The markets made some marginal new highs during the quarter, but could not hold them.
The S&P 500 Index eked out a gain of 1.13% (total return), but the broader market as measured by the Russell 2000 Index weakened considerably, posting a negative total return of 7.36%.*
There are a few themes worth discussing briefly. First, there are some major and widening divergences among sectors of the market. Second, the Nasdaq index is approaching the same level it reached when the bubble burst in 2000 – albeit with very different valuations. Third, there is significant disagreement among some experts about current valuations. Fourth, U.S. stocks look pretty reasonable compared to the rest of the world. For instance, the German DAX fell 3.6% for the quarter and Hong Kong fell 1.1%. Moreover, the dollar is at a four year high versus a basket of major currencies. We are likely to continue to outperform most international markets, but a remaining question is whether foreign instability can unnerve domestic markets.
Perhaps the most important theme is that despite the Fed’s best efforts to stimulate the economy, a deflationary wind is blowing through the markets and possibly the broader economy. Despite tensions in the Mideast, oil prices fell about 12% this quarter and are at a two-year low. (Energy stocks did not help the cause this quarter). Gold prices fell nearly 10% this quarter. The overall U.S. annual rate of change in the Consumer Price Index rose above 2% over the summer, but has since fallen back to 1.7%. The yield on 10-year Treasury securities has fallen from 3% to 2.5% this year. If that seems low, try 0.95% in Germany and 0.52% in Japan. Even Spain’s 10-year government bond yields are lower than ours!
After the 1.13% gain for the quarter, the S&P 500 index and has provided a total return of 8.34% for the year. After the sharp drop this quarter, equities of smaller firms measured by the Russell 2000 Index have now declined 4.4% for the year. So there is a gap of 12.75% in total return between the S&P 500 and the Russell 2000; the former is near its high for the year and the broader index near its low. Although we draw ideas from the Value Line universe of 1700 stocks, I’ve tried to make your portfolio correlate much more closely to the S&P 500. Given these market conditions, I think our results were reasonable; the average account was down 0.04%.
The divergence between large cap stocks that dominate the S&P 500 Index and the smaller cap universe is the largest divergence between these two indices since 1998 (though 2007 was close). If you think of a pyramid structure, you have some strong stocks like Celgene and Microsoft sitting firmly atop the structure, but the base of the pyramid is weakening. That is cause for concern, and you might notice that we have higher cash levels than usual. I’m willing to give up a little bit of the upside here. The S&P 500 Index is stronger than both the Dow and the Russell 2000 because of a select few stocks, and over the long term we have benefitted by not being overly concentrated in a very small group of stocks.
Divergences are also apparent within industry groups. Consumers usually account for about 70% of GDP, and consumer stocks generally perform well in a bull market. Not so much this year. The Morningstar index of consumer cyclical stocks is up less than a percent this year. Meanwhile, technology stocks were the only real bright spot this quarter and have been strong all year.
Let’s talk briefly about valuation. One could pose it as Penn v Yale. Jeremy Siegel of U Penn thinks a fair multiple for stocks now is a PE ratio of 18 versus the current 16.3. Robert Schiller of Yale, who has been perennially pessimistic, says the market is overvalued based on his model that averages ten years of earnings; yet his most recent comments are that stocks still may be a good investment. I have gone back through his numbers and find the market is no more expensive today per his methodology than it was in the mid-1990s. And I’m not sure that an average that includes 2009 earnings tells you much. Since Princeton is in the middle of these two schools, I think we should have the last word.
Once again, I like a bottom-up approach based on the stocks we own. You are by now familiar with my “payback” approach. Right now Celgene is projected to generate enough earnings to pay back its stock price in 9.5 years; that implies a 7.5% compound annual rate of return. I’d rather invest in that than in a 10-year Treasury bond that yields 2.5%.
We can apply a similar analysis to the market as a whole. The earnings yield on stocks is 6.13% – calculated as the reciprocal of the price-earnings ratio of the S&P 500 (using 2014 estimated earnings of $121 for the S&P 500). That is 3.63% above the 10-year Treasury yield – a historically wide margin for the so-called “equity risk premium”. This compares favorably to recent levels – 2.92% at the beginning of the year and essentially the same as the 3.66% cited in our April letter.
As discussed in previous letters, some argue that the equity risk premium is skewed by artificially low interest rates. But ironically, interest rates in this country are high compared to places like Germany and Japan. Moreover, even if interest rates rose by a full percent, the equity risk premium would still be reasonable.
Obviously shocks to the system can change things quickly. News out of Europe, the Mideast, and China has certainly been disconcerting. But so far, investors are saying that these problems are not adversely affecting i-phone sales or Celgene’s research pipeline or searches on Google. To state the obvious, if the risks to peace increase, all bets are off; recall the terrible market reaction to the anticipation of war with Iraq in 2002.
I do think that markets can be affected by psychology. So the S&P 500 closed above but could not hold the 2000 level, at least on the first pass. Perhaps more significantly, the Nasdaq Composite Index topped at just over 5000 back in 2000. Obviously, the Nasdaq market was way overvalued then. But psychology is what it is, and we will simply be mindful of it.
This was a pretty quiet quarter, with not a whole lot of turnover. I added some very small positions in some very promising but highly speculative biotechnology companies. My timing wasn’t great, but my hope is that the companies are. We also took a small position in Chambers Street Group, which is a smaller and diversified real estate investment trust with smart management; we locked in a 6.25% yield. Our timing on that wasn’t brilliant either. On the brighter side, we took a 23% profit in Bally Technologies after owning it for only about three months.
As I noted in our last letter, we do our best to let profits run. So last quarter, I noted that we had done well in Greenbrier (GBX), but that it was now fairly valued. We might not buy it here, but it is still experiencing strong demand and earnings estimates often go up in such circumstances. Greenbrier ended at $57.47 in June, and rose to $73.38 this quarter. It now has a payback period of 10.25, implying a compound annual return of 7%.
Blackstone (BX) is another stock that we hope to hold long term. It is up 33% in the past twelve months, but was off 4.2% this quarter. But you may remember the same phenomenon in other great companies like Celgene – flat one quarter, up a lot in another. I can’t predict those sequences.
Given the weakness in the broader market, it has been a tough year to outperform the S&P 500 but our absolute return is quite good. We would have been better off owning 20 large cap stocks. But that approach gives us neither the diversification nor the growth that we have achieved over a longer time horizon. Moreover, I keep a good sample of 175 well-regarded mutual funds on my Morningstar screen, and we are ahead of 74% of them. So not outstanding, but not bad.
As you know, we stand ready to answer any questions or help in any way. Please don’t hesitate to reach out when you need us. Thanks 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.