SCHB: Short- To Mid-Term Investors Should Search For More Selective Opportunities

Investment brief

The selloff in broad equities has opened the scope for potential allocations to stocks in the long account. For those with a directional view on the market, tactical shorts may even be considered until the market digests the swath of macroeconomic crosscurrents driving money flows.

The Schwab U.S. Broad Market ETF (NYSEARCA:SCHB) provides investors with diversified exposure to the performance of the Dow Jones' Broad Market Index, investing 90% of its total assets in the largest 2,500 U.S. stocks trading on public exchange.

It has $21.6Bn in AUM at the time of publication, charging a 0.03% expense ratio on AUM. Distributions, paid quarterly, yield 1.6% as I write (TTM) with a $0.77/share dividend. It's top 10 holdings concentrate ~27% of the portfolio, with Apple (AAPL), Microsoft (MSFT) and Amazon (AMZN) the largest 3 positions, comprising ~15% weighting. Sector wise, the fund is weighted ~28% to tech, and 13% to healthcare + financials.

Figure 1. SCHB Holdings-Sector Weightings

Like the U.S. benchmarks, SCHB has broken its 200DMA and 50DMA's in recent weeks, now testing its '22 range. Critically, Q3 earnings season has produced some curious insights into returns over the coming 1-3 years. Valuations, should they continue to contract, may also provide compelling entry points, potentially improving subsequent 12 month returns. For U.S. equities, the Richter scale has swung between hard and soft landing scenarios, with both GDP and earnings revisions pointing to a more favourable outcome than first thought. In that vein, my recommendations on SCHB across all 3 investment horizons is as follows:

Fundamental-

• Short-term (next 12 months)- Neutral - There may be potential with a further contraction in multiples to the 15x earnings region, but these remain elevated at ~18x as I write. Range trade supported with further sideways price development, pullbacks to $45 region not unlikely.
• Medium-term (18 months-3 years)- Neutral - Sales and earnings growth + projections have surprised in Q3 '23. The outlook has turned more constructive, with decent growth across sectors, particularly tech. However, real rates are at restrictive levels, combined with sticky inflation and geopolitical risks, could push volatility higher in the mid-term.
• Long-term (3+ years) - Bullish - U.S. equities still possess a compelling long-term growth outlook, with particularly high capital productivity, margin growth and capital turnover. U.S economic outlook, whilst murky in the near-term, remains well positioned on GDP estimates. Look to add on sharp pullbacks, then size up on confirmed reversal above $50.

Technical-

• Neutral across all time horizons. Reasons are shared in this report. Breakout trade is not yet supported, but range trade is supported for coming 3-6 months.

Net-net, for investors with a mid to long-term holding period, there is value in buying SCHB on pullbacks to the $45 region. In the short to mid-term, there are structural risks that cannot be overlooked, which may erode capital on longs if entering today. Consequently, I rate SCHB a hold for short to mid-term investors, and SCHB a buy for the long-term investor.

Figure 2. SCHB long-term price evolution, breaking 200DMA + 50DMA, testing FY'22 average highs.

Talking points

• Macroeconomic backdrop

Where to start? Inflation? Rates? Employment? AI? So much has been thrown at us as investors so far this decade that we'd need an AI assistance to record it all.

The consensus view is that stocks offer less upside premium over the coming 5-10 years as they did in the prior decade. A shifting regime in macro policy and tighter credit standards are beneath this, but average multiples are still high, and passives still dominate the capital flows.

Bob Elliott, CEO & CIO at Unlimited, fund manager of the Unlimited HFND Multi-Strategy Return Tracker ETF (HFND) had this to say in a recent post:

[S]tocks...are much more volatile than bonds which means they drive much more of the portfolio return. And that comes at a time when the equity risk premium today is at the lowest it's been in decades-with only the peak of the tech bubble seeing lower expected long-term returns above bonds."

The market has agreed with Bob so far in '23; if you strip out the "magnificent 7", stocks have been flat this YTD on aggregate. Although, each market in history has had its leaders and laggards that prop up the indices, so this isn't out of the norm compared to history.

What is out of synch with recent history is the level of real rates, which are currently at "clearly restrictive levels" according to Bill Ackman's presentation (via Pershing Square) to the Investor Advisory Committee on Financial Markets in mid-October.

Even with inflation at multi-decade highs, real rates at ~2.5% are at "a level that has rarely been sustained for any significant period of time since the 1990s", as seen in Figure 3. Let's not forget Pershing booked a c.$200mm gain on its US Treasuries short, which closed out in October.

Figure 3.

The crowd at Pershing also envision a weaker fiscal + economic outlook in the coming periods, as seen in Figure 4.

Figure 4.

• Coming 12 months returns hindered by still-high multiples

Starting valuations on SCHB are at ~18-19x earnings, marginally above the broad universe and ~2x the FactSet segment average. It sells at a 7.8% cash flow yield, and the distribution yield of ~1-2% doesn't offset this premium in valuation. As a reminder, multiples paid have a heavy bearing on 12-month returns after initial investment. The fund's trailing ROE is 22.3%, but you're paying a weighted 3.5x book value, reducing the investor's ROE to 6.4% (22.3%/3.5 = 6.4%).

• Q3 earnings season a surprise

A good chunk of S&P 500 companies have reported positive earnings growth with an equal number surprising to the upside. FactSet reports that "49% of the companies in the S&P 500 have reported actual results for Q3 2023 to date. Of these companies, 78% have reported actual EPS above estimates, which is above the 5-year average of 77% and above the 10-year average of 74% [as of October 27th, 2023]".

If 2.7% is the actual growth rate for the quarter, it will mark the first quarter of year-over-year earnings growth reported by the index since Q3 2022."

Critically, in contrast to Pershing's view, the outlook for earnings growth remains sound into FY'24, as seen in FactSet's review of forward estimates in Figure 5. This supports a constructive view over the coming 1-3+ years, particularly beyond FY'25.

Figure 5.

Still, money weightings are currently biased to the downside for SCHB, with August-Oct proving to be a sharp exit of the fund, continuing the longer-term downtrend that's been in situ since May this year (Figure 6). This may be important information for the coming 6-12 months and supports a neutral view over this time.

Figure 6.

Technical factors for consideration

1. Regarding momentum

SCHB has just completed a 3-waves down move like many of its constituents and competing ETFs. Overall momentum is biased to the downside, with 3x bearish crosses on the MACD since July. The pink MA's in Figure 7 show the 1-month avg. rolling high and lows. Critically, SCHB has crossed beneath this channel, adding to the restrictive view on the long account.

Figure 7.

2. Skew, directional bias of price distribution

• Observations: Bell curve was completed in Q1-Q2, which called for a directional move (Figure 8). Adding historical context, prior distributions exhibit a low usage area from $50-$47.00. We opened Q3 to the downside as expected from this, and a pocket of low usage has formed between the $45-$50 region (in contrast to the high usage are in the $51-$53s). We have a low-volume node forming an under-developed ledge in this region and in my opinion, investors will continue to fill this ledge to match the superior ledge of the profile (Figure 9). When ledges aren't fully developed, we will likely see rotation from the top and bottom of value until the distribution is completed in this zone, to build a matching ledge (Figure 10). SCHB is also testing the auction low with multiple prints at this level, which could extend the range lower. The distribution is negatively skewed, adding to the potential for further incremental losses with snap-back rallies.
• Key levels: Investors should monitor the $45-$49 level as a rotational area at the lower forming ledge. If price remains trapped here, further sideways trade is justified.
• Actionable strategy: Range-trade the underdeveloped ledges between $47-$50, buying the bottom of value, selling the top. Avoid breakout as distribution not yet completed. Look out for range extension below $45 with initiative selling.

Figure 8.

Figure 9.

Figure 10. Incomplete distribution, congestion trade supported moving forward.

We have downsides to $46.00 supporting this notion, having knocked out the prior targets of $49, then $51.75, as shown in Figure 11. The time horizon for these targets is the coming weeks, so we shouldn't discount a further consolidation to this level, and then observe a rotation between here and $49-$50.

Figure 11.

3. Directional bias of trend action

My judgement on the recent trend action also calls for a neutral outlook.

Figure 12. Short-term (60-minute chart, looking to coming days)-

Observations, key levels:

1. This snapback rally fits within the broader range trade outlined earlier. Another advance higher would call for $48.80 then $49, and break above the cloud. Lagging line must knock these levels out to turn bullish in the short term.
2. $51 marks the prior high, seems like a stretch at the time being.
3. Again, $47-$49 appear the levels to watch in the coming days on the upside, $44-$45 on the downside.

Figure 13. Medium-term (daily chart, looking to the coming weeks)-

Observations:

1. Bearish engulfing at A took out nearly all of July's range and marked the end of the bullish trend. Tested the cloud 2x at B, unable to trade higher.
2. Gap down at C hasn't been retaken, despite ~1 week of attempted rallies.
3. Broke the marabuzo line of October large green candle at D, and in my view, the reversal off the downtrend was a liquidity grab to take out those stops positioned above the trend. Subsequent too, market character changed again.
4. Last few days look to be a continuation as we haven't retaken much of the last few bearish candle's range. Still neutral beneath the cloud.

Key levels:

1. $51 looks to be the key upside level, coinciding with gap down in September.
2. $49 is the top of range to the upside; $46 is the key downside level to break lower.

Figure 14. Long-term (weekly chart, looking to coming months)-

Observations:

1. Took out marabuzo line of last steep candle at 1), clear downside bias following this.
2. Haven't retaken marabuzo line set by the continuation at 2), despite 2x attempts in October. Lagging line has since crossed into the cloud at 3).
3. Heading towards cloud, would need to find support at the $49s to bounce again.

Key levels:

1. Next downside level is $46 at 4).
2. Again upside would need to pierce the $51s to warrant a bullish view. Probability small at this stage, in my opinion.

Discussion summary

In short, equities are exhibiting a mixed outlook over the coming 3-6 months. Investors have discounted a range of possible distributions of the economy going forward, but: 1) there are still exogenous 'shocks' to be expected (inc. geopolitical risks), and 2) multiples on aggregate still remain stretched. Not to mention, the risk-reward to adjacent markets-including fixed income and alternatives-is suspicious. For SCHB, the recommendations are:

Fundamental bias- Neutral on short and mid-term, bullish on long-term. Potential value to allocate below $45.00.

Technical bias- Neutral across all time frames, range trade supported, don't play for direction. Key levels are $45-$50 in coming days to weeks.

Net-net, for investors with a short to mid-term holding period, there are more selective opportunities elsewhere at present. I rate SCHB a hold over this horizon.