January 2023 Update

Adam Gould, CFA
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Key Takeaways
  • Our stock rating model wrapped up a strong 2022 with continued outperformance in December. For the month, the basket of favored stocks outperformed the S&P 500 by 1.5%. Over the full year, the stock rating model’s basket of favored stocks returned 9.3% in excess of the S&P 500.
  • The stock rating model uses five composite factors to rank individual stocks. Of those five composite factors, four outperformed the S&P 500 index in December, with the momentum and estimates composites each contributing +1.6% excess return.
  • Our market valuation methodology continues to see equities as overvalued relative to investment grade fixed income. We continue to expect muted returns and elevated volatility for the equity market in the coming months.

Quantitative Stock Rating Model: Performance and Discussion

Our quantitative stock rating model, launched at the beginning of 2022, uses composite factors across five dimensions (value, quality, momentum, estimates, and investment) to predict individual stock performance. The stock rating model produces a list of 100 favored investments from across the S&P 500.

After turning in a fantastic November, the model continued to pick winners in December, as its basket of favored stocks outperformed the S&P 500 index by 1.5%. For 2022, the favored basket outperformed the S&P 500 by 9.3%. Fig. 1 shows the performance of the basket of favored stocks and the S&P 500 by year, starting in 2001.

Fig. 1 – Annual Performance of Stock Rating Model

Source: S&P, FactSet, Fundstrat analysis.January 2023 Update
Note: Shows yearly returns for the S&P 500 (light blue bars) and for the stock rating model (dark blue bars). Period of analysis is from 2001 through December 2022. Transaction costs are not considered.

Fig. 2 shows the performance for each of the 5 composite factors that make up the stock rating model (dark blue bars), along with the performance of the overall model (light blue bar at right) during December. Of the five composite factors, four outperformed the overall index. The momentum and estimate composites each contributed 1.6% of relative outperformance.

Fig. 2 – Performance of Composite Factors and Overall Model for December

Source: S&P, FactSet, Fundstrat analysis.January 2023 Update
Note: Shows the performance for December 2022 for the top quintile of the five composite factors (value, quality, momentum, estimates and investment – blue bars) and for the overall model (orange bar). Baskets are weighted using square root of market capitalization. Universe is the S&P 500. Transaction costs are not considered.

Market Valuation: Residual Income Model

We use a residual income model to value the market[1]. The residual income model produces an estimate for the equity risk premium, or the additional return that equity investors are compensated over the risk-free rate.

Using the equity risk premium, we can evaluate the relative attractiveness of equities compared to investment grade fixed income via the ratio of their yields (see Fig. 3). Historically, when equities are expensive compared to fixed income (i.e., equities have a relatively low yield) the stock market experiences smaller average returns and higher volatility. The latest reading for the yield ratio indicates that equities remain overvalued relative to investment grade fixed income. As a result, we expect muted returns and higher volatility for the equity market over the next 3 months.

Fig. 3 – Yield Ratio Shows Equities as Expensive

Source: Ice Data Indices, LLC, retrieved from FRED, Federal Reserve Bank of St. Louis; December 31, 2022, FactSet, Fundstrat analysis.January 2023 Update
Note: Shows ratio of equity to investment grade yield (dark blue line). Equity yield is computed as the sum of the 10-year Treasury yield and the equity risk premium derived from a residual income model. Investment grade yield is computed as the sum of the 10-year Treasury yield and the ICE BofA US Corporate Index Option-Adjusted Spread. Upper (lower) dashed gray line shows the rolling 75th (25th) percentile observation using a rolling 60-month window. Period of analysis is from January 2006 through December 2022.

[1]See Market Valuation Report

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Adam Gould, CFA
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