The stock market continued to defy skeptics by moving even higher in the second quarter, but at a much slower rate of gain than in the first quarter. The deceleration was due in large part to a 6% selloff over a four week period ending June 24 due to the prospect of tighter monetary policy in both the US and China. Even so, the S&P 500 total return of 2.87% for the quarter was a fine result. Your account gained 2.83%.
Some of our longer term holdings were great this quarter and others were quieter. One can never tell when attractively valued stocks are going to move. For instance, Celgene is up 49% for the year but virtually all of that gain came in the first quarter. General Electric has also had a reasonably good year but a flat 2nd quarter. In contrast, Microsoft had a mediocre first quarter but a 21.5% gain in this quarter. The same is true of Raytheon – a barely positive first quarter and a 13.4% gain in the second. It is hard to tie these results to the most current news. Celgene has had positive announcements while on the contrary, Microsoft rallied despite still dealing with a mess of its Windows 8 release. Thus the results for these stocks seems counter-intuitive. But markets try to see around the bend rather than reflect current news. Sometimes prices do that well. For example, Apple is still a great company but no longer invincible – the stock price started to decline before that was widely perceived. But sometimes price dips anticipate trouble that isn’t there. That is why we’ve stayed with Celgene and other holdings that did not beat the market this quarter.
The basic overall themes remain the same: valuation and the Fed. As we noted in January, the price-earnings ratio of the overall market was likely to expand just to get back to norms. That was bound to happen even without help from the Fed. We also expected that modest earnings growth would add to likely appreciation; this has occurred. Now the question is whether the market can sustain these levels when the Fed cuts back on its stimulus program. Note that stimulus is not likely to end abruptly; it will begin tapering, to cite Ben Bernanke’s descriptor, and the open question is simply a matter of degree and time.
We have already exceeded the predictions of many pundits regarding the market’s high for the year. That probably helps to explain the market’s drop between May 21 and June 24. However, valuations in general do not strike us as excessive. Most of our stocks have payback periods of 8 to 9 years; that implies a compound annual return of 8 to 9 percent. In other words, if you give me $100 today and I give you back $200 at this time in 2021, you will have made an annual return on that money of 9.05%. That beats the bank and Treasury securities by a lot. Most economists predict GDP growth of 2 to 3 percent in the second half of the year, so absent any shocks there is not a high probability that economic weakness derails the market.
We try to find stocks that have even better payback periods than average. So while we see many good values, we also think that a fair number of stocks are overpriced and should be avoided. The range of valuation among various stocks in the marketplace is very wide, which never ceases to amaze me. I see this phenomenon largely as a reflection of the tides of human emotion.
A major irony is that so-called “conservative” stocks are very often the ones that are overpriced in this environment. In 2000, it was the dot-com stocks that were in a frenzy. In 2005, it was the housing stocks. By 2007, it was the financials. So what happens? There is a human tendency to fight the last war. So this time, the herd decides that to be careful and only buy things like Coca-cola, McDonalds, Proctor & Gamble, utilities and other “safe” things with good dividends. Well, now it is those stocks that have been bid up to the point where they exceed their normal valuations. If their PE ratios get too far ahead of their earnings growth rates, they may not be quite as safe as everyone assumes. Morningstar reported that consumer defensive stocks lost 0.28% for the quarter.
On the other hand, there are many stocks that remain well within historical valuation parameters. One example is JP Morgan. All the politicians clucked when the bank lost money in one big trading screw-up. But $6 billion relative to JP Morgan’s $230 billion in shareholder equity was a minor blip in relative terms, so the selloff in the stock provided a buying opportunity. A year later, the stock is over 50 percent higher. No surprise. It is one of our largest holdings.
Raytheon fits neatly between these two categories. We bought it because it was reasonably valued and it is the defense stock most associated with electronic warfare and related security issues. The stock gained 13.4% for the quarter and still has a dividend yield of 3.3%.
Bloomberg puts the average PE of the S&P 500 since 1954 at 16.3 (based on trailing 12 month earnings). Based on forward earnings, the PE ratio is now 13.8; the index ended the quarter at 1606 and the most recent estimates suggest earnings of about $116 for the next twelve months. Even if today’s historically low interest rates rise a bit more, it would appear that the PE ratio still has room to rise. It is hard to argue that today’s PE ratio constitutes a bubble. Let’s look at it another way. What stocks right now have a PE ratio of about 16?
Johnson & Johnson closed at $85.86, and is expected to earn $5.41 this year, which translates to a PE ratio of 15.9. The company is expected to earn $5.76 per share next year and to grow earnings at a modest 7% annually in the next few years. If those projections are met, JNJ’s earnings stream would add up to today’s stock price in 10.8 years. A payback period of 10.8 years implies a compound annual return of 6.7%. That doesn’t seem too bubbly to me. Nor are the projections based on “go-go” estimates. Companies such as Honeywell and American Express carry similar valuations today.
This discussion of individual stocks has focused on the so-called “bottom-up” approach of looking at individual companies. At the same time, it would be foolish to ignore the “top-down” macro-economic situation as influenced by monetary and fiscal policy.
Back in 2009, the Fed’s stimulus program was brilliant. The unprecedented amount of monetary stimulus provided then may well have prevented another depression. The current debate is over when (and how) this stimulus should end. There is growing concern that it is becoming counter-productive. The Federal Reserve is now keeping interest rates artificially low by purchasing Treasury securities. In other words, the government is buying vast amounts of its own debt instead of addressing excessive spending policies. The lack of discipline around our growing indebtedness could tip us into recession at a time when the government has shot its wad in terms of ability to offset such a downside. It is for these reasons that Mohammed el-erian (formerly of the Harvard endowment and now of Pimco) has opined that this market cycle could “end in tears”. He could be right, but this scenario is likely to take years if it occurs at all.
The question for policymakers and their advisors is how much of a good thing is too much? On the right, you have Arthur Laffer who says tax cuts are the key to economic growth. So if we keep cutting taxes, does the economy keep growing faster and faster? Clearly, there is some point at which the marginal benefit of more tax cuts is below the marginal cost associated with them. Alternatively, on the left Paul Krugman argues for more government spending and more government debt until we have reached full employment. This raises the same question about marginal benefit. The liberals say keep spending and don’t worry about unintended consequences, despite the risk that we’re becoming addicted to free money and lots of entitlements. Meanwhile, we ignore the prospect of a Greek-style tipping point where markets decide the economy just can’t sustain any more debt. When markets decide, they can do so abruptly – much like a dam breaking.
We have demonstrated an ability to go heavily into cash if market conditions so warrant. Fed tapering could cause more of a downturn that we anticipate. The Economist magazine warns that Europe could erupt anew. Bad things that we fail to anticipate may occur. We will lighten up on weakness if need be.
But we have also demonstrated ability to profit from a trend for as long as it is in place. Right now the uptrend seems justified by both valuations and the (albeit slowly) improving performance of the economy. There are certain people who have been perpetually bearish – some since 1982! Presently, statistics indicate that many investors are still on the sidelines due to long-term worries. Many market analysts regard that as substantial buying power that is still on the sidelines.
For now, the market continues to demonstrate resilience and valuations remain reasonable in general and exceptional in certain places. We’ll do our best to try to find those exceptional places. Thank you for your continued confidence. If you have time, I’d enjoy grabbing lunch this summer.
* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers include all actively managed equity accounts and reflect the reinvestment of dividends and deduction of all fees. As one can not invest in an actual index, for comparative purposes we show returns and other statistics of the Vanguard 500 Index Fund, a mutual fund that very effectively tracks the performance of the Standard & Poor’s 500 Index.