The second quarter was not an easy one, as the stock market churned. It peaked in late April and sector rotation made it hard to capture large gains in any industry group. That sector rotation left us in some of the wrong stocks during a bad period in late May and June. For instance, energy went from good to bad and health care stocks went from moribund to good.
The quarter began and ended well, but the S&P 500 Index peaked in late April at 1363. From there, as worries about Europe and Fed policy increased, the S&P 500 tumbled over 7% to as low as 1263, touching its 200 day moving average, before a rally in the last few days brought the S&P back to 1320.
The market’s total return for the quarter was 0.1%. We got more defensive in May, but did so by raising cash rather than rotating into defensive stocks. The defensive sectors such as health care and consumer staples and utilities actually had a good month in May, but I view that as probably a short-term move. We cannot responsibly turn over the portfolio to try to catch every such blip. Thus we missed a bit of upside in those sectors. We were running a fairly aggressive portfolio in April, cut our exposure back considerably as the market began to weaken, and were left a little too defensive as the market rallied sharply in the final week of the quarter. Your account lost 1.6% for the quarter.
There are parallels to last year, when the market fell 13% as the Fed withdrew stimulus. When the Fed announced another round of stimulus in August 2010, stocks rallied sharply. It is not clear whether the roadmap for the rest of this year will be the same. There seems to be a developing consensus that there is only so much that monetary policy can do before risking worrisome side effects. The Fed is in a bit of a Catch-22:
* If stimulus is halted, the question is whether the economy can grow without such an aggressive monetary policy. Metaphorically, when dad lets go of the bike, does the kid remain upright? Put another way, if the Fed’s main booster rocket didn’t quite get us beyond gravitational pull, can the private sector’s stage two rocket do the job?
* So just keep the stimulus going, right? Not so easy. Some say that the “stimulus” is printing money which pumps up asset prices but does not spur real economic activity. All the Fed is really doing is buying Treasury debt and thus reinforcing bad fiscal behavior by the Federal government. This has consequences. In the past four years, the dollar has lost a bit of ground against the Euro. But this has masked more serious declines against other currencies: 8% versus the Canadian dollar, 20% against the Australian dollar, 35% against the Japanese yen, and who knows how much versus the Chinese yuan.
A weaker dollar means more expensive oil and a higher cost for other imports. A key part of the whole debate over government policy is likely to come to a head in the next month as the federal government runs into its debt ceiling. We are keeping a close eye on the congressional debate over borrowing and its potential impact on the market. Many market observers believe that a technical default lasting a few days may be inconsequential, but that may be underestimating the impact of flight from money market funds and the influence of credit default swaps. Having said all this, the Obama Administration will want stimulus as we come into an election year. The conventional wisdom is that this should underpin the market.
Meanwhile, Europe remains a mess. Greece is too small an economy to matter that much, but it could have ripple effects and provide a window into how policymakers may deal with problems in larger European economies. One never knows when the European situation might either take a sharp turn for the worse or perhaps be vastly improved, for instance by some arrangement involving China.
Finally, banking regulators have called for increased reserve requirements to stabilize large institutions. This so-called Basel III is being hailed in the press as a positive step to avoid a repeat of 2008. However, the new rules will further constrain bank lending and are thus likely to be a contractionary force.
These macro-economic forces are beyond our control, so we focus on the micro level by looking for stocks that have good odds of doing well in any economic climate. I think we’ve done well relative to the market over time for three basic reasons:
* identifying good, solid investment opportunities
* recognizing when something isn’t working (or has stopped working) and getting out in timely fashion (the part of our
approach that was emphasized this quarter!)
* catching a few really good waves
Those waves were hard to come by in the past quarter. For instance, I thought the refining stocks might double in price or more given the expansion in refining margins. We did well in them, but they did not run anywhere near as far as they did in 2003. This time, they sold too much product in the forward market and could not take full advantage of the higher spot prices. Second, perceptions of a weakening economy caused selling in these very cyclically sensitive stocks. In attempting to “let our profits run”, we suffered some drawdown from peak profit. For instance, Valero peaked at around 30 but we hoped to let profits run and thus did not substantially reduce the position until the stock had fallen 10% or more from its peak.
Our best run has been in Valeant Pharmaceuticals (VRX). This maker of generic drugs and skin care products returned a modest 4.3% for the quarter but 84% for the year to date. We’ve had good returns elsewhere in the healthcare sector, whether in Johnson & Johnson, Merck, Bristol Myers, Celgene or the biotech ETF (symbol IBB) or in health insurers such as United Health Group or Wellpoint. I think these returns have more to do with a move toward more defensive stocks rather than any amazing developments in health care. In fact, the Financial Times recently reported that approvals of new medicines have slumped to the lowest level in a decade.
The same defensive theme was apparent in consumer staple stocks. For instance, Pepsi rose 9.4%. Certain consumer cyclical stocks did well too. Amazon also posted a respectable 13.5% return for the quarter. But there are few bargains in this sector and there is no strong case for a major cyclical upturn in consumer spending, except possibly in luxury goods.
As noted, a number of things that seemed promising simply did not work this quarter. For instance, the one place where I thought we might benefit from a real technology breakthrough was in Universal Display (PANL), a local company which makes advanced, energy-efficient backlighting for electronic devices such as cell phones. The stock nearly doubled in the first quarter, but has recently fallen sharply due to jitters over competition and patent issues. However, it remains above its year end level of $30.65.
We have invested in certain ADRs when my system projects a compound annual return that is north of 30%. Several years ago, we tripled our money in two Asian stocks. This quarter, we took a position in Zhongpin – a hog producer that is growing rapidly and had a PE ratio of 8 and rising earnings estimates when we bought. Nevertheless, the stock has skidded sharply along with many Chinese ADRs and led to a short-term loss.
Another frustration this quarter was that many commodity stocks did much worse than their underlying assets. For instance, gold moved 4.4% higher this quarter while a popular index of gold stocks fell 7.2%. Our largest gold stock, Nova Gold (NG), did considerably worse – plunging 32% despite owning a huge stockpile of gold in Canada. We still have a modest profit in the stock. It was also frustrating to give up a fair amount of our gain in silver in a sudden four day plunge in May; we got out of some of the position quite well.
One more enormous frustration is Hewlett Packard (HPQ). The stock lost 11.2% this quarter, from a low base of $40.97. My model projects a 19% annual return on the stock if they can simply manage 10% earnings growth. Earnings growth has recently slowed from about 15% annually to about 7%; the question is whether that was due to the much-publicized management mess or to more fundamental changes in consumer preferences. There is certainly a move toward cloud computing and away from Microsoft-based systems. But HP is diversified among printers and ink, PCs, services and enterprise computing and should be able to return to 10% growth now that new management is in place.
We have a solid core portfolio. JNJ is one of our top holdings – it gained 12% for the quarter. Its manufacturing problems seem to be behind it and it has one of the best new product pipelines in the industry. Gold remains a major holding due to the continuing weakness of the dollar; GLD rose 4.4% last quarter. Mathews Pacific Tiger Fund (MAPTX), which returned 4% for the quarter and has an outstanding long-term track record in a key part of the world. Exxon was a short-term disappointment; it dropped 3.3% to 81. Morningstar still pegs its fair value at $99 and my system projects a return of 11%, so the stock’s poor performance has been puzzling even in light of the recent weakness in energy prices. We also have a fair amount of Chevron; its valuation is at the low end of its range for the past decade, and the stock yields 3.1% as well. Certainly energy prices can weaken more in the short term, especially as oil in the strategic petroleum reserve is released, but the secular trend in energy prices should remain higher due to demand from Asia. Apple stock might be even higher but for the concerns about Steve Jobs’ health. Apple has been growing earnings at over 50% annually. My system assumes earnings growth of only 17% and still projects a compound annual return of 25% on the stock if it hits that earnings growth target. IBM has achieved earnings growth in the low double digits, even through the recession and has a PE ratio that surprisingly, is slightly lower than its earnings growth rate. Amazon also posted a respectable 13.5% return for the quarter. It is not only a powerhouse retailer, but also a force in the world of cloud computing. The iShares Nasdaq Biotechnology ETF (symbol IBB) is an optimal way to gain exposure to the biotech sector. Its largest holdings are in Amgen, Celgene, Teva, Gilead, Vertex, Alexion and Biogen. This security appreciated by 6.5% for the quarter. Intel has had record revenue, but you’d never know it from the stock price. Even though it sells at a very attractive valuation, the concern is whether tablets and smartphones completely undermine notebooks.
As we look long-term at hundreds of stocks, it is amazing that over an essentially flat decade, some companies managed to increase earnings substantially, while other companies were shrinking. An obvious example of decline is in media companies such as the New York Times. Certain retailers have also faded. Meanwhile, stocks such as Apple, Panera, Coach, Monsanto, Oracle and many others have grown earnings by a factor of several. These data strengthen our view that there are good investments in any macro climate. Over the years, I believe that we have done a good job of finding enough of those situations to generate returns that have been materially above the market. However, we have not done so in every quarter, and this was one of the more disappointing ones. We’ll keep working hard, keep doing ever more analytical work, in the belief that this will continue to pay off over the long haul.
What we try to provide over time is strong relative performance. The idea is that if the S&P appreciates by an average of 8 to 10 percent a year – again, on average – and we can add a bit to that in our equity portfolios, we’ll have excellent returns over time. But in a bad year, good relative performance may not be good enough for everyone. In that case, another option is to shift asset allocation more toward fixed income and less in stocks. We are always happy to discuss optimal asset allocation parameters with you. As always, contact us anytime with any questions or concerns. Thanks you 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.