What the Shifting Earnings Stream Tells Us About the Market by Jeremy Schwartz, Director of Research, The WisdomTree Blog
At WisdomTree, we believe strongly in relative value rebalancing. The act of rebalancing constituents of an index back to their fundamental values is important, given our belief that stocks often overshoot their underlying fundamentals. Consequently, investors run the risk of paying too much for stocks that have become more expensive compared to their fair value. A disciplined strategy of reweighting allocations back to attractively valued stocks, through the annual rebalance process, is an important element in managing market valuation risks.
Below we start with a discussion of how the Earnings Stream grew between the 2013 and 2014 Index screening dates dates—as the Earnings Stream is the key factor that drives exposures in the WisdomTree Earnings Index family.
Gauging the Earnings Stream over Time (as of 11/30/14 Index Screening)
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• 7% Total Earnings Stream Growth in 2014: The Earnings Stream in 2014 hit a record high of $1.14 trillion, which is 7% higher than the 2013 Earnings Stream and 24.4% higher than the 2007 stream.
• 8 of the 10 Sectors Displayed Positive Earnings Growth: Telecommunication Services, Industrials and Financials displayed the highest year-over-year Earnings Stream growth at 24.7%, 20.4% and 13.7% respectively. The two sectors that witnessed a contraction in their Earnings Stream were Consumer Staples and Consumer Discretionary, which experienced a contraction of 3.7% and 2.3%, respectively.
• Financial Earnings Only 2% from Peak: Before the financial crisis and as of the 2007 Index screening, the Financials sector’s Earnings Stream was $248 billion. At the nadir of the crisis, the 2009 Index screen, the Financials sector’s earnings had collapsed by about 70% to just $72 billion. As one sign the financial companies are moving beyond the crisis operating environment, the earnings of the Financials sector at this rebalance were $243 billion, up nearly 14% on the year and now within 2% of the all-time highs. Note that these companies continue to repair their balance sheets by returning less cash to shareholders, as their dividend distributions still need to grow 20% to reach their record levels in 2007, as we discussed in the WisdomTree Dividend Index rebalance.
• Information Technology Leaders: The Technology sector saw its U.S. Earnings Stream grow the fastest over the last seven years: approximately 92.9% cumulative growth from 2007 through 2014.
The growth in earnings is an important element of the annual rebalance. The other critical factor is stock price performance. Rebalancing back to the Earnings Stream forces a discipline to sell stocks that have become more expensive—in other words, selling stocks that have appreciated relative to their earnings (see rising price-to-earnings ratios).
Below we look at the characteristics of the changes that occurred in the WisdomTree Earnings Indexes.
WisdomTree Earnings Family Rebalance Illustrated (as of 11/30/14 Index Screening)
For the Broad-Based WisdomTree Earnings Index (WTEI):
• The companies that saw their weight increased at the rebalance had a median earnings growth of 21.4%, which was greater than the median earnings growth of all companies at 7.4%. Companies that saw their weight lowered at the rebalance had below-average earnings growth of just -10.4%.
• Moreover, price performance was also a key driver of relative changes. The stocks that saw their weight increased at the rebalance had below-average returns of 4%. The typical stock that saw its weight increased had a median total return that was more than 8.9% lower than the median of stocks that had their weights lowered. The typical stock that saw its weight decreased had a median total return that was 5.2% higher than the median of all stocks.
Additionally, we see that the earnings methodology has consistently raised weights to companies that have grown their earnings across the broad, large, mid– and small-cap spaces and lowered weights to companies that have contracted their earnings. The second prong to the rebalance is that it results in raising weights to constituents that have underperformed and lowering weights to constituents that have outperformed.