OEF - OEF: Priced For Perfection

2023-07-17 02:52:38 ET

Summary

• Despite iShares S&P 100 ETF's strong recovery from the bear market lows in late 2022, a few indicators suggest caution for the bulls.
• OEF's high valuation coupled with the ongoing quantitative tightening by the Fed will add to the headwinds over the next months.
• OEF's large outperformance relative to the Russell 2000 indicates that a change in leadership will happen at some point in the future.

Investment Thesis

In this analysis, we explore the performance and potential risks of the iShares S&P 100 ETF ( OEF ). Despite a strong recovery from the bear market lows in late 2022 fueled by a very resilient economy and the revival of the Fed put during the regional banking crisis, a few indicators suggest caution. OEF's high valuation, coupled with the ongoing quantitative tightening by the Fed and the absence of rate cuts will add to the headwinds over the next months. Lastly, large caps have been leading this market higher but this is subject to change. The large outperformance relative to the Russell 2000 indicates that a change in leadership will happen at some point in the future, and I believe it will not benefit OEF.

About OEF

OEF is an exchange-traded fund that aims to track the performance of the S&P 100 Index, comprising the top 100 large-cap U.S. companies. With a focus on established market leaders, OEF provides investors with a convenient way to gain exposure to the core of the U.S. equity market.

As part of an investment portfolio, OEF offers diversification benefits through its broad exposure to leading companies. By allocating a portion of their assets to OEF, investors can access the stability and growth potential of established market leaders, while reducing the risk associated with individual stock selection.

For more details on OEF, please check the fund's webpage .

From the Jaws of Bear Market to the Resilience of Bulls

OEF has successfully recovered a significant portion of its losses since the onset of the bear market in late 2021 and is currently trading at a level that is less than 10% below its all-time high. Many find this development astonishing, considering the rapid increase in interest rates and the initiation of quantitative tightening. However, the surge in stock prices has been primarily driven by an economy that has proven more resilient than expected in recent months, fiscal spending, along with the revival of the Fed put during the regional banking crisis in March 2023.

In terms of valuation, OEF is currently not cheap. The portfolio trades at nearly 21x earnings, over 4x book value, and offers a dividend yield of only 1.55%. While companies comprising the fund have demonstrated exceptional historical sales and earnings growth, it is unlikely that they will achieve the same level of growth in the near future. These firms have benefited from substantial monetary and fiscal support following the Covid crisis, coupled with inflation boosting nominal values. However, we are now witnessing a decline in inflation, which will ultimately curtail the pricing power of these companies.

Considering that the Fed is still implementing quantitative tightening and has no plans to cut rates this year, I believe the current valuation of this fund is stretched and the recent rally has run ahead of itself. Although the market continues to rely on the Fed put, the trigger levels at which it will be activated remain uncertain. I am confident that we are far from those levels, and another sharp drop in US equities would likely be welcomed by Fed officials in the short term as it would tighten financial conditions and target inflation.

The relative outperformance of OEF compared to the Russell 2000 is another noteworthy concern for the bulls. This reading is currently one of the highest in the past 20 years. Based on historical patterns, it is highly likely that mid and small-cap stocks will outperform OEF in the coming years, as has been observed in the past.

Examining the beginning of a new bull market reveals conflicting signals in the data, with a bearish setup emerging. Industrial sectors have been lagging behind both the overall market and OEF in recent months, which is atypical during the start of a new bull market. Conversely, industrials typically lead the charge during this phase.

The same observation can be made regarding financials, which experienced setbacks during the regional banking crisis in March 2023. Bank stocks are currently underperforming relative to the overall market and OEF, indicating a potential slowdown in the economy.

For those who believe that we are still in a bear market, it is important to note that this may be one of the longest bear market rallies in history. Personally, I remain skeptical of the bull market narrative. In essence, I have found limited historical examples of a bull market commencing with an inverted yield curve.

Key Takeaways

Despite a robust recovery from the lows of the bear market in late 2022, driven by a resilient economy and the resurgence of the Fed put during the regional banking crisis, several indicators warrant caution. OEF's elevated valuation, alongside the ongoing quantitative tightening by the Fed and the absence of rate cuts, present additional challenges in the coming months. Moreover, the current market rally led by large caps may undergo a shift in leadership, which I believe will not favor OEF, as evidenced by its significant outperformance relative to the Russell 2000.

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