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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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MV Weekly Market Flash: Right Back Where We Started From

October 24, 2014

By Masood Vojdani & Katrina Lamb, CFA

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For a brief few intraday trading moments last week the S&P 500 fell below the level of 1848 (year of revolutions!) where it started 2014. The ensuing v-shaped rally has pushed the index fairly comfortably back into positive territory. But the price-equity (PE) ratio remains a bit below where it opened the year; the twelve trailing months (TTM) PE ratio as of October 23 is 16.3 as compared to 16.5 at the beginning of January. The chart below shows how the PE ratio has trended over the course of this year.

What the PE Ratio Tells Us

The PE ratio is a valuation metric. Think of it as a yardstick for how much investors are willing to pay for a claim on a company’s earnings. For example, a PE ratio of 10x at ABC Company means that investors are willing to shell out $10 for each dollar of ABC Company’s net earnings per share (EPS). If the PE goes from 10x to 12x it signifies that investor perceptions of ABC company have improved; they are now willing to pay $2 more for that same dollar of earnings. A fall in the PE – say from 10x to 8x – would mean the opposite. Value investors, in particular, analyze companies with low PE multiples (relative to the market or their industry peer group) to see if there is a bargain to be had; to see whether there is value in the company that the market, for whatever reason, is not recognizing.

The Multiple and Its Message

Bringing the discussion back to the above chart, it would seem that investors’ attitude towards stocks in general isn’t far today from where it was in January. There were a couple rallies that pushed the PE higher and a couple pullbacks that brought it back down, but over the course of the year the multiple has repeatedly reverted towards the mean (average) level of 16.5x. In our opinion there is a good reason for this, and potentially a message about where stocks may be heading as we start planning our allocation strategy for 2015.

The consensus growth estimate for S&P 500 earnings in 2014 is around 6%; in other words, earnings per share on average should be around 6% higher at the end of the year than they were at the beginning for the companies that make up the index. As it happens, 6% is not too far from the index’s price appreciation this year. We would not be surprised to see this relationship still largely intact as the year closes: a positive year for stocks in which the PE multiple neither expands nor compresses, with mid-upper single digit gains for both share prices and earnings.

Still Not Cheap

The recent pullback has done little to change the fact that stocks are still expensive, on average, relative to long term valuation levels. In the chart below we see the same PE ratio as in the first chart, but the time period goes back ten years to October 2004.

For the last ten years the average TTM PE ratio was 14.6x, considerably below the current level of 16.3x. Remember that the higher the PE, the more expensive the market. In fact, prices are currently higher than at any time since 2005 (we should note, though, that they are still far below the stratospheric levels achieved in the final frenzied years of the late ‘90s bull market). This prompts us to recall the title of the 2014 Annual Outlook we published back in January: “How Much More?” In other words, how much more multiple expansion could we expect to see given how high the multiple already is?

For the past three years the Fed has been the driving force behind an across-the-board rally in U.S. and, mostly, global equities. With QE3 coming to an end (probably) and rates heading slightly higher next year (probably), stocks will be left more to their own devices. We think it reasonable to assume a base case of positive growth in share prices more or less in line with earnings; in other words, a continuation of the 2014 trend. We also see a good case to make for a return to focus on quality and selectivity – companies with solid cash flows and robust business models – rather than an indiscriminate buy-everywhere approach. We may be wrong. Late-stage bull markets can lure cash in from the sidelines and expand PE levels ever higher, as in 1998-99. Conversely, any number of things from Europe’s economy to a China slowdown to worsening geopolitics could spark more broad sell-offs. When we establish a base case we do so with several alternative scenarios. Our thinking may change – we are data-driven and not ideological. But right now, growth without much multiple expansion seems plausible.

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MV Weekly Market Flash: The Cupertino Circus

September 12, 2014

By Masood Vojdani & Katrina Lamb, CFA

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Apple is a phenomenally successful company, and at $607 billion it is also the world’s most valuable enterprise. So it is probably not surprising that new product announcements would command Wall Street’s attention. But there is a level of showmanship and high drama to Apple’s product launches unparalleled in the annals of modern markets. The effect these feats of corporate kabuki have on the stock market should put the definitive nail in the coffin of the Efficient Market Hypothesis and the idea that the market is in any meaningful way rational. 

Fanboys and Haters

This past Tuesday Apple convened a conference in its Cupertino hometown to announce a sequence of new offerings: new versions of the iPhone, a new payment application called Apple Pay, and its debut into the so-called “wearables” market with Apple Watch. How did the markets react? A picture says a thousand words. 

 

“Don’t fall in love with a stock” is a timeless maxim, but one seemingly lost on the vast legions of Apple devotees as well as the less populous but still prominent haters of everything Jobs, Cook & Co. The skeptics had the upper hand as CEO Cook described the features of the new iPhone 6 and 6 Plus. Perhaps the market’s dour take on the new 4.7 and 5.5 inch screens is that they address a market where Apple’s rivals, notably Samsung, have an existing advantage. In any event, the bulls regrouped when Cook moved on to the second innovation, a payment system aimed at nothing less than consigning the credit card to the dustbin of economic history. Finally came the product tech blogs and fanboy sites have been chatting about for weeks: the Apple Watch. Some observers seemed to like it – the Financial Times correspondent Tim Bradshaw spent part of his liveblog coverage doing a selfie/demo of his Watch-adorned wrist. Oh, and U2 performed live! But Wall Street turned its nose up and the share price plummeted.

Intraday Ranges and Small Countries

Let’s put some quantitative context into that wild roller coaster of a price ride. The intraday spread between the high point reached after the Apple Pay announcement and the post-Watch low was 7.2%. Now, 7.2% of $607 billion is about $44 billion. By comparison the total Gross Domestic Product of Botswana is about $34 billion. Yes, more money changed hands in reaction to a single company’s product launch than the total economic worth of several dozen sovereign nations.

Did the net present value of Apple’s future cash flows really change by a magnitude of $44 billion in the space of an hour? After all, the fundamental value of any stock is nothing more or less than the sum total of the expected future cash generated by its assets, discounted at an appropriate cost of capital. Now, these new products will very likely make a significant contribution to Apple’s earnings for years to come. But there is plenty of uncertainty about the future for any business, including category-killing Apple. That uncertainty should in theory keep a lid on immediate changes in the stock price. But financial theory is often starkly at odds with financial practice.

The Wisdom of Crowds

Is there anything useful to be gained from this snapshot of the collective response to Apple’s new products? We do think the crowd got it right in one sense, which is that Apple Pay was probably the most interesting, and potentially game-changing, announcement of the day. Although the technical details are still coming out, one of the apparent features of this platform is a security function giving added protection to customers’ financial data. Neither Apple nor the merchant will collect user data during a transaction; payment approval will be transmitted by a unique code. Given the unsettling, and likely continuing, rise in cyber fraud, Pay could prove to be a very strong addition to the Apple product line.

But that remains to be seen. Apple is best known for sleek, engaging and user-addicting consumer technology. Apple Pay is a deviation from the standard playbook that Steve Jobs handed off to Tim Cook. We probably will not know for some time whether the crowds truly were wise in their insta-valuation of Apple Pay.

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