Posts published in March 2014
Stop us if you’ve heard this one before: an Internet company with an unproven, highly risky business model values itself at gajillions of dollars and offers its shares to credulous investors who never seem to learn their lesson…
2014 has been a choppy year for equities thus far, with the S&P 500 struggling to keep itself above the level at which it ended 2013. But weakness in the broad market has not stopped entrepreneurs and venture capitalists from enjoying the most fecund environment for initial public offerings – IPOs – since the final spurt of the dot-com bubble in the first three months of 2000. Sixty-two new issues have been priced and offered so far this year. But this week gave a sign that the good times may be coming to an end. That sign has a befitting name: “Candy Crush”.
This past Wednesday King Digital Entertainment PLC, a U.K. company with an online game application called Candy Crush Saga, went public with a $6.8 billion price tag. That’s right – a company known for a single (albeit extremely popular) game was deemed to possess a higher market worth than Avon Products or Goodyear Tire, to name just two well-known brands that have been around for a much longer time. That valuation was based on the set offering price of $22.50. On this day, though, the market did not agree with the numbers wisdom of King and its investment bankers, JPMorgan. Share prices quickly went into freefall and finished the day at $19.00, 15.9% below the offering price. Perhaps virtual lollipop hammers which crush gumdrops are not all they’re cracked up to be…
King’s miserable opening performance was not entirely of its own doing; there are other signs of a chill in the high growth sectors of late. Earlier in the week the red-hot biotech sector gave up more than 6% in a broad two day sell-off, sparked by concerns over a Congressional inquiry into the pricing practices of Gilead Sciences, a maker of drug treatments for hepatitis C. The blues surrounding the King IPO caught other tech names in its downdraft – sector darlings Twitter and Facebook, among others, were big losers that day. In the broader market we see the evidence slowly mounting for a rotation away from growth back into value sectors and styles.
Beware the IPO Hype Machine
IPOs are sexy: there is hype and glitz and new gizmos ready to turn the world as we know it upside down. But they often have considerably less appeal as smart investments. There are exceptions, of course. Google’s shares today are worth more than 1,000 times where they debuted in 2004. But those are the exceptions, not the rules. Most IPO companies do not, in fact, go on to “change everything” as the hype promises. Maybe those lollipop hammers really can beget a category killer for the ages. But in our opinion it may be a bet worth not taking.
The utilities sector is the traditional safe port in a storm among the nine major industry groups that make up the U.S. stock market. It is typically the last space investors vacate when risk turns up and the threat of a market correction looms. Over the last twelve months, however, the world of power grids and water treatment facilities has been anything but boring or predictable. This has very little to do with the basic business models of the sector, which mostly involve collecting regular, easily quantifiable monthly payments from residential and business customers. Rather, the volatile price performance of utilities stocks illuminates the far-reaching and sometimes unexpected ways that the Fed’s monetary policy decisions continue to impact the equities market. It was on display again this week, as Janet Yellen made her debut post-Fed meeting press conference.
The chart above shows a close correlation between the performance of the utilities sector (shown here by the SPDR S&P 500 Utilities Sector ETF) and key Fed events over the past year. During the first four months of 2013 utilities, along with health care and consumer staples, led a broad-based market rally. But in early May utilities parted company with those other two traditional defensive sectors as the word “taper” escaped from Ben Bernanke’s lips into the market lexicon. Having led the market up, utilities was now at the leading edge of a cyclical pullback, falling twice as far from its peak to trough as the overall S&P 500. That is not typical behavior for an asset class typically thought of as a relatively safe haven. Why did utilities fall so far, so fast, and then go on to do a repeat performance later in the summer of ’13?
All About Yield
The answer to that question is summed up in one word: yield. In the yield-parched world of the past several years, investors have gone hunting outside the traditional confines of investment grade fixed income products to increase their portfolios’ yields. Utilities names have been one of the big beneficiaries of this trend: dividends tend to make up a larger percentage of the total return for utilities than is the case for other sectors. Of course, owning shares in utilities companies is riskier than owning triple-A corporate or U.S. government bonds, but investors increasingly put these risk concerns on the back burner in the quest for yield.
When the “taper talk” began last May, yields on Treasuries and other interest rate-sensitive securities soared. The 10-year Treasury yield, a key benchmark interest rate, surged a nearly unprecedented 160 basis points from May to September. Suddenly those yields from the utilities sector started looking less appetizing. Even when the Fed pulled back from a widely expected tapering decision in September, the consensus view had already set in that rate increases were only a matter of time. The utilities sector finished the year far behind the broader market: a total return of 13% versus 32% for the S&P 500.
Will utilities be a permanent casualty of a long-term structural trend towards higher rates? For now it’s too early to make that case, partly because we don’t know with any certainty what that rate trajectory will look like. In her inaugural post-meeting press conference on March 19 Fed Chairwoman Yellen removed quantitative benchmarks from the forward guidance equation. With the unemployment rate hovering just above the earlier 6.5% benchmark, the Fed has given itself more leeway to hold down rates for longer if it believes that is more advisable.
Of course, the markets blithely overlooked that and reacted instead to a slight rise in the Governors’ consensus views on the likely Fed funds rate in 2015-16. Treasury yields shot up, and utilities stocks duly tumbled. Whether this presages another irrational rate surge is anybody’s guess, but it could make for another tough year for utilities.
This week has served up a large plate of negative macro events, and global asset markets have reacted accordingly. The S&P 500 is currently hovering right around its recent technical support level of 1850, about 1.5% down from the record high set a week ago and about where it was at the beginning of the year. International markets are faring worse; the MSCI Emerging Markets Index is down by -5.6% for the year to date, Japan is off -5.2% and the Eurozone is about 1.5% lower than where it was on January 1. The classic risk on / risk off play also seems to be back in vogue: the 10-year Treasury yield has fallen from 3.0% to 2.6% over the last two and a half months.
The headline events driving the recent wobbly asset performance are the geopolitical conflict between Russia and Ukraine, and mounting concerns over a string of weak macroeconomic data from China. Other issues lurk not far from center stage, including economic woes in Brazil and a worsening employment situation in peripheral Eurozone countries. And this bout of event risk is happening at a very inopportune time, as it coincides with equity valuation levels at ten year (or longer) peaks. Investors cannot be faulted for wondering how much more there is to gain from being fully invested in the current climate.
The above chart shows one view of U.S. equities which may be fueling the embers of doubt among investors. This shows the rolling 5-year cumulative price return for the S&P 500 from 1960 to the present. In other words, each point on the line represents how much the S&P 500 gained from the previous five years to that point. It is clear that the current 5-year cumulative return level is well above the average; in fact it has been at this elevation only twice before – at the peak of the late-1990s bull market, and during the initial growth phase of the macro growth market of 1982-2000.
None of this necessarily means that markets are ready for a significant intermediate reversal. The situation in Ukraine still has to play out, and in the end the negative effects may be localized in Russia’s already poorly performing economy and financial markets. China remains the larger concern, though there is a positive interpretation to some of the latest numbers. China’s policymakers appear serious about implementing some much-needed reforms in an effort to rebalance the composition of GDP. If a handful of small to mid-sized companies default on their bond obligations it may a necessary – and manageable – price to pay. This requires close monitoring, but remains well short of a panic situation.
With a little more than a month to go before U.S. companies begin reporting 1Q earnings, the focus will likely start to shift away from global macro events to corporate performance. 2013 ended on a positive note, with S&P 500 company earnings growing by a blended 8.6%. That helped reduce some of the multiple expansion we were seeing in valuation levels (multiple expansion is simply when stock prices – the numerator of the P/E equation – grow at a faster rate than per share earnings). This is illustrated in the chart below.
If 1Q earnings – and perhaps more importantly top-line sales – are generally favorable that could give a renewed tailwind to equity indexes, provided that we don’t see a significant elevation in the threat level of the various macro events at play. In the interim, we expect that baseline risk will likely continue trending upwards with periodic large intraday movements. In our opinion it is not a time to run for the exits – but neither is it a time to sit back complacently.
The markets seem to like what new Federal Reserve Chairwoman Janet Yellen has to say, which may be surprising since Ms. Yellen herself has expressed some confusion about the current economic data in front of the Fed. After one of the now seemingly routine DC snowstorms derailed the February 13th meeting, Ms. Yellen testified in front of the Senate Banking Committee on February 27th to discuss the recent soft economic data, weather woes, and the Fed’s outlook for its bond buying program. Nonetheless, U.S. equities have continued on their merry way to successive record highs.
Ms. Yellen did not deviate much from the views of the Fed at the last meeting in January and the monthly tapering program remains in place. However, members’ uncertainty over the current state of the economy has become increasingly apparent.
Economic Data: A Mixed Bag
Some less than stellar economic data have trickled in over the past couple of weeks. U.S. retail sales fell 0.4% (the most since June 2012), industrial production was down 0.3%, and housing data has been mixed. Questions remain about recent employment numbers: Thursday’s jobless claims were 323,000 versus the projected 336,000, but the absolute level would seem to be a bright spot of sunshine. February’s nonfarm payrolls were 175,000, an improvement over January, but the unemployment rate ticked up to 6.7%. The average monthly payroll gain for the December-February period is 129,000 versus 230,000 for the same period one year ago.
A question that has been on everyone’s mind is how much these numbers can be attributed to the unusually harsh winter weather. The soft economic data “may reflect in part adverse weather conditions, but at this point it is difficult to discern exactly how much” stated Yellen, and any effects could be felt months down the road. Investors will be taking an especially hard look at the forthcoming spring numbers to see if there is a resumption of the more robust growth numbers we were starting to see last fall.
Despite the Fed’s uncertainty on this issue, it is expected that March’s FOMC meeting will see continued tapering, which would trim bond purchases another $10 Billion to a total of $55 Billion. Ms. Yellen did not think that the recent soft data was enough to constitute a continued bond buying program, but “if there’s a significant change in the outlook, certainly [the Fed] would be open to reconsidering.”
QE: The Debate Continues
While the consensus remains that QE is in its sunset phase, not all members of the Fed are gung-ho to be done with the program. Philadelphia Fed president, Charles Plosser, is “very worried about the potential unintended consequences” from the unwinding of the program and warned that it may be “many, many years” before the economy returns to growth rates seen before the recession. On Wednesday, U.S. GDP was revised downwards to 2.4% for Q4 2013, a disappointing revision from the initial report of 3.2%.
Elsewhere in the world, the Bank of England and Bank of Japan have followed the Fed’s lead, both embarking on asset buying programs of their own and bringing interest rates to or maintaining them at historic lows. Plosser noted that pressure on central banks to provide stimulus to their struggling national economies is at “unhealthy highs”, giving voice to doubts that the programs may be sustainable for much longer.
The Fed’s effect on the fortunes of emerging markets currencies continues, exacerbated by various geopolitical flashpoints including the turmoil in Ukraine (and, by extension, Russia) and uncertainly in advance of India’s forthcoming national elections. While none of these events by themselves may pose an extreme risk, the heightened baseline volatility in world asset markets is likely to be on the Fed’s radar screen as they ponder the data ahead of this month’s meeting.
Again, our baseline view is little changed: we expect to see the Fed continue with its QE taper and for macroeconomic data to show renewed strength as spring finally arrives. The next set of readings may tell us a great deal about where asset prices are headed in the coming months.
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