#equity review

[shannoninvestment]

4Q18 Equity Review

The stock market (represented by S&P 500 above) opened the 4th quarter around 2925 and generally fell from there. That opening level essentially was also the high for 2018. The October decline came as “too-good-to-be-true” names (e.g. FAANGs) became suspect - which led investors to question valuations across the market. Heightened concerns around tariffs and a slower global economy brought stalwarts like Caterpillar and 3M under pressure as well and further reinforced any negative sentiment.

For the 4Q18, Utilities was the only sector with positive returns at a measly +0.51%. Energy was the biggest decliner (-24.28%) as oil prices fell due to higher production levels and general concerns regarding slowing global growth. Oil then fell further due to confusion around Iranian sanctions going from “off” to “on” to “sort-of on”. Other sectors with 15% or more declines were Industrials, Technology, Consumer Discretionary and Communication Services.  

On the positive side, as third quarter earnings were released at the beginning of 4Q, companies were again growing earnings in the mid-20% range, which should be supportive of share prices. Unemployment rates are at all-time lows. However, all this good news (Good Is Bad?, Issue 15) came as the economy nears its ten-year anniversary of uninterrupted growth and the Fed stays intent on preventing the economy from overheating. Continued rate hikes and QT (please see Jargon) instituted by an untested Fed regime made many investors nervous. All this combined with slowing growth in China, geo-political concerns in Saudi Arabia and Italy, Apple’s poor earnings guidance, falling oil prices, tariff battles with China, and Mnuchin liquidity statements (please see What Were You Thinking?) was too much for the market. On Christmas Eve, the S&P 500 closed at about 2350, its lowest level in a year and a half.  

Since then, an apparently more patient Fed, modest stock valuations and few signs of recession resulted in renewed stock fervor and a 13% jump from its Xmas lows, while underscoring the risks of sitting out a market rebound.   

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3Q18 Equity Review

The U.S. economy is growing (and growth is possibly accelerating) but that can make some nervous. Since the 2009 end of the Great Recession, subsequent GDP growth has been notably sluggish in pace but notably prolonged in length. Will higher growth escalate inflation and therefore keep the Federal Reserve on its rate hike path? Be careful what you wish for.

The U.S. stock market, as represented by the S&P 500, extended its positive run in the 2nd quarter, rising to 2,914 at the end of 3rd quarter, good for a 7.7% return (including dividends) over the three-month period. However, it would be careless not to mention that 1) in the last two weeks of September the S&P 500 hit an all- time high and 2) in the first two weeks of October the S&P 500 slid to 2,766, a 6.66% decline over the 2- week period.

Within the U.S., the Healthcare sector again led the way in the quarter followed by Technology and Industrials. Laggards were Communication Services (which was recently reconfigured), Energy (which was a leader in 2Q18) and Real Estate. Year-to- date, Healthcare and Technology are again the frontrunners in addition to the Consumer Discretionary sector (think Amazon) coming in as the top performer.

In general, corporate earnings have been strong which makes forward valuations and share prices on the reasonable side of high – should future earnings come in as expected. Consumer confidence remains high, capital goods spending should be strong and the full impact of tax cuts may yet be realized. However, the possibility of increased raw material costs and/or falling revenues (both impacted by trade tariffs) combined with potentially higher interest and labor costs could erode earnings. At the same time higher interest rates could lead to lower stock valuation multiples and therefore lower stock prices.

Looking across the globe, U.S. equity returns led the way at +7.7% for the 3rd quarter, supported by solid economic growth. As to other large markets, the European and Latin American indices generated (barely) positive 3rd quarter returns at +0.1% and 1.5%, respectively while the Pacific Region and Emerging Markets significantly lagged at -2.6% and -2.7%, respectively for the same period. Trade tariffs and protectionism remain concerns - particularly regarding China.

A natural outcome of the disparate returns between the U.S. and the world markets has led to foreign market valuations being all-the-more appealing on a relative value basis. However, this relationship has been in place for some time and may not normalize. Caution is merited and compelling asset class alternatives may be scarce.

[shannoninvestment]

2Q18 Equity Review

In 2Q18, the U.S. stock market, as measured by the S&P 500, made some progress in recovering from the selloff in February. but remains below the January high of 2,872. For the three and six-month periods, the index had total returns of 2.88% and 1.67%, respectively. In comparison to other popular benchmarks, the S&P 500 significantly trailed the tech-heavy NASDAQ return of 6.31% for the quarter, though outperformed the MSCI EAFE (Europe Australasia and Far East) minus 2.34% for the three months. These foreign developed markets lagged the U.S. as a global economic recovery no longer seems in place and European countries wrestled with political, trade and tariff issues, which were felt even more painfully in emerging markets (MSCI EM minus 7.96% for 2Q18).

The biggest (and lately an infrequent) contributor to index performance in 2Q18 was the Energy sector, up over 12% as WTI jumped $10/barrel over the three months. Other sectors driving second quarter performance were Consumer Discretionary (Netflix and Amazon) and Technology (Microsoft, Apple, Facebook and Alphabet). Real Estate, Healthcare and Utilities, often viewed as defensive sectors provided more modest, but still positive contributions to S&P 500 results. Sectors dragging down performance were Industrials, Financials, Consumer Staples and Telecom. The fact that certain Consumer Discretionary and Technology names (think FAANG) once again dominated performance has raised questions about the recent lack of breadth in the equity market. With six stocks accounting for 98% of S&P 500 performance over the last quarter, some worry if there are enough other stocks to keep the market moving higher should these few names falter. (At the same time, betting against FAANG and similar names has not been a winning proposition.) However, whether due to animal spirits, tax cuts, sentiment, share buybacks or deregulation, earnings have been impressive in general and broader market participation may be merited. According to Thompson Reuters, S&P 500 earning were up an average 26.6% year-over-year in the first quarter and 20+% earnings growth are expected in 2Q18. With stock prices stagnant while earnings continue to rise, price earnings ratios fall and stock market valuations may seem more reasonable (please see Worth 1000 Words for P/E ratio graph, elsewhere in this Issue). As such, continued broad exposure to equities may be merited for those investors with suitable objectives, time horizons and risk tolerances. 

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1Q18 Equity Review

The adjacent graph shows the performance of the S&P 500 for the 6- months ending 3/31/18, with the dotted line representing the 2017 closing level. The new year saw an extraordinary 5.5% increase for the S&P index in the month of January alone, in what may have been a perfect combination of a synchronized global recovery, expectations for higher corporate earnings and low interest rates. This “Goldilocks mix” of growth and rates was shattered with the jobs announcement in early February which hinted of inflation with wages showing the strongest gain since mid-2009, though still a relatively modest increase from 2.5% to 2.9%. The result was an 8.5% stock market selloff from the end of January level and a 10.3% fall from the January peak – enough to trigger the declaration of a “correction”. The rest of the quarter saw the index bounce between 2600 and 2800 as the market consensus shifted between concerns that extraneous events will derail economic growth or that a too robust economy will require aggressive Federal Reserve interest rate tightening. For the quarter, the S&P 500 was down 1.2% - with a lot going on in between.

Technology and consumer discretionary were the only sectors with positive performance for the 1st quarter – but it wasn’t due to the usual suspects. In an interesting twist, the tech part of FAANG (Facebook, Apple, Amazon, Netflix, Google) stumbled as concerns with privacy and sales growth slowed Facebook, Google and Apple, with their under-performance accelerating around quarter’s end. In a win for diversification within a sector, “old school” tech names like Adobe, Hewlett Packard Enterprises and Micron Technologies surged to allow that sector deliver good (+2.3%) returns for the quarter. Consumer staples, energy, materials and real estate were the worse sectors for the quarter.

April provided what may be a more significant win for general diversification across all sectors. While consumer discretionary and tech were the best performers for 1Q18, they were also the laggards in April as more headlines focused on privacy and postal rates. At the same time, growing concerns with a trade war benefited domestic sectors with the real estate, utilities and energy were the only sectors to deliver positive performance in April.

Another notable theme for 1Q18 was the strength of smaller size companies. Mega-cap names under-performed large- cap names that further under-performed small-cap companies. This could be attributable to the negative headlines for many of the largest names as well as concerns about the impacts of a trade war and/or a continued weak dollar. A final theme for 1Q18 was the performance of foreign markets wherein U.S. markets under-performed non-U.S. developed markets which further under-performed emerging markets.

All of this support continued diversification across names, sectors, market-caps and geographies.

[shannoninvestment]

A Mean Reversion?

Coming off such a strong year for the US (and global) equities, some investors have voiced concern that the stock market can be expected to fall. Putting simple numbers to the issue, the thought is that as the S&P500 returned 20% in 2017 (twice the long-term average S&P return of ~10%), it can be expected to fall back toward its long-term average return. Again simplistically, a 0% return in 2018 would roughly get us back to an average 10% return over the two-year period.

In the investment field, this theory is known as mean reversion, wherein the rate of return (or various other statistics) will move back toward the long-term average (aka mean) after a period of abnormal performance. While I support the notion that trends generally revert toward “normal”, it is a theory best applied over longer periods of time and does not preclude one strong year from being followed by second. Much like a basketball player with season-long shooting success of 50%, if he makes three shots in a row doesn’t mean his 4th shot can’t go in. Staying with the basketball analogy, shooters and markets can be “streaky” and what has been working for an athlete (or economy) may continue for longer than expected.

The adjacent graph is a good depiction of equity market performance and one I’ve used to highlight volatility of returns. The blue bars show the annual return for the S&P 500 for 1970 to 2015 with the orange line representing the average annual return. What’s notable is that, while the average (mean) return over the period is about 11%, you seldom get an actual return of 11% in any given year. Rather, returns are well above or below 11% - like +21.6% in 2017 or -36.6% in 2008 (a very mean reversion). But note the “streakiness” of returns, particularly on the upside. Successive strong years can arise from depressed markets, strengthening economies or the absence of investment alternatives. The current market i s a challenge to understand but reflexively sitting out any given year can be perilous.

[shannoninvestment]

4Q17 Equity Review

The stock market’s notable run in the first nine months of 2017 continued into the 4th quarter. Focusing on the S&P 500, the index broke through 2600 in November and 2700 in December. Another popular benchmark, the Dow 30 (Dow Jones), broke multiple thresholds as well in passing 24,000 and 25,000 in the 4Q17. For the quarter and year, the S&P500 had total returns of roughly 4% and 21%, respectively.

In retrospect, it could be viewed as a year that would be painful to have sat out – but maybe even more difficult to buy into. With the current US economic expansion now the 2nd longest on record, and many having viewed the market valuations as already stretched, some investors reportedly sought “better entry points” at which to buy . Unfortunately for those waiting for a dip, the S&P500 has gone 66 weeks without posting a 2% weekly price drop. Similarly, the S&P 500 had positive returns in each month of 2017 – for the first time since at least 1970. Not surprisingly, the VIX or “fear index” (see Jargon, elsewhere in this issue) remained at historically low levels throughout the year.

The performance for the 4th quarter (as well as for the year) was pretty broad based. While some interest rate sensitive sectors (e.g. REITs & Utilities) in addition to Healthcare delivered modest total returns for 4Q17, all other sectors returned ~6-to-10% for the quarter, led by Financials, Consumer Discretionary, and Technology.

While domestic stock delivered exceptional gains in 2017, for the first time since 2012, international shares did even better. This was part of a synchronized global recovery where economic growth and earnings growth combined to deliver better than expected returns and resulted in new highs being repeatedly achieved across markets.

Though it occurred late in the period, the dominate equity market news of the quarter (and possibly going forward) was the passing of a Federal tax bill. While the impact on the individual side will vary significantly, the changes on the corporate side should be universally positive. In the first sweeping tax law restructuring in 30 years, corporations should see lower tax rates, accelerated (or even full) depreciation further sheltering income, repatriation of cash held abroad, a boost to capital expenditures, increased mergers & acquisitions and should result in more buybacks, dividends and other earnings- friendly activities. The benefits to equity markets is already being realized.

[shannoninvestment]

Back To The Future

Microsoft Word - Issue 12, Winter 2018.docx

Two years ago, as I wrote Issue 4 of the SIM newsletter, the stock market was stagnant or declining and investors were trying to manage around a stubbornly weak U.S. economy, a slowdown in China, tumbling oil prices and a Federal Reserve that just raised interest rates for the first time in seven years. As I wrote at the time:

“While the S&P 500 started and ended 2015 around 2050, it sits at 1880 as of this writing – a level experienced in August and again in October 2015. Even after the 8% sell-off YTD, there can be no assurances that the current level will hold - but with the existing low interest rates, a patient Fed, strong US labor market and a 15.8X multiple to forward earnings, the current market is closer to its long-term average than a peak level whereby patience is recommended.”

What subsequently happened in 2016 and beyond was that the interest rates remained low, the Fed remained patient, unemployment continued to shrink and the S&P 500 returned approximately 12% and 20% in 2016 and 2017, respectively.

Now looking back, the subsequent two-year stock run might have seemed easy but there was plenty to worry about along the way (e.g. Brexit, U.S. elections, drug pricing, N. Korean aggression, Russian meddling, Mideast tensions, healthcare and tax reform). And now there are different things to worry about as the S&P is up 33% over the past two years. Sure, interest rates are still historically low but are rising and the Federal Reserve has a new chairperson. But the other two issues raised in January 2016 have changed. The U.S. unemployment rate fell from 5.0% to 4.1% and employment gains for 2017 hit 2.1 million, the 7th straight year of job gains above two million – a run we’ve seen only once before. Jobs and the economy have been growing and are reflected in that 33% S&P 500 gain. However, the market multiple currently sits at almost 19X forward earnings – a level that makes an unwavering commitment to equities a little more difficult. Then again, the recent tax cut might change everything.

[shannoninvestment]

1Q17 Equity Review

The strong equity market returns experienced in 4Q16 continued into the 1st quarter of 2017, but did take a pause in March. Nevertheless, the stock market - as measured by the S&P 500 - returned 5.53% for the quarter (with dividends) and reflects steady appreciation since the January 2016 selloff. A closer look might reveal that some themes initially favored in a “Trump trade” may have stalled, if not fully reversed.

Under a pro-business administration, reduced taxes, less regulation and more infrastructure spending would be expected to combine to lead to job and economic growth - but with higher inflation. Unsurprisingly, the best performing sectors over the last six months were Financials, Industrials and Materials sectors. This all was logical as a surging economy would likely result in rate hikes - benefitting banks, insurance and other financial companies while renewed public and private capital expenditures would advance manufacturing and construction companies as well as the use of metals, mining, chemicals and construction products

Things changed in the first two weeks of March, when both the S&P 500 and 10-yr Treasury yield hit recent peaks. Since then, economic growth prospects appear to have moderated, taking the steam out of stocks. Falling bond yields are also viewed as reflecting diminished growth prospects.  For the last 30 days (March 12th to April 12th) sector performance turned upside down, with Financials now the worst performer followed by Healthcare and Industrials. The best two performing sectors over the 4-week period were Real Estate and Energy - after these same two sectors were the worst performers over the last 6 months.

The turn in the market has coincided with the new administration’s growing challenges in implementing domestic policies while geopolitical concerns with Russia, Syria, North Korea and others grew. As discussed in You Never Can Tell, managing around headlines could prove both difficult and fool hearty, so a look at the economy is warranted. Notably, unemployment remains low, inflation is under control, consumer confidence is strong, China seems stable, housing data is positive, leading indicators are up, corporate earnings turned positive in 3Q16 and the economy is growing - though not a 3-4% targeted growth rate.

While there is plenty of news out there, it’s important not to lose sight of the strength of the economy and long-term appeal of equities.