM NTM Health Care 14.5 11.9 2.1 2.4 2.5 1.2 1.2 7.5 7.5 Technology 14.7 13.0 1.0 1.1 3.5 2.4 2.2 8.1 7.3 Staples 16.0 14.9 2.9 3.2 3.7 1.0 0.9 9.5 9.1 Industrials 14.5 13.0 2.2 2.5 2.8 1.2 1.1 9.6 8.9 Telecom 17.3 16.8 5.6 5.6 1.9 1.1 1.1 5.7 5.6 Financials 13.1 10.8 1.7 2.1 1.0 1.4 1.6 -- -- Materials 13.7 12.7 2.1 2.2 2.5 1.2 1.1 7.3 6.8 Discretionary 17.0 15.0 1.4 1.7 3.3 1.1 1.0 8.3 7.7 Energy 11.3 10.8 1.8 2.0 2.0 0.9 0.9 5.1 4.9 Utilities 13.6 14.2 4.2 4.3 1.5 1.2 1.2 8.0 7.7 S&P 500 13.9 12.7 2.0 2.2 2.2 1.3 1.2 8.1 7.6 Russell 2000 22.4 17.4 2.3 2.2 1.7 0.9 0.9 9.3 8.2 Note: S&P 500 sector indices. NTM is comprised of bottom-up consensus estimates from FactSet. *Valuation score is the renormalized sum of normalized relative valuation metrics expressed in common units of standard deviation away from the mean (z-score) since 1973. Source: FactSet, Barclays Capital. Figure 4: S&P 500 net EPS revisions Figure 5: Equity risk premium (to real IG credit yields) Index % 60 13 12 40 11 10 20 9 8 0 7 6 -20 5 -40 4 3 -60 2 1 -80 0 -1 -100 -2 05 06 07 08 09 10 11 12 76 81 86 91 96 01 06 11 Net Revisions: S&P 500, 13wk ma 4wk ma Real Credit ERP Mean +/- SD Source: Barclays Capital Source: Barclays Capital 9 March 2012 14 Barclays Capital | U.S. Portfolio Strategy Weekly EARNINGS UPDATE 484 companies, 99% of the S&P 500 market cap, have reported 4Q11 results. 56% have topped revenue estimates and 67% earnings. Aggregate earnings results have exceeded estimates by 3.8%, and revenues have beaten by 1%. Blended revenue growth is 8.2% and earnings growth is 6.5%; excluding Energy, revenue growth is 8% and earnings 5.7%. Blended margins are down 15 bps y/y, up 4 bps excluding Energy and Financials. Figure 1: Earnings are exceeding estimates by 3.8% and Figure 2: 67% of companies have beat earnings estimates revenues have beaten by 1% Revenues, Surp % Earnings, Surp % Sector 3Q11 4Q11 3Q11 4Q11 % DIS 1.0 0.0 2.0 4.8 90 82 82 79 76 74 74 74 73 76 73 STA 2.2 0.2 1.4 0.4 80 67 67 ENR 4.8 (0.4) 7.2 (0.3) 70 59 59 FIN 2.6 11.2 17.2 1.0 60 HLC 1.4 0.9 5.1 2.5 50 IND 0.6 (0.7) 4.6 7.9 40 TEC 0.3 1.1 3.2 9.0 30 MAT 2.4 1.0 3.8 3.7 20 TEL (0.2) 0.9 6.3 (11.5) 10 UTL (5.7) (9.0) 4.1 4.2 0 SPX 1.7 1.0 6.1 3.8 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 SPX ex-FIN 1.6 (0.1) 4.1 4.2 SPX ex-ENR 1.1 1.3 5.8 4.4 S&P 500 % Positive EPS Surprise SPX ex-FIN,ENR 0.8 (0.1) 3.5 5.1 Source: FactSet, Barclays Capital Source: FactSet, Barclays Capital Note: Actual results relative to consensus estimates (actual / estimates -1) Note: Number of companies that beat estimates as a percentage of total Figure 3: S&P 500 4Q11 blended revenue growth is 8.2% and earnings growth is 6.5% Revenues, $Bn Earnings, $Bn Profit Margin 4Q11 4Q11 4Q11 S&P 500 sector 4Q10 (A) (Blend) y/y % 4Q10 (A) (Blend) y/y % 4Q10 (A) (Blend) y/y ppt DIS 323 349 8.1 21.3 22.6 6.1 6.6 6.5 (0.12) STA 388 415 7.0 24.4 25.1 2.8 6.3 6.1 (0.24) ENR 346 379 9.4 26.8 29.9 11.7 7.7 7.9 0.16 FIN 251 283 12.8 33.4 32.1 (4.0) 13.3 11.3 (1.98) HLC 284 299 5.3 26.7 28.4 6.3 9.4 9.5 0.09 IND 270 286 5.8 21.8 24.9 14.1 8.1 8.7 0.63 TEC 254 284 11.7 48.5 56.1 15.5 19.1 19.7 0.64 MAT 80 86 7.2 5.8 5.0 (14.0) 7.3 5.8 (1.44) TEL 71 78 9.6 4.3 3.1 (28.7) 6.1 3.9 (2.12) UTL 76 77 2.1 5.6 5.7 1.7 7.3 7.3 (0.03) SPX 2,343 2,536 8.2 218.6 232.7 6.5 9.3 9.2 (0.15) SPX ex-FIN 2,092 2,253 7.7 185.2 200.6 8.3 8.9 8.9 0.05 SPX ex-ENR 1,997 2,158 8.0 191.9 202.8 5.7 9.6 9.4 (0.20) SPX ex-FIN,ENR 1,746 1,874 7.3 158.4 170.7 7.8 9.1 9.1 0.04 Source: FactSet, Barclays Capital 9 March 2012 15 Barclays Capital | U.S. Portfolio Strategy Weekly ANALYST(S) CERTIFICATION(S) I, Barry Knapp, hereby certify (1) that the views expressed in this research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. 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