Despite speculation about a possible recession on the horizon, the stock market held its own in the quarter ended September 30. The usual fears – a seasonally weak period, inverted yield curve and perhaps negative interest rates, declining world trade and other international concerns – did not stall the uptrend/derail the market. The S&P 500 Index provided a total return of 1.7% while the tech-heavy Nasdaq Composite had a barely positive return thanks to dividends, and the broader Russell 2000 Index had a negative return of 2.4% even with dividends. These results reflect flows toward size and safety.
Low interest rates remain a bullish influence on the stock market, and rates have continued to drop. This makes stocks even more attractive relative to fixed income alternatives. The ten year Treasury note began the quarter at about 2% and dropped all the way to 1.5% before ending at 1.7% – still a substantial decline which arguably justifies higher PE multiples on stocks. Moreover, corporate earnings for 2020 are projected to grow 11% over the 2019 results. Unless those estimates prove too optimistic, they produce a fairly reasonable forward P/E multiple of 16.2x. That translates to an earnings yield that is 4.5% higher than the yield on the ten year Treasury.
There is some debate over whether the Fed was correct to cut rates. There is also the argument that they had little choice. The market largely decides long-term rates, and they continue to drop – perhaps pulled down by still lower rates in most of the developed world. If the Fed lets the yield curve get too inverted, then regional banks cannot make money on their loans (less of an issue for money center banks). Naturally, lending slows. When lending slows, the economy tends to slow. So if the Fed leaves short rates much higher than long rates, they are potentially inducing a recession. That made sense in 1979-80 when Paul Volcker broke the cycle of inflation, but it makes no sense when inflation is as low as the current 1.7%.
Economic fundamentals remain solid, though GDP growth has slowed to 2%. In the past dozen quarters, GDP growth has averaged 2.5% with a range of 1.1% to 3.5%. We are in a sweet spot with a low unemployment rate of 3.7% and a low inflation rate of 1.7%; this was unthinkable to most economists not so long ago. Retail sales are on par with recent norms. There is some weakness in manufacturing indicators; industrial production has been slowly declining over the past twelve months. The Index of Leading Economic Indicators points to a still expanding economy but at a slowing pace.
Yet concerns persist about whether all the good news of this economic cycle is already reflected in stock prices; ie, what else is there that can propel the market higher. To be sure, that question has been asked many times during this bull market. But now there are concerns that cracks in the private markets may start to spill over into the public markets; initial public offerings for WeWork and other firms are being pulled or re-evaluated and some weaker EBIT-DA numbers are apparently being reported to private debt holders. There are many stocks that are far from their highs, with room to rally. If companies do what they do well while ignoring politics, earnings and stock prices can continue higher. Moreover, there is a school of thought that the current atmosphere in Washington may pressure President Trump to reach a trade deal with China sooner than later.
There is an old saying that the stock market is a market of stocks; ie, there are substantial variations among industry groups and among stocks within each group. Not surprisingly, utility stocks did very well due to their high correlation with interest rates. It is also no surprise that a lot of health care stocks did poorly given the political rhetoric around drug prices, the opiod crises, and the perceived threat to private health insurance. There was a time when pharmaceuticals were seen as perhaps the safest, most bond-like stocks. Times change.
Today the safety label attaches most closely to consumer staple stocks such as Procter and Gamble (P&G). Even in recessions, people will buy their household products – Olay, Gillette razors, Pampers, Tide, Ivory, Vicks, Crest, Head & Shoulders, Pepto Bismol (especially in bear markets), Pantene, and Mr. Clean – and many more. The stock price continues to run up because it is seen as “safe” – and indeed it recently reported better than expected earnings on accelerating organic growth and cost cuts. It returned 14.2% for the quarter. No matter how good the news, valuation becomes a concern at least in the short-term.
We’ve been very pleased with the performance of CVS, which has recently become one of our largest holdings. They have become an integrated healthcare company combining the largest pharmacy chain with the largest pharmacy benefits network – and a leading managed care organization. Despite the inherent conflicts between these lines of business, they have a credible plan to grow through comprehensive service and wringing more efficiency from the system.
Another winner was alternative asset manager KKR. The stock was up 6.8% for the quarter despite a sharp selloff in the last two days of the period due to concerns about leverage in parts of the private market. KKR has about $150 billion under management. It did well at a time when many traditional financial stocks did not have such a great period. As noted, many bank stocks are harmed by a flat yield curve. But we consider JP Morgan the best in class in banking; it is less affected by the yield curve and returned 5.9% for the quarter. Insurance company stocks also have trouble with interest rates as they are because their bond portfolios do not yield much in this atmosphere. We have stayed away from these stocks.
Energy stocks remained weak despite a short-term spike in oil prices from the attacks on Saudi production facilities. We remain underweighted in this sector, with Exxon Mobil as our biggest position. Chevron would have been a slightly better holding this quarter, but that varies by period. Particularly inasmuch as both financial and energy stocks tend to have low P/E ratios and be classified as “value” stocks, those stocks continued to lag growth stocks in performance.
Technology stocks continue to be market leaders. Microsoft is one of our largest holdings, and it provided a total return of 4.1% for the quarter. Google had a strong quarter, gaining 12.8%. Apple and Amazon are a mix of two leading sectors – technology and consumer discretionary. Apple gained 13.6% but Amazon continued to frustrate by ending toward the lower end of a trading range between $1700 and $2000. We still have very solid long-term gains in the stock, but the PE ratio and other valuation ratios have contracted sharply in recent months even as revenues and earnings continue to grow. These stocks have driven a lot of the total return in the overall market. In the interest of appropriate diversification, we do not overweight these stocks because any sudden change in their fortunes could have too large an impact on your overall financial situation.
We have focused our consumer exposure on companies that don’t compete with Amazon. As we know, people are spending more on “experiences” and relatively less on “goods”. So we like the cruise ship companies, which are attractively priced. All three of the major cruise lines have lagged the market this year. Carnival is the biggest. But it has been the weakest. We bought on a dip after they announced that Hurricane Dorian and fuel prices kept good earnings from being even better. The stock ended the quarter at a PE ratio of 10. That ratio has fluctuated between 10 and 30 in the past decade, so the stock seems to be a very good value here.
There were other disappointments as well – particularly Mohawk Industries. We bought Mohawk well early in the year, as discussed in our March letter. The stock rallied strongly until they issued a mediocre earnings report in late July that noted shrinking margins. The stock gave back all that it had gained. We liquidated the position and have moved on. Usually letting profits run is a sensible approach, but not in this case.
We continue to add strong investment capability. Last quarter, we welcomed JASON RAPP to the team. A number of Jason’s insights have contributed much to our performance this quarter. In September, we welcomed BRIAN ARENA to the team. Brian had an amazing career running the $25 billion equity portfolio for the State of New Jersey pension system. A top professional in the public pension world calls Brian “the best stock guy I’ve ever met”.
We have a team that excels on all fronts – stock investing, fixed income investing, and long-term planning. Given ART’s ability to exploit inefficiencies in the fixed income markets, we have generated excess returns relative to short duration benchmarks in that asset class. Separately, we recently supplemented our internal planning capabilities with eMoney software, which is now at your disposal. Should you wish us to walk you through its financial planning capabilities, just contact us.
We are grateful for the opportunity to serve you, and we are always ready to assist with whatever your financial needs in any way we can.