Despite projections that the Federal Reserve would relax interest rates in early 2024, the Fed continues to prioritize maintaining price stability. The other side of its dual mandate, promoting full employment, continues to reside on the back burner. A shift in Fed policy to an expansive stance will likely occur when the Fed believes either of the following situations exists, inflation subsides sufficiently to allow for the shift, or weakness in economic conditions warrants positive stimulus. The market consensus, as reflected in fed funds futures prices at July 30, 2024, calls for such a shift in September 2024.
The IFED strategy, which determines the composition of the IFED indexes, relies on Fed policy shifts to identify impending changes in market conditions. When such a shift is signaled by Fed actions, each IFED index is adjusted such that its composition aligns with the new market environment. The strategy uses 12 firm financial metrics to identify stocks that best align with a newly signaled environment. The other circumstance that elicits a reallocation of IFED index holdings is when the characteristics of the index constituents drift sufficiently away from optimal levels. On June 1, 2024, a reallocation of IFED index holdings was triggered to refresh stale firm financial metrics.
The most recent prior change in IFED index constituents occurred in June 2023 and was also initiated to update stale financial metrics. On average, IFED index holdings have been updated slightly less than twice per year, 80% of the time due to changes in the market environment and 20% of the time to update stale metrics.
IFED Index Performance – Full Period and Live Period
EIA’s first two customized indexes, Nasdaq IFED-L and Nasdaq IFED-LV have been publicly available since June 9, 2020, and July 19, 2022, respectively. Nasdaq IFED-L is a large-cap, US equity index, whereas Nasdaq IFED-LV is a large-cap, low volatility US equity index. Exhibit 1 presents performance data for Nasdaq IFED-L (Panel A) and Nasdaq IFED-LV (Panel B).
Exhibit 1: Nasdaq IFED Index Performance (through June 10, 2024)
The performance statistics reported in Exhibit 1 support several important conclusions as follows:
Both indexes produced large annual alphas during the full period and since launch (the live period).
The similarity in alphas during the two periods and across the two indexes supports the robustness of the IFED strategy.
The % of months with positive alphas indicate that the superior performance of the IFED indexes was not driven by a few extreme monthly return observations, but rather resulted from a systematic pattern.
The data supports EIA’s promotion of the IFED strategy as a long-term strategy intended to capture return patterns that generally prevail but do not appear each month.
Nasdaq IFED-L’s outperformance was better during the full period relative to its live period, whereas Nasdaq IFED-LV’s outperformance was better during its live period.
In general, the performance is consistent with the IFED strategy design, which is to prosper when normal return patterns prevail while limiting underperformance when unusual factors drive returns. For both indexes, outperformance was not a guaranteed monthly occurrence. This observation corresponds with the myriad of unexpected risk factors that drive returns over short periods of time. When normal return patterns prevail however, which represent over half of the months, the indexes have prospered. For example, in the 54% and 56% of cases when Nasdaq IFED-L produced positive alphas, the level of outperformance had to be prominent to produce the sizeable average alphas reported. Likewise, the underperformance when unusual factors drove returns did not offset the superior outcome when normal patterns prevailed.
Nasdaq IFED-L Index Composition
Nasdaq IFED-L is comprised of the 75 large-cap U.S. stocks with the highest IFED Scores, i.e., the 75 stocks best positioned to prosper in the current restrictive market environment. The index’s top ten holdings as of June 28, 2024 are shown in Exhibit 2.
Exhibit 2. Nasdaq IFED-L Largest Holdings
Nasdaq IFED-L has a wide dispersion in index holdings with limited concentration, which results due to the reliance on 12 diverse financial metrics in selecting stocks. The largest allocation is only 4.13% and the top 10 holdings comprise less than 30% of the total allocation. The largest holding in Nasdaq IFED-L is Dell Technologies and there are two technology companies included in the list of largest constituents, CrowdStrike Holdings being the other.
The IFED strategy tends to underweight “glamour” companies, such as the Magnificent 7, because the 12 metrics used to select stocks for the IFED indexes focus on firm fundamentals. The metrics favor firms with attractive valuations and strong financials, which diminishes the role that speculative elements and emotion play in determining price. For example, Nvidia, which is a prominent current glamour technology stock has a price-to-sales ratio exceeding 42, whereas the comparable values for CrowdStrike and Dell Technologies are less than 30.
Avoiding the speculative/emotional elements of stock price can harm relative performance during periods when investor euphoria drives prices; however, the EIA team believes that selecting stocks based on valuation fundamentals is the superior approach in the long run. For example, during 2023 when the Magnificent 7 produced a 107% return vs 24% for the S&P 500, Nasdaq IFED-L underperformed by about 6%; however, during the 2022 bear market Nasdaq IFED-L substantially outperformed by 18%.[1] Furthermore, over this two-year period, Nasdaq IFED-L produced an annual alpha exceeding 7%. Thus, the outperformance more than offset the underperformance that occurred when prices were driven to extreme levels. Exhibit 3 reports relative performance for Nasdaq IFED-L during this two-year period.
Exhibit 3. Nasdaq IFED-L and S&P 500 Performance, 2022 and 2023
While the IFED strategy typically avoids glamour stocks, investors in the IFED strategy need not be concerned that they are destined to always miss the star performer. Note that the largest holding in Nasdaq IFED-L before its June 2024 rebalance was Super Micro Computer (SMCI), which entered the index in June 2023. During the subsequent 12 months, SMCI appreciated by 233% and grew to be the largest holding in Nasdaq IFED-L. In comparison, Nvidia appreciated by 208% over the same period.
Exhibit 4 shows Nasdaq IFED-L’s sector composition as of June 28, 2024. Recall that stock selection for the IFED indexes is sector agnostic since constituents are selected based on 12 firm features.
Exhibit 4. Nasdaq IFED-L Sector Allocation
Nasdaq IFED-L is overweight the Financial sector, and to a much lesser extent, the Consumer Discretionary sector. The index has the greatest underweight positions in the Information Technology and Communication Services sectors. In the current restrictive market environment, the IFED strategy favors firms that have strong financial positions, attractive valuations, and are paying lofty dividends.
Currently, there is an abundance of financial firms that meet these criteria. In general, the leading financial firms are financially strong with above average dividend yields and below average price multiples. For example, Wells Fargo, Nasdaq IFED-L’s largest financial holding, has a P/E ratio of 12.5 and a dividend yield of 2.3% versus the S&P 500 average P/E of 28.0 and dividend yield of 1.3%.
The valuations for Financials are depressed due to the 2023 inexplicable failure of several large regional banks that were somehow caught off-guard by the long-anticipated increase in interest rates. This episode rekindled the lingering fears of the financial crisis, which continues to taint even the safest financial firms. History has shown, however, that as time passes, emotional considerations subside, and normal return patterns prevail.
Nasdaq IFED-LV Index Composition
The top ten holdings and sector composition for Nasdaq IFED-LV as of June 28, 2024, are shown in Exhibit 5, Panels A and B, respectively. Nasdaq IFED-LV is comprised of the 75 large-cap, low volatility US stocks with the highest IFED Scores.
Exhibit 5: Panel A. Nasdaq IFED-LV Largest Holdings
Exhibit 5: Panel B. Nasdaq IFED-LV Sector Allocation
As with Nasdaq IFED-L, Nasdaq IFED-LV has an overweight position in the Financial sector and to a lesser extent it is overweight the Communication Services sector. The index holds underweight positions in the Utility and Consumer Staples sectors. Six of the index’s top ten holdings are from the Financial sector, with Wells Fargo representing 4.00% of the index weight.
The financial strength and stability of the Financial sector has improved substantially since the financial crisis, however, bank valuations have not kept pace. For example, the largest five US banks currently pay an average dividend yield exceeding 2.5% and have substantially increased their average ROE from 4.27% during the financial crisis year of 2008 to 11.20% in 2023. Their average P/E, however, was only 13.19 at the end of 2023, far below the market average of 28. Furthermore, the Tier 1 capital level for the US banking system more than doubled since the financial crisis. Therefore, the Financial sector offers opportunities to invest in relatively low risk stocks, with attractive valuations, and prominent dividend yields, which are features targeted during a restrictive market environment.
Investors Should Be Patient Regarding the Fed’s Next Move
I recently returned from a week-long vacation with my daughter and her family, which includes three children with the oldest being seven. Before we left for the airport, my daughter informed me that I needed to remember to wear my patient pants for the next week. The advice was spot on.
The EIA team encourages investors to take the same tact regarding Fed actions. Based on over 30 years of research, EIA’s founders designed and developed the IFED strategy. The founder’s research established that the most crucial aspect of a Fed policy shift was selecting portfolio composition “after” the Fed signals a change in policy direction. The research indicated that efforts to predict Fed policy changes were futile, whereas, focusing those efforts on stock selection following a Fed shift could be handsomely rewarded with the correct implementation.[2]
So put on your patient pants and sit back and relax. Anticipating or fretting about a Fed move, or lack thereof, is counterproductive.
[1] See as examples, "The Role of Monetary Policy in Investment Management." The Research Foundation of the CFA Institute and Blackwell Series in Finance, 2002. Gerald R. Jensen, Robert R. Johnson and Jeffrey M. Mercer and, Gerald R. Jensen and Jeffrey M. Mercer. "Security Markets and the Information Content of Monetary Policy Turning Points." Quarterly Review of Economics and Finance 46, September 2006, 477-494.
[2] The Magnificent 7 includes Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla.
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