What are we looking for?
Constituents of a high-flying index that now may be venturing too close to the sun.
The screen
The S&P 500’s current bull run, the longest in history, celebrated its 10th birthday on March 9, and has shown no signs of slowing, posting more than a 15-per-cent return since then. The price of the index is now 22.5 times aggregate earnings, the highest price-to-earnings ratio in more than 15½ years and higher that at any point during the run up to the financial crisis. All this comes against the backdrop of a trade war with China chief among a number of geopolitical concerns and historically low interest rates. (During the 40 years from 1969 to 2009, the Federal funds rate averaged 6.5 per cent; it has averaged 0.5 per cent in the 10 years since.)
In short, investors in U.S. large caps have had a good run, and for those keen to crystallize gains before the good times end, we will look for companies that have performed well recently and may be due for a pullback.
First, we screen for S&P 500 companies where short interest is at least 15 per cent of shares outstanding. This suggests that institutional investors, or “smart money," have not only sold the stock, but have actually taken a large active bet on the stock price falling.
Among these, we screen for only companies with a one-month and three-month total return of at least 2 per cent and 5 per cent, respectively.
Finally, we use the Refinitiv credit-ranking quantitative model to identify companies likely to be downgraded. The model considers things such as leverage, profitability and liquidity as well as using artificial intelligence to text-mine transcripts, news, filings and research to calculate an implied credit rating for a company. When this implied rating is lower than the rating given by the ratings agencies – Standard & Poor’s, Moody’s, Fitch – the company is four times as likely to be downgraded as upgraded. We will refine our search to only companies whose implied rating is lower than that assigned by the ratings agencies.
More about Refinitiv
Refinitiv, formerly the financial and risk business of Thomson Reuters, is one of the largest providers of financial markets data and infrastructure, serving more than 40,000 institutions worldwide. With a dynamic combination of data, insights and technology, as well as news from Reuters, our customers can access solutions for every challenge, including a breadth of applications, tools, and content – all supported by human expertise.
What we found
The screen yields three companies, and all three are in the consumer discretionary sector, which is cyclical in nature and tends to see falling earnings, and thus falling share prices, in an economic slowdown. The sector in general has a forward (next 12 months) P/E ratio of 22 times. This makes it the second-most expensive sector behind only real estate, which is generally much more stable through a slowdown. The results of the screen might be indicative of a slowdown in the broader sector as U.S. consumers lose confidence in the economy and spend less of their discretionary income.
The two companies with the highest short interest – Macy’s Inc. and Nordstrom Inc. – are both department stores. The issues facing this type of bricks-and-mortar business model in a time of rapidly expanding online retail through Amazon.com Inc. and others is well documented, and the results of the screen only reinforces these views.
Investors are advised to do their own research before trading in any of the securities shown here.
Hugh Smith, CFA, MBA, is the manager of Refinitiv’s investment management business for the Americas and is a director on the board of the Responsible Investment Association of Canada.
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Hugh Smith, CFA, MBA