This quarter was all about Brexit; the market moved more in both directions shortly after that vote than it did during the rest of the quarter. Until that referendum, the S&P 500 Index was up a modest 2.6% for the quarter. Then the world changed. The question is how much. The market dropped to three months lows in two days, and in the next four days moved right back almost to the highest levels of the year. One thing is for sure – the range of possible outcomes just widened. If possible upside is the numerator and risk is the denominator, the risk-reward equation got worse with the Brexit vote. That doesn’t mean upside won’t occur; it just means that investors now have to take more potential risk to capture it.
What exactly are those risks? First, trade barriers will go up and that is generally not a good thing for worldwide GDP growth. Morgan Stanley estimates that world GDP growth may decline by 0.5% as a result of Brexit. Second, Brexit may lead to further dismemberment of the EU – which would heighten those trade barriers and potentially increase political tensions among nations. Never good. Third, the international banking system is weakened. Barclays stock plunged by a third and Royal Bank of Scotland fell even more between the vote and quarter end. Deutsche Bank lost nearly a quarter of its value. Some of the major U.S. banks initially fell by over 10% but rebounded much more sharply than their European counterparts. Weaker trade and weaker European banks may translate into weaker stock prices. We have taken a slightly more conservative posture, and thereby are positioned to potentially miss a bit of upside.
There is a more optimistic view of Brexit – i.e. that it’s really more of a vote against socialism. In other words, enough Brits are skeptical of the European welfare states and want to keep their distance. Some have argued to me that in this vein, the vote should be seen as pro-capitalist and the British will be able to cut a side deal (a la Norway) that keeps them close to the EU without being subject to the parts they do not like. But Norway has open borders, and Angela Merkel has already served notice on the Brits that they will not cut a better deal than Norway.
Things have been counter-intuitive in a number of ways. First, the Brexit result was a surprise. Then the market’s strong rally back after the initial strong selloff was equally surprising. So the market doesn’t seem too concerned with the initial implications of Brexit, but there are still questions about the long-term overhang and the potential aftershocks.
Things have been paradoxical in other ways as well. Long term interest rates have fallen 75 basis points since the start of the year, suggesting deflation. Gold has risen nearly 25% this year, suggesting inflation. So gold stocks have been market leaders. But utility stocks have also benefitted, as their dividend yields look good relative to bonds. Inflation itself isn’t suggesting much of anything – rising 1% year over year – though core inflation (omitting food and energy) is now rising at about 2.2% annually.
Our view is that maybe all this is not as inconsistent as it seems. The world is still threatened by deflation, but that could turn suddenly given easy money or an oil price spike. Moreover, gold’s strength is likely more a reflection of instability than of inflation. Europe’s future and America’s future for that matter are of concern as both areas flirt with a retreat from globalization.
One more inconsistency has influenced our results. Normally stocks with a combination of good earnings and reasonable valuations relative to those earnings do best. That has helped us build an excellent track record over time. We have a large database where we rank stocks by past and expected future sales and earnings growth, as well as by valuation based on price-to-earnings and price-to-cash flow ratios. Normally stocks that rank well on both the growth and valuation scales have strong relative performance. Lately this has not been the case. In the aggregate, stocks whose earnings are projected to fall over the next five years outperformed stocks whose earnings are expected to grow 10% or more per annum. Not a trend that we would expect to last.
For example, Toll Brothers is ranked in our top decile. Its most recent earnings were up 38% year over year. We touted it in our last letter, and noted that Barron’s saw 40% upside. Nevertheless, it dropped slightly during the quarter.
Travel–related stocks are also highly ranked on our database, and yet had a particularly rough go. Royal Caribbean’s net income rose 43% last year and the stock has been sideways to down all year. Airline stocks have been even worse; investors seem to be discounting the worst case rather than crediting them for operational efficiencies. Delta Airlines is trading at a current PE multiple of only 6 despite earnings growth of 25% per year since 2009. Even so, airline stocks really put a dent in our performance this quarter. Brexit clearly played a role as many airline stocks plunged about 10% in the wake of the vote; there is more uncertainty around air traffic rights.
Apple was a particular disappointment – top ranked decile overall despite some slippage in growth – top decile for value – but a return of negative 12% for the quarter. Yes, earnings growth has decelerated from nearly 50% a year to around 20%, but the company has over $10 of cash per share and still trades at a PE of about 11. Even though earnings growth is nearly twice the PE ratio, investors are conditioned to hearing about new innovations before bidding up Apple stock.
Amazon was an interesting case. It has grown into one of our largest positions, and was in the top decile for growth but the bottom decile for valuation. It climbed over 20% for the quarter. Amazon continues to be a unique force of nature as it dominates more and more retail space, and profits handsomely from Amazon web services (AWS). While perceived publicly as a retailer, Amazon has supplied the web backbone for many businesses. The company is growing its cash flow at over 25% per year. Its price-to-cash flow ratio is about 39 – rich, but reflecting dominance in a huge space. Amazon has become about a 2 percent position in your portfolio. Unlike Apple, the market is still optimistic about continued or even accelerated earnings growth here as Amazon cashes in on years of huge capital spending at the expense of earnings.
Leadership within the equity market has changed as well this year. Utility stocks have been strong, and we are underweighted there. They are big beneficiaries of lower interest rates, but tend to plunge on any hiccup in rates. Stocks that generally do well in a strong economy are doing less well. That has impacted our results. Moreover, the health care sector with some notable exceptions has taken a pause from its long-term market leadership. And the financial sector has been weak due to Brexit, low rates, and regulatory changes. There can be a human tendency to fight the last war, and I have heard Harvard economist Gregory Mankiw posit that tightened bank regulation has costs the economy about a half point annually in productivity growth.
Many traditional growth stocks were softer this quarter. Examples:
All of this may be statistical noise, erased by one good earnings report. But it shows that it wasn’t easy to make much money this past quarter. And so our results were only mediocre.
It seems to be a muddle along market and a muddle along GDP. Gross domestic product in the United States expanded 1.1% in the first quarter of 2016 and stood 2.2% higher than the same quarter of the previous year; GDP growth has averaged 3.21 percent in the post WW II period. Meanwhile in the markets it has been a strange period of leadership by utilities and materials stocks, which normally do not move together. Over time, we expect our approach to ranking stocks by both growth and valuation metrics will add value as it has for most of the past 15 years. We thank you for your continued business and 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.