• Rally continues in Q3, but September highlights need to diversify
• September decline coincides with Value outperforming Growth
• International indices overexposed to Banking risks
• Energy risks weigh on performance, especially for Small Caps
• Economic Breadth Indicator points to modest gains in Q4 2020

Rally continues in Q3, but September highlights need to diversifyFollowing the abrupt sell-off in Q1, the strong equity market recovery continued in the third quarter. The S&P 500 rose 8.9% in Q3, driven by strong performance in the IT, Consumer and Industrials sectors. The Stratified LargeCap Index delivered a 6.0% return, underperforming its cap weighted counterpart largely due to a lower weight in IT (12.6% versus 21.3%).
Other equity universes also performed strongly, though they did not keep up with the US large caps. The S&P MidCap 400 rose 4.8%, the S&P Small Cap 600 rose 3.2% and MSCI EAFE rose 4.9%. Stratified weight outperformed by 2.2% in small caps by diversifying business risk concentrations in poor performing Energy companies and by 0.4% for SEADM, due to the oversized weight that MSCI EAFE gave to the underperforming banking stocks (8.1%).
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Exhibit 1. Core Index Comparison: Stratified, Cap, and Equal Weight

The strong quarterly performance masked a weak September as a rise in COVID-19 infections globally suggested that a second wave is likely and that the pandemic will persist longer than previously expected. Stratified Weight offered some protection from the weakness in September as the Stratified LargeCap index outperformed by 1.1% that month and the Stratified Small Cap and EAFE universes outperformed by 0.5% (Exhibit 2).

‍Exhibit 2. Stratified Weight offers some protection from September weakness

September decline coincides with Value outperforming Growth

Value stocks outperformed Growth in the S&P 500 last month. This is unusual for two reasons. Firstly, since January 2019 there have been only three months where this has happened and secondly, Value outperformed even as the market declined.

Exhibit 3. S&P 500 and Growth – Value Return Differential

In September, the S&P 500 Growth index declined 4.6% as investors questioned the inflated valuations of technology stocks. Even though the broad market fell 3.8%, the Information sector (which has been viewed as defensive during the pandemic) lost 6.6% as investors exited a crowded trade.

Value companies, which have been derated relative to growth, fared better, falling only 2.5% in September. The relative performance of Value versus Growth was echoed by the ETF flows during Q3 2020 which saw $4.8bn leave the largest S&P 500 Growth ETFs (IWF and VUG) and $1.7BN flow into S&P 500 Value ETFs (IWD and VTV). This was the strongest relative quarterly flow differential of Value versus Growth ever.

International indices overexposed to Banking Risks

The Financial sector represents one of the more homogeneous set of business risks across the eight broad economic sectors in the Functional Information System (FIS). International indices often carry a large exposure to Financials and especially banking companies, as most countries have at least one listed banking institution. Of the 21 countries In MSCI EAFE, 18 have at least one major banking institution (we note that Bank of Ireland left the MSCI large cap universe in May 2020 as its market cap dropped below the minimum threshold).

In MSCI EAFE there are 67 banking stocks which comprised 8.1% of the overall index. This overexposure was a headwind for the MSCI EAFE index as banking stocks lost 4.3% in Q3 2020. In contrast the SEADM banking group made up 6.2% of the index and returned 0.4%.

The large weight that MSCI EAFE allocated to Financials was balanced by a small weight in IT (5.5%) and highlights the business risk biases which exist due to the sheer number of companies in certain segments relative to others. For example, there are 50 Japanese Financials companies in MSCI EAFE, more than the number of companies in the entire IT sector (43). This concentration bias lead to a further drag on performance as IT was one of the best performing sectors in the MSCI EAFE universe this quarter.
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Energy risks weigh on performance, especially for Small Caps

The Energy sector continued to underperform this quarter. Year-to-date it was the worst performing sector in all broad US universes (S&P 500, 400 and 600). In EAFE, it was the second-worst (see Appendix for sector breakdown).

Weak global demand for travel amidst the pandemic has put pressure on the oil price and hurt the income statements and cash flows of many oil extraction and services companies. This is especially problematic for the smaller drillers which are highly leveraged and whose profits and cashflows are directly linked to the oil price. The increased default risk was most evident in the S&P 600 where 40 oil stocks lost 62% YTD on average (Exhibit 4).

Exhibit 4. Related Business Risk: S&P 600 has 40 oilfield and extraction companies

In fact, seven out of the 40 oil-related companies in the S&P 600 have already entered into Chapter 11 this year. Such a concentration of companies which are tied to the same business risk highlights the importance of stratification.

At the start of the year, the 40 oil stocks in Exhibit 4 represented 6.7% of the S&P 600 on an equal weighted basis and 3.8% of the cap weighted index. By contrast, the Stratified SmallCap index allocated only 2.3% to the them.

Economic Breadth Indicator points to modest gains in Q4 2020

Last quarter we introduced our Economic Business Breadth Indicator, a measure of the degree that the market return was driven by a single or a broad range of business risks.

We view Business Breadth as a confirmation of positive demand for an equity index. When Business Breadth is high, S&P 500 Equal Weight index returns have historically been positive the following quarter. Since 1992, there have been 26 quarters when breadth was above 80% (i.e. 80% or more business risk groupings delivered positive returns over the quarter) and the index rose the following month 85% of the time.

Very low levels of Business Breadth (0-20%) have historically been a contrarian signal that markets are overly pessimistic, as was the case in Q1 2020.

Exhibit 5. S&P 500 Equal Weight Returns by Business Breadth Quintile

When economic breadth is low (20-40%), the market has historically struggled to perform the following quarter.In Q3 2020, 79% business risks (130/165) delivered positive returns. Though this is a relatively high level of market breadth, it is lower than we saw in Q2 and consistent with only modest market returns in Q4 2020.
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Exhibit 6. Business Breadth for the S&P 500 Equal Weight Index

Sector and Composite Performance

US LargeCap (S&P 500 universe)

US MidCap (S&P MidCap 400 universe)

US SmallCap (S&P SmallCap 600 universe)

International Developed (MSCI EAFE universe)

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Important Disclaimers

This document is for informational purposes only and is not intended to be, nor should it be construed or used as an offer to sell, or a solicitation of any offer to buy, any security. Additionally, the information herein is not intended to provide, and should not be relied upon for, legal advice or investment recommendations. You should make an independent investigation of the matters described herein, including consulting your own advisors on the matters discussed herein. In addition, certain information contained in this factsheet has been obtained from published and non-published sources prepared by other parties, which in certain cases have not been updated through the date hereof.  While such information is believed to be reliable for the purpose used in this factsheet, such information has not been independently verified by Syntax and Syntax does not assume any responsibility for the accuracy or completeness of such information. Syntax LLC, its affiliates and their independent providers are not liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein.

Past performance is no guarantee of future results. The inception date of the Syntax Stratified LargeCap and Syntax Stratified MidCap Indices was December 27, 2016. The inception date of the Syntax Stratified SmallCap Index was January 3, 2020. The inception date of the Syntax Europe & Asia Developed Markets (“SEADM”) Index was January 1, 2016. Charts and graphs are provided for illustrative purposes only.

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The S&P 500® Index is an unmanaged index considered representative of the US mid- and large-cap stock market. The MSCI EAFE Index is an unmanaged index considered representative of the European, Australian, and East Asian large-cap stock market. Benchmark data for the S&P 500, S&P MidCap 400, and S&P SmallCap 600 Indices are provided by S&P Dow Jones through FactSet®. Benchmark data for the MSCI EAFE index is provided by MSCI through FactSet.