The stock market continues to march ahead and, despite troubling geopolitical headlines, has already exceeded the projections of many analysts for the year. But economic growth is solid, inflation is minimal, and corporate earnings and profit margins are at record levels. Regardless of foreboding headlines, great strides continue in technology and health care and those sectors justifiably lead the market.
The economy grew at a 3% pace in the 2d quarter. Second quarter earnings for S&P 500 companies are projected to grow by 12.4% versus last year and are estimated at about $134.70 – which translates to a price-earnings ratio of 18.6 with the S&P 500 Index at 2519. That in turn implies an earnings yield of 5.35% – which is not bad given the ten year Treasury yield of 2.33%.
So given the good news out of corporate America, it is not surprising that the S&P 500 has returned 14.24% so far in 2017. That includes a gain of 4.48% for the 3d quarter.
The market is hardly a monolith. The Vanguard Growth Index is up 21.02% for the year, while the Vanguard Value Index is up only 9.15% for the year. The biggest technology and health care ETFs are up over 20 percent, while the Energy SPDR is down 6.6% so far. And certainly not all stocks within a sector move in tandem; in tech, firms such as Nvidia (chips for video and smart cars) Control4 (smart home systems) are leading while “older” stocks such as IBM, Xerox and NCR are all still lower for the year. We are up 56% and 115% in Nvidia and Control4, respectively. But we have an unrealized loss in IBM; a key question is whether Watson can lead a turnaround.
Consumer staples – a defensive sector – have gained a modest 6.6% this year. In most past bull markets, consumer stocks were leaders because 70% of GDP is consumer based. But much of that sector has lagged – due to Amazon, changes in consumer preferences, and a debt-laden younger generation.
Speaking of Amazon, the stock peaked at about $1080 per share in a buying frenzy in late July. We took a tiny bit off the table for those who were most overweighted, but beyond that we think that Amazon is still increasing in dominance with a valuation that is not cheap but is in the ballpark given its growth trajectory. Despite some recent deceleration, it has been growing cash flow at a compound annual rate of over 30% over the past three years, and ended the quarter valued at a multiple of 27 times cash flow. The percent of total domestic retail sales done online has about doubled since 2007 and is at about 30% now.
The financial sector is up about 12.5% this year. Higher interest rates, seemingly more likely given Fed Chair Yellen’s recent comments, should be good for bank and insurance stocks. Meanwhile, the Russell 2000 Index has lagged with a more modest gain of 10.9 so far this year, meaning that small cap stocks have not kept pace with their large cap brethren. This is a shift from pre-2008 when smaller growth companies tended to lead the market. Tax reform, if any, would likely benefit smaller firms more than larger ones.
Another noteworthy development is the re-emergence of the emerging markets. Despite repeated optimistic predictions, the emerging markets have badly lagged US stocks since 2009. They’ve made up a lot of ground this year. An emerging markets ETF (symbol EEM) has been one of our biggest positions this year; it has gained 28.6%.
There is a view that the market rally has been artificially induced by the huge buildup in the Federal Reserve’s balance sheet, and that given its recently stated intent of reversing that, stock prices might reverse – and perhaps sharply. One indicator cited is the ratio of overall market capitalization to GDP, which at 1.76 is– ominously close to its all-time high of 1.81 during the first quarter of 2000. That period, of course, marked the beginning of the dot.com bust and subsequent bear market and recession. Stocks could reverse for any number of reasons – depending in part on the geopolitical state of affairs. But there is a strong alternative case to be made that what the Fed did was provide a long runway for the private sector to regain confidence and take off, and that a gradual adjustment should not hurt the private sector now that it is flying right.
What about psychological barriers? Dow 1000 was a ceiling for much of the 1960s and 1970s. Will the 2500 level on the S&P turn out to be similar? I think there are so many potential psychological barriers that Dow 1000 was more of a coincidence in the rear view mirror – and the end of that bull market had much more to do with the guns-AND-butter policies of the time.
So as always, we look for the best risk-reward stocks to own at any given point in time. We follow fundamental developments and integrate all that with a disciplined quantitative analysis and relative ranking of over 3000 stocks. Each stock gets a “score” – based on past and projected growth not only of earnings, but also revenues and cash flow to get a more complete assessment. Then we apply valuation ratios to each of those measures. We are mindful of how a stock’s current valuation ratios compare to what PE and price-to-cash flow ratios that stock traded at in past years. So it is a pretty reasoned approach – though hardly foolproof. We may miss certain winners because they seem too overvalued and yet continue to go up – either on irrational momentum buying or because earnings accelerate even beyond optimistic assessments. And other stocks that have strong histories and reasonable valuations may not persist. Large chunks of the retail sector are the most obvious example of that. Nike comes immediately to mind. GE also adversely impacted our results this quarter; it has swung from way overvalued at the end of the Jack Welch era to pretty undervalued at the end of the Immelt era.
Why do we look at cash flow as well as earnings? Shouldn’t their growth be pretty much the same? Usually, but not always. Boeing is a good example. Its earnings have grown at a lethargic 3.3% annual rate in the past three years. Then why is the stock soaring? Well, Boeing’s free cash flow has grown at a compound annual rate of 16.6% during the same period, and its operating cash flow has grown at 14.3%. The disparity is caused largely by changes in assumptions about pension liabilities (a hit to earnings) and large write-offs related to products that Boeing has decided won’t fly (so to speak). These are non-cash charges which affect earnings but not cash flow.
We’ve stuck with certain stocks that are dormant or worse for a while with the view that they are good and cheaply valued companies. Toyota has ranked well on our metrics, but trended lower during the first half of the year. It has rebounded nicely and rewarded us with a 13.5% gain this quarter. Fiat Chrysler is another stock that looked very attractive on our metrics; it rallied 68% this quarter in part on buyout speculation. The hurricanes also perversely helped the auto stocks because so many cars were destroyed.
But patience has not always been rewarded. Consider Ciena. They’ve grown earnings at over 20% annually over the past five years. The company reported revenue and earnings slightly ahead of supposed expectations in late August, and the stock quickly fell 8%. It now trades at a valuation that is about 20 percent below its historical norm. Ugh.
Many of the stocks leading the market are the sort that could be down 5% on a day that the market tumbles 2%. We don’t see that as likely, but we don’t see it as remote either. If a geopolitical event causes a sudden turn in the market, there might not be much time to react. So we’re not looking to grab every last dime from this bull market or from the highest flying stocks. We’ll keep doing our best to optimize your portfolio by looking for good new opportunities and peeling back on stocks whose prospects seem to have dimmed.
Thank you again for your confidence in us. We work hard day and night to earn it, and are available to you day or evening for any questions or concerns. Enjoy autumn and feel free to get in touch anytime.