Posts tagged Current Market Trends
It seems like the easiest trade in the world: interest rates go up and the price of high dividend stocks go down. Yield-intensive shares have taken a beating this year, none more so than the beleaguered utilities sector. While the S&P 500 is struggling to stay above break-even for the year to date, investors who took on exposure to high dividends are firmly in negative territory: DVY (the iShares ETF) is down by almost 5% as of yesterday’s close. XLU, the SPDR ETF which seems to have become a proxy for a pure play on the dividends-rates trade, is down by almost 12% for the same period.
As investors contemplate a likely secular environment of rising rates, it would seem sensible to reduce the enhanced dividend slice of a diversified portfolio, no? That approach could be a smart tactical play heading into the fall, with possible rate action on the calendar for the September and December meetings of the FOMC. But with below-trend growth likely to keep interest rates below historical norms for some time to come, we would caution against reading last rites on high yielding stocks.
In the chart below we use XLU, the SPDR Select Utilities Sector ETF, to illustrate the uncannily tight negative correlation to bond yields that has characterized high dividend shares’ performance so far this year. This chart plots XLU’s price performance against movement in the 10-year Treasury yield.
The 10-year yield rose from 2.17% at the beginning of January to 2.42% as of the July 1 close. The average dividend yield for the S&P 500 utilities sector is 3.9%. Clearly, the negative correlation between rates and dividend shares has little to do with rational expressions of income preference. Traders make use of ready proxies like XLU simply to trade the day’s news on rates. Many algorithms in this trade key off events like FOMC meetings and the monthly release of jobs numbers. For example, the jobs report released back on February 6 contained a number of upside surprises, indicating a healthier than expected economy. On that day the 10-year yield spiked up 7.7 percent, from 1.82 percent to 1.96 percent, while XLU shares tanked by 4.1 percent. Irrational? Sure, but that’s the way of things in short-term trading. This rate-dividend pattern continued to be reliable as interest rates resumed their upward trend in late April, this time with US benchmarks following the unexpected reversal in Eurozone bond prices.
Give, Give, Give
Dividends, of course, are only part of the widely-followed metric of Total Shareholder Returns (TSR), the other and often larger component of that metric being share buybacks. The two often go hand in hand: as companies move off the steep stage of their growth cycle (the famous S-curve), they tend to give increasing portions of their earnings back to shareholders through buybacks as well as increases in the dividend rate. Over the course of the current six year bull market, top-line revenue growth has waned for a growing number of companies across all industry sectors. During the same time the pace of shareholder returns has quickened; companies are set to return over $1 trillion in buybacks for 2015, a record level representing more than 90% of total S&P 500 operating profits.
Critics will note that buybacks are easy in an environment where borrowing costs are ridiculously low. Rising rates could bring the buyback bonanza to an end, which would seem to be one more reason to be wary of overexposure to stocks and sectors with higher than average TSR yields. While we see logic in that argument we believe it oversimplifies the situation.
Quality, Not Quantity
We believe TSR will continue to be an important metric in evaluating the relative attractiveness of shares, but that the quality of TSR programs will become increasingly important. Companies that can meet their TSR goals largely with free cash flow (FCF) rather than tapping the debt markets will, all else being equal, be preferable to those with growing amounts of net debt on their balance sheets. Investors should also be able to see that buyback programs are being used for more than just insider stock and option awards. A good way to track this is by monitoring the number of fully diluted shares outstanding from quarter to quarter. Large buyback programs without a commensurate reduction in shares outstanding are likely going right into the pockets of options-holding insiders, and doing little to benefit outside shareholders.
Bond yields may be headed north from the historically low floor of the past six years. But “lower for longer” is still in our opinion the most likely scenario for the intermediate term. Lower for longer means that investors should continue to place a premium on shareholder returns. Once the short-term frenzy over the first rate hikes settles down, we expect that premium will come back into clearer view.
Britney Spears and ‘N Sync were blowing up the charts, President Clinton was dominating the headlines in a most unfortunate way, and households all across the country were lovingly attending to their pet Furbys. 1998 seems a world away from that which we inhabit today, seventeen years later. Yet the economic headlines, if not exactly repeating, do seem to rhyme a bit. There are some history lessons here worth bearing in mind as our attention turns to managing our portfolios through the second half of this year.
Here We Go
In 1998 we were well into the multi-year bull market in US equities that began in 1995, but there were serious concerns elsewhere in the world that investors feared would spill over and spoil our party. Following the collapse of the Thai baht in the summer of 1997, East Asian currencies fell by as much as 80 percent against the US dollar over the next year. Their stock markets were likewise pummeled as foreign portfolio capital made a mad scramble for the exit. The S&P 500, shown in the chart below, was stuck in a three month rut as the 1998 calendar flipped to June. It would enjoy an upside breakout through the first half of July, but more ugliness lay in store.
Summertime ended early for traders in 1998 with word that Russia was defaulting on its sovereign debt. Russian government bonds (GKOs) with their generous yields were a favorite asset holding among foreign investors. After the Russian government liberalized the GKO market in 1997, foreigners grabbed around 30 percent of the total market. The likes of Goldman Sachs and Morgan Stanley opened Moscow offices and competed furiously for mandates, right up to the end of the party on August 17 when the government announced its intention to default.
Nowhere was the demise of the Russian bond market felt with more dismay than in the plush offices of Long Term Capital Management, the prominent hedge fund run by ex-Salomon Brothers star trader John Meriwether and options guru Myron Scholes, one half of the Black-Scholes formula that begat the modern derivatives industry. LTCM’s exposure to Russia led to its bankruptcy and – foreshadowing the Lehman Brothers menace of ten years later – fears of an industry-wide contagion. The specter of a bear market loomed, and indeed the 20% peak-to-trough threshold was tested in early October.
…and Shock Absorbers
As we all know now, that bear never got traction. Policymakers and bankers figured out how to put LTCM out of its misery without taking the rest of the industry down with it. All hailed Messrs. Greenspan, Rubin and Summers as the “Committee to Save the World”. With the US economy continuing to hum along nicely and with continuing problems elsewhere in the world, US stocks once again looked like a pretty good comparative bet. The party would roar along for a couple more years, until “Oops! I did it again” would come to describe the vibe in the worlds of both pop music and capital markets in 2000. Investors who bailed out in the late 1998 turmoil missed out on another 59% of capital gains from the 10/8 trough to the March 2000 peak.
Lessons for Today
What can the 1998 experience tell us about today? Clearly the world is a different place. The US economy is growing, with low unemployment and tame inflation, but it is not growing at anything like the pace of the late 1990s. Still, the US continues to look pretty good compared with other parts of the world. The Greek crisis could yet throw cold water on the recent spate of relative good news in the Eurozone. China’s domestic stock market is a bubble showing an unhealthy uptick in volatility, as seen in the chart below.
The Shenzhen A Share index booked a year-to-date gain of 122 percent on June 12, but experienced back-to-back losses of 3.5 percent and 5.9 percent over the last two trading days. China – which comprises about 25 percent of the MSCI Emerging Markets index – has done the lion’s share of the lifting in pulling EM stocks up this year. A collapse in Chinese equities would be likely to bring the rest of the asset class down with it. The herd effect of portfolio capital that tanked emerging markets in 1997-98 is alive and well.
Greece and/or China could be a catalyst for the long-expected pullback in US stocks. The S&P 500 has not closed 10% or more below the last peak since 2011. But – and here is where we see the usefulness of the 1998 parallel – any such pullback is in our opinion likely to play out relatively quickly and present the potential for further gains before this bull fully plays out. Investors have to put their money somewhere. If the rest of the world looks more unsettling than our home market – and this in the context of a bond market that is, if anything, harder to navigate than equities – we do not see a compelling script for a secular bear in US stocks. Navigating pullbacks requires discipline, but history shows there can be rewards for those who keep their emotions in check.
We are now one third of the way into 2015. What can we say about the state of things in the capital markets? US equities would appear to merit little more than “meh”. The S&P 500 saw out the month of April with a 1 percent drop and the Nasdaq pulled back 1.6 percent. As the chart below shows, stocks have spent most of the year so far alternatively bouncing off support and resistance levels. The longest breakout trend so far was the rally that started and ended almost precisely within the calendar confines of February. A directional move one way or the other will eventually happen, but the sluggish current conditions could persist for some time yet.
Unenthusiastic and Confused
If one could attribute human characteristics to the stock market, Mr. or Ms. Market would merit the sobriquets “unenthusiastic” and “confused”. These two attributes derive from already-expensive valuation levels, uninspiring company earnings, and a muddied picture of the overall economy in the wake of some recent soft headline numbers. At 17.0 times next twelve months (NTM) earnings, the S&P 500 is considerably more expensive than it was at the peak of the 2003-07 bull market, when the NTM P/E failed to breach 16 times. At the beginning of 2012 the NTM P/E was 11.6 times. After three years of multiple-busting expansion, investors’ current lack of conviction would hardly seem irrational.
Earnings: Clearing a Very Low Bar
This brings us to earnings. Expectations were grim as the Q1 earnings season got under way, with analysts forecasting negative growth in the neighborhood of -4 percent. That appears to have been a rather exaggerated take on the impact of the dollar, oil prices and other factors on earnings. With 72 percent of S&P 500 companies reporting, earnings per share (EPS) growth is 2.2 percent. The current consensus is for EPS growth to be more or less flat year-on-year when the results are all in (40 percent of energy companies have not yet posted, and their contribution will be largely negative). But zero percent growth, even if better than expectations, is not euphoria-inducing. The current EPS growth consensus for the full year is 1.5 percent. That’s roughly equal to the S&P 500’s price appreciation for the year to date, which may help to explain the stickiness of the current resistance levels.
Growth or No Growth?
Finally, an increasingly mixed picture of the US economy is stumping pundits and Fed governors alike. The Q1 GDP numbers released this week add another data point to the case for weak growth, joining the March jobs numbers, a string of below-trend retail sales figures, a downtick in consumer confidence, and soft manufacturing data. The question is whether this is merely a repeat of 2014 or something more enduring. Last year, an unusually cold winter helped drive negative Q1 GDP growth, but the economy snapped back nicely to grow at an average rate of 4.8 percent over the ensuing two quarters. Such was the gist of the Fed’s post-FOMC message this week: let’s wait and see what happens once the effects of winter and West Coast port problems are removed from the equation.
Since Q2 GDP will not be known before the Fed’s June conclave, we see almost no likelihood of any action on rates coming out of that meeting. That in turn will keep markets guessing for longer – potentially prolonging the duration of this uninspired “meh” market.
If you parked a chunk of cash in emerging markets equities at the beginning of this year, you are probably giving yourself a pat on the back for your keen investment acumen. While the S&P 500 struggles on either side of break-even for the year to date, the MSCI Emerging Markets index is up a brisk 8% for the same period. And since most broader EM indexes are still well below their recent and all-time highs, one might argue that there is plenty of room for more upside. That may well be – short-term market movements seldom bear any resemblance to rationality. But economic fundamentals reveal a cloudier picture, something more structural than the usual peaks and valleys of animal spirits that drive capital flows into and out of the developing world.
Growth Engines No More
The growth question is at the top of concerns nearly everywhere in the global economy. Nowhere is this more so than in the countries recently known as the world’s growth engines. The chart below shows real GDP trends for the past five years in the four core EM economies of China, India, Russia and Brazil.
Growth is below trend in all four countries. China and India continue to do comparatively well – most countries would be thrilled to post GDP numbers in the 5-7% range. But China in particular faces a stiff set of challenges as investment, which has been the country’s principal growth driver, is slowing amid growing fears of a severe contraction in property values. Meanwhile, the dismal state of affairs in Brazil and even more so in Russia should make it clear that treating these four countries – the BRICs – as anything remotely like a single asset class theme is misguided. The problems in the BR of BRIC – brrr indeed – appear structural rather than cyclical.
Currencies and Capital Flows
The relentless upward pace of the US dollar is a problem for emerging markets in several ways. The strong dollar is driving near-record levels of EM capital outflows, which exceeded a quarter of a trillion dollars in the fourth quarter of 2014 and continue apace so far this year. For resource exporters like Russia, Brazil and Malaysia, the pain from exiting capital is exacerbated by continuing weakness in commodities prices. Meanwhile, countries with high levels of dollar-denominated debt are falling into the trap of fewer resources with which to make increasingly expensive payments. A recent report by McKinsey notes that emerging markets collectively accounted for 47% of the $49 trillion increase in debt outstanding through the end of 2013. Not all of that is dollar-denominated, of course. But, generally lacking the ability to conduct international trade in their own currencies, emerging markets are at the mercy of the dollar. There is not much mercy to be found there these days.
Breakup of an Asset Class
The chart below shows the boom-and-bust pattern of emerging markets equities (iShares ETF ticker EEM) over the past three years, a period in which it has spent roughly proportional amounts of time above and below its 200 day moving average.
As the chart shows, the current price remains well below the previous highs of September 2014 and January 2013. And that last-three-years 9/14 high itself is almost 20% below the record high for EEM reached in October 2007. There may be enough momentum to propel the current rally further, but we would be inclined to proceed with caution. As we noted above, emerging markets really is no longer a single asset class. Going forward, we see more value in addressing this section of our portfolios in its component parts. Asia remains promising despite some potential road bumps along the way from China. Brazil will likely continue to be a drag on Latin America, but other regional economies including Mexico are still worth a look. As for Russia – “nyet” for the foreseeable future. Russian equities are actually going gangbusters this year. But that is coming off the trough of last year’s meltdown, and in a context where almost nothing looks good as far as the eye can see.
Large cap US stocks are barely treading water for the year to date; the S&P 500’s marginally positive return of 0.34% through Thursday’s close derives entirely from dividends. Meanwhile, small cap stocks have opened up a comfortable performance gap relative to their larger cousins. The S&P 600 small cap index is up 2.6% year to date. That’s hardly a barnstorming show of strength, but it does provide a welcome port of call in the generally choppy seas the capital markets have served up this year. Small caps may be in favor for a handful of reasons: comparative immunity from the soaring dollar’s collateral damage and mean-reversion after last year’s underperformance are two popular arguments. Is it too late to reap benefits from a tactical venture into small cap land?
Small Caps and the Dollar
The chart below shows the relative performance trend of large caps and small caps so far this year. The indexes tracked closely for much of this time, but small caps were a bit quicker pulling out of the early March pullback, and went on to chart new record highs while the S&P 500 hit resistance headwinds.
That March time period also coincided with another mini-rally in the dollar. The greenback jumped against the euro in the wake of the March 6 jobs report, bolstering the case that a strong dollar is an established feature of the intermediate term landscape. Since smaller companies on average derive a smaller portion of their revenues from overseas, investors tend to see small caps as less vulnerable to the FX headwinds that have thrown a wet blanket on large companies’ recent earnings reports.
But currency doesn’t seem to be the whole story here. After all, the dollar rallied strongly against most currencies in January, yet, as the above chart shows, small caps were not outperforming then. To understand more of the dynamics at play, we need to break down the small cap universe into its growth and value components. Style trends appear to be a more decisive factor than the currency impact.
In the chart below we see the relative performance of small cap value and growth for the year to date. This shows a style breakout that started well before small caps overall gained the upper hand over large caps.
A simple explanation to the divergence of value and growth styles lies in relative sector exposures. Two of the best-performing sectors for much of this year – healthcare and technology – account for about 35% of the S&P 600 small cap growth. Conversely, over 40% of the small cap value index is made up of financials and industrials, both of which have somewhat lagged the market this year. In fact, the entire small cap vs. large cap outperformance derives from growth stocks; the S&P 600 Value index actually trails the S&P 500 by a small amount year to date.
Bubble, Bubble, Toil and Trouble?
Over the past few days we have seen some jitteriness among names in some of the highest-flying sectors of late, notably biotech. Does this presage an imminent bubble burst? Given the sector exposures we discussed above, a meltdown in key healthcare or technology industries would likely bring a quick end to the growth-driven outperformance gap. On the other hand, there is no particular reason to pin a specific date on the trend reversal, and we’re not yet seeing much data for which value sectors would lead on the reversal’s flip side.
Moreover, while small caps are by no means cheap, a median NTM P/E of 18.6 does not necessarily scream “bubble”. Small caps underperformed large by about 4% on average last year, so a certain amount of mean reversion is likely baked into the current trend. On balance, we continue to see a reasonable case for maintaining a tactical overlay in small caps, with a more or less neutral balance between value and growth.