Style: Growth / Value

Highlights The ECB loaded a bazooka, and core Eurozone yields rose: The ECB surprised dovishly last Thursday, and European bond yields duly fell … for an hour. Then they began to back up as fast as they fell, and when Friday’s trading ended, only Greek and Italian yields were lower than where they started. The market action supports our contention that things are not so bad, assuming the worst-case trade scenarios do not materialize: Underpinned by a robust labor market, the U.S. should have little trouble growing at a trend pace over the next twelve months. Meanwhile, the global economy may be in the process of turning. Reversals within the U.S. equity market have gotten a lot of attention so far this month, but it’s too early to claim that a broad factor inflection is underway: If global growth prospects have bottomed, defensive sectors’ outperformance is due to reverse, which will cause havoc for momentum strategies. It is premature to call for a value revival, however. Feature Maybe long Treasury yields aren’t going to zero after all. After bottoming just below 1.43% the day after Labor Day, the 10-year Treasury yield surged 45 basis points across eight sessions as of Friday’s lunchtime peak (Chart 1). The move has been enough to retrace better than three-fifths of its steep slide from mid-July to the beginning of September, but relative to the extended plunge from 3.24% that began last November, the bounce barely registers. Chart 1Up, Up And Away Here Comes The Cavalry (Again) Here Comes The Cavalry (Again) Chart 2Pulled Lower By Expected Rate Cuts... Pulled Lower By Expected Rate Cuts... Pulled Lower By Expected Rate Cuts... The takeaway is that it’s important to keep the moves in context. Just as the collapse in Treasury yields didn’t indicate that the U.S. economy was headed for an imminent recession, their modest, if rapid, recovery doesn’t indicate that all the dark clouds are gone from the horizon. From a purely domestic perspective, the 180-basis-point (“bps”) peak-to-trough decline in the 10-year Treasury yield unfolded nearly step-for-step with an equivalent decline in the expected fed funds rate twelve months out (Chart 2). Since a 1.25% target fed funds rate this time next year is incompatible with our view of the economy, we expect rates will move higher. The ECB committed itself to accommodation for longer than markets had expected; … Chart 3...And Other Sovereign Yields ...And Other Sovereign Yields ...And Other Sovereign Yields Chart 4Better Times Ahead? Better Times Ahead? Better Times Ahead? The Treasury market doesn’t exist in a vacuum, however. Yield moves in similarly-rated sovereign bonds have an effect on Treasuries, and declines in European sovereign yields have exerted a gravitational pull all year long (Chart 3). The backup in yields that followed the ECB’s dovish surprise on Thursday suggests that Eurozone sovereign bond markets may have bought the rumor and sold the news. If global growth is in the process of bottoming, as global leading indicators suggest, falling yields would run counter to the fundamental backdrop (Chart 4). You May Fire When Ready, Draghi To judge by the spate of columns urging helicopter-style accommodation measures, the expectations bar for the European Central Bank’s long-awaited September meeting had been set pretty high. The cut in the ECB’s deposit facility rate to -0.5% from -0.4%, with provisions to mitigate the pressure negative rates exert on banks, was in line with the market consensus, as was a resumption of quantitative easing. Investors did not foresee that the ECB would embark on open-ended bond purchases, however, a plan quickly labeled “QE Infinity.” The ECB also dumped its no-hikes-before-mid-2020 guidance – now it won’t move until the inflation outlook “robustly” moves toward its 2% target – and lengthened the maturities on TLTRO loans while lowering their rates.1 The surprise indicated that the ECB is taking the slowdown seriously, at home (most evident in Germany, which is flirting with recession after a quarter-over-quarter GDP contraction) and abroad. It is premature to declare the action a flop, as headline writers were quick to do, citing the evanescent decline in core bond yields and the euro, because QE impacts are subject to several factors. Sovereign yields can rise on QE announcements if markets judge the impact of relaxed inflation vigilance will outweigh the impact of the entry of a new, price-insensitive buyer to the marketplace. As long as real yields fall, the central bank will have achieved its goal. … if it develops that the incremental accommodation wasn’t necessary, equities and spread product should reap the benefits. U.S. investors are mostly concerned with the impact on global markets and the global economy. Even if nominal sovereign yields have bottomed and competitive devaluation has neutered the currency channel, incremental easing should boost risk assets’ prospects, via pushing incumbent sovereign holders into spread product (the portfolio balance effect), promoting business and consumer confidence, incentivizing bank lending, and nudging other central banks (like Denmark’s, which immediately cut its policy rate in response) to ease monetary conditions themselves (Figure 1). On those counts, we view the ECB’s surprise as modestly improving the prospects for risk assets. TINA is alive and well. Figure 1Monetary Policy And The Economy Here Comes The Cavalry (Again) Here Comes The Cavalry (Again) The Employment Situation We have repeatedly cited the robustness of the labor market as a reason for not giving up on the U.S. economy, or equities and spread product. If expanding payrolls and increasing compensation can keep consumption growing at just a 2% clip, the probability of a U.S. recession, and of an equity bear market and a new default cycle, is fairly slim. If the labor market isn’t as strong as we’ve judged, more defensive portfolio positioning may be in order. Since the beginning of the second quarter, the monthly employment situation reports have revealed a slowing in hiring activity, halting the quickening that stretched from last year through the end of the first quarter (Chart 5). The slowing trend is less concerning than it might appear to be on its face. The current expansion, 122 months old and counting, is the longest on record, and now that it has already drawn considerable numbers of people back into the labor force and back to work, it has become increasingly difficult to find and attract new workers. Even the current monthly pace of job gains, 156,000 over the last three months, still puts downward pressure on the unemployment rate, as it takes less than 110,000 new jobs to maintain the status quo. With net job gains outpacing new entrants into the labor force, wages should rise. Average hourly earnings rose 3.2% in August on a year-over-year basis, though the 0.4% month-over-month gain suggests they may be about to challenge the top end of the tight 3.1-3.2% range that’s prevailed all year. Investors’ and economists’ patience with the Phillips Curve is increasingly wearing thin, as they wait for the decline in the unemployment rate to show up in wage gains, but we consider the underlying supply-demand relationship to be immutable. The prime-age employment-to-population ratio hit an 11-year high in August, and is solidly back in the middle of the range that has prevailed over the 30 years that female participation gains have stabilized (Chart 6). Chart 5Slower Payroll Gains... Slower Payroll Gains... Slower Payroll Gains... Chart 6...Will Still Tighten The Labor Market ...Will Still Tighten The Labor Market ...Will Still Tighten The Labor Market Chart 7The Unkinked Phillips Curve Here Comes The Cavalry (Again) Here Comes The Cavalry (Again) The prime-age employment-to-population ratio is an important measure for the Phillips Curve because it exhibits a consistent linear relationship with wage gains. The fit between the non-employment-to-population ratio (1 minus the employment-to-population ratio) and the employment cost index (Chart 7, top panel) is a little tighter than the fit with average hourly earnings (Chart 7, bottom panel), but both regression equations project an annual increase in wages of 3.3% at the current 20% (1-80%) level, and a 7-bps gain for every 20-bps decline in the prime-age non-employment-to-population ratio. Given that our payrolls model projects a pickup in the pace of hiring (Chart 8, top panel), and the quits rate just moved off of its extended plateau (Chart 9), upward pressure on wages will continue to build.   Chart 8Demand For Workers Is Still Solid Demand For Workers Is Still Solid Demand For Workers Is Still Solid Chart 9Movin' On Up Movin' On Up Movin' On Up Bottom Line: Payroll gains are slowing, but they remain robust enough to push the key prime-age employment-to-population ratio higher, and exert upward pressure on wages.   Factor Rotation Chart 10Momentum Hits The Wall,... Momentum Hits The Wall,... Momentum Hits The Wall,... Reversals within the U.S. equity market have been drawing increasing amounts of attention, as momentum stocks have hit a wall while long-suffering value stocks have begun to peel themselves off the canvas (Chart 10). We can easily see a scenario in which the momentum factor has a very difficult time, if relative performance shifts from defensive sectors to cyclical sectors as investors begin to perceive that they have been overly pessimistic about the domestic and global business cycle, and cease to hide in bond proxies like Utilities and REITs. Given the defensives’ run of outperformance over the last year, momentum indexes disproportionately favor them over cyclicals. The S&P 500, MidCap 400 and SmallCap 600 Momentum Indexes all show a pronounced defensives bias, with Health Care, Utilities and Real Estate all commanding double their baseline weight in at least one index (Table 1), making S&P’s momentum indexes vulnerable to a defensives-to-cyclicals rotation. Table 1The Dullest Stocks Have Been The Hottest Here Comes The Cavalry (Again) Here Comes The Cavalry (Again) Over the last three years, we have thought a lot about the value factor, asking how it should be defined, which financial statement metrics indicate its presence, and the business and monetary policy cycle backdrops that are most conducive to its outperformance. Low-priced stocks have been in a punishing extended slump versus high-priced stocks since early 2007 (Chart 11), and we think they have yet to bottom. The recent value stock rally has been a function of higher 10-year Treasury yields, and banks’ (which account for an outsized share of popular value benchmarks) recent tendency to trade in lockstep with them. We do not think a two-week backup in yields is the stuff that a genuine value factor inflection point is made of. Chart 11...But The Value Factor Has Yet To Turn ...But The Value Factor Has Yet To Turn ...But The Value Factor Has Yet To Turn A detailed explanation of our rationale is beyond the scope of this report,2 but the following points summarize our take: The value factor has gotten killed since the crisis, but we doubt that it’s dead. Value has historically treaded water during bull markets, and shined in bear markets. The fed funds rate cycle is the best predictor of value’s relative performance. Value has historically crushed the overall market when monetary policy is restrictive. The most popular style indexes have barely any factor merit. The S&P 500’s Growth and Value indexes are little more than Tech and Financials proxies. Value will shine again, but not until monetary policy is restrictive. If the Fed doesn’t hike the fed funds rate above the equilibrium fed funds rate until 2021, value investors will have to gut out another year-plus of underperformance. Bottom Line: The momentum factor could suffer in the near term if cyclicals reassert primacy over formerly hot defensives. The value factor’s fortunes will not turn for at least another year. Investment Implications We understand the discomfort of investors who feel like ZIRP, NIRP and QE have obliterated normal investing relationships. Disorienting as it has been to see nominal Treasury returns shrivel, the rising tide of negative-yielding bonds is like a surreal detail from a David Lynch movie. The investment world has indeed turned upside-down when investors buy bonds for capital gains to offset the interest they have to pay for the privilege of lending. Austrian School advocates are surely not the only dearly departed investing veterans rolling in their graves. It’s not the environment we wanted, but it’s the environment we got, so we’re going to buck up and do our best to squeeze excess returns out of it. We have to invest in the markets we have, however, not the markets we want. It does neither ourselves nor our clients any good to throw up our hands, bitterly lament our fate and wish ill upon the exponents of the activist, ultra-accommodative approach to central banking that is now in fashion. Some old relationships still apply, and the combination of a quietly improving global economic backdrop with incremental monetary accommodation everywhere one turns is good for risk assets. We continue to recommend that investors resist the urge to get defensive before the excess-return window closes for this cycle. We are not advocating that investors let their guard down, and assume that central banks will be able to keep the plates spinning indefinitely. They will not – monetary interventions are a poor substitute for organic growth in productivity or the size of the working-age population, and so are inefficiently directed fiscal spending programs – but we bet they can through the next quarterly or annual period over which an institutional manager is going to be evaluated. The upshot is that investors should remain especially vigilant for signs of trouble, and be prepared to act more tactically than normal to adjust their portfolios, but shouldn’t de-risk them yet, lest they miss the last of the fat-year returns they’ll need to tide themselves over during the coming lean years.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Targeted longer-term refinancing operations (TLTROs) are ECB loans to banks intended to encourage lending to households and non-financial corporations. 2 Interested readers should see the May 16, 2018 Global ETF Strategy/Equity Trading Strategy Special Report, “Smart-Beta ETF Selection Update – Is Value Still Worth It?,” the October 2018 Bank Credit Analyst Special Report, “Is It Time To Buy Value Stocks?,” and the October 2, 2018 U.S. Investment Strategy Special Report, “When Will Value Work Again?,” available at etf.bcaresearch.com, www.bcaresearch.com and usis.bcaresearch.com, respectively.

A client recently came to us asking the question: what percentage of the SPX was classified as value and what was classified as growth? While a simple enough question, it spurred some discussion regarding the classification itself. The S&P classifies the S&P 500 into value, growth and a lucky combination of value and growth (i.e. some constituents, including Google for example, belong to both lists). We thought it worthwhile to separate the stocks into their pureplay components and the result was interesting. As shown in the left piechart below, the market cap weighted styles are actually fairly evenly split between value, growth and the combination thereof. On a count basis (right pie chart), growth stocks fall to under a quarter of the SPX, a logical result considering the mega market cap sizes of the SPX’ growth companies. If you would like to receive our segmented list of tickers, please email our client requests department here. Chart 1 Chart 2      

Highlights U.S. growth remains robust, despite some temporary softness in recent months. Ex U.S., growth continues to fall but, with China probably now ramping up monetary stimulus, should bottom in the second half. Central banks everywhere have turned more dovish, partly in an attempt to push up inflation expectations. The combination of resilient growth and easier monetary policy should be good for global equities. We remain overweight equities versus bonds. Bond yields have fallen sharply everywhere. However, with U.S. inflation still trending up, and central banks unlikely to turn any more dovish this year, yields are unlikely to fall much further in 2019. We recommend a slight underweight on duration. We remain overweight U.S. equities, but are on watch to upgrade the euro zone and Emerging Markets when we have stronger conviction about China’s stimulus. Given structural headwinds in both Europe and EM, this would probably be only a tactical upgrade. We have been tilting our equity sector recommendations in a more cyclical direction, last month raising Industrials and Energy to overweight. We also prefer credit over government bonds within the fixed-income category, though we warn that spreads will not fall much further given weak corporate fundamentals. Feature Recommended Allocation Quarterly - April 2019 Quarterly - April 2019 Overview Don’t Fight The Doves The performance of risk assets essentially comes down to a battle between growth and monetary policy/interest rates. Last September, despite the fact that global economic growth was clearly slowing, the Fed sounded hawkish; this triggered an 18% drop in global equities in Q4. But, since late last year, all major developed central banks have turned more dovish, culminating in March’s decision of the ECB to push back its guidance for its first rate hike, and the FOMC’s wiping out its two planned hikes for 2019. But, at the same time, U.S. economic growth is showing resilience, and we see the first “green shoots” of a cyclical pickup in growth outside the U.S. This is an environment in which risk assets should continue to perform well. Why did the Fed back off? The most likely explanation is that it wants to give itself more room to act come the next recession. Inflation expectations have become unanchored, with 10-year breakevens over the past decade steadily below a level that would be consistent with the Fed achieving its 2% core PCE inflation target in the long run. In the period since the Fed formally introduced this (supposedly “symmetrical”) target in 2012, it has exceeded it in only four months (Chart 1). Around recessions over the past 50 years, the Fed has on average cut rates by 655 basis points (Table 1). It sees little risk, therefore, in letting the economy “run a little hot” and allowing inflation to rise somewhat above 2%. This would reanchor expectations, and eventually get nominal short- and long-term rates higher before the next recession. Chart 1Market Doesn’t Believe The Fed’s Target Market Doesn't Believe The Fed's Target Market Doesn't Believe The Fed's Target Table 1Fed Won’t Be Able To Cut This Much Next Time Quarterly - April 2019 Quarterly - April 2019   Chart 2Financial Conditions Now Much Easier Financial Conditions Now Much Easier Financial Conditions Now Much Easier Chart 3Housing Market Bottoming Out Housing Market Bottoming Out Housing Market Bottoming Out Meanwhile, U.S. growth seems to be stabilizing at a decent level after signs of weakness late last year caused by tighter financial conditions, a slowdown elsewhere in the world, and the six-week government shutdown. An easing of financial conditions since the beginning of the year should help to keep U.S. GDP growth above trend at around 2.0-2.5% this year (Chart 2). Most notably, interest-rate sensitive areas of the economy that were under pressure last year, especially housing, are showing signs of bottoming (Chart 3). Consumption also should be robust, given strong wage growth, consumer confidence close to historic record high levels, and amid no signs of a deterioration in the labor market (Chart 4). Chart 4No Signs Of Weaker Labor Market No Signs Of Weaker Labor Market No Signs Of Weaker Labor Market Chart 5Some 'Green Shoots' For Global Growth Some "Green Shoots" For Global Growth Some "Green Shoots" For Global Growth   A key question for us over the next few months will be when to shift allocations to more cyclical, higher-beta equity markets such as the euro area and Emerging Markets. These have underperformed year-to-date despite the strong risk-on market. China’s nascent reflationary stimulus will decide the timing and level of conviction of this shift. As we explain in detail on page 6, we think the jury is still out on whether China is injecting liquidity on anything like the same scale as it did in 2016. Even if it is, historically it has taken six to 12 months before the effect showed through via a rebound in global trade, commodity prices, and other China-related indicators. The first early signs of a bottoming are emerging: Chinese fixed-asset investment and the Caixin Manufacturing PMI beat expectations last month, the German ZEW Expectations indicator has started to recover, and the diffusion index of the Global Leading Economic Indicator (which often leads the LEI itself by a few months) has picked up (Chart 5). We are on watch to shift our allocation1 but, given the long-term structural headwinds against both Europe and EM, we need to be more convinced about the strength of Chinese stimulus before doing so. The seeds of recession are sown in expansions. Eventually, we see the newly dovish Fed falling behind the curve. The Fed Funds Rate is still below the range of estimates of the neutral rate – hard though this is to estimate in real time (Chart 6). If the economy remains as strong as we expect, sometime next year inflation could begin rising to uncomfortable levels (and asset bubbles start to be of concern), which would push the Fed back into hiking mode. Given that the market is pricing in Fed rate cuts, not hikes, and that the Fed can hardly sound any more dovish than it does now without moving to an outright easing path, it seems to us that long-term rates are very unlikely to fall from here (Chart 7). Chart 6Fed Still Below Neutral Fed Still Below Neutral Fed Still Below Neutral Chart 7Can The Fed Get Any More Dovish Than This? Can The Fed Get Any More Dovish Than This? Can The Fed Get Any More Dovish Than This? In this environment, therefore, we continue to expect global equities to outperform bonds over the next 12 months. However, a recession is possible in 2021 triggered by the Fed late next year needing to put its foot abruptly on the brake.   What Our Clients Are Asking Chart 8Ex-U.S. Equities Driven By China Stimulus Ex US Equities Driven By China Stimilus Ex US Equities Driven By China Stimilus When Is The Time To Switch Allocations To Europe And EM? It is slightly surprising that the 12% rally in global equities this year has been led by the low-beta U.S., up 13%, rather than Europe (up 9%) or emerging markets (up 9% - and much less if the strong Chinese market is excluded). Is it time to switch to these underperforming, more cyclical markets? Our answer is, not yet. Global growth ex-U.S. continues to weaken. It is likely to bottom sometime in the second half, as a result of Chinese growth stabilizing. However, the jury is still out on whether the increase in Chinese credit creation in January was a one-off, or major policy reversal. Even if it is the latter, a revival in global growth (and cyclical markets) has typically lagged Chinese stimulus by 6-12 months (Chart 8, panel 1). There are also significant structural headwinds for both the euro zone and Emerging Markets which make us reluctant to overweight them unless there are clear cyclical reasons to do so. Both have lagged global equities fairly consistently since the Global Financial Crisis, with only brief outperformance during periods of economic acceleration, such as in 2016 and 2012 (panel 2). The euro zone remains challenged by its banking system. Loan growth has been stagnant for years, and banks remain undercapitalized relative to their U.S. peers, and highly fragmented (panels 3 and 4). Emerging markets are hampered by their high level of foreign-currency debt (which makes them highly sensitive to U.S. financial conditions), dependence on China, and lack of structural reform. We could see ourselves shifting our recommendation from the U.S. to the euro area and EM, and becoming outright bearish on the U.S. dollar (a counter-cyclical currency), over the coming months if we find confirmation of a bottoming of global cyclical growth and become more confident in the size of China’s stimulus. But given the structural headwinds, and the steady underperformance of these markets, we need stronger evidence first.   Chart 9Oil, Positioning, And Housing Oil, Positioning, And Housing Oil, Positioning, And Housing Why Is The 10-Year Bond Yield So Depressed? Despite U.S. equities rallying back to within 4% of a record high, the U.S. Treasury bond yield has fallen further this year (Chart 9, panel 1). Moreover, the 3-month/10-year yield curve has briefly inverted. Besides the Fed’s recent more dovish turn, what has depressed bond yields? We would pin the cause on the following factors: Dampened inflation expectations: Over the past few years the 10-year yield has been closely correlated with the oil price via inflation expectations. A temporary supply shock in Q4 caused oil prices to decline sharply. But tighter supply this year should allow the oil price to recover further. This should cause a rise in inflation expectation (panel 2). Trade positioning: Late last year,  speculative short positions in government bonds were at their highest levels since 2015. However, the Q4 equity selloff pushed investors to cover their positions; these are now close to neutral (panel 3). Home Sales: Housing data has been weak over the past few quarters, with both existing and new home sales declining. But there are now signs of recovery: mortgage applications have started to pick up, which should in turn push home sales higher (panel 4). This should also allow for a rise in bond yields. Our key take-away from March’s FOMC meeting, when the tone turned decidedly dovish, is that the Fed is focusing on re-anchoring inflation expectations, which should push nominal yields higher. We think the market is very pessimistic by pricing in 42 and 56 bps of rate cuts over the next 12 and 24 months respectively. It would take a significant further weakening of economic data to make the Fed’s stance turn even more dovish and for nominal yields to fall even further.   How Will U.S. Corporate Bonds Perform In The Next Recession? Historically high levels of U.S. corporate debt, as well as declining credit quality in the investment-grade space, have started to worry investors (Chart 10). Specifically, investors are worried that, when the next default cycle comes, a large portion of investment-grade debt will be downgraded to junk, forcing fund managers who are constrained to hold certain credit qualities to sell. These worries seem to be justified. Investment-grade bonds of lower credit quality tend to experience large increases in migration to junk status during credit recessions (Chart 11). Given the current composition of the U.S. investment-grade corporate bond universe, a credit recession would imply a downgrade to junk status of 4.6% of the index if we assume similar behavior to previous recessions. Depending on the speed of the selloff, such a downgrade could also have grave consequence for liquidity. According to the Securities Industry and Financial Markets Association (SIFMA), average daily turnover in the U.S. corporate bond market was 0.34% in 2018. Thus, it is not hard to envision a situation where forced selling could surpass normal levels of liquidity. However, it is hard to tell what would be the effect of such a fire-sale on credit spreads, given that they tend to widen in recessions regardless. While this asset class could perform poorly in the next recession, we don’t expect that its weakness will translate to the real economy. Leveraged institutions such as banks hold just 18% of corporate credit. Furthermore, despite being at all-time highs, U.S. nonfinancial corporate debt to GDP is still at a much healthier level than in other countries (Chart 12). Chart 10Declining Quality In Investment Grade Declining Quality In Investment Grade Declining Quality In Investment Grade Chart 11 Chart 12U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World   Chart 13A Value Rebound? A Value Rebound A Value Rebound Chart 14   Is It Time To Favor Value Over Growth Again? Since it peaked in May 2007, the ratio of global value to growth has attempted to rebound several times amid a sustained downtrend (Chart 13). Due to the cyclical nature and the neutral relative valuation of the value/growth indexes, we have preferred to use sector positioning (cyclicals vs. defensives) to implement a value/growth style tilt in our global portfolio since March 20162 (Chart 13, panel 1). Lately, we have received many requests on the topic of the value-versus-growth-ratio. After reaching a historical low in August 2018, the  value/growth ratio slightly rebounded in Q4 2018 before reversing some of its gains so far this year. Additionally, the value/growth valuation gap as measured by both price-to-book and forward P/E has reached a historically low level (Chart 13, panel 4). As we have often noted, the sector composition of both the value and growth indexes changes over time.2 Chart 14 shows the current sector weights of S&P Pure Value and Pure Growth Indexes.3 It’s clear that now a bet on Pure Value versus Pure Growth is essentially a bet on Financials (which account for 35% of the Pure Value index) versus Tech and Healthcare (which together account for 38% of the Pure Growth index) - see also Chart 13, panel 2. Given the cyclical nature of the value/growth ratio and also the sector concentration, it’s not surprising that the value/growth play is also a play on euro area versus U.S. equities (Chart 13, panel 3). Currently, we are neutral on Financials and Tech, while overweight Healthcare in our global sector portfolio, and we are putting the euro area on an upgrade watch (see page 14). Therefore, maintaining a neutral stance between value and growth is in line with our sector and country views. However, a close watch for a possible upgrade of value is also warranted given the extreme valuation measures.   Global Economy Overview: U.S. growth has slowed recently, though it remains more robust than in the more cyclical economies in Europe and emerging markets. Central banks almost everywhere have recently turned dovish. However, China’s increased monetary stimulus should help global growth bottom out in H2. This could lead the Fed and central banks in other healthy economies to return to a rate-hiking path. U.S.: The U.S. economy has been weak in recent months. The Citigroup Economic Surprise Index (Chart 15, panel 1) has collapsed, and the Fed NowCasts point to only 1.3-1.7% QoQ annualized GDP growth in Q1 (compared to 2.2% in Q4). But the slowdown is mostly due to the six-week government shutdown (which probably took 1% off growth), some seasonal adjustment oddities (which leave Q1 as the weakest quarter almost every year), and tighter financial conditions in H2 2018 which have now largely reversed. The manufacturing and non-manufacturing ISMs in February were  still healthy at 54.2 and 59.7 respectively. Consumption (propelled by strong employment growth and accelerating wages) and capex remain strong (panel 3). BCA expects GDP growth in 2019 to be around 2.0-2.5%, still above trend. Euro Area: The European economy continues to slow, driven by weak exports to emerging markets, troubles in the banking sector, and political uncertainty. Q4 GDP growth was only 0.8% QoQ annualized, and the manufacturing PMI has fallen to 47.6 (with Germany as low as 44.7). But there are some early signs of an improvement. The ZEW Expectations index for Germany has bottomed (Chart 16, panel 1), fiscal policy should boost euro area growth this year by around 0.5 percentage points, and wage growth has begun to accelerate. The key remains Chinese stimulus, whose positive effects should help European exports recover sometime in H2. Chart 15U.S. Growth Slowing But Still Robust U.S. Growth Slowing But Still Robust U.S. Growth Slowing But Still Robust Chart 16Signs Of Bottoming In Global Ex-U.S.? Signs Of Bottoming In Global Ex-U.S.? Signs Of Bottoming In Global Ex-U.S.? Japan: Japan also remains highly dependent on a Chinese stimulus. Machine tool orders (the best indicator of capex demand from China) fell by 29% YoY in February. Despite stronger wage growth, now 1.2% YoY, inflation shows no signs of moving up towards the Bank of Japan’s target of 2%: ex energy and food CPI inflation is still only 0.4%. The biggest risk in 2019 is October’s planned consumption tax hike from 8% to 10%. Prime Minister Abe has said that he will cancel this only in the event of a shock on the scale of Lehman Brothers’ bankruptcy. The government has put in place measures to soften the impact (most notably a 5% rebate on purchases at small retailers after October 1 paid for electronically), but consumption is still likely to fall significantly. Emerging Markets: China seems to have ramped up its monetary stimulus, with total social financing in January and February combined up 12% over the same months last year. Recent data have shown signs of a stabilization of growth: the manufacturing PMI rebounded to 49.9 in February from 48.3, and fixed-asset investment beat expectations at 6.1% YoY in January and February combined. Nonetheless, the size of liquidity injection is likely to be smaller than in previous episodes such as 2016, since Premier Li Keqiang and the PBOC have warned of the risk of excessive speculation. Elsewhere, some emerging economies (notably Brazil and Mexico) have showed signs of recovery after last year’s deterioration, whereas others (such as South Africa, Indonesia, and Poland) continue to suffer. Interest rates: Central banks worldwide have generally turned more dovish in recent months, with the Fed and ECB both moving to signal no rate hikes this year. This has pushed down long-term rates globally, with 10-year bond yields falling below 0% again in Germany and Japan. However, with global growth likely to bottom over the next few months, rates may not stay at current depressed levels. U.S. inflation, in particular, continues to trend up, and the Fed’s target PCE inflation measure is likely to exceed 2% over coming months. We see the Fed turning more hawkish by year-end, and long rates globally more likely to rise than fall from current levels.   Global Equities Chart 17Watch Earnings Watch Earnings Watch Earnings Remain Cautiously Optimistic: We added risk in our January Portfolio Update4 by putting cash back to work in global equities, and then in the March Portfolio Update5 we reduced the underweight in EM equities and increased the tilt to cyclicals at the expense of defensives, to hedge against a continuing acceleration in Chinese credit growth. All these came after our risk reduction in July 2018.6 GAA’s portfolio approach has always been to take risks where they are most likely to be rewarded. BCA’s macro view is that global economic growth data is likely to be on the weak side in the coming months, but will pick up in the second half. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. At the asset-class level, our positioning of overweight equities versus bonds while neutral on cash, reflects the “optimistic” side of our allocation. However, the rebound in global equities since the December sell-off has been driven completely by a valuation re-rating, while earnings growth has been revised down sharply. (Chart 17). As such, within global equities, our preference for low-beta countries (favoring DM versus EM, and favoring the U.S over the rest of DM) reflects the “cautious” aspect of our allocation. Our macro view hinges largely on what happens to China. There are signs that China may have abandoned its focus on deleveraging, yet it is too early to tell if it has switched back to a reflationary path. Therefore, our global equity sector overlay has a slight cyclical tilt by overweighting Industrials and Energy, which are among the main beneficiaries of Chinese reflationary policies or a positive resolution to U.S.-China trade negotiations. Chart 18Warming Up To The Euro Area Warming Up To The Euro Area Warming Up To The Euro Area Euro Area Equities: On Upgrade Watch We have favored U.S. equities relative to the euro area since July 2018.7 Since then, the U.S. has outperformed the euro area by 11% in USD terms and by 8% in local currency terms, with the difference being attributed to the weakness of the euro versus the U.S. dollar. Given BCA’s view on the global economy and the U.S. dollar, however, we are watching closely to switch our recommendation between the U.S. and euro area equities, for the following reasons: First, as shown in Chart 18, panel 1, the relative performance between the euro area and the U.S. is highly correlated with the EUR/USD exchange rate. BCA believes that the U.S. dollar is set for a period of weakness starting in the second half of the year,8 which bodes well for the outperformance of euro area equities. Second, relative earnings growth between the euro area and the U.S. is driven by the underlying strength of the economies, as represented by PMIs (panel 2). Both the relative earnings growth and relative PMI have stopped falling and have begun to bottom in favor of the euro area; Third, even though the euro area’s beta has been declining while that of the U.S. has increased, euro area beta is still higher than that in the U.S., making it more of a beneficiary of a global growth recovery; However, the relative valuation of euro area equities to their U.S. counterparts is now  neutral not at the extreme level which historically has been a good entry-point into eurozone  equities (panel 4).   Chart 19Becoming Less Defensive Becoming Less Defensive Becoming Less Defensive Global Sector Allocation: Gradually Becoming Less Defensive GAA’s sector portfolio took profits on its pro-cyclical positioning and went defensive in July 20189 and remained so until the March Monthly update10 when we upgraded Energy and Industrials to overweight from neutral, while downgrading Consumer Staples two notches to underweight from overweight (Chart 19). The upgrade of Industrials was mainly a hedge against further acceleration in China’s credit growth. But why did we upgrade Energy to overweight yet maintained an underweight in Materials? Long-term GAA clients know that, in terms of global sector allocation, we have structurally favored the oil-related Energy sector to the metals-related Materials sector since October 2016, because oil supply/demand is more global in nature while the supply/demand of metals, especially industrial metals, is closely linked to China (see also the Commodity section of this Quarterly on page 18). From a cyclical perspective, the relative performance of the two sectors has historically closely correlated with the relative prices of oil and metals, as shown in panel 2. This is not surprising because changes in forward earnings for the two sectors are also closely linked to change in the corresponding commodity prices (panels 3 and 4). BCA’s Commodity and Energy Strategy service has an overweight rating on oil and a neutral stance on metals, implying that the growth in the oil price will outpace that of metal prices, which suggests that the Energy sector will outperform the Materials sector (panel 2).   Government Bonds Maintain Slight Underweight On Duration. Global equities have recovered 16% since reaching the low of 2018 on December 24, yet the global bond yield has decreased by 21 bps over the same period. While the directional movement of bond yields is somewhat puzzling given such strong performance in equities (see page 7 for some explanations), it’s evident that the bond markets have been driven by the recent weakness in global growth (Chart 20, panel 3), and are pricing out any expectation of rate hikes over the coming year in major developed economies. Given the surprisingly dovish tone at the March FOMC meeting and BCA’s House View that global economic growth will rebound in the second half, bond yields are now highly exposed to any hawkish shift in central bank policies and any recovery in inflation expectations. As such, it’s still appropriate to maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Depressed inflation expectations have been one reason why global bond yields have decoupled from equities. However, the crude oil price, which closely correlates with inflation expectations, has stabilized. BCA’s Commodity & Energy Strategy service expects Brent crude to end 2019 at US$75 per barrel (Chart 21). This implies a significant rise in inflation expectations in the second half of the year, supporting our preference for inflation-linked bonds over nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest “buying TIPS on dips”. Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive versus their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Chart 20Rates: Likely More Upside Risk Rates: Likely More Upside Risk Rates: Likely More Upside Risk Chart 21Favor Inflation Linkers Favor Inflation Linkers Favor Inflation Linkers   Corporate Bonds Chart 22Tactical Upside Remains For Credit Tactical Upside Remains For Credit Tactical Upside Remains For Credit In February, we raised credit to overweight within a fixed-income portfolio while underweighting government bonds. So far, this has proven to be the right decision, as corporate bonds have generated excess returns of 90 basis points over duration-matched Treasuries. We based our positioning on the mounting evidence that global growth is turning up: credit impulses are starting to rebound in several major economies, monetary conditions have eased, and our diffusion index of global leading indicators has rebounded sharply, indicating that there remains tactical upside for global credit (Chart 22– panel 1 and 2). When will we close our tactical overweight? Our U.S. Bond Strategy Service has set a target for spreads of U.S. corporate bonds with different credit ratings. According to their targets, which denote the median spread typical of late-cycle environments, there is still some room for further spread compression in non-AAA credits (Chart 22 – panel 3 and 4). However, the upside is limited and, if spreads keep tightening, we will probably close our position by the end of Q2. On a cyclical horizon, the fundamentals of corporate health are still a headwind, with both the interest-coverage and liquidity ratio for U.S. investment-grade corporates standing near 10-year lows.11 Moreover, we expect these ratios to deteriorate further, as corporate profits will likely come under pressure due to increasing wage growth. Finally, we expect that the Fed will turn more hawkish by the end of 2019, turning monetary policy from a tailwind to a headwind. Thus, we recommend investors to remain overweight, but be ready to turn bearish in the back end of the year.   Commodities Chart 23Prefer Oil, Watch Metals Prefer Oil, Watch Metals Prefer Oil, Watch Metals Energy (Overweight): Stable demand, declining Venezuelan production due to U.S. sanctions, instability and possible outages in Libya, Iraq, and Nigeria, alongside the GCC’s commitment to cut output through year-end, should support oil prices and allow further upside (Chart 23, panels 1 & 2). While U.S. crude production is on the rise, bottlenecks in its export capabilities should limit market oversupply. Crude supply shocks should outweigh any slowdown in demand, specifically from emerging markets. BCA’s energy strategists expect Brent to average $75 and $80 throughout 2019 and 2020 respectively, and for the gap between WTI and Brent to narrow significantly. Industrial Metals (Neutral): China, the world’s largest consumer, still plays a big role in the direction of industrial metals. Year-to-date, metals prices have been supported partly by a more stable dollar. For now, we maintain a neutral stance until we see confirmation that Chinese stimulus will trigger further upside to metal prices perhaps in the second half. However, a lack of sustained Chinese demand, alongside weaker global growth over the next few months, would weigh down on metal prices (panel 3). Precious Metals (Neutral): Gold has reversed its downslide and rallied by over 10% from its Q4 2018 low. With the market pricing out any Fed rate hikes this year, rising inflation expectations, a weaker USD by year-end, and lower real rates should help gold outperform other commodities in this late-cycle phase. We recommend an allocation to gold as an inflation hedge, as well as a hedge against geopolitical risks (panel 4).     Currencies Chart 24The End Of The Dollar Bull Market The End Of The Dollar Bull Market The End Of The Dollar Bull Market U.S. Dollar: Our bullish stance on the dollar has proven to be correct, as the trade-weighted dollar has appreciated by 5% in the past 12-months thanks to the slowdown in global growth. However, the two reasons for the growth slowdown – Fed tightening and Chinese deleveraging – have started to ease. On March 20 the Fed revised its forward guidance to no rate hikes in 2019 and only one rate hike in 2020. Meanwhile, Chinese total social financing relative to GDP has bottomed, indicating that Chinese authorities have opted for a pause in their deleveraging campaign (Chart 24, panel 1). These developments will likely boost global growth and hurt the countercyclical greenback. Therefore, we recommend investors to slowly shift to a cyclical underweight on the dollar. Euro: Most of the factors that dragged the euro down last year are fading: political risk in Italy has eased, fiscal policy is moving from a headwind to a tailwind, and the relative LEI between the EU and the US has started to pick up (panel 2). Moreover, we see little scope for euro area monetary policy to turn any more dovish versus the U.S., since forward rate expectations currently stand near 2014 lows (panel 3). Thus, we expect the euro to be one of the best performing currencies this year. Yen: Easy monetary policy by global central banks will boost asset prices and reduce volatility, creating a risk-on environment that is typically negative for the yen (panel 4). Moreover, the IMF still projects Japan to have a negative fiscal drag of 0.7% this year, which will force the BoJ to prolong its yield curve control regime. As a result, we expect the yen to be one of the worst performing currencies this year.       Alternatives Intro: Investors’ allocation to alternatives is on the rise as we get closer to the end of the business cycle along with increasing realized volatility in traditional assets. In the alternatives assets space, we recommend thinking about allocations through three buckets: 1) return enhancers, means of outperforming traditional equity, fixed income, and mixed-asset strategies; 2) inflation hedges, means of preserving capital throughout periods of elevated inflation; and 3) volatility dampeners, means of reducing drawdowns and portfolio volatility during periods of market drawdowns. Return Enhancers: In our July and October 2018 Quarterly reports, we recommended investors trim back on PE allocations and reallocate towards hedge funds. Growing competition in the PE space has pushed up multiples. Given where the business cycle currently is, we favor macro hedge funds, as they tend to outperform in this sort of environment as well as in downturns and recessions (Chart 25, panel 1). Inflation Hedges: In our July 2018 Quarterly, we recommended investors pare back their real estate allocations, given the backdrop of a slowdown/sideways trend in the sector, and specifically within the retail segment. Given that the end of the current cycle is likely to be accompanied by elevated levels of inflation, we recommend clients to modestly allocate to commodity futures on the likelihood of a softer dollar and rising energy prices (panel 2). Volatility Dampeners: We continue to recommend both farmland and timberland since they have lower volatility than other traditional and alternative asset classes (panel 3). While timberland is more impacted by economic growth via the housing market, farmland has a near-zero correlation with economic growth. We do not favor structured products due to their unattractive valuations. Chart 25Prefer Hedge Funds Over Private Equity Prefer Hedge Funds Over Private Equity Prefer Hedge Funds Over Private Equity   Risks To Our View Our economic outlook is quite sanguine. What would undermine this scenario? Many investors have become nervous about the inversion of the U.S. yield curve. And we have shown in the past that an inversion of the 3-month/10-year yield curve has been a reliable indicator of recessions 12-18 months ahead.12 Its inversion in March, then, is a concern. But note that the indicator works only using a three-month moving average (Chart 26); the curve often inverted for a brief period without signaling recession. We expect long-term rates to rise from here, steepening the curve. But a prolongation of the current inversion would clearly be a worrying signal. The direction of China continues to play a key role in defining the macro picture. Our current allocation is based on the view that China is doing some monetary and fiscal stimulus but that, at the current pace, it will be much smaller than in 2016 (Chart 27). The weak response of money supply growth suggests, as Premier Li Keqiang has complained, that the liquidity is mostly going into speculation (note that A-shares have risen by 20% this year) rather than into the real economy. The March Total Social Financing data, released in mid-April, will give a better read of the degree of the reflation. If it is bigger than we expect, this would suggest a quicker shift into euro area and Emerging Market equities than we currently advocate. The U.S. dollar remains a key driver of asset allocation. The dollar is a counter-cyclical currency and, with global growth slowing, has continued to appreciate moderately this year (Chart 28). We see a weakening of the dollar later this year, when global growth picks up. But if this were to happen more quickly or dramatically than we expect – not impossible given the currency’s over-valuation and crowded long-dollar positions – EM stocks and commodity prices, given their strong inverse correlation with the dollar, could bounce sharply. Chart 26Yield Curve Inversion Yield Curve Inversion Yield Curve Inversion Chart 27How Much Is China Reflating? How Much Is China Reflating? How Much Is China Reflating? Chart 28Dollar Is Counter-Cyclical Dollar Is Counter-Cyclical Dollar Is Counter-Cyclical   Garry Evans, Chief Global Asset Allocation Strategist garry@bcaresearch.com Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com Juan Manuel Correa Ossa, Senior Analyst juanc@bcaresearch.com Amr Hanafy,  Research Associate amrh@bcaresearch.com   Footnotes 1      Please see the Equities Section of this Quarterly on page 14 for more details. 2      Please see Global Asset Allocation “GAA Quarterly,” dated March 31, 2016 available at gaa.bcaresearch.com 3       Please see https://us.spindices.com/documents/methodologies/methodology-sp-us-style.pdf 4       Please see Global Asset Allocation “Monthly - January 2019,” dated January 2, 2019 available at gaa.bcaresearch.com 5     Please see Global Asset Allocation “Monthly - March 2019,” dated March 1, 2019 available at gaa.bcaresearch.com 6       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 7       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 8       Please see Global Investment Strategy Weekly Report, “What’s Next For The Dollar?” dated March 15, 2019  available at gis. bcaresearch.com 9       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 10    Please see Global Asset Allocation “Monthly Portfolio Update,” dated March 1, 2019 available at gaa.bcaresearch.com 11    Based on BCA’s Global Fixed Income Strategy’s bottom-up health monitor. 12   Please see Global Asset Allocation Special Report, “Can Asset Allocators Rely On Yield Curves?” dated June 15, 2018 available at gaa.bcaresearch.com GAA Asset Allocation

Dear Client, I had the pleasure of participating in the Affin Hwang Capital conference in Kuala Lumpur on November 8th. In addition to sharing my views on today's macro environment, I discussed BCA's recent successes in developing quant-based solutions for bottom-up stock picking and market timing. I have transcribed my remarks on the latter topic below. Best regards, Peter Berezin, Chief Global Strategist Feature The Arithmetic Of Active Management Every active investor wants to outperform the market. Unfortunately, just like everyone cannot be above-average in height, beauty, or intelligence, not every investor can outperform their benchmark. I think very few people in the audience would dispute this assertion. What could be more surprising to some of you is the following claim, which is that active investors as a group will always underperform the market. I say this not because I have any ill will towards active investors. I'm an active investor myself. I say this simply because it is a mathematical tautology. As Bill Sharpe has emphasized, the market return is simply the weighted average of the returns that passive and active investors earn before fees.1 The passive return must, by definition, equal the market return. This necessarily implies that the average active return must also equal the market return. Since active investors incur higher costs than passive investors, the former group will always underperform the latter group on average. That's the bad news. The good news is that not all active investors are the same. Some are better than others, and while it is not easy, it is possible to isolate certain strategies that active managers employ that help them outperform the market. Before I discuss these strategies, let me make a generic point, which is that most so-called active investors are not particularly active. In fact, according to one academic paper, the fraction of truly active investors - those whose returns deviate significantly from the market benchmark - shrank from 60% in 1980 to less than 20% in 2009 (Chart 1). In contrast to active investors whose portfolio returns broadly mimic the market's, genuinely active investors typically outperform their benchmarks (Chart 2).2 Chart 1How Active Are Active Investors? Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing Chart 2Active Stock Pickers Outperform Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing What are successful active investors doing to beat their benchmark? Well, first of all, let me tell you what they are not doing: They are not taking on more risk. Don't Bet On Beta Chart 3 shows that there is no clear relationship between a stock's beta and its expected return.3 To those familiar with the CAPM model, this may be surprising. The CAPM model predicts that higher-beta stocks will earn superior returns because they are riskier. High-beta stocks outperform the market when the market is going up, but underperform the market when it is going down. Since the market tends to go up more often than it goes down, the expected return to high-beta stocks should exceed the expected return to low-beta stocks. Chart 3Don't Bet On Beta Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing As I will discuss, the reason this theoretical prediction is refuted by the empirical evidence is because the market is rife with inefficiencies. What is more, these inefficiencies reflect pervasive institutional and behavioral biases that are engrained within the market's very own DNA. Active managers who understand these biases can exploit them to outperform their benchmarks. Let me start with the former: institutional biases. The investment industry often encourages a "heads I win, tails you lose" mentality: If a fund manager takes on a lot of risk and gets lucky, he or she will be well remunerated; if the manager is unlucky, he or she may have to look for a new job, but the primary losers will be the clients of the fund. Such an incentive structure encourages managers to take on excessive risk by purchasing, among other things, high-beta stocks. This bids up the price of these stocks to the point where they no longer offer enough additional return to compensate for their higher risk. Size And Value If buying high-beta stocks simply adds more risk without generating more reward, what types of stocks do outperform the market on a risk-adjusted basis? Much of the early academic literature focused on two factors: size and value. Historically, it has been the case that small caps and value stocks have outperformed large caps and growth stocks. Some academics have offered risk-based explanations for the size and value effects. Personally, I find these explanations unconvincing, especially in the case of value stocks. The main problem with risk-based arguments is that they fail to convincingly identify the nature of the risk that investors who purchase value stocks are being compensated for. It is certainly not market risk - value stocks tend to be low beta (Chart 4). Revealingly, companies that do face greater existential risks - those that have high levels of debt relative to equity, for example - tend to underperform the market.4 This is exactly the opposite of what risk-based arguments would predict. Chart 4Value Tends To Outperform Growth When The Stock Market Is Falling Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing The presence of market inefficiencies provides a more compelling explanation for why small caps and value stocks outperform. Consider two companies, identical in every way except that one has a lower market capitalization than the other. Since the only difference between the two companies is the price of their shares, the "cheaper" company will generate higher returns for shareholders over the long haul. The cheaper, smaller capitalization company will also initially trade at a lower price-to-earnings and price-to-book ratio. In other words, it will look more like a small cap value stock. Thus, it is not necessary to invoke complex, risk-based explanations for why small caps and value stock outperform. It is exactly what one would expect if markets are not perfectly efficient. Ignore The Analysts? Of course, some stocks are cheap for a reason. How can we distinguish between hidden gems and fool's gold? Wall Street is populated with thousands of analysts paid to make that determination. But are they any good? For the most part, the answer is no. Chart 5 shows analysts' published earnings forecasts versus realized earnings growth. Analysts have had some success at predicting earnings growth over a one-to-two year horizon, but are almost useless over a five-year horizon.5 In fact, large cap companies favoured by analysts tend to underperform companies that analysts pan. Chart 5A Mug's Game Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing There are two exceptions to this rule. The first applies to small caps. Since many smaller companies are not widely followed, analysts that do follow them often add significant value. Unlike their large cap brethren, small cap stocks with buy recommendations tend to outperform stocks with sell recommendations. Second, changes in analyst recommendations do predict returns. Stocks that have recently been upgraded tend to outperform those that have recently been downgraded.6 Insiders And Short Interest How about insiders? Here, the data suggests that insiders know what they are doing. The shares of companies with a lot of insider buying tend to rise more than those that have experienced insider selling. Short interest also predicts returns. Heavily-shorted companies tend to underperform companies that have attracted few short sellers. Combining data on insider activity and short interest can help supercharge returns. Chart 6 shows the highest returns are earned when insiders are buying and short interest is decreasing.7 The worst-performing stocks end up belonging to companies where insiders are heavy sellers and short interest has risen over the prior 12 months. Chart 6Prefer Stocks Where Insiders Are Buying And Short Interest Is Falling Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing Mo' Money What about technical analysis? The academic literature on this topic is a mixed bag, with some studies deeming it useless and others suggesting it can be useful in certain situations. For most technical indicators, the noise-to-signal ratio is very high. Nevertheless, some technical indicators are worth following. Momentum is one of them (Chart 7). Over short-term horizons of about one month, mean reversion prevails - stocks that did well over the prior month tend to do poorly during the subsequent month. In contrast, over medium-term horizons of about 12 months, return continuation is the name of the game - stocks that have done well over the last 12 months tend to do well during the subsequent month. Interestingly, at very long time horizons of three-to-five years, mean reversion takes over again: Stocks that have done well over the last five years tend to do poorly over the subsequent month. The implication is that the best stocks are those that have underperformed the market over the past one month and over the past three years, but have outperformed the market over the past 12 months. Chart 7The Three Phases Of Momentum The Three Phases Of Momentum The Three Phases Of Momentum Putting aside the short-term reversal effect which, in practice, is hard to exploit due to trading costs, what are the drivers of the medium-term return continuation effect and the longer-term return reversal effect? I think three factors explain the medium-term return continuation effect. The first is institutional inertia. A large money manager cannot instantly jump in and out of a position. It may take many months to build a position to its desired size and just as much time to liquidate it. Persistent buying and selling generates momentum in equity returns. The second factor is imperfect information. A lot of the return continuation effect occurs around the time of earnings reports. If a company reports better-than-expected earnings, its stock goes up. As others hear about and process the good news, the stock usually continues to advance over the subsequent days. The third factor is behavioral biases. People tend to be quite eager to lock in gains but are usually reluctant to realize losses. When a company reports good news, investors are too quick to sell. This premature selling prevents the stock price from rising to its fair value instantaneously. During the time it takes the stock to reach fair value, the share price displays upward momentum. Conversely, when the company reports bad news, investors avoid taking losses, hoping instead that some miracle will bail them out. The lack of willing sellers prevents the stock from falling to its fair value immediately. In the time it takes investors to come to terms with the fact that a miracle is not forthcoming, the share price displays downward momentum. What about the longer-term return-reversal effect? Ironically, it is probably a function of the medium-term return continuation effect. Upward momentum attracts interest from trend-following investors. People who sold too early or never got in from the beginning kick themselves and look for the slightest dip to buy. All this buying interest eventually pushes the stock price above its fair value, setting the stage for a prolonged period of subpar returns. Anomalies Abound Let me briefly mention a few other factors that predict equity returns. Share turnover is one of them. Investors often presume that high turnover is intrinsically a good thing. Terms such as "healthy volume" abound. The truth is that companies with low rates of share turnover actually outperform the market, all things equal.8 Part of this outperformance reflects a liquidity premium. Part of it may also simply reflect the fact that undervalued companies often hide in the shadows of the market, away from the spotlight. There are also balance sheet and earnings quality factors that are worth highlighting. I already mentioned that companies with high debt-to-equity ratios tend to underperform the market on a risk-adjusted basis. It is also true that companies with high accruals - firms that fail to convert most of their earnings into cash flow - underperform the market. More surprisingly, companies whose assets have been growing very quickly also tend to underperform the market. Such asset growth often ends up reflecting empire building rather than prudent corporate management. Relatedly, a significant dispersion in analyst earnings estimates is often a red flag.9 Companies with something good to say usually say it. Companies that do not have much good to say often clam up, leading to greater uncertainty about their earnings prospects. When analysts have little visibility on what earnings a company is poised to deliver, be careful. Picking Stocks With ETS I have discussed a variety of factors that help predict the performance of individual stocks. There are dozens of others that I could have mentioned but did not. Clearly, successful bottom-up investing requires that one sort through a lot of information. What one would like is a system that distills all this information into a single score that ranks stocks from best to worst. The ideal system should dynamically adjust factor weightings to account for the fact that there is momentum in factor returns. For example, if value stocks have recently been doing well, they are likely to continue to do well. At BCA Research, we have constructed our Equity Trading Strategy (ETS) to do just that.10 Chart 8 shows the backtested returns of the ETS model. As you can see, they are quite impressive. Chart 8ETS Model Back Tested Performance To Date Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing I have been personally trading a variant of the ETS model for the past 18 years and once wrote a blog chronicling the journey.11 I have added a line in the chart that shows my own personal performance on a pre-tax basis inclusive of brokerage commissions and other trading costs. I typically hold about 30 to 50 stocks. Except in very rare cases, I don't let any single stock exceed five percent of my portfolio. I normally hold a cash cushion of about 10%-to-15%, although occasionally, as in late 2008/early 2009, I have bought stocks on margin. I have lost a lot of money shorting stocks, so I rarely do it. I am not sure how lucky I have been over the years or how scalable my results are - I generally invest only in small cap companies that most money managers would not touch. But it does give you a sense of what is possible with this system. Market Timing With MacroQuant Of course, stock selection is only one half of a successful investment formula. The other half is market-timing - knowing when to scale back or increase exposure to the stock market. That's where our soon-to-be-released MacroQuant model comes in. The model uses over 100 variables on the economy, financial and monetary conditions, sentiment, and valuations to predict the direction of the stock market. Chart 9 shows the back-tested performance of the model. Chart 9MacroQuant* Model Suggests Caution Is Warranted Quant-Based Approaches To Stock Selection And Market Timing Quant-Based Approaches To Stock Selection And Market Timing What is MacroQuant saying today? The signal from the model moved into bearish territory in the lead up to October's correction and continues to flag downside risks to stocks. This is mainly because the leading economic data has softened outside the United States, and more recently, in the U.S. itself. Financial conditions have also tightened on the back of rising bond yields, wider credit spreads, and a stronger dollar. Sentiment enters our model in both level and directional terms. We have found that the best configuration for stocks is when sentiment is bearish but improving while the worst configuration is when sentiment is bullish but deteriorating. Going into October, sentiment began to slip from very bullish levels, which was a warning sign for stocks. Valuations have improved over the past month, but still remain somewhat stretched by historic standards. We do not believe that we are at the beginning of a bear market in stocks. However, our model does suggest that the correction may have further to run. With that, let me conclude my formal remarks, and open it up to questions. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 William F. Sharpe, "The Arithmetic of Active Management," The Financial Analysts Journal 47:1 (January/February 1991): 7-9. 2 Antti Petajisto, "Active Share And Mutual Fund Performance," Financial Analysts Journal 69:4 (July/August 2013): 73-93. 3 Andrea Frazzini And Lasse Heje Pedersen, "Betting Against Beta," Journal Of Financial Economics 111:1 (January 2014): 1-25. 4 John Y. Campbell, Jens Hilscher, and Jan Szilagy, "In Search Of Distress Risk," The Journal of Finance 63:6, (December 2008): 2899-2939. 5 Louis K. C. Chan, Jason Karceski, And Josef Lakonishok, "The Level And Persistence Of Growth Rates," The Journal Of Finance, Vol. 58, No. 2 (2003): 643-684. 6 Ireneus Stanislawek, "Are Stock Recomemndations Useful?"1741 Asset Management Ltd Research Note Series, (IV 2012). 7 Amiyatosh K. Purnanandam, And H. Nejat Seyhun, "Do Short Sellers Trade On Private Information Or False Information?"Journal of Financial and Quantitative Analysis, Vol.53, 3 (2018): 997-1023. 8 Vinay T. Datar, Naik Y. Narayan, and Robert Radcliffe, "Liquidity And Stock Returns: An Alternative Test," Journal of Financial Markets 1:2, (1998): pp. 203-219; and Charles M.C. Lee and Bhaskaran Swaminathan, "Price Momentum And Trading Volume," The Journal of Finance 55:5, (October 2000): 2017-2069. 9 David Veenman and Patrick Verwijmeren, "Earnings Expectations And The Dispersion Anomaly," (January 2015). 10 Please see Global Investment Strategy and Equity Trading Strategy Special Report, "Introducing ETS: A Top-Down Approach To Bottom-Up Stock Picking," dated December 3, 2015. 11 My now-defunct blog, stockcoach.blogspot.com, discussed my real-time trading progress between 2004 and 2007. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

As promised in early September, this is the third installment of our four part Indicators series. In this Special Report, we follow a similar script to Part II but instead of sectors, we now cover the S&P 500, non-financial equities, cyclicals/defensives, small/large and growth/value, and document the most important Indicators in the same four broad categories (where applicable): earnings, financial statement reported data, valuations and technicals. Once again this is by no means exhaustive, but contains a plethora of Indicators we deem significant in aiding us in our decision making process of setting/changing a view on the overall market, cyclicals/defensives portfolio bent, and size and style preference. As a reminder, the charts in this Special Report are also available through BCA's Analytics platform for seamless continual updates. Finally, we are still aiming before the end of 2018, to conclude our Indicators series with Part IV that would feature our most sought after Macro Indicators per the eleven GICS1 S&P 500 sectors, along with value/growth, small/large and cyclicals/defensives. We trust you will find this comprehensive Indicator chartbook useful and insightful. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Dulce Cruz, Senior Analyst dulce@bcaresearch.com S&P 500 Chart 1S&P 500: Earnings Indicators S&P 500: Earnings Indicators S&P 500: Earnings Indicators Chart 2S&P 500: Earnings Indicators S&P 500: Earnings Indicators S&P 500: Earnings Indicators Chart 3S&P 500: ROE And Its Components S&P 500: ROE And Its Components S&P 500: ROE And Its Components Chart 4S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators Chart 5S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators Chart 6S&P 500: Valuation Indicators S&P 500: Valuation Indicators S&P 500: Valuation Indicators Chart 7S&P 500: Technical Indicators S&P 500: Technical Indicators S&P 500: Technical Indicators Non-Financial Broad Market Chart 8U.S. Non-Financial Broad Market: ROE And Its Components U.S. Non-Financial Broad Market: ROE Ant Its Components U.S. Non-Financial Broad Market: ROE Ant Its Components Chart 9U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators Chart 10U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators Chart 11U.S. Non-Financial Broad Market: Valuation Indicators U.S. Non-Financial Broad Market: Valuation Indicators U.S. Non-Financial Broad Market: Valuation Indicators Chart 12U.S. Non-Financial Broad Market: Technical Indicators U.S. Non-Financial Broad Market: Technical Indicators U.S. Non-Financial Broad Market: Technical Indicators S&P Cyclicals Vs. Defensives Chart 13Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Chart 14Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Chart 15Cyclicals Vs Defensives: ROE And Its Components Cyclicals Vs Defensives: ROE And Its Components Cyclicals Vs Defensives: ROE And Its Components Chart 16Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Chart 17Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Chart 18Cyclicals Vs Defensives: Valuation Indicators Cyclicals Vs Defensives: Valuation Indicators Cyclicals Vs Defensives: Valuation Indicators Chart 19Cyclicals Vs Defensives: Technical Indicators Cyclicals Vs Defensives: Technical Indicators Cyclicals Vs Defensives: Technical Indicators S&P 600 Vs. S&P 500 Chart 20S&P 600 Vs.S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators Chart 21S&P 600 Vs.S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators Chart 22S&P 600 Vs.S&P 500: Valuation Indicators S&P 600 Vs S&P 500: Valuation Indicators S&P 600 Vs S&P 500: Valuation Indicators Chart 23S&P 600 Vs.S&P 500: Technical Indicators S&P 600 Vs S&P 500: Technical Indicators S&P 600 Vs S&P 500: Technical Indicators S&P 500 Growth Vs. Value Chart 24S&P 500 Growth Vs.Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators Chart 25S&P 500 Growth Vs.Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators Chart 26S&P 500 Growth Vs Value: Valuation Indicators S&P 500 Growth Vs Value: Valuation Indicators S&P 500 Growth Vs Value: Valuation Indicators Chart 27S&P 500 Growth Vs.Value: Technical Indicators S&P 500 Growth Vs Value: Technical Indicators S&P 500 Growth Vs Value: Technical Indicators Table 1S&P 500 Growth/S&P 500 Value Sector Comparison Table White Paper: U.S. Equity Market Indicators (Part III) White Paper: U.S. Equity Market Indicators (Part III) Table 2S&P 600/S&P 500 Sector Comparison Table White Paper: U.S. Equity Market Indicators (Part III) White Paper: U.S. Equity Market Indicators (Part III)

Highlights Value is the most storied of all the factors discovered by academicians, and some of the most revered investors of all time have been those most closely associated with value investing. Over the nearly 92 years covered by Fama and French's data set, stocks with the highest book-to-price multiples have outperformed the overall market by three percentage points annually, but they have underperformed by two percentage points a year since their pre-financial-crisis peak. Fama and French's top value cohort has spent much of the post-crisis period mired at relative levels it first surpassed in early 2001, leading to whispers that value might be finished. It may take another year or two, but nothing ails value that a good bear market couldn't cure. The most popular value indexes are poor proxies for the value factor identified by Fama and French. We turn to our proprietary Equity Trading Strategy service's model for better insight into the metrics that separate value stocks from the rest of the field. Feature Macro students and investors are captivated by "factors," independent variables that are widely recognized as persistent drivers of equity returns, and BCA researchers are no exception. Although we have little time for the new factor "discoveries" that are accumulating at a rate that might make a bitcoin miner jealous, the established factors - Value, Size, and Momentum - have earned their stripes. We are card-carrying members of Professor Fama and French's fan club, and well-thought-out strategies attempting to harness their insights merit serious consideration. This Special Report updates a Special Report published jointly by our Global ETF Strategy and Equity Trading Strategy (ETS) services in May with insights from a custom value index just created by The Bank Credit Analyst and ETS teams.1 It compares today's popular conceptions of value to the principles of Benjamin Graham, the "father of value investing," and finds that off-the-shelf value indexes fall far short of the value ideal. We seek to answer two questions with far-reaching investment implications: Is value dead? If not, how will investors know when it's about to reclaim its former glory? In our view, value is not dead, it's only sleeping, even if its hibernation is starting to feel like Rip van Winkle's. Although it is not yet time to tilt a portfolio in its direction, the Value factor is alive and well, and simply biding its time until the next bear market and recession. Decomposing value investing's performance across market and policy cycles shows that it edges out the equity universe when policy is easy and bull markets are in force, but crushes it when policy is tight and stocks are in a bear market. The investment strategy conclusion is one with the empirical record: non-dedicated investors should look to value stocks when the weather turns rough. What Is Value? As our ETF and ETS teams lamented in their initial smart-beta ETF selection Special Report,2 the principles established by Benjamin Graham and Fama and French have faded with the passage of time. The essential notion that value is a by-product of temporary dislocations has slipped from popular understanding, making room for a simplistic, one-size-fits-all index-construction method that grants bank stocks lifetime membership. Those who bothered to read Fama and French's paper quickly forgot step one of its methodology, which stated, "We exclude financial firms." Financials' higher debt loads depress their price-to-book multiples relative to their nonfinancial counterparts', making direct comparisons dubious. The result has been to tether off-the-shelf value indexes' relative performance to the relative performance of the Financials sector (Chart 1). Since Tech stocks account for a similarly outsized proportion of the market cap of most growth indexes, value vs. growth boils down to a binary choice between Financials and Tech (Chart 2). Style investing is presumably meant to be something larger than a head-to-head battle between Financials' and Tech's prospective returns. It is certainly a long way away from the margin-of-safety concept that Graham applied to every investment. Chart 1Value Indexes' Permanent Residents Value Indexes' Permanent Residents Value Indexes' Permanent Residents Chart 2In A Standard Index, Value Is To Growth ##br##As Financials Are To Tech In A Standard Index, Value Is To Growth As Financials Are To Tech In A Standard Index, Value Is To Growth As Financials Are To Tech What's The Big Deal? Shorn of the margin-of-safety concept, value investing ceases to provide investors with downside protection. Regardless of the metric(s) used to measure an investor's margin of safety (Graham preferred a multiple of future earnings, conservatively estimated; Fama and French found that trailing book-to-price in isolation best explained subsequent returns), securities bought with a large one provide investors with a cushion against untoward future developments. That cushion is readily apparent in Fama and French's high book-to-price portfolios' performance relative to low book-to-price portfolios', and to the overall equity market (Chart 3): they outperform in bull markets, albeit at a modest pace, but they blast ahead during bear markets and recessions (Table 1). Long bull markets, like the one that was mainly in force from 1982 to 2000, and the current one, which just established a postwar record of over nine-and-a-half years, are a drag on rolling (Chart 3, middle panel) and cumulative returns (Chart 3, bottom panel). Chart 3Making Hay While The Rain Falls Making Hay While The Rain Falls Making Hay While The Rain Falls Table 1Value Portfolio Returns, July 1967 - July 2018 When Will Value Work Again? When Will Value Work Again? By contrast, the S&P 500 Value Index offers very little protection in times of stress, nosing out the broad S&P 500 in the one-seventh of the time a bear market has been in force since its 1975 launch, while lagging the broad index over the other six-sevenths (Table 2). The result is steady underperformance that adds up over time (Chart 4), and mirrors the relative performance of the S&P 500 Financials (Chart 4, bottom panel). Since value investors are conceding performance to growth investors in boom times, they really need to make hay during slumps, which the S&P 500 Value Index has failed to do, outside of the bursting of the dot-com bubble. The empirical record suggests that the main off-the-shelf value index's construction methodology leaves a lot to be desired (Chart 5). Table 2S&P 500 Value Index Returns, ##br##February 1975 - July 2018 When Will Value Work Again? When Will Value Work Again? Chart 4A Simplistic Proxy ... A Simplistic Proxy ... A Simplistic Proxy ... Chart 5... That Can't Hold A Candle To The Real Factor ... That Can't Hold A Candle To The Real Factor ... That Can't Hold A Candle To The Real Factor Building A Better Value Index The standard value indexes have several shortcomings. They are backward-looking, overly reliant on earnings as a cash-flow metric, blind to serial acquirers' accumulation of book-to-market-flattering intangible assets, and oblivious to sector-neutrality's charms. The value metrics in our Equity Trading Strategy (ETS) model correct for all but sector biases. They incorporate forward P/E multiples alongside trailing multiples; they consider cash-flow multiples; and their use of price-to-tangible-book, in place of simple price-to-book, partially corrects for acquirers' cosmetic advantage. Our Bank Credit Analyst colleagues turned to the ETS software to screen for candidates that more fully live up to Graham's value ideal. To combat sector biases, they grouped large- and mid-cap U.S. stocks3 by sector and evaluated their value characteristics only against each other, identifying the top three (value) and bottom three (growth) deciles within individual sector silos. Then and only then did they bring the value and growth pools together into market-wide baskets. Every sector is equally represented in its value and growth indexes, which bring together the best- and worst-value stocks from every sector. The ETS approach, which may do a better job of screening out value traps than simple book-to-price multiples alone, shows promise. The ETS value: growth index has outperformed Fama and French's high-minus-low index by an annualized 4 percentage points over its 22-year life (Chart 6). The ETS index rebalances monthly, making it more costly to track than Fama and French's high-minus-low (HML) index, but does not ride the same Size factor tailwind.4 We estimate that the Size factor contributes more to Fama and French's HML than ignoring commissions contributes to the ETS index. Chart 6Standing On The Shoulders Of Giants Standing On The Shoulders Of Giants Standing On The Shoulders Of Giants When Will Value Regain Its Footing? The Value factor has underperformed the broad market before, but its rolling 10-year returns have never been underwater for so long. Relative to the bottom three deciles of stocks on a book-to-price basis, the top three deciles have spent much of the post-crisis period bumping along a level they first reached in February 2001, when the stock market was in the midst of furiously unwinding the excesses of the dot-com era (Chart 7). Seventeen years of sideways action have emboldened skeptics to suggest that Value might have met its end at the hands of overexposure and increased short-term pressure on professional investors. Chart 7A Historically Long Value Slump A Historically Long Value Slump A Historically Long Value Slump Count us among those who believe Value's demise has been greatly exaggerated. We've seen this movie before - the Value factor posts its strongest relative gains during bear markets and/or recessions - and the last 17 years have been market-friendly away from the crisis, when high book-to-price stocks uncharacteristically underperformed. Consistent with its comfort in adverse conditions, Value has performed best when monetary policy settings are restrictive (Table 3). Policy has now been accommodative for a record 10 consecutive years and counting (Chart 8), subjecting the high book-to-price stocks to a persistent relative headwind. Table 3High-Minus-Low* Annualized Returns By Fed Funds Cycle Phase, August 1961-July 2018 When Will Value Work Again? When Will Value Work Again? Chart 8Easier For Lo-o-o-onger Easier For Lo-o-o-onger Easier For Lo-o-o-onger The policy backdrop may provide the surest route back to Value outperformance. Based on the tight-as-a-drum labor market and budding inflation pressures, we expect the FOMC to maintain its 25-basis-points-a-quarter pace throughout 2019, putting the target fed funds rate on a path to cross our estimate of equilibrium sometime around the middle of next year. Tight policy would be conducive for Value outperformance and potentially plant the seeds for a recession and equity bear market at some point in 2020. As our ETF and ETS teams showed in their review of equity factors and the fed funds rate cycle, countercyclical Value naturally diversifies a portfolio with pro-cyclical Size and Momentum exposures,5 suggesting that Value exposure could be a welcome input to a recession portfolio. Investment Implications Prime time for the Value factor still appears to be a year off, but the time for considering new, or increasing existing, exposures is approaching, and another year of Fed hikes will bring it squarely into view. Value investing will never die as long as significant segments of the investing public pursue instant gratification, or are drawn in by the siren song of potentially supercharged growth opportunities.6 The current cycle is simply extended, and just as it remains appropriate to stick with equities overall, it remains appropriate from a factor perspective to de-emphasize Value in the near term. We remain on the style-investing sidelines, waiting for the next policy-cycle phase. Once it arrives, investors would be well-advised to apply the ETS approach to uncovering the best value candidates for an equity portfolio. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the May 16, 2018 Global ETF Strategy/Equity Trading Strategy Special Report, "Smart-Beta ETF Selection Update - Is Value Still Worth It?" available at etf.bcaresearch.com, and the October 2018 Bank Credit Analyst Special Report, "Is It Time To Buy Value Stocks?," available at www.bcaresearch.com. 2 Please see the February 15, 2017 Global ETF Strategy Special Report, "Smart-Beta ETF Selection, Part I - Value Funds," available at etf.bcaresearch.com. 3 The ETS model draws its index members from the top three deciles of U.S. stocks by market cap. 4 Fama and French's HML index is equally composed of the top three book-to-price (B/P) deciles less the bottom three B/P deciles of the stocks above the median market cap and the top three B/P deciles less the bottom three B/P deciles of stocks below the median market cap. The ETS index is drawn from the largest three deciles of all stocks by market cap. The net effect is for the HML index to include stocks with much smaller market caps than the ETS index, allowing it to derive an added benefit from the Size factor (smaller stocks outperform larger stocks over time). 5 Please see the May 17, 2017 Global ETF Strategy Special Report, "Equity Factors And The Fed Funds Rate Cycle," available at etf.bcaresearch.com. 6 Please see the June 20, 2018 Global ETF Strategy/Equity Trading Strategy Special Report, "Why Anomalies Persist," available at etf.bcaresearch.com.

Per the most commonly referenced growth and value indexes, growth has been outperforming value for over 11 years, the longest stretch in the history of the series. Growth's extended winning streak has split investors into two camps: those who believe that value is finished because of overexposure and shortened investor timeframes, and those who are trying to identify the point at which reversion to the mean will ensue. In this Special Report, we argue that the traditional off-the-shelf indexes are poor proxies for true value. Their methodology strays quite far from the principles enumerated by Benjamin Graham, the father of value investing, and Fama and French, the researchers who demonstrated that lower-priced stocks have outperformed over time. The headline S&P 500 indexes currently differentiate between growth and value stocks using simplistic metrics that introduce considerable sector bias, reducing the difference between growth and value to a binary choice between Tech and Financials. Using tools developed by BCA's Equity Trading Strategy service, we create sector-neutral U.S. value and growth indexes that correct for the off-the-shelf indexes' flaws, and broaden the range of metrics Fama and French employed to make style distinctions. The ETS-derived indexes appear to better distinguish between value and growth stocks. The ETS value-versus-growth portfolio beat its Fama and French counterpart by four percentage points annually over its 22-year life. We join our custom value and growth indexes to Fama and French's to study the impact of macro variables on relative style performance over time for the purpose of gaining insight into the most opportune points to shift between styles. Relative style performance has not corresponded consistently or robustly enough with the business cycle, inflation, interest rates, or broad market direction to support reliable style-decision rules. We find that monetary policy settings, as defined by our stylized fed funds rate cycle, are a consistently reliable predictor of relative style performance. Per the fed funds rate cycle, tight policy is most conducive to value outperformance. From this perspective, value's decade-long slump is not a surprise, given that the ultra-accommodative tide has been lifting all boats. There is no rush to increase value exposure while policy remains easy, but investors should look to load up on value once policy becomes tight, using the metrics in our ETS model to identify true value stocks. We expect that the policy inflection will occur sometime in the second half of 2019, or the first half of 2020. Growth stocks have been on a tear for the longest stretch in the history of the series, based on the most commonly referenced growth and value indexes, even if their gains haven't yet matched the magnitude of the 1990s (Chart II-1). It is no surprise, then, that growth stocks are as expensive as they have ever been, outside of the tech-bubble era in the late 1990s. Many investors are thus wondering if the next "big trade" is to bet on an extended reversion to the mean during which value regains the ground it has given up. Chart II-1A Lost Decade For Value Stocks A Lost Decade For Value Stocks A Lost Decade For Value Stocks In this Special Report, we argue that the traditional off-the-shelf indexes are not very good at differentiating growth from value stocks. Trends in relative performance have much more to do with sector performance than intrinsic value, making the indexes a poor proxy for investors who are truly interested in selecting stocks based on their value and growth profiles. We create U.S. value and growth indexes that are unaffected by sector performance, using stock selection software provided by BCA's Equity Trading Strategy service. The results will surprise readers who are used to dealing with canned measures of value and growth. What Is Value Investing? Value investing principles have been around at least since the days when Benjamin Graham was a money manager himself. Style investing has been a part of the asset-management lexicon for four decades. Yet there is no universally agreed-upon definition of a value stock versus a growth stock. Based on our reading of Graham's Intelligent Investor, we submit that an essential element of value investing is the identification of stocks that are temporarily trading below their intrinsic value. The temporary drag may persist for a while - stock markets can remain oblivious to fundamentals for extended stretches - but it is ultimately expected to dissipate. Value investing is a play on negative overreaction or neglect, and dedicated value investors have to be contrarians, not to mention contrarians with strong stomachs. The temporary nature of undervaluation is a recurring theme in Graham's book. The stock market's ever-present proclivity toward overreaction ensures a steady supply of value opportunities: "The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.1" "[W]hen an individual company ... begins to lose ground in the economy, Wall Street is quick to assume that its future is entirely hopeless and it should be avoided at any price.2" "[T]he outstanding characteristic of the stock market is its tendency to react excessively to favorable and unfavorable influences.3" Graham viewed security analysis as the comparison of an issue's market price to its intrinsic value. He advised buying stocks only when they trade at a discount to intrinsic value, offering an investor a "margin of safety" that should guard against significant declines. His favorite measure for assessing intrinsic value was a sober, objective estimate of average future earnings, grossed-up by an appropriate multiple. A low price-to-average-earnings ratio was the linchpin of his margin-of-safety mantra. Decades after Graham's heyday, University of Chicago professors Eugene Fama and Kenneth French bestowed the academy's seal of approval on value investing. Their landmark 1992 paper found that low price-to-book ("P/B") stocks consistently and convincingly outperformed high P/B stocks.4 Several "growth" and "value" indexes have been developed over the years, but they bear no more than a passing resemblance to Graham's, and Fama and French's, work. It is important to realize that the off-the-shelf indexes are far from an ideal proxy for the value factor that Fama & French tried to isolate. Traditional Growth And Value Indexes Are Wanting The off-the-shelf growth and value indexes shown in Chart II-1 all share similar cyclical profiles, with only small differences in long-term returns. Given the similarity of the indexes, we will focus on Standard & Poor's/Citigroup methodology for the purposes of this report.5 The headline S&P 500 indexes currently differentiate between growth and value stocks using the following metrics: 3-year growth rates in EPS, 3-year growth rates in sales-per-share, and 12-month price momentum; along with valuation yardsticks including price-to-book, price-to-earnings, and price-to-sales. Companies with higher growth rates in earnings and sales, and better price momentum, are classified as growth stocks, while those with lower valuation multiples are considered value stocks. Several stocks are cross-listed in both indexes, which is baffling and counterproductive for an investor seeking to implement a rigorous style tilt.6 Table II-1 contains a summary of the current sector breakdowns for the S&P 500 Growth and Value indexes. Table II-2 sheds light on each index's aggregate geographical and U.S. business cycle exposure, the former of which is based on our U.S. Equity Strategy service's judgment. Table II-1Current S&P 500 Style Index Exposures October 2018 October 2018 Table II-2The Value Index Has Less Global ##br##And Late Cyclical Exposure October 2018 October 2018 Growth is currently heavily weighted in Health Care, Technology and Consumer Discretionary sectors, while value has a high concentration of Financials, Energy and Consumer Staples (Table II-1). Table II-2 shows that the growth index has a clear current bias toward sectors with global economic exposure that typically outperform the broad equity market late in the business cycle. The value benchmark flips growth's global/domestic exposure, and has slightly more exposure to defensive sectors, while splitting its cyclical exposure evenly between early and late cyclicals. Sector Dominance Unfortunately, the reigning methodology creates a major problem - shifts in the relative performance of growth and value indexes are dominated by sector performance. Financials' higher debt loads, and banks' low-margin operations, depress their multiples relative to nonfinancial firms. Thus, Financials hold permanent residency in the off-the-shelf value indexes. Conversely, Tech stocks perennially account for an outsized proportion of most growth indexes' market cap. Value-versus-growth boils down to a binary choice between Financials and Tech.7 The growth/value price ratio has closely tracked the Technology/Financials price ratio since the late 1990s (Chart II-2, top panel). The correlation was much less evident before 1995, when Tech stocks accounted for a much smaller share of market capitalization. Chart II-3 demonstrates that the positive correlation between growth/value and Tech has steadily climbed over the decades to almost 1, while the correlation with Financials has become increasingly negative (currently at -0.75). Chart II-2The S&P 500 Style Indexes Merely Mimic Relative Sector Performance The S&P 500 Style Indexes Merely Mimic Relative Sector Performance The S&P 500 Style Indexes Merely Mimic Relative Sector Performance Chart II-3Style Capture Style Capture Style Capture In contrast, the Fama/French approach, which focuses exclusively on price-to-book while ensuring equal representation for large- and small-market-cap stocks, appears much less affected by sector skews; the growth/value index created from their data has not tracked the Tech/Financials ratio, even after 1995 (Chart II-2, second panel). Moreover, note that the extended downward trend in the Fama/French growth/value ratio is consistent with other academic research that shows that value stocks outperform growth over the long-term. The off-the-shelf indexes show the opposite, but that is because they are merely tracking the long-term outperformance of Tech relative to Financials. The bottom line is that the standard indexes incorporate flawed measures of growth and value that limit their usefulness for true style investing. Conventional Wisdom With respect to style investing and the economic cycle, the prevailing conventional wisdom holds that: Inflation - Growth stocks perform best during times of disinflation and persistently low inflation, whereas value stocks perform best during periods of accelerating inflation; Interest Rates - Periods of high and rising interest rates favor value stocks at the expense of growth; and Business Cycle - It is believed that growth stocks outperform value during recessions, because the latter tend to be more highly leveraged to the economic cycle than their growth counterparts. According to the conventional view, value stocks shine in the early and middle phases of a business cycle expansion. Growth stocks return to favor again in the late states of an expansion, when investors begin to worry about the pending end to the business cycle and are looking for reliable and consistent earnings growth. Do the traditional measures of growth and value corroborate this conventional wisdom? Chart II-4 shows that the S&P value/growth index and headline CPI inflation have both trended lower since the early 1980s, but there has been no tendency for value to outperform when inflation rises. Value has shown some tendency to outperform during rising-rate phases since the mid-1980s, but the relationship with the level of the fed funds rate is stronger than its direction, as we discuss below. The growth-over-value relationship with the business cycle is complicated by the tech bubble in the late 1990s, which heavily distorted relative sector performance. The Citigroup measure of growth began to outperform very late in the cycle and through the subsequent recession in some business cycles (1979-1981, 1989-1991, and 2007-2009; Chart II-5). The early and middle parts of the cycles, however, were a mixed bag. Chart II-4Spiting The Conventional Wisdom Spiting The Conventional Wisdom Spiting The Conventional Wisdom Chart II-5No Consistent Relationship With The Business Cycle No Consistent Relationship With The Business Cycle No Consistent Relationship With The Business Cycle The bottom line is that there appears to be some rough correspondence between the Citigroup index and the interest rate and growth cycles, but it is too variable to point to reliable rules for shifting between styles. Ultimately, determining the direction of the growth and value indexes is more about forecasting relative Tech and Financials performance than it is about identifying cheap stocks. A Better Value Approach We identify four broad shortcomings of off-the-shelf value indexes: They exclusively use trailing multiples, a rear-view mirror metric. They rely on simple price-to-book multiples, which flatter serial acquirers. They rely entirely on reported earnings, which are an imperfect proxy for cash flow. A share of stock ultimately represents a claim on its issuer's future cash flows. They make no attempt to place relative metrics into historical context. Without a mechanism to compare a particular segment's valuation relative to its history, structurally low-multiple stocks will be over-represented and structurally high-multiple stocks will be under-represented. BCA's Equity Trading Strategy (ETS) platform provides a way of differentiating value from growth stocks that avoids these problems. The web-based platform uses 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top decile of stocks ranked using the "BCA Score" methodology has outperformed stocks in the bottom decile by over 25% a year. The overall BCA Score includes all 24 factors when ranking stocks, but to develop our custom value index, we use only the five valuation measures in the ETS database: trailing P/E, forward P/E, price-to-tangible-book, price-to-sales and price-to-cash flow. Every quarter we rank the stocks within each of the 11 sectors based on an equally-weighted composite of the five valuation measures. Note that we are using the data to rank stocks only against other stocks in the same sector. We calculate the total return from owning the top 30% of stocks by value in each sector. We do the same with the bottom 30% and refer to this as our "growth" index.8 We then compute an equally-weighted average of the total returns for the growth indexes across the 11 sectors. We do the same for the value indexes. By comparing stock valuation only to other stocks in the same sector, this approach avoids the sector composition problem suffered by the off-the-shelf measures. Chart II-6 compares the ETS value/growth total return index to the Fama/French value/growth index. Data limitations preclude comparing the two measures before 1996, but the ETS index confirms the Fama/French result that value trumps growth over the long term. The ETS index follows a similar cyclical profile to the Fama/French index from 1997 to 2009, rising and falling in tandem. The two series subsequently diverge: per the criteria ETS uses to identify value and construct an index, lower-priced stocks have outperformed higher-priced ones for most of this expansion, while the Fama/French methodology suggests the reverse. Chart II-6The ETS Model Builds On Fama And French's Work The ETS Model Builds On Fama And French's Work The ETS Model Builds On Fama And French's Work By avoiding sector composition problems and using a wider variety of value measures, the ETS approach appears to be a superior measure of value. An investor that consistently over-weighted value stocks according to the ETS approach would have outperformed someone who did the same using the Fama methodology by an annual average of four percentage points from 1996 to 2018. The history of our ETS index only covers two recessions, limiting our ability to gauge its performance vis-Ã -vis a variety of macro factors, so we extend the ETS index back to 1926 using the Fama/French index. While joining two indexes with different methodologies is less than ideal, we feel the drawbacks are outweighed by the benefit of observing growth and value relative performance across more business cycles. The top panel of Chart II-7 shows U.S. real GDP growth, shaded for recessions. The bottom panel presents our extended ETS value/growth index, shaded for declines of more than 10%. The shaded periods overlap in many, but not all, cycles (indicated by circles in the chart). That is, growth stocks have tended to outperform during economic downturns, although this is not a hard-and-fast rule. Chart II-7No Hard-And-Fast Relationship With The Business Cycle... No Hard-And-Fast Relationship With The Business Cycle... No Hard-And-Fast Relationship With The Business Cycle... Value-over-growth relative returns exhibit some directionality with the overall equity market when looking at corrections (peak-to-trough declines of at least 10%, as shaded in the top panel of Chart II-8), though it should be noted that it is nearly impossible to flag a correction in advance. The relationship weakens when considering bear markets, i.e. peak-to-trough declines of at least 20%, which can be forecast with at least some reliability.9 The bottom panel is the same as in Chart II-7; the extended ETS index, shaded for periods of significant value stock underperformance. The correspondence between the shaded periods is hardly perfect, and there does not appear to be a practical style exposure message, even if an investor could call corrections in advance. Chart II-8...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years ...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years ...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years Valuation Relative valuation also provides some useful information on positioning, though it is not always timely. Chart II-9 presents an aggregate valuation measure for the stocks in our value index relative to that of the stocks in our growth index. Value stocks are expensive relative to growth when the valuation indicator is above +1 standard deviation, and value is cheap when the indicator is less than -1 standard deviation. Historically, investors would have profited if they had over-weighted value stocks when the valuation indicator reached the threshold of undervaluation, although subsequent outperformance was delayed by as much as a year in two episodes. In contrast, the valuation indicator is not useful as a 'sell' signal for value stocks because they can remain overvalued for long periods. Value was overvalued relative to growth for much of the time between 2009 and 2016. Value stocks have cheapened since then, although they have yet to reach the undervaluation threshold. The Fed Funds Rate Cycle While relative style performance may generally lean in one direction or another in conjunction with the business cycle, inflation, interest rates, or broad equity-market performance, there are no hard-and-fast rules. It is difficult to formulate any sort of rotation view between styles, and history does not inspire confidence that any such rule would generate material outperformance. The monetary policy backdrop offers a path forward. We have found the fed funds rate cycle offers a consistent guide to equity and bond returns in other contexts, and our Global ETF Strategy service has found a robust link between the policy cycle and equity factor performance.10 We segment the fed funds rate cycle into four phases, based on whether or not the Fed is hiking or cutting rates, and whether policy is accommodative or restrictive (Chart II-10). Our judgment of the state of policy is derived from comparing the fed funds rate to our estimate of the equilibrium fed funds rate, the policy rate that neither encourages nor discourages economic activity. Chart II-9Sizeable Undervaluation Flags Turning ##br##Points, But You May Have To Wait A While Sizeable Undervaluation Flags Turning Points, But You May Have To Wait A While Sizeable Undervaluation Flags Turning Points, But You May Have To Wait A While Chart II-10The Fed Funds Rate Cycle October 2018 October 2018 As defined by Fama and French, value stocks outperform growth stocks by a considerable margin when monetary policy is restrictive (Table II-3 and Chart II-11, top panel). Considering value and growth stocks separately, both perform extremely well when policy is easy (Chart II-11, second panel), but growth stocks barely advance when policy is tight, falling far behind their value counterparts. A strategy for generalist investors may be to seek out value exposure when policy is tight, while investing without regard to styles when it is easy. Table II-3The State Of Monetary Policy Is The Best ##br##Guide To Style Performance October 2018 October 2018 Chart II-11The State Of Monetary Policy ##br##Drives Style Performance The State Of Monetary Policy Drives Style Performance The State Of Monetary Policy Drives Style Performance Investment Conclusions: U.S. equity sectors that have traditionally been considered "growth" have outperformed value sectors for an extended period. The long slump has led some investors to argue that value investing is finished, killed by a combination of overexposure and short-term performance imperatives. Other investors see value's long drought as an anomaly, and are looking for the opportune time to bet on a reversal. We are in the latter camp. The difficulty lies in finding an indicator that reliably leads value stocks' outperformance. Most macro measures are unhelpful, though broad market direction offers some insight, as stocks with low price-to-book multiples have outperformed their high-priced peers by a wide margin during bear markets. Bear markets aren't the most useful timing guide, however, because one only knows in retrospect when they begin and end. The monetary policy backdrop holds the most promise as a practical guide. Although our determination of easy or tight policy turns on the modeled estimate of a concept and should not be looked to for absolute precision, it has provided a timely, reliable guide to value outperformance. We expect the relationship will persist because of the cushion provided by less demanding multiples. Earnings and multiples surge when policy is easy, lifting all boats. It is only when policy is tight, and the tide is going out, that the margin of safety offered by lower-priced stocks yields the greatest benefit. Per our estimate of the equilibrium fed funds rate, we are still firmly ensconced within Phase I of the policy rate cycle, and expect that we will remain there until sometime in the second half of 2019. We therefore expect that value, in Fama and French terms, will continue to underperform growth for another year. The clock is ticking for growth, though, as the expansion is in its latter stages and building inflation pressures will likely force the Fed to take a fairly hard line in this rate-hiking cycle. Once monetary policy turns restrictive, investors should hunt for value candidates using a range of valuation metrics, and combine them in a sector-neutral way, as we have via our Equity Trading Strategy service's model. Mark McClellan Senior Vice President The Bank Credit Analyst Doug Peta Senior Vice President U.S. Investment Strategy 1 Graham, Benjamin, The Intelligent Investor, Harper Collins: New York, 2005, p. 97. 2 Ibid, p. 15. 3 Ibid, p. 189. 4 Fama, Eugene F. and French, Kenneth R., "The Cross-Section of Expected Stock Market Returns," The Journal of Finance, Volume 47, Issue 2 (June 1992), pp. 427-465. 5 S&P currently brands its Growth and Value Indexes as S&P 500 Dow Jones Indexes, but Citigroup has the longest history of compiling S&P 500 Growth and Value Indexes, beginning in 1975, so we join the Citigroup S&P 500 style indexes to the Standard & Poor's series to obtain the maximum style-index history. We use the terms Citigroup and S&P interchangeably. 6 The Pure Value and Pure Growth indexes include only the top quartile of value and growth stocks, respectively, with no overlap between indexes, and are therefore better gauges of true style investing. 7 The Tech-versus-Financials cast of the indexes endures because all of the other sectors, ex-regulated Telecoms and Utilities, which account for too little market cap to make a difference, regularly move between the indexes as their fundamental fortunes, and investor appetites, wax and wane. The current Early Cyclical/Late Cyclical/Defensive profiles are not etched in stone and should be expected to shift, perhaps considerably, over time. 8 We created a second growth index by taking the top 30% of stocks ranked by earnings momentum. However, it made little difference to the results, so we will use the bottom 30% of stocks by value as our measure of "growth" for the purposes of this report, consistent with Fama/French methodology. 9 Please see The Bank Credit Analyst. September 2017, available on bca.bcaresearch.com 10 Please see the May 17, 2017 Global ETF Strategy Special Report, "Equity Factors And The Fed Funds Rate Cycle," available at getf.bcaresearch.com.