Discerning sector value in surprisingly stable interest rate environment

This was supposed to be the quarter in which the Federal Reserve raised interest rates and put a lid on the stock market rally.  Well, the Fed did raise rates. But they can only control short-term interest rates, not long-term rates.  And remarkably, long-term rates fell to new lows for the year despite the Fed tightening, and despite an economy that is nominally at full employment with strong growth in corporate profits.  And although declining long-term interest rates and a flattening yield curve are thought to foreshadow economic weakness, the stock market continued to rally – at least until mid-June.

So what do we make of all this?  First, valuation is tricky.  Stocks are still cheap relative to bonds but they are not cheap relative to most historical measures such as price to earnings ratios.   Second, lower bond yields may not last as European central banks appear to be in the initial phases of tightening monetary policy.  So the downward pressure on rates may have more to do with comparisons to European rates – and may not last.  But for the moment, our Treasuries pay far more interest than German bunds or even notes issued by Italy and Spain.  No wonder huge international investors have a strong appetite for US Treasuries.

These conditions are not easy to evaluate or reconcile.  That’s why we tend to stay the course – adjusting chiefly to limit our downside volatility; market timing is notoriously difficult and can be downright counter-intuitive – as well as costly in terms of both opportunity loss and tax efficiency. It makes more sense to look for great companies at reasonable prices than to try to anticipate macro trends.

Sector Differentiation.  The stock market is reflecting different degrees of strength or weakness in different industry groups.  Let’s look at that in more detail.  Most technology stocks are rallying while most energy stocks have actually declined despite the market’s overall strength.  This does indeed reflect underlying economic reality.  Year over year, S&P 500 earnings are up 15%.  Technology stocks led the advance.  Meanwhile, US crude oil production has doubled since 2010 and the excess supply has put downward pressure on both crude prices and company profits.  But even those profits have rebounded nicely off 2016 lows.  Nevertheless, most energy stocks are down a lot this year.  Exxon and Chevron are down less than 10% and they are the strong performers among the carbon stocks; solar and certain other alternative energy stocks are finally stabilizing and/or rallying.

The Nasdaq is well above its peak in 2000 and I hear some concerns about another tech bubble.  Our letter of April 2015 did a quick look at some valuations now and then; here is a quick review and update:

Stock Price Feb.2000 EPS 2000 P/E 2000 P/E 2015 P/E 2017 Price June 2017 Price June 2017
Cisco 132.19 0.53 249.4 12.2 13.2 31.30 2.38
Intel 113.00 1.57 72.0 13.1 11.8 33.74 2.86
Microsoft 89.38 0.85 105.1 14.1 22.7 68.93 3.03
Apple 112.56 1.17 96.2 13.3 16.1 144.02 8.94

But cheaper than the extreme bubble of March 2000 doesn’t mean cheap by any other measure.  There is a material risk that stock prices have discounted bullish things that may never occur – such as big tax cuts.  Investor psychology can change rather suddenly; witness August to October 1987, March 2000, or the more gradual shift in 2007-08 when stocks spent months ignoring serious cracks in the credit markets.  So I am skeptical of phrases like “permanently high plateau”.  But I am also skeptical of anyone’s ability to call a market top – which is why I think the best approach is to let profits run until drawdowns from peak require a certain amount of defensiveness from a capital preservation standpoint.

So far we have only mentioned the tech sector and energy stocks.  Health care stocks have resumed a leadership role in the market after a quiescent period in 2016.  JNJ is up 16% for the year.  Celgene has returned 12%.  Merck is up 10.5%.

Biotechnology may be the center of the next great leaps in American progress.  This is a hard space that requires incredibly specialized knowledge and constant updates.  Thus we find it more prudent to gain exposure through use of an ETF – in this case the iShares NASDAQ Biotechnology Index Fund (IBB).

Shifting Consumer Sector.  Consumer stocks have traditionally been market leaders during good times as about 70% of GDP is consumer-based.  How things have changed – in two significant ways.  The first is almost exclusively due to Amazon.  That is why Amazon is among our largest positions.  One has to look at cash flow rather than earnings to properly assess Amazon’s value to shareholders.  The company is consistently growing operating cash flow at over 40% annually.  With its recent purchase of Whole Foods, it is reasonable to ask if this is the equivalent of the efforts by empire builders to conquer Moscow – i.e., has Amazon stretched itself too thin by expanding into perishable goods?  We’ll see; the market’s initial reaction was a strong vote of confidence in the company’s ability to conquer this space too.  This may be due to Whole Foods strong footprint in urban areas.

Meanwhile, Amazon is decimating many other retailers.  How about these for some comparative returns – quarterly, year-to-date, and compound annual for the decade:

Ticker Name Current
2nd Quarter Return YTD Return 10 Year Annualized
AMZN Amazon.com Inc 968.00 11.62 30.15 30.45
AN AutoNation Inc 42.16 -3.41 -13.79 6.45
BBBY Bed Bath & Beyond Inc 30.40 -22.28 -24.40 -1.57
BBY Best Buy Co Inc 57.33 20.58 35.79 3.47
COH Coach Inc 47.34 14.03 35.74 1.61
COST Costco Wholesale Corp 159.93 -0.75 4.07 12.43
DKS Dick’s Sporting Goods Inc 39.83 -19.16 -25.44 4.40
FL Foot Locker Inc 49.28 -34.99 -30.48 9.96
FOSL Fossil Group Inc 10.35 -40.66 -60.32 -10.02
GPS Gap Inc 21.99 -9.14 0.09 3.95
JCP JC Penney Co Inc 4.65 -23.93 -44.16 -19.19
KSS Kohl’s Corp 38.67 -4.16 -20.88 -3.82
LOW Lowe’s Companies Inc 77.53 -6.40 8.69 10.52
LULU Lululemon Athletica Inc 59.67 -10.86 -9.06
NKE Nike Inc B 59.00 -5.88 5.31 14.67
PETS PetMed Express Inc 40.60 102.04 77.20 13.71
RGC Regal Entertainment Group 20.46 -8.12 1.07 4.05
RCL Royal Caribbean Cruises 109.23 10.95 34.36 10.49
SHLD Sears Holdings Corp 8.86 -26.09 -8.50 -17.25
SIG Signet Jewelers Ltd 63.24 -9.88 -31.82 4.91
SPLS Staples Inc 10.07 19.02 14.03 -5.07
SBUX Starbucks Corp 58.31 1.86 6.02 16.84
TGT Target Corp 52.29 -4.46 -26.22 0.38
HD The Home Depot Inc 153.40 4.09 14.81 15.44
UAA Under Armour Inc A 21.76 3.35 -26.64 14.08
URBN Urban Outfitters Inc 18.54 -24.46 -35.25 -2.61
WMT Wal-Mart Stores Inc 75.68 8.06 11.33 6.63
WHR Whirlpool Corp 191.62 10.56 4.60 6.70
Average of Non-Amazon -2.23 -3.85 3.89
S&P 500 Index 3.09 9.34 7.13

Buying dips where a stock seems to be a good value is fraught with risk, as I demonstrated with a recent purchase of Bed Bath & Beyond.  Despite earnings estimates of over $4 per share for the current fiscal year, which translated to a PE ratio of about 9 in mid-June, the stock has continued to fall.  The market is not confident that BBBY can maintain its revenue growth or its operating margins given the challenge from Amazon.  I guess Whirlpool still works because it is hard for a drone to deliver a washing machine.  Finally, people spend on pets.  Sorry I missed that one.

The second major shift is in the consumer behavior of millennials – and perhaps society more generally.  Consumption is shifting from goods to services and notably, experiences.  That is one reason that we own travel-related stocks such as cruise lines.  Not all consumer stocks are down for the year.  McDonalds, which I have mis-judged, is 27% higher.  Many luxury goods, pet products, consumer staples, and the aforementioned experience-related stocks are up.  So is Walmart.  More surprisingly, so is Best Buy.  It is heartening to see personal service rewarded.

International Diversification.  Given our earlier comments about overall market valuation, it makes particular sense to look at the potential to diversify with international markets.  Many experts believe that the valuation gap between the US and emerging markets are as wide as in memory, and many emerging economies are likely to grow faster than the US economy.  We have increased our allocation to foreign markets, primarily using exchange traded funds.  We have a gain of 9.2% in the EEM (iShares MSCI Emerging Markets ETF) added in February and about 16% on the overall position, which was initiated about a year ago.  We have a gain of 21% in the Mexican ETF (EWW), which we bought late last year at the peak of Trump’s anti-Mexican rhetoric – betting that it would amount to very little of substance.  We have upped our exposure to Europe as well with the purchase of one more ETF – this one the HEDJ / Hedged European Equity Fund.  This holding has done less well due to the strong Euro, but we still have a modest gain of 2.8% in it.

Bottom Line.  So what is the bottom line for now?  The economy is strong and stocks reflect that.  Picking tops is a fool’s errand.  Warren Buffett didn’t get rich by timing the market (but he did invest a lot when people were terrified in early 2009).  Nevertheless, we try to avoid large drawdowns and are mindful that late summer through early autumn has at times been a period of re-assessment – or what we call the spooky season.  We tend to be more conscious of downside risk during this period.  That is especially tricky in taxable accounts as we don’t want to trigger tax liabilities on such contingencies.  One alternative that may or may not be appealing is to have the ability to sell SPY ETFs (i.e. – sell short the S&P 500 Index) to effectively raise cash in a portion of one’s account.  However, this requires having a margin account rather than just a cash account.  If this is something you wish to discuss, just let us know.

Otherwise, we will continue to do what we do – look for the best relative values at a given point in time.  That is working reasonably well so far this year and there are no proximate signs of any material change.

Thanks as always for your confidence in us.  We are available to you whenever you wish to discuss any topic or concern, including assistance with investing and financial planning.

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