The stock market ended the quarter near a record high, and so did your account. On the other hand, although we are near all-time highs, the market isn’t far from where it was eighteen months ago. It goes up on good economic news and has bouts of fear related to a possibly intensifying trade war or other international tensions. On this chart, you see that after steady rise post the 2008 crisis, the S&P 500 Index has been capped at just below the 3000 level – unable to break through that barrier for the past 18 months.
The market seems to feel that Trump feints and pivots well enough to avoid a major trade crisis – much less a war with Iran. There is major risk if any of this proves to be incorrect. The underlying economy remains strong, but there is often some statistic that gives rise to concerns about an economic slowdown. The most recent such data was a weaker employment number in June. Morgan Stanley also has an index that recently suggested a pronounced decline in business conditions.
It seems unusual to have stocks and gold both at multi-year highs at the same time – particularly in the absence of any substantial inflation – and also to have interest rates at secular lows. It is unclear how these seemingly conflicting price patterns resolve. Some analysts argue that having the market led by defensive sectors such as consumer staples is not encouraging.
Valuation. Meanwhile, the market is priced reasonably relative to corporate earnings. The S&P 500 Index ended the quarter at 2941, providing a total return for the quarter of 18.54%. Earnings for 2019 are projected at $167 this year and $186 next year. That translates into a current PE ratio of 17.6 and a forward (2020) PE ratio of 15.8. In turn, that means a current earnings yield of 5.68 versus a yield on the ten year Treasury of 2.00%. That gap of 3.68 basis points is wider than it has been 73 percent of the time since 2003 on an absolute basis, and wider than it has been 79 percent of the time on a ratio basis over the same time period. That is one indication of reasonable value in the marketplace. Earnings are expected to grow by about 11 percent in 2020 – though such projections often come down as a year progresses.
Sectors. The gap in performance between growth stocks and value stocks remains pronounced. In times past, being a “prudent” investor was generally associated with stocks that paid a solid dividend. But many of those stocks have lagged the market, particularly as growth in technology, advances in health care, and consolidation in the consumer space have driven returns. Over a three year period, growth stocks have returned about 20% more than value stocks – roughly 7% per year or nearly 2% per quarter. The gap this year is 8.39% – 21.63% for growth versus 13.24% for value. But most of that gap occurred during the first quarter. Growth beat value by a modest 1.4% this quarter as measured by the difference between the Vanguard Growth and Value ETFs.
Indeed, so-called value stocks ranging from major energy stocks to telecom stocks such as Verizon and AT&T have continued to lag behind growth names like Microsoft, but the trend is not uniform. Some high flyers had mediocre quarters either because they had gotten ahead of themselves (e.g. Amazon) or because fundamental circumstances were perceived to have deteriorated (e.g. Google in the cross-hairs of anti-trust regulators). Regarding Google, the impact of anti-trust enforcement may depend on what remedy, if any, the government seeks. Breaking up the company may increase shareholder value – parts being worth more than the whole. On the other hand, restrictions on what business they can pursue could put a lid on the stock price.
We welcomed JASON RAPP to Byrne Asset Management this quarter. Jason brings an incredibly strong background in stock selection and portfolio management to us; he has deep knowledge of different businesses which we believe will add great value to portfolios over time. He was educated at the University of Chicago, earned his M.B.A. at Harvard Business School, and worked for several of the top people on Wall Street over the years (biographical details are on our website). Jason brings a strong “best of breed” focus and experience in deep analysis of companies and industries, while bringing a background in financial analysis and valuation. Thanks to Jason’s analysis of deep value, we were accumulating Allergan shares and had a sizeable position at the time the takeover offer by AbbVie sent the stock soaring by 25%.
Model Portfolio. We have developed a model portfolio that we believe will lead to strong long term performance while providing the flexibility and customization to address each of our individual client’s needs. We shifted some holdings (in a tax efficient manner where applicable) to a few new stocks after a firm-wide review initiated by Jason. For example, in our model portfolio, we have continued to strongly favor the Information Technology sector and overweight it versus the broader market. Within Information Technology, we have emphasized companies with strong competitive positions, secular growth tailwinds and high barriers to entry and have de-emphasized companies and sectors that are too subject to cyclical forces or competitive pressures.
Our model portfolio is slightly underweight the health care sector. While the sector has underperformed year-to-date, we recognize many of the appealing characteristics of this industry including secular demand growth from aging demographics, broadly attractive valuations (the sector is trading at a discount to the broader S&P 500) and less sensitivity to economic cycles. However, we are heading into a contentious Presidential election where healthcare will be one of the main areas of focus in part driven by rapidly increasing costs, and rising levels of frustration amongst the voting public. In prior presidential elections where healthcare was a major election issue, significant parts of the healthcare sector materially under-performed. In 2012 when the focus was on the repeal of ObamaCare, and hence the managed care names had the biggest exposure, the managed care index of the S&P 500 was down ~11% in the two quarters leading into the election compared to the S&P 500 being up ~1% over that period of time. In 2016 when the focus throughout the year (and even post-election, with some of Trump’s tweets and interviews) was on drug pricing, the biotech index was down ~21% in 2016 compared to the S&P 500 being up ~10%. We have shifted away from sectors within healthcare that have a meaningful exposure to pricing pressures. We have instead emphasized companies with more muted exposures to these risks, but with strong business models and attractive long-term prospects, who still stand to benefit from the industry’s secular tailwinds.
We think the chances for a meaningful government led reform (ranging from Medicare for All to a full repeal of ObamaCare) to the healthcare system are low but not nil. However, some material changes are likely; President Trump AND Democrats have been very vocal on drug pricing. Trump has in the past backed many of the same measures promoted by Democrats – such as the government directly negotiating Medicare drug pricing.
As noted, one constraint in terms of shifting portfolios is the tax consequences. You have substantial gains of double or three-fold or more in a number of stocks — and unless an investment alternative appears compelling enough to make up for any tax liability in short order, it gets tougher and tougher to make such switches where there are large taxable gains.
Industry leadership is a strong focus across the board. As applied to airlines, we have focused on Delta Airlines as the best-managed domestic airline. Within technology, we lean toward firms that emphasize internet security, cloud computing (Amazon, Microsoft) and other particular niches within the tech space. Microsoft was up 13.6% for the quarter and has provided a total return of 31.9% for the year to date. Within finance, we see JP Morgan as the strongest bank with the best leadership and PNC Bank as conservative with a higher proportion of its profit coming from service and processing fees than from risky lending. Banks in general have had a mediocre year due largely to the compression in interest rates and thus lending spreads.
Psychology. It is interesting how psychology around a given stock can change. In mid-2017, viewership on ESPN was going to continue to dry up and Disney stock fell from $115 to $98, lagging the S&P by nearly 25% in that time frame. But now the focus is on Disney as a king of content, and it has provided a total return of 27.35% through mid-year.
Great companies can hit short-term crises. Boeing is a current example. There has been a drip, drip, drip of bad news surrounding the Boeing 737-MAX and broadening from that. Two crashes blamed on failing sensors. Then news implicating the company in short-circuiting the regulatory design approval process. And most recently, an investigation into allegedly deficient manufacturing processes at their non-union plant in South Carolina. Boeing has fallen from a peak of $446 to $364 at mid-year. We are of the view that Boeing remains the leading aircraft manufacturer in a market with growing demand, and that the stock should continue to provide superior returns over time.
We have a disciplined process for frequently re-evaluating market conditions and our individual holdings. The pace of gains slowed in the second quarter, and the total return in the second half of the year is unlikely to match that of the first half – in both a probability and fundamental sense. It is time to start watching political trends and polls; if a consensus develops that the 2020 election may lead to massive change in our economic system, it could have serious consequences for the markets. United Healthcare was at $287 and in a strong uptrend in December, but has fallen to $244 now on concerns about Medicare for All squeezing out private insurance altogether. That is a decline of 15% at a time when the market has risen by 18%. So probability assessments of major public policy shifts do matter to public markets.
We will continue to monitor the policy world, the Fed, and continuously assess individual securities to look for ways to optimize your investment returns. Thank you for your continued confidence in us.