Stock market momentum accelerated to the downside this quarter. Some may see this as ironic in that the economy has been gradually strengthening to a 3.9% GDP growth rate now, but markets look ahead. As you recall, returns were modestly positive in the first quarter, and slightly negative in the second quarter. Essentially, the market stalled mid-year and then broke sharply at the end of August. Here a picture may be worth a thousand words – this depicts the previous twelve months of the S&P 500 Index:
But the index does not tell the whole story. First of all, the chart begins with last autumn’s strong rebound from a sharp sell-off. That pattern has not repeated. Second, energy and commodity stocks have been particularly weak groups, while health care stocks performed well until a very recent break. Many healthcare stocks are richly valued, and the pinprick was renewed criticism by politicians of high drug prices.
It is also true that a few large cap stocks were strong, and the broader market was weaker. The S&P 500 Index lost 6.44%. But the same stocks, when not weighted by market capitalization, lost 7.54%. The Nasdaq Composite was down 8.35%, and the Russell 2000 Index of smaller cap stocks lost 11.92%. Unfortunately our performance mirrored these broader measures more than the S&P 500 itself as we lost 8.97%.
One positive is that we were reasonably defensive especially during the steepest part of the market drop. Our “downside capture” would be considered pretty respectable by most analysts. If you would prefer a more conservative posture going forward, please let us know. In assuming a more defensive posture we also lagged on up days. Further, we have some newer holdings that have been disappointments to date. And certain stalwarts in which we have accumulated large gains, such as Celgene and Regeneron, softened during the quarter.
Still, there were bright spots. As noted in previous letters, airlines are more profitable thanks to better load factor management and more aggressive fees. Now add low energy costs to the mix. The stocks are still reasonably cheap, but they are certainly volatile. We have been over-weighted in airlines, but their volatility limits our position sizes. United seemed to be the cheapest – until its CEO was forced to resign.
There was considerably more wreckage than the indices reflect. Consider the following percentage changes for the quarter in these stocks:
|Johnson & Johnson
|Procter & Gamble
As you can see, many good companies took pretty big hits. Many of them now have lower PE ratios than their average for the past decade. Of course, PE ratios can go up either because prices go up, or because earnings go down.
There is a widespread view that the continued Fed policy of easy money is doing much more to pump up asset prices than to stimulate the real economy. The Fed’s balance sheet has expanded from about $1 trillion to $4.5 trillion since the financial crisis. Since fixed income investments now offer minimal returns, the Fed policy may drive individuals to buy more stocks than they might otherwise in search of higher returns. Moreover, cheap money is causing many corporations to issue debt and use the proceeds to buy back stock. The concern has been that when the Fed tightens, it will adversely impact stock prices. But there is a particular irony here. Many believe that the market tanked after the Fed’s September 17 announcement that it would NOT raise rates. That caused discomfort for two reasons. First, there is the concern that the Fed will allow too much artificial inflation of asset prices. Second, the Fed voiced new concerns about overseas economic growth, creating some fears of a broader slowdown.
Has the Fed really allowed stocks to become too rich? There appears to be a wide dispersion in valuations. We track the average price-to-earnings (PE) and price-to-cash flow ratios for stocks in our database. Many stocks are trading at richer levels than their norms for the past decade. Stocks such as Home Depot and Church & Dwight are at levels more than 20% richer by this measure than their 10-year mean. Disney was at a similar premium, but the stock fell from a high of $122 in August to just below $100 now.
On the other hand, energy stocks in particular are trading well below their traditional valuations as earnings momentum continues to deteriorate. But since earnings estimates are still falling in the energy sector, it does not necessarily follow that these stocks are compelling buys yet. For instance, back in June it was thought that Chevron would earn $6.26 per share in 2016. That estimate has dropped 30 percent to $4.42. Same story throughout the energy sector. There will be huge opportunity when this trend reverses. Certain issues particularly in the master limited partnership space seem quite oversold; these firms are dependent on volume, not price, and seem to reflect more panic than fundamentals. For instance, Enterprise Products Partners (EPD) has fallen far more than was justified; it rallied 12.7% on the last day of the quarter.
There are plenty of other stocks that are trading well below historical norms. For example, Taiwan Semiconductor has traded at an average PE multiple of 14.6 since 2006. It has grown earnings at a compound annual rate of 17.5% over the past three years and 21.6% over the past six years. But now its PE is 11.4 due to a decline from about $23 in late June to as low as $19.63 in late September – a 15% decline. There is some concern about inventory levels, but Value Line calls this stock “a good choice for conservative accounts seeking a technology presence”. Except in August.
Another particular area of weakness this quarter was in public companies that do private equity – firms including Blackstone, KKR, and Fortress (FIG). A large amount of their earnings comes from incentive fees. These fees are bound to be considerably lower this year than last. While this is presumably a temporary situation, it is clearly reflected in stock prices. We’ve cut back our holdings somewhat; perhaps I should have done more. Blackstone lost 22.5% for the quarter, KKR fell 26.5% and FIG dropped 24%.
Health care stocks have been a mainstay of our portfolio for quite some time, but many of them took a big hit this quarter as well. Celgene has produced an average annual return of 23.4% in the past decade. It was at $140 as recently as late July, but moved sharply lower along with most stocks in the sector and ended the quarter at $108. Stocks such as Johnson & Johnson, Merck and Bristol Myers all fell sharply in the same time frame. They are all still great companies.
We started to nibble in some of the weakest sectors. When a stock is projected to generate enough earnings to pay back its stock price in five years, it is certainly worth a serious look. Doubling one’s money in five years equates to a 14.87% compound annual return. We bought some Freeport McMoran and some Huntsman on this basis. Of course, if earnings estimates continue to decline, all bets are off. Moreover, markets can simply overshoot in either direction, and that appears to be happening in both of these stocks.
Another major disappointment was Cerner. We bought it in July. The stock has had very steady double-digit earnings growth each year over the past decade. The only exception was 2009; as many firms saw sharp declines in earnings, Cerner grew earnings by a mere 9.4%. It seemed like a reasonable value. Even though they announced 30% earnings growth in August, a slight miss on revenues caused the stock to tumble. A disappointment, at least in the short term. As a matter of risk control, I usually trim losing positions, even recently acquired ones.
So what are some things that did well this quarter, and why didn’t we own more of them? Well, things like McDonalds and Coca-cola were modestly higher this quarter. We’ve avoided them because we feel they face long-term challenges as diet patterns change. Amazon returned 18% for the quarter, and we maintain a modest position in it. One thing that I fault us for missing is Nike – it continues to power ahead with strong earnings and consequent price gains.
September and October are often tricky times in the stock market. November through March tends to have the strongest positive seasonality. While economic fundamentals ultimately govern, it seems as though the market is creating some reasonably good values, rather than getting too far ahead of itself as we have suggested in some earlier letters. This should bode well for the period ahead. Meanwhile, we are doing our best to navigate the shoals – with higher than usual cash balances and some tax loss harvesting where appropriate. The market occasionally reminds us that it does not go straight up. But it remains the best place to invest over the long term.
Thank you for your continued confidence. Never hesitate to get in touch when you want to discuss anything relating to your financial future.
* 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.