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MV Weekly Market Flash: Small Caps: Dollar Haven or Danger Zone?

March 27, 2015

By Masood Vojdani & Katrina Lamb, CFA

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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.

Sector Drivers

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.

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MV Weekly Market Flash: NASDAQ Fever, v2.0

February 27, 2015

By Masood Vojdani & Katrina Lamb, CFA

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It was a giddy era, a time of seemingly endless possibilities. At the beginning of 2000, New Media upstart AOL announced a planned takeover of one of the storied blue-bloods of the print world, Time Warner. Silicon Valley was awash in engineers and secretaries alike cashing in their millions in stock options and buying vineyards in Napa Valley. Affixing a “dot.com” to the name could turn just about any run-of-the-mill business proposition into a high-flying multimillion dollar enterprise.

And then it all ended, horribly. The NASDAQ Composite index, home to virtually all the newly-minted Internet hotshots, crashed through record high after record high on its way to 5048, the March 10, 2000 close. And that was the last time NASDAQ ever saw daylight, to paraphrase the movie Titanic’s Rose Dawson. In fact the trajectory of NASDAQ’s rise and fall bears appropriate resemblance to an iceberg, as shown in the chart below.

The Long Road Back

Well, it may have taken 15 years to get here, but the NASDAQ Composite is now poised to put the final coda on the Great Macro Reversal of the 2000s. The S&P 500 and the Dow Jones Industrial Average both surpassed their previous records in 2013. NASDAQ is the third of the so-called headline U.S. stock indexes, the ones that news announcers unfailingly recite in their daily financial news segments. Of course, there is nothing intrinsically special about 5000 or 5048 – a price by any other name is still just a price. But perception often becomes reality, as long-term students of the ways of markets understand. Round numbers and prior highs matter because they are triggers embedded in the bowels of thousands of algorithms. When the trigger activates, the money flows. Momentum doesn’t last forever, but it can lend a tailwind to near-intermediate term price trends.

Not the NASDAQ of Yore

Beyond the “NASDAQ 5000” headlines there are fundamental differences between the index circa March 2000 and that of today. Nowhere is that more clear than in a valuation comparison. At its 2000 peak, NASDAQ sported an eye-popping LTM (last twelve months) P/E ratio of 100. Of course, many of the most popular trades of the day didn’t even have a meaningful “E” to put in the denominator of the equation – they had no earnings to speak of for as far ahead as the eye could see. Investors bought these first-gen Internet companies on a wing and a prayer.

Today’s NASDAQ includes a handful of survivors from the Fall, as well as others that have made an indelible mark on the world since. The top 15 companies by market cap on the index (which collectively account for just under 40% of the total market cap of all 2500+ companies listed on the Composite) are a veritable Who’s Who of the industry sectors at the forefront of U.S. economic growth. Leading the way is Apple, of course, with a $750 billion market cap and a stranglehold on the smartphone industry. Apple’s share of all global operating profits from smartphone sales was an astounding 89% in the 4th quarter of 2014.

The other names in NASDAQ’s elite bracket are likewise familiar, including Internet giants Google, Amazon and Facebook, biotech leaders Gilead and Amgen, mobile chip maker Qualcomm and still-feisty Microsoft. Now, it’s still not a particularly cheap proposition; the average LTM P/E for this top 15 is 29.1 versus 20.5 for the entire index (which in turn is about a 1.15x premium to the S&P 500’s LTM P/E of 17.8). At the same time, though, it is a very far cry from the silly nosebleed valuations prevailing at the turn of the century.

L’économie, c’est l’Internet

In 2000 the Internet still accounted for only a small sliver of real economic activity. Social media had yet to be born, online retailing was still embryonic, and few companies outside the tech sector had any real clue about how the New Economy affected them, beyond the basic effort of putting up a static corporate website. In the span of fifteen years, the Internet has come in from the periphery to envelop practically every conceivable sphere of economic activity. By all appearances, its influence will only grow more pervasive. Now, this of course does not mean that NASDAQ has nowhere to go but up. At some point a significant correction will likely be in the cards. But it seems hard to imagine how a properly diversified portfolio in the second decade of the 21st century could avoid meaningful strategic exposure to the NASDAQ Composite’s leading lights.

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MV Weekly Market Flash: Melt-up? Earnings vs. Animal Spirits

December 19, 2014

By Masood Vojdani & Katrina Lamb, CFA

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Over the past several weeks we have considered various scenarios for capital market performance in 2015 among various asset classes. For U.S. equities we have converged on a base case that sees continued upside in price performance, but with that upside more or less limited by earnings growth. In other words, if earnings were to grow in the upper single digit range as is the current consensus, we would expect to see similar growth for stock prices. While we believe this case to be reasonable, there are other ways 2015 could unfold. We consider one of those alternatives in this article: a late-stage bull rally, or “melt-up”.

The Case for Earnings

The reasoning behind our thinking for the earnings-led rally is nicely encapsulated in the chart below. This shows that over the past three years stocks have grown at a much faster clip than earnings: the S&P 500 has appreciated by 71% over this time while earnings per share (EPS) for S&P 500 constituent companies have grown at a more modest rate of 18%.

With these numbers in mind, let us consider why our base case posits earnings growth as the likely key driver of stock price performance in 2015. In essence, a company’s stock price is nothing more than a reflection of the potential future value of all its cash flows. It’s not terribly difficult to value these potential future cash flows using time-tested techniques like discounted cash flow models. In theory, the net present value of all these future cash flows, expressed on a per-share basis, should exactly equal the company’s stock price.

The real world is messier than theory, though, so we use metrics like the price to earnings (P/E) ratio as a shorthand way to gauge value. The P/E tells us how much investors are willing to pay for each dollar of net income the company earns. As the above chart illustrates, over the past three years investors have been willing to pay ever more for that same dollar of earnings – that is why stock prices have risen more than three times as fast as the underlying earnings. The P/E ratio for the S&P 500 is higher than it has been at any time since 2004. Margins – income as a percentage of sales – are at historic highs. But those sales have grown at fairly modest rates relative to historical norms. If the top line – sales – is growing at only 2-3%, which is typical for many large cap U.S. stocks, then profit margins must continually improve (e.g. through cost-cutting and business process efficiencies) to support bottom line growth in the 6 – 10% range that has been characteristic of the past several years. We think EPS growth in excess of 5% is reasonable to expect, but see a less compelling case for double digit upside.

So: an expensive P/E multiple, and single digit EPS growth in the context of a benevolent macroeconomic environment argues for stock price growth more or less in line with those mid-upper single digit earnings. It seems reasonable. But there are other variables at play that could produce a different outcome. Enter animal spirits.

The Case for Animal Spirits

John Maynard Keynes coined the phrase “animal spirits” to reflect the less rational, more emotional side of investing and economic decision making – specifically, the emotions of fear and greed that habitually drive market price trends. It is safe to say that the animal spirit presiding over the second half of 2014 has been the bull. The chart below shows the S&P 500 price performance for this period, and a couple things here are instructive.

First, we have seen the market appreciate by about 6% over this period. But, impressively, this appreciation has come with three fairly significant pullbacks in July, October and December. Each pullback turned out to be incredibly short-lived, with the V-shaped recovery ever steeper. In the most recent December event the pullback was over almost before anyone could actually register that it was happening.

This kind of daily trading pattern indicates a growing level of volatility that was missing for most of 2013 and the first half of this year. Such volatility is sometimes the precursor to a late stage bull market – “melt-up” is the favored industry jargon. Melt-ups happen when money that has been sitting on the sidelines – cash, fixed income portfolios, hedge funds with neutral or short equity positions – comes flooding into high-performing stock markets. This happened in the late stages of the 1990s growth market, when everyone and her grandmother wanted a piece of the dot-com action.

A 2015 melt-up would imply the P/E multiple expansion that our base case discounts. It would probably benefit some of the traditionally riskier asset classes like small caps and emerging markets, as well as beaten-down commodities like oil, natural gas and industrial metals. It would probably require some macroeconomic and geopolitical tailwinds: improvement, or at least no significant worsening, of troubled economies in Europe and Japan, a resumption of trend growth in China, relatively little material fallout from Russia’s ongoing weakness, and a continuation of the positive U.S. economic narrative. And the specter of rising rates could be a catalyst to pull in money parked in fixed income asset classes.

To be clear, our default case remains earnings-led growth with little or no multiple expansion. But market conditions suggest that a melt-up is entirely possible. We remain on the lookout for any attendant tactical opportunities that may present themselves.

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MV Weekly Market Flash: Giving Thanks

November 26, 2014

By Masood Vojdani & Katrina Lamb, CFA

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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.

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MV Weekly Market Flash: Time for a Check-up: Assessing Performance in the Health Care Sector

November 14, 2014

By Masood Vojdani & Katrina Lamb, CFA

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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.

Inclusive Rally

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.

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