The average pundit surveyed by Business Week for their January 1 issue predicted that the S&P 500 would reach 1501 by the end of 2007, up from 1418 at the end of 2006. By February 20, we were already halfway there – at 1460. A week later, things seemed even better as the private equity world re-affirmed that “liquidity” was driving the market ever higher with a $32 billion buyout of Texas Utilities – the largest buyout ever.
I was at an investment conference in Colorado with CEOs and CFOs of major corporations and remember saying to whoever would listen that when the main bullish argument hinges on “liquidity”, I get uneasy. Just because people have money doesn’t mean they have to spend it. That word was too frequently thrown around at market peaks in the 1960s, 70s and 80s (eg: “There’s just too much liquidity out there” – WSJ quoting Piper Jaffray’s chief market strategist on the day the market peaked in 1987). At the least, the 3.5% plunge on February 27 is a reminder that the S&P is not going to 1501, or anywhere else, in a straight line. The market is still reasonably valued if not cheap, and should be able to grind modestly higher absent external shocks.
Note – The February 27 plunge was blamed largely on the unwinding of the so-called yen carry trade. A detailed explanation would not fit in this letter, but if you are interested in more detail, email me and I will forward a brief narrative.
Grind modestly (or barely) higher is pretty much what the market did this quarter. After the zigs and zags, the S&P 500 Index gained 0.2% last quarter. Your account gained 1.5 %. Once again, we demonstrated that even in a flat market, one can still make money with allocation to appropriate sectors of the market and selection of good stocks.
In most cases, we did that allocation reasonably well this quarter. For instance, the energy sector had an excellent 3 months, with refiners leading the pack. I was particularly pleased with the results of our purchase of Valero Petroleum, the nation’s largest refiner, midway through the quarter. Refining margins, as measured by the so-called “crack spread”, were rising sharply in late January and early February while Valero stagnated. Moreover, the price of Valero had deviated substantially from its historical relationship with Tesoro, another major refiner. So we bought Valero at $54.07, and it ended the quarter at $64.49. Crude oil itself rose in price, and we benefited from our holdings in Conoco. I am amazed that one of our largest energy holdings, Canadian producer Penn West, is not trading higher given its 11.8% yield. Investors are reacting to the Canadian government’s plans to raise taxes, effective 2011, on companies organized as royalty trusts. The stock seems cheap even when you account for the direct and indirect effects of this tax increase.
Another place that we did quite well was in steel stocks. Ryerson (RYI) is instructive. My system had it dirt cheap during the second half of last year, and it couldn’t budge from the low 20s. It ended 2006 at $25.09 and finished the 1st quarter at $39.62, up 58 %. I can’t explain the timing, other than to say that I don’t think markets always reflect information as efficiently as some academics would have you believe. Global demand for steel in general was as strong when RYI was at $25 as when it hit $39. Korean steelmaker Pohang (PKX) was our other big winner, up 29% for the quarter. Pohang’s rise has been steadier in the past year than Ryerson’s. Steel stocks are volatile, and are susceptible to big percentage declines anytime that Asia sneezes, so our exposure to them is limited.
Most telecommunication stocks have remained strong, and we have continued to do well in Mobile Telesystems (MBT), the Russian provider. My system agrees with Morningstar research that Tele Norte in Brazil is perhaps the best value among such companies globally at the moment, and we recently took a position in this carrier as well. We have owned positions in other overseas telecomm providers for some time.
Both steel and telecomm benefited from economic growth outside of the United States, particularly in Asia. This is a long term trend that I expect to continue. Thus we have some general exposure to this region through an exchange-traded fund called the MSCI Pacific ex-Japan i-shares (ticker symbol EPP). This fund appreciated by 7.3 % for the quarter, well ahead of the US market. We also own a modest amount of the Japan Equity Fund.
Part of why we did well is a function of what we avoided. We had a great run in housing stocks a few years ago, when many investors had trouble believing that housing would thrive while the tech bubble was bursting. Now we may have the opposite phenomenon in housing. Normally, economists can’t agree on anything. But I saw a survey in February that said 96% of economists thought the housing market would bottom no later than the end of 2007. This view of housing prices was apparently discounted into the prices of housing stocks as they rallied nicely in January. We missed it. Good thing. Housing stocks (as measured by Morningstar) were 17.7 % lower for the quarter as sales numbers disappointed and the sub-prime loan picture worsened. People have a tendency to underestimate the length of trends. Housing stocks have low PE ratios and can be good “value” stocks as long as you judge the volatile “E” part of the PE ratio reasonably well. I hope to identify another good entry point, but am glad that we missed the sucker’s rally in January.
Some other sectors were simply unexciting. Technology stocks had a poor quarter. Financial stocks dropped about a percent. Banks face an inverted yield curve, investment banks face concerns that they may be leveraged in sub-prime mortgage vehicles, and insurers are heading into another hurricane season. I did take the rare step of putting some of your money into a mutual fund that invests in overseas real estate (FIREX) because capacity is very tight in office markets in parts of the world where this fund is concentrated. Despite concerns that consumer spending would suffer from falling home prices and rising oil prices, the Morningstar Consumer Goods Index managed to rise 3.6 %. Among the bright spots were Joseph A Bank (+20%), Tempur Pedic (+27%), and the rebound in Avon Products (+12%).
A major disappointment was the continued lag of some big cap stocks that are becoming better and better relative values. I prefer situations like Valero that became a good relative value when we owned little if any, and then went up after we bought a lot! But some stocks like Johnson & Johnson (- 8.7 % for the quarter), Amgen (- 18%), Home Depot (- 8.5%) and Microsoft (- 6.7%) have continued to disappoint and cost us. The Morningstar Large Cap Core Index fell by 0.9% for the quarter while the Morningstar Mid-Cap Core Index rose 4.1%. At some level, if we can outperform while owning things that are cheap and defensive, that is not altogether bad. However, I’m hoping to report better results on these stocks later this year.
We were underweighted in one sector that has continued to do very well – utilities. We have small positions in utility stocks, but it is the one place where I have regretted taking profits. Although utility valuations are high by historical standards, the atmosphere for utilities has been favorable due to de-regulation, low interest rates, and increasing demand for electricity, gas and water. Of course, one must wonder what it says about the overall market when the best performing sector is the most defensive.
Can the market move higher from here? A recent research piece from Goldman Sachs called the market 11% undervalued. An analysis from Morningstar called it 4% overvalued. Value Line predicts 40% appreciation over the next 3-5 years. There are few radical departures from this general band of views.
As long-time clients know, I focus on a few measures. One is the earnings yield on stocks versus the yield on the five year Treasury note. The PE ratio on the Value Line Index at quarter-end was 18.6, and the earnings yield is its reciprocal of 5.38%. The five year Treasury yield ended the quarter at 4.54%. That produces a ratio of 1.18. Based on historical data, that ratio suggests room for the market to go up modestly. If the ratio gets to the 1.05 – 1.10 range, it is often a barrier to further gains. If rates and earnings both stay where they are, we could have 7% price appreciation before that ratio gets to 1.10. Beyond that, if earnings grow 7% in the next twelve months, the same ratio band would allow stocks to appreciate by at least 14%. But that is only one variable; there are countless other variables that can influence the overall direction of the market.
The market is generally sensitive to earnings momentum, and particularly to rates of change there. Corporate earnings have been growing at a double-digit rate for nearly four years, and many analysts are forecasting only about 6% growth in 2007. That is still reasonably healthy.
As I have said before, I see no predictive value in moving averages. However, if the market has been consistently above its 200 day moving average, it indicates a bullish trend. The S&P 500 Index has not been below its 200 day moving average since last August. Unless and until that changes, it is reasonable to assume that a bullish trend is intact. With the tension around Iran and other hot spots, there may be more potential than usual for external shocks. This does not strike me as a period in which to be overly aggressive, as I was in early 2003. But it does strike me as a time when we can earn a solid return from stocks. I will continue to search as broadly as possible for the best investment opportunities available.
Finally, some administrative notes. TD Waterhouse has merged with Ameritrade. They are combining their clearing systems, which means you will get a new, improved monthly statement. They promise that tax basis information will be included going forward. Your account number will change, but nothing else should. As required by the SEC, your annual privacy notice is enclosed. Finally, the SEC also requires that I formally offer to deliver to you annually a copy of Part II of SEC Form ADV (a registration document) or a similar document containing at least as much biographical and related information. Kindly let me know if you require such documentation. As always, please do not hesitate to get in touch if there is anything you want to discuss at greater length.
* 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.