Goldman's David Kostin is out with his latest chartpack which is as always chock full of pretty pictures, and the usual set of Monday morning quarterbacked recommendations. Just as it was Zero Hedge who first called Goldman's BS out in December of 2010 on their economic "fundamental shift" resurgence call, so it was ZH again first who suggested the QE Unwind compression trade, "Utilities and Consumer Staples as the long led in a compression trade, while shorting Industrials and Consumer Discretionary." Sure enough here comes Goldman observing "The rotation away from Cyclicals (Financials, Industrials, Materials) and into Defensive sectors (Health Care, Utilities, Consumer Staples, Telecom) continues to follow closely the historical trading pattern typically exhibited when the ISM index is declining from a peak back to 50" following a week in which "every US economic data release disappointed relative to consensus expectations. ISM manufacturing index (53.5 actual vs. median consensus expectation of 57.1), consumer confidence (60.8 vs. 66.6), nonfarm payrolls (54,000 vs. 165,000), and unemployment rate (9.1% vs. 8.9%) all posted negative surprises and pushed the cumulative 22-day rolling US MAP (macro data assessment) score to its lowest level since the beginning of our data in 2001. Domestic vehicle sales (9.2 million vs. 9.7) and home prices as measured by S&P/Case-Shiller index also disappointed." Perhaps it is time to launch the REDI Zero soft dollar machine: if Goldman makes billions and is dead wrong all the time, we would be trillioniares...So naturally, here's Goldman, pitching the high "Sharpe Ratio" basket, or back to defensives. Of course, anyone who listened to use almost three weeks ago already has this on.
Every US economic data release this week disappointed relative to consensus expectations. ISM manufacturing index (53.5 actual vs. median consensus expectation of 57.1), consumer confidence (60.8 vs. 66.6), nonfarm payrolls (54,000 vs. 165,000), and unemployment rate (9.1% vs. 8.9%) all posted negative surprises and pushed the cumulative 22-day rolling US MAP (macro data assessment) score to its lowest level since the beginning of our data in 2001. Domestic vehicle sales (9.2 million vs. 9.7) and home prices as measured by S&P/Case-Shiller index also disappointed.
S&P 500 fell 2% this week and has now dropped more than 4% since the end of April when it peaked at 1363. The rotation away from Cyclicals (Financials, Industrials, Materials) and into Defensive sectors (Health Care, Utilities, Consumer Staples, Telecom) continues to follow closely the historical trading pattern typically exhibited when the ISM index is declining from a peak back to 50. We discussed this playbook in our US Equity Views report Managing the US business cycle transition and global rotation (May 4, 2011) and it is one reason we recently adjusted our sector recommendations to raise Consumer Staples and lower Consumer Discretionary weightings. We remain overweight Energy. History also suggests net profit margins will begin to contract a year after ISM peaks, consistent with our 2012 forecast.
How should investors position a portfolio given the transitioning macro environment? We believe many mutual fund managers could boost the performance of their funds on a long-term basis by incorporating riskadjusted analysis in their stock selection process. Making this adjustment could also help mutual fund organizations stem the tide of cash into ETFs and other passive investment products by boosting the risk-adjusted return at the fund level versus benchmarks and versus competitors.
Our high “Sharpe Ratio” basket consists of a sector-neutral, equalweighted portfolio of 50 stocks with the best risk-adjusted prospective returns (Bloomberg ticker: <GSTHSHRP>). We define risk-adjusted return as the ratio of return to consensus target price divided by six-month implied volatility. The basket has outperformed the S&P 500 by 23 percentage points (47% vs. 24%) since inception in December 2009 and has outperformed the market by 10 percentage points (21% vs. 11%) since it was last rebalanced.
We continue to recommend investors buy this basket versus S&P 500. The median stock in our newly re-balanced “Sharpe ratio” basket offers more than two times the expected return of the median S&P 500 stock (29% vs. 11%) with similar risk (six-month implied volatility of 28% vs. 26%).
Simply put, portfolio managers should evaluate stock investments on a “Sharpe Ratio” basis rather than just looking at upside to target prices. Even though the two strategies tend to result in similar stock selection, a significant number of stocks that screen well on a Sharpe Ratio basis are often overlooked by portfolio managers. Incorporating implied volatility also helps exclude stocks with large expected returns but embedded uncertainty.
Our analysis suggests a “Sharpe Ratio” strategy may cause core mutual fund managers to rethink roughly 20% of their holdings. Specifically, we find roughly 80% “cross-over” between the top absolute and risk-adjusted return strategies. We believe incorporating Sharpe ratio analysis can make a meaningful difference to investment returns and managers would be more likely to outperform the benchmark and their peers on a multi-year basis.
Recent results: Our Sharpe basket outperformed the 200 largest Lipper large-cap core mutual funds by assets during the past six months on both a total return and a realized risk-adjusted return basis. Mutual fund absolute returns ranged from 1% to 16%. Our high “Sharpe ratio” basket returned 21.0% (100th percentile) versus 11.4% for the S&P 500 (65th percentile). Results were broad-based, with 37 of 50 stocks outperforming the S&P 500. Realized risk-adjusted returns (return/realized volatility) ranged from 0.0 to 1.3 for the 200 mutual funds. Our basket generated a riskadjusted return of 1.6 (100% percentile) versus 1.0 for the S&P 500 (73rd percentile). See Exhibit 50 for a list of current constituents.
Long-term results: Since 1999 the “Sharpe ratio” strategy has outpaced the S&P 500 by 421 bp on a semi-annual basis (not annualized returns) with an outperformance “hit-rate” of 72%. A basket of high “Sharpe Ratio” stocks generated a strong and consistent track record through the business cycle. The “hit rate” of outperformance historically averaged 59% in a down market and 81% in an up market (“up” and “down” periods measured over 6-month time horizon). Constituent turnover of the back-test portfolios averaged 72% on a six-month basis.
The objective of our back-test was to determine the incremental return that might be gained by incorporating a measure of risk-adjusted return potential into the stock selection process. Our Sharpe ratio strategy rebalanced semi-annually since 1999 has an information ratio in the 76th percentile compared with a universe of 118 funds (of the largest 200 largecap core funds at launch) that have performance track records since 1999. Our report Semi-annual rebalancing of our High Sharpe Ratio basket (June 1, 2011) ranks all S&P 500 stocks by Sharpe Ratio within each sector.
And complete chart porn: