Posts published in November 2014
On this holiday-shortened week we like to take a brief pause from the focus on day-to-day trends that normally fill up the pages of our Weekly Market Flash, and reflect on things at a more expansive level. 2014 has had its ups and downs, but mostly it has been a kind year to investors. As is our custom, we offer here some of the events and developments of the year that cause us to give thanks.
Spirit of America
Once again the U.S. has been the bright spot – among major economies the lone bright spot really – in continuing and strengthening the post-2008 recovery. Every quarter we closely analyze the performance of companies in our portfolios and listen to their management teams comment on the three months gone by and the outlook ahead. We are – not always, but generally – impressed by resourcefulness and discipline we hear on these calls and continue to believe that high quality U.S. stocks are attractive for long term portfolio performance. It’s easy to become disillusioned with institutions both public and private in our day and age. But we’ll take the American model over anything else we see out there.
Foreign Bond Investors
Back in January there was as clear a consensus as ever there was on Wall Street that interest rates were headed higher. The 10-year Treasury yield was over 3% and the Fed had just announced it would start reducing its monthly intermediate and long term bond purchases. Twelve months later, the 10-year yield is closer to 2% than 3% - this despite a continual stream of good macroeconomic numbers, corporate earnings and consumer sentiment. What’s keeping rates so firmly entrenched at historical low levels? A major contributing factor has been a massive wave of bond purchases from investors in Europe, Japan and elsewhere. 2.3% is a pretty lousy yield, except when compared to the sub-1% yields to be had from Bunds, JGBs or the like. We sense that the music will likely stop at some point – making for some tricky terrain – but the day is not yet at hand.
Cool Heads, Low Vol
A year ago, the S&P 500 rang out 2013 with not only the highest total return since 1997, but the highest risk-adjusted return in, well, forever. Too good to continue? Well, volatility stayed in the valley for most of 2014 as well. The CBOE VIX, a broad measure of market risk, currently trades more than a third below its long term historical average. The handful of pullbacks we have seen this year – and the attendant spike in headline risk – have been exceedingly brief and mostly shallow. The biggest risk event of the year played out over a few days in the middle of October, and still failed to break through the -10% threshold that would have signified a technical correction. Why so tame? The “Yellen put” is a favorite answer: the belief that the Fed will always step in. We think a bit differently. When the tailwinds seem stronger than the headwinds, as we believe is currently the case, investors will use pullbacks as an excuse to buy at slightly cheaper valuations, not to panic and run for the fire exit.
We may be thankful, but we are not complacent. 2015 will no doubt present its own special set of challenges, and we have to be ready to meet them head on. In the meantime, though, let us all take a few to focus on the people and things in our lives we cherish. May each and every one of you have a very happy Thanksgiving.
With a little more than one month left until the Champagne corks pop on New Year’s Eve, it’s a good time to survey the investment landscape and see how we might be ringing out 2014. With U.S. equity market indexes back in double digits, it looks very likely to be another good year for long-only portfolios loaded up with domestic stocks. And fixed income has not disappointed either; the Barclays U.S. Aggregate bonds index is up a bit more than 5% as of the 11/20 close. Not bad for a year which began with an overwhelming consensus among market watchers that bond prices would fall as interest rates continued to rise. Should we flip the cruise control switch and ride the wave into 2015, or are there still some bumps in the road that could make for tricky navigating?
The seasonal phenomenon of Black Friday – and its new twin sister Cyber Monday – puts retail spending firmly in the spotlight. The consumer discretionary sector has underperformed the broader market for most of the year, and there are some signs that mainline and specialty retail names with relatively cheap valuations are attracting investors. The National Retail Federation forecasts a 4.1% growth rate for holiday spending this year, a better performance than last year and well above the average for the past ten years. What may make shares in this sector even more attractive is fund managers looking for ways to beef up their portfolios before year-end. This has been a dreadful year for active fund managers, fewer than 20% of whom have beaten their benchmark in the U.S. large cap space. “Window dressing” is the (somewhat derisory) term of art to describe late-season fund manager scrambling to embellish their numbers, and it would seem to be a likely year for this activity to make the scene.
As good a year as it has been for stocks, commodities have suffered mightily. Oil prices reached a peak in June and began a downward spiral of more than 30% -- good for consumers at the gas pump but unwelcome for oil production companies and emerging markets resource exporters. Investors have been looking for a potential catalyst in this sector that could spur a rally. They may have found one in the surprise announcement this morning that China’s central bank is cutting its benchmark lending rates. While cheaper credit in China could signal building weaknesses for the longer term, the more immediate effect would likely stimulate growth in areas like infrastructure and construction. That would provide a decent tailwind to the prices of commodity inputs for which China is the world’s leading customer.
So far so good – but it is never a good idea to be too complacent. One joker in the deck is the U.S. political landscape, where another deal on the budget and debt ceiling – sound familiar? – will face lawmakers in December. With the executive and legislative branches doing their best imitation of an OK Corral standoff, swift resolution of this deal is anything but certain. Odds are that we’ll wind up with some messy but workable compromise, but we will keep a close eye on how these shenanigans unfold. It’s never a bad idea to expect the unexpected – particularly when it comes to the unfortunate dysfunction of our political system.
The health care sector has done more recently than to supply therapies and cures for mental and physical ailments. It has also showered investors with very healthy portfolio gains. In 2013 the S&P health care sector index returned over 41%, a good 10% more than the broad S&P 500 index. The good times continue to roll; sector gains in 2014 to date are just under 25%, more than double the broader market’s total return. This kind of sustained performance logically leads to the question of whether it can last and, if so, for how long?
Follow the Earnings
We have spent some time in recent weeks talking about the importance we place on earnings as a guide to what might happen in equity markets next year. Specifically, with valuation multiples already expensive by long term historical comparisons, we don’t see a particularly compelling case for multiple expansion – for stock prices to gain significantly more than the pace of underlying earnings per share (EPS) growth. “Follow the earnings” is as good a mantra as any, in our opinion, for 2015 portfolio choices. With this in mind, let’s take a closer look at the internal dynamics of the health care sector as it stands today.
One distinguishing feature of this year’s rally in health care stocks is that it is very broad-based. Of the five major industry groups – biotech, equipment & supplies, insurance providers, pharmaceuticals, and life sciences – four are up by more than 20% year to date. And within each industry group the spoils are widely distributed among larger and smaller companies alike. Contrast this dynamic to the state of play in information technology, another outperforming sector year to date. In tech, a disproportionate share of the outperformance is concentrated in the market cap leaders – behemoths Apple, Microsoft, Intel and Facebook are all up by more than 30%. This is an instructive point of comparison. Selection and business model scrutiny is currently happening in technology, and we think it is likely to be a more defining variable in healthcare going forward than it has been to date.
Not All Multiples Are Equal
So if asset selection does become a bigger deal in health care, where are the chips likely to fall? One interesting comparison we see is between biotech and health care providers. At first glance biotech looks prohibitively expensive, with an industry group P/E of around 45x earnings. And the sector is up more than 40% this year. Unsustainable and crazy expensive, right? But a closer look shows the average consensus estimate for S&P 500 biotech EPS growth to be 80%. They may not be cheap, but it is growth, not multiple expansion, leading the way.
By comparison, health insurance providers are up 21% or so year to date, and the P/E is a seemingly more appealing 16x earnings. But 2014 consensus EPS growth for this industry group is a mere 3% - the price performance is largely due to multiple expansion. And 2015 could be a troubled year for providers, which have greatly benefitted from the Affordable Care Act’s implementation. The ACA will be in the spotlight next year with a potential Supreme Court ruling that could have an adverse impact on insurance rosters in 36 states. Wall Street hates uncertainty. Uncertainty plus slow growth could make providers a troublesome corner of the market. We still see good fundamentals in healthcare overall, but we believe the rewards may be more stingily bestowed.
It’s not a good time to be a consumer in Russia, particularly if that consumer is drawing her salary in the local currency. Since the beginning of 2014 Russia’s currency, the rouble, has declined by more than 30% against the U.S. dollar. In the past week alone it has fallen by more than 7%. The Bank of Russia, after spending $30 billion in October to defend the currency, is for the moment throwing in the towel and allowing market forces to take over. That may bode worse still for the local economy, and potentially beyond to other markets.
In Russia’s consumer economy a currency depreciation against the dollar or euro shows up nearly instantly on grocery and department store shelves. A bottle of milk that cost 100 roubles in January may fetch 130 roubles today. Local employers, on the other hand, are not so wired into currency trends. The rouble-denominated salary of our consumer, staring at the 30% hike in dairy prices at her local Okei (a popular grocery chain), probably hasn’t changed at all over the course of the year. In a very real way, the relatively far-off conflict that began in the Crimea and spread to eastern Ukraine is showing up in the daily lives of Russia’s large, recently vibrant middle class.
Old Story, New Twist
This is by no means the first time that Russia’s financial system has seriously malfunctioned. In 1998 the Bank of Russia, the central bank, sharply devalued the rouble and the Russian government defaulted on its sovereign debt. The ensuing selloff of Russian assets was the critical factor in the collapse of vaunted hedge fund Long Term Capital Management, which required a major intervention by the Fed, Treasury Department and a coterie of Wall Street banks to stave off a financial pandemic. Capital fled Russia during the global 2008 financial crisis as well.
But there are important differences this time around, principally geopolitics and growth. Since the annexation of the Crimea earlier this year, relations between Russia and the West have grown increasingly antagonistic. Western sanctions are beginning to have an effect on the local economy and in particular the operating functionality of the financial system. Russian sanctions have also had a negative impact on foreign companies active in the region, including McDonald’s and Schlumberger among others. Then there is oil. Russia is the world’s largest oil exporter by volume, and the economy is largely dependent on hydrocarbons. The near-30% decline in oil prices since June has laid bare the lack of a diversified economic base to contribute to growth in a weak price environment.
It is hard to measure the extent to which Russia’s woes have the potential to create severe problems elsewhere, but it would not serve one well to be overly complacent. Russia is one leg of the BRIC economies, the large emerging market growth engines also including Brazil, India and China. What happens in the BRICs matters elsewhere in the world. Brazil is also facing some stiff economic headwinds, though not of the magnitude of Russia’s. China and India are doing relatively better, but growth trends are below recent norms. All of which is not to mention the dicey macroeconomic climates in Europe and Japan.
Our concern is that a long-tail event – a collapse of the rouble, sovereign debt default or something of a similar impact – could trigger enough instability elsewhere to jeopardize the still-fragile global recovery. We believe such an event has a fairly low probability. But they do happen. As sentinels of your capital, we need to be on guard.