Posts tagged Sec
Should you be concerned about the somewhat bumpy ride US stocks have encountered in the past couple days? Or is this a welcome chance to get in some long overdue bargain hunting before the S&P 500 resumes its lazy upward drift to a series of new highs?
The answer would depend, we imagine, on whether you see the unrest on the Korean peninsula – arguably the best go-to explanation for yesterday’s 1.45 percent pullback in the US benchmark index – as something genuinely serious and potentially destabilizing, or as little more than a spate of made-for-Twitter taunts that will, as these things generally do, settle down. As you contemplate this, bear in mind that most of the intense geopolitical flashpoints in history (notably including the 1962 Cuban Missile Crisis) have had relatively negligible impacts on asset returns in the months following the event. We have noted before that disaster doesn’t strike far more often than it does strike.
Caveat Bargain Hunter
That being said – and our instinctive proclivity towards bargain-hunting notwithstanding – there are some reasons entirely unrelated to geopolitics that merit some thought before doubling down on your equity market exposure. This comes back to a theme we have discussed extensively with clients in recent weeks, namely, the rather listless, leaderless nature of the market’s upward drift this summer. Consider the chart below, which shows the relative performance of the main S&P 500 industry sectors against the benchmark index for the year to date.
In this chart we draw particular attention to three sectors: technology, financials and energy. These are the three sectors that were the key drivers of profit growth in the just-concluded second quarter earnings season. Energy led the way with a triple-digit earnings rebound from the depths of the sector’s miserable 2016. Technology and financials both enjoyed double-digit earnings growth and the tech sector’s top line was strong as well, helped along by the benign tailwind of a weaker dollar against major trading partners.
With the exception of tech, though, these earnings haven’t translated into share price performance. Energy continues to be the market’s problem child, seemingly unable to convince investors that the current trough recovery in earnings is sustainable. Financials, of course, were the darling of the post-election reflation trade before that ill-conceived flight of fancy crashed and burned in this year’s first quarter. Banks and their ilk have trailed the benchmark since then. And tech, even though it maintains a solid performance lead this year, has shown itself to be vulnerable on several occasions, most notably with that big pullback in early June.
The apparent lack of attention paid to earnings extends to the level of individual stocks as well. A Financial Times article earlier this week reported on the market’s apparent failure to reward companies beating their Q2 earnings estimates, noting that “there has been little or no reward for companies reporting better than expected earnings per share and sales.” This observation fits in squarely with our contention that, while the market drifts higher in the absence of a compelling negative headwind, it lacks a sustaining theme. And without such a sustaining theme the market is, we believe, more vulnerable to the types of external shocks we have seen this week.
Labor Day Looms
As we write this before Friday’s market open, we have no crystal ball to tell us whether yesterday’s pullback will extend for a few more days (S&P 500 futures are about flat with 20 minutes to go before the open). We haven’t seen a multi-day pullback for more than a year and a half, but they do happen with some regularity. We think it more likely than not that the Korea kerfuffle will subside in due time, playground taunts from both heads of state kept in check by cooler heads. But the listless market will still be exposed to these kinds of periodic shocks, and they may come into sharper focus as the traditional back to school season approaches. Yesterday the VIX, the market’s “fear gauge”, shot up above 17 after weeks of historically low dormancy. Until we have another compelling, sustainable positive trend narrative, we should not be surprised to see more of these periodic, brief solar flares.
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.
Today’s Gen Y-ers are intuitively proficient at tapping into the cloud to glean wisdom from multiple sources. Friends, circles, people you have never met and never will meet, all can contribute to a steady drip-feed of insights about anything from where to get your hair done to the best place for Belgian mussels to how to brew India Pale Ale. So perhaps it is no surprise that one of the fastest growing trends in the investment world is a phenomenon known as crowdfunding. There is a growing movement bringing together entrepreneurs, intermediaries like angel investor networks, and the investing public. The SEC has weighed in with a proposed regulatory framework for crowdfunding, in response to legislation passed by Congress in 2012. For better or worse crowdfunding is part of the financial landscape now, and needs to be analyzed and understood.
The Wisdom of Crowds
Some years ago James Surowiecki, a social sciences author and commentator, published a book called The Wisdom of Crowds containing much of the philosophical view that informs crowdsourcing. One of the interesting cases in the book tells of studies conducted at county fairs in Britain some time ago. Fairgoers were invited to guess the weight of a particular livestock animal on display, such as a pig or cow. They would write down their guess on a piece of paper and put it in a jar with all the other guesses.
All the guesses by the passers-by were tallied up and averaged. The crowd’s average was then compared to the individual estimates of three livestock experts familiar with the physical characteristics of the animal on display. Almost invariably, the crowd’s average estimate was closer to the animal’s actual weight. As Surowiecki goes on to show in his book, this dynamic plays out in a variety of settings and subject matters. “Common wisdom” seems to be a real thing, not an oxymoron. Does common wisdom apply in the evaluation of investment opportunities?
Late last year the SEC released a proposed regulatory framework for crowdsourcing, including disclosure requirements, caps on issue amounts, marketing and communications guidelines for intermediaries, and anti-fraud protections. This has given rise to a new Wall Street acronym: PIPR (Private Issuer Publicly Raising). PIPRs are limited to a maximum issue size of $1 million for publicly crowdfunded deals. Separately, though, the SEC issued Rule 506(c) removing any marketing limitations at all for PIPRs if the target audience comprises accredited buyers only ($200,000+ in annual income and/or $1 million or more in investable net worth).
Much about crowdfunding remains to be studied and evaluated. There are clearly risks to be considered, and the opportunity certainly is not for everyone. But in an environment where traditional financial channels – bank loans and the like – are increasingly difficult for young enterprises to come by, the appeal of crowdfunding is obvious. And for investors interested in playing a role in the next generation of business growth stories, a sound regulatory and capital markets infrastructure for the dealflow may help to facilitate their involvement.
Our brains are wired to seek explanations for things - to weave a sensible narrative around events in the hope of making them seem less random or threatening. We see this play out every time a reporter stares at us assuredly from behind the anchor desk and tells us that “the stock market did X today because of "Y”. “Y” could be the release of Fed meeting minutes, or Russian troops amassing on the border of Ukraine, or a Chinese bond auction failure. It doesn’t really matter what the day’s headline is; the news anchor is crafting a story out of the millions of random buy and sell orders flashing in trading system centers around the world. The stories may help us process information, but there are limits to how much light they can really shed on the goings-on of the capital markets.
Cyclicals and Defensives
One of the recurring favorites of Wall Street storydom is how various industry sectors and investment styles perform at different stages of the business cycle. The rule of thumb is that defensive sectors tend to do well when the economy turns down; conversely, cyclicals have a history of outperformance during times of economic strength. Slowdowns favor value-oriented stocks, where dividends contribute significantly to total return. Growth stocks are the leaders during the good times. Or so the story goes.
Time for a Value Story?
Consider the last twelve months; we show here below the performance of US large cap value and growth equities.
The chart shows a seemingly nice, tidy style trend. Growth stocks decisively took command in summer 2013 and led the market’s rally through January 2014. That trend started to run out of steam in February and went into sharp reversal last month, with value back in the ascendant. How closely does this trend track the business cycle from last summer through the present?
Quite a lot, perhaps, at least on the surface. During the fourth quarter of 2013, a series of macroeconomic data built a case for stronger than expected growth. The Fed’s December Board of Governors meeting ended with a decision to begin tapering the QE program, another sign of confidence in economic recovery. Markets rallied strongly through the end of the year. But the New Year presented headwinds. Jobs data painted a mixed picture: lower unemployment, but less-than-stellar payroll gains. A harsh winter took a toll on much of the country. Russia amassed troops on the Ukrainian border. This would seem to paint a compelling value/defensive narrative.
More Than Meets the Eye
If you look closely enough at the underlying data in any given market trend, though, you are likely to see more complexity than the top-line narrative would suggest. Consider that the top-performing sector during that growth run in the second half of 2013 was healthcare, traditionally considered to be one of the more defensive sectors. Or that the cyclical materials and consumer discretionary sectors were strongest during the February pullback.
Moreover, with the harsh winter behind us, the US economic picture for the rest of the year continues to look relatively upbeat. Economists have lowered their expectations for first quarter earnings, but expectations for the full calendar year are in the high single digits – hardly indicative of a burgeoning slowdown.
Certain growth sectors do indeed seem to be reversing – much of the decline in major US indexes this week has come from the tech and biotech sectors. But that may be more about investors rebalancing their portfolios – buying the losers and selling the winners – than it is about any meta “return to value” narrative. If there is a sector story, maybe it is simply this: mean reversion happens. Every now and then it’s time for something to mean-revert up, and something else to mean-revert down. It’s not a very colorful story, to be sure. But letting the data speak for themselves may be a better way to invest than trying to guess what the next big-picture story will be.