“I worry now — I look out of the corner of my eye to the ‘94 period,’’ Goldman Sachs’ Lloyd Blankfein noted at a conference in Washington sponsored by the Investment Company Institute. The Federal Reserve increased its benchmark rate 3 percentage points from February 1994 to February 1995, from a then-record-low 3% to 6%. The yield on the 30-year U.S. Treasury bond surged above 8% in late 1994 from below 6% a year earlier. The rate increase and corresponding collapse in bond prices and stock markets caused losses for Wall Street trading desks and investors.
Investors have tended to dump financial issues in periods of rising interest rates on the assumption that the companies’ cost of money will rise faster than the rates they can charge on loans (in the case of banks), and because higher rates choke off demand for financial services in general. In addition, rising rates threaten to push marginal borrowers into default, boosting financial companies’ credit losses and depressing earnings.
We used the features of the Bloodhound System to evaluate certain aspects of 1994 including running historical screens, building simulated portfolios, and searching Bloodhound’s strategy research library for certain performance characteristics during the year. Our data is the most comprehensive point-in-time data available. As such, we have detailed financial and pricing information dating back to 1987. As such, we can competently evaluate the results of 1994 without the benefit of surivorship or forward-looking bias.
Let’s put it all in context. Looking at the index results for the 18 months begining in January 1994, the Fed began raising the Fed Funds rate in February 1994. Treasury yields themselves actually began to rise in October 1993 – approximately five months ahead of the Fed’s move. Between October 1993 and December 1994, the S&P financials index dropped 16%, while the S&P 500 index was off about 5%. We show both the individual monthly returns for the S&P 500, the S&P 400 MidCap, and the S&P 600 Small Cap indicies as well as the cumulative results beginning in February.
The damage to the equity markets was primarily done by November 1994 even though the Fed was not yet complete with its tightening actions.
We searched the Bloodhound Research library to find strategies that returned positive results in 1994. The library is comprised of 10-, 20- and 50- stock strategies. We focused on 50- stock strategies to avoid the likelihood that one or two positions influence the results. Additionally, to measure breadth, we isolated strategies that had 90% winning trade rate in that year.
Six investment strategies emerge. The basis of those strategies which rank with return on equity (ROE 12m) and other profitability measures as well as have hurdle rates based on research & development expenses are naturally building portfolios focused on Healthcare, Technology and other growth names. Although capital may become more scarce in a rising interest rate environment, the effect of rising rates in general has less impact on high growth entities. That played out in 1994. We built portfolios that track certain sectors. We focused on the 50 largest capitalized stocks in the sector. Technology stocks in 1994 (at the forefront of the immergence of the Internet) were the best performers. Healthcare -although trailing by a fair degree – ranked second. Compare that to the other major sectors we follow.
We ran a strategy for the 50 highest ranked stocks solely based on ROE in the last twelve months without the R&D hurdle referenced above. Breaking that down into two portfolios – one with only financial stocks and one with non-financial stocks, the results were compelling. The portfolio of financial stocks was down 9.5% in 1994 whereas the non-financial stock portfolio was up 2.4%. Similarly, asset turnover as a ranking method showed the same pattern. Financial stocks lost 1.1% whereas non-financials returned almost 6%. Conversely, on a value perspective, EV/FCF helped weed out poorer financial performers, but put identified weaker non-financials. Ranking enterprise value to free cash flow from low to high (identifying “cheap” names), resulted in a loss for financial stocks, but to a lessor extent (2.2%). In the non-financial stock group, returns in 1994 were a loss of 7.2%
The following graphical representation of overall equity class returns in 1994 and the bookend years surrounding it tell a similar story. Large Cap and Growth held their own, whereas as Mid and Small Cap and Value names were weaker.
(Source: INVESCO)
As expected, Fixed Income performed the worst in 1994. What did that mean to dividend payors? We looked at four dividend parameters and ranked two 50-stock portfolios (financial and non-financial) on each factor. Like the Value parameter discussed above, the dividend factor helped financial names, but placed the investor in poorer performing non-financials.
The difference in results between the year end payout ratio and the trailing twelve month payout ratio on the financial side is heavily influenced by two small banks that each increased their dividend in the beginning of 1994, but were both acquired during the year. As such, one name was up 45% and the other up 36% – partially skewing the results to the upside. The results suggest dividend-paying stocks were hurt in the interest rate rise. Although wider than the S&P 500’s results, it is not materially different from that of the Mid Cap and Small Cap indicies. Given the criteria of the dividend portfolio includes a minimum threshold of $250 million in market cap as opposed to the much larger threshold of the S&P 500, it appears that dividend paying names performed mostly in-line with the general market. However, if we increase the market cap threshold to $1 billion, the results depend on what ranking factor is used. With Dividend Yield, the larger market cap hurdle puts investors in more energy names, particularly utility names which did not do well in 1994. Conversely, Dividend Payout which places investors in more real estate and other industries returned a loss of 1.1%, which is more in-line with the S&P 500.