The stock market held its ground this quarter despite warnings about everything from valuation to Greece. The S&P 500 Index edged to a positive total return of 0.28% thanks to dividends. The Dow Jones Industrial Average was marginally lower and the broader market was slightly higher. Through June 30 the S&P 500 total return was 1.23%. For several years, the broad market rally was driven by justified expansion in the price-earnings ratio. This year market movements have been more dependent on industry specific factors. For instance the S&P healthcare sector index was up 9.56% at mid-year while energy was down 4.66%, financials were down 0.37% and technology was up a modest 0.76%. One conclusion is that baby boomers will pay a lot for different types of drugs at different stages in their life cycle. We are over-weighted in health care, but prudence dictates that we keep you diversified.
We are still ahead of the S&P 500 for the year, but no thanks to the second quarter. Our quarterly result was a loss of 0.72%, but we remain ahead of the market for the year with a gain of 1.99%.
Recent economic performance helps justify a stock market that is both volatile and yet uncommitted to an overall direction. GDP fell 0.2% in the first quarter but appears to be bouncing back currently; twelve month trailing growth has generally been between 2.2% to 2.9% for some time. Industrial production has been weak but personal consumption and confidence have been strong. Unemployment continues to drop, and is now at 5.3%, though wage growth and the lowest labor participation rate in almost 40 years highlight continuing problems. Inflation remains tame, and the index of leading indicators has been strong in recent months.
A question is whether the market can maintain current levels. Most significantly, the Nasdaq Composite Index had an intraday high of 5132 way back in March of 2000. It finally closed above that level on three days in late June. With valuations somewhat stretched and an overhang of problems such as Greek debt, is a ceiling in place for a while? Possibly. But as discussed in our last letter, valuations in the tech sector are nowhere near as stretched at they were in 2000 – no comparison. On the other hand, valuations in the biotech sector and in health care in general are pretty rich. A precise measure is tough in biotech because many companies show great potential but no earnings to date. While it has been tempting to put even more money into a sector that is doing well, it is important to maintain a valuation discipline.
I tend to be a little cautious about playing for every last bit of upside. Unfortunately, that mindset plus a few bad investment decisions contributed heavily to our lag this quarter.
On the bright side, stocks still offer a much better deal than bonds at least as measured by the equity risk premium. The latest estimate is that the S&P 500 will earn $119 this year and $133.60 next year. The index ended the quarter at 2063, which translates to a PE of 17.3. The reciprocal of the PE is the earnings yield; here 5.77%. Subtracting the 10-year Treasury yield of 2.35% from the earnings yield renders an equity risk premium of 3.4% – down from 3.93% last quarter but still quite attractive. However, interest rates have started to rise. If they go up much more, psychology will change and relative valuation will adjust. The return on fixed income securities was actually negative this quarter for the first time in a long time. The five year Treasury yield rose from 1.37% to 1.63%, the ten year yield rose 40 basis points from 1.94% to 2.34, and the thirty year rose from 2.54% to 3.11% – giving a long bond a return of negative 10.46% for the quarter.
Most stocks are well ahead of their historical valuation parameters at the present time. We examine at least a decade’s worth of price to cash flow and price to earnings ratios for a given stock. We calculate a mean ratio in each case. Then we look at cash flow and ‘street’ earnings projections for 2015, and use those numbers to calculate where a stock would be trading given these earnings and cash flows if they were valued at their mean PE and price-to-cash flow levels. Of course, these ratios should be above the mean given today’s low interest rates but the valuation premiums are quite large for many stocks. It is difficult to say how much of a premium should exist for a given level of interest rates, particularly since they are not static. But some stocks are as much as 30% above these mean levels, and that seems unduly rich.
So there is some air in the balloon. What could puncture it? Greece? Instability in the Chinese market? Inflation? Low domestic GDP growth? Or perhaps nothing – we could certainly continue with a market that just grinds a bit higher each quarter.
As we have pointed out many times, not all stocks are alike and not all sectors perform in the same way. Health care stocks remain quite strong. But they don’t all move in tandem either.
Syngeva more than doubled on a takeover by Alexion. Regeneron powered ahead by 13% from $451 to $510. United Therapeutics, which gained 37% in the first three months of the year, rose a more modest 1% this quarter. Celgene has gained 30.8% in the past year, but only 0.4% of that came in the latest quarter. Rational? Who knows. There are very few stock chart patterns that are straight lines.
Similar variances exist in other sectors. Amazon continued its climb, gaining 16.7%.
This contrasts with more traditional consumer stocks: Walmart lost 12.1%, Home Depot dropped 1.4%%, and even normally stable Hershey slipped 12%.
We may have stayed in certain inflation-sensitive stocks for too long. Southern Company, for example, offers a dividend yield of 5.18%. But the stock has fallen from a peak of about $51 in January to $41.90 on June 30 as a reaction to higher interest rates. I should have done more to reduce the portfolio’s sensitivity to rising interest rates.
Technology stocks have not been too helpful recently. Micron Technology (MU) has fallen on concerns about lower PC sales, and we held on to much of it for too long because it seemed cheap even despite that concern. As a matter of discipline, we did reduce our position but fundamentally misjudged how much ground it would lose. Apple, Microsoft and Oracle were all modest losers this quarter. Moreover, in our last letter, we wrote: “Taiwan Semiconductor has grown earnings at a double digit rate over the past decade, and the stock would be 10% higher if the P/E ratio were to regress to the mean.” Instead, TSM fell 2.6% for the quarter – hardly disastrous, but still frustrating.
We remain underweighted in energy stocks because they are still in a downtrend and rich relative to expected earnings. For example, Chevron now has a PE ratio of 24. Nonetheless, oil prices rebounded more sharply than most expected this quarter, so there may be upside earnings surprises in the oil patch.
The strength in energy prices in turn put a damper on the airlines, which had a great rally between early 2013 and early 2015. They’ve consolidated since, causing us to give a little money back on profitable positions. Worse, we got an ill-timed buy signal on Southwest Airlines. But there are fewer major carriers today than at any time in recent history and airlines could be in a long up cycle.
It is difficult to comment on the situation in Europe and Greece in particular, because events are so fast-moving. Our view is simply that a negative outcome could hurt global markets given current high valuations more than a positive outcome would spur a major rally. Beyond that, we are not experts but we will offer some comments that are meant to be thought-provoking rather than predictive.
Let’s compare who was hurt by the Lehman collapse versus who would be hurt by a Greek default. Lehman had two major adverse consequences. First, the commercial paper market froze because Lehman was the biggest dealer in that market. This made it difficult for firms such as GE to finance ongoing businesses. Greece would have no impact on the commercial paper market. Second, a money market fund “broke the buck” because of its holdings of Lehman paper. This caused a mass exodus out of money market funds, which in turn meant massive selling of corporate debt obligations. Money market funds today are not betting their future on Greece.
So if there is a panic, it won’t be for the same reasons. Most Greek debt is now held by public institutions such as Euro area governments, the IMF, and the European Central Bank. So they would have to write it down. But these are public or quasi-public entities. The ECB can just print more money. In the past, that has been inflationary. But since 2008, even government printing has not spurred inflation.
It is less likely that there would be an immediate impact, but there might be unsettling longer term consequences. Speculators might start probing the other weak links in the Euro chain, namely Spain and Portugal. We could have more austerity demands on them, which would be contractionary. And if Greece is seen as getting away with this, it might lead to the election of more leftist governments in these countries.
Finally, the Greek situation may cause an inflection point simply because the market is seen as richly valued, with no compelling reason for much upside. That alone is a reason to remain conservative in this environment. It is kind of stunning that Greece could have such an impact, with a population not much larger than that of New Jersey and a share of global GDP below 0.3%.
There are pockets of opportunity in any market climate. Insurance companies have been doing well lately, and there could be more upside as evidenced by the recent buyout of Chubb at a substantial premium. We have done well with our position in Prudential recently. Ditto a number of the banks. And we noted many good gains in the health care sector.
The bottom line is that there are almost always pockets of opportunity in the market. Normally, we are pretty good at spotting them but our batting average was lower than usual in the past quarter and some of our most profitable longer term holdings were flat to modestly lower this quarter. However, our returns remain ahead of the S&P 500 for the year and we’ll do our best to keep delivering excellent returns – both on an absolute and on a risk adjusted basis. We’re also always happy to be helpful with other longer term financial planning needs. Get in touch whenever you need us. Thanks again for your continued confidence.
* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers reflect the addition of certain dividends and deduction of all fees. S&P numbers are based on the total return of Vanguard’s S&P 500 Index Fund.