Jul 01, 2015
Beware Greeks Bearing Gifts (or Referendums)
A relatively quiet quarter for stocks was interrupted at quarter-end as the charade of negotiations around Greece’s solvency had an untimely reality check. Modest equity gains that had accumulated over the quarter were given back in the process, leaving equity returns flat to slightly lower for the three months. Prior to this hiccup, two earlier sources of volatility, falling oil prices and a rising dollar, had moderated in the second quarter, creating a more stable backdrop.
For much of the quarter, stocks showed good resilience in the face of rising bond yields. Before pulling back on Greece concerns, the 10-year Treasury yield had jumped from the sub 2% levels to almost 2.5%, before settling at 2.3%. This prompted some to recall the “Taper Tantrum” that occurred in the summer of 2013, when bond yields spiked from 1.6% to 3.0%. At the time, then Fed Chair Ben Bernanke had suggested that the Fed’s stimulative bond buying program was ready to gradually wind down. Stocks sold off then as interest rates moved higher, before recovering when the Fed backtracked on a policy change. Current Fed Chair, Janet Yellen, has been more careful in her language about rate hikes. To keep markets from overreacting, Yellen has stressed that it is not the “liftoff” date that’s important, but rather the trajectory of the entire rate policy. For now, her message seems to be working.
For the quarter, the S&P 500 gained 0.3%. Non-U.S. stocks gave back strong gains late in the quarter to end flat. Growth and Value equity strategies performed similarly for the quarter and Small-cap returns matched Large-cap, with Mid-cap stocks lagging both. The NASDAQ had another relatively strong performance, while the Dow was flat. Bonds posted negative returns in the -1% to -2% range.
It’s Different This Time
Markets are often characterized by the kind of news that drives stock prices. There are times when this news is dominated by global, macro headlines or themes, and other times when stocks are driven by news more specific to relevant business conditions and individual company issues. For a lengthy time following the financial crisis that bottomed in early 2009, stocks around the world continued to be impacted by common concerns about banking system stress, the global recession and Central Bank policy. Not surprisingly, individual stock fundamentals took a back seat to these issues.
This was also true in 2012 when markets first dealt with the possible withdrawal of Greece from the European Union. The implication of a “Grexit” three years ago, when Europe was in the middle of its own debt crisis, was not well understood. Investors were naturally concerned that this could lead to broader contagion in the region, holding markets captive until an austerity and debt reorganization package was eventually agreed upon. This pattern of fear repeated on a smaller scale a year later when similar solvency issues developed around Cyprus.
This latest episode with Greece is grabbing headlines and, on a short-term basis, may continue to disrupt markets. No one can be sure we have a handle on all the unintended consequences, but markets are doing a better job keeping this risk in perspective (as they did with Russia’s annexation of Crimea from the Ukraine about a year ago). Greece’s austerity plans are out the window, but in the interim period, Europe has done a credible job implementing structural changes and building firewalls to insulate its own stability from such a one-off event. A good portion of Greece’s debt has been written down or moved out of private hands, and other peripheral countries that once seemed as financially tenuous – Ireland, Portugal and Spain – have actually improved their lot through a combination of austerity and growth initiatives. As some have ascribed, this Greek tragedy is self-inflicted.
As mentioned earlier, top-down macro influences have played a significant role in shaping the environment for stocks over the past six years, but more recently, we have seen a better balance of these influences with those from a bottom-up perspective dealing with individual company fundamentals. This is showing up in a greater differentiation among the performance of individual stocks, which we believe signifies a “healthier” stock market and one that should provide greater opportunities for investors to translate good stock level research and analysis into superior returns.
Bottom-up investment processes that firms like Meritage and others employ are based on the fundamental relationship between a company’s stock price and its own business prospects. We are keenly aware of big picture factors, especially in assessing risk and establishing asset mix targets for clients, but the most effective use of our time is understanding what an individual company is worth. When the performance of two coffee related investments like Starbucks (+38% YTD) and Kuerig Green Mountain (-40% YTD) diverge like this, we can understand this probably has less to do with the macro narrative and more about two distinct sets of company fundamentals at work.
The Haves and Nots
In terms of what investors paid attention to in the second quarter, there is evidence of stockholders paying up for companies that can grow irrespective of the current slow growth environment. This preference for relative growth would typically favor classic growth sectors like Health Care and Technology, but this has also been more visible on an individual stock basis within sectors. The broad Tech sector has essentially been flat for the year, but the divergence in performance between industries within Technology has been wide. The Retail group has registered strong returns, but less so across the board when you strip out the outsized returns from internet retailers, Netflix and Amazon.
For many sectors, the strongest performers this year have been driven by companies involved in merger and acquisition activity, skewing a sector’s return between the have and have-nots. Year-to-date statistics show the current pace of consolidation is close to historic levels. Cash and valuation-rich companies have found this to be an effective way to add top-line growth at a time when the underlying economy is lifting fewer boats. No reason to expect this trend to change in the second half.
Health Care has had the best combination of real growth and corporate buy-outs, particularly in the managed care and biotech groups. Our Value strategy has had good exposure to the former, and biotech is well represented in our Growth strategy, with both industries ranking well in our selection process. With the economy operating at below capacity levels, these fundamentally sound businesses should continue to perform well. We also know momentum driven investors can push stock prices beyond reasonable valuations, so we rely on our investment ranking process to provide this valuation discipline. When we sell a successful investment, it doesn’t mean we think the stock will necessarily decline any time soon, but more likely the risk-reward trade-off is no longer skewed in our favor.
This emphasis on relative growth, in turn, has held back returns in businesses more closely tied to the economic cycle. Key groups among these have been the rails and airlines, energy and semiconductors. Yield-oriented investments like REITs, MLPs, Telecoms and Utilities have languished as investors seem to be anticipating that interest rates will rise further.
As is sometimes the case, some of these yield investments may have run too far when investors were clamoring for income in recent years, but when the Fed eventually lifts rates above the zero threshold, equity yield should still be distinguished from traditional, safe fixed income alternatives and the demand for that yield should remain attractive, especially to investors more suited to seeing a dependable income component to their return. Yield-oriented equity strategies that stay true to their discipline, like our Yield-Focus approach, should continue to produce solid long-term results, though we understand there will always be times when a particular style is out of favor.
Despite the current bull market now passing the six-year mark, nothing has changed in our intermediate view on equity returns. The underlying support of low interest rates and monetary accommodation remain in place, extending this favorable multi-year backdrop for stocks. Valuations remain in the upper-end of a normal range, but as we discussed in our Investment Update last quarter, valuation provides little help in identifying market tops and bottoms. First quarter earnings were not strong, but they were better than recently lowered analyst estimates. With the dollar and oil prices more stable this past quarter, second quarter earnings should fare better.
Investment strategists remain measured in their equity projections and sentiment measures show investors have become more skeptical as the market has moved sideways over the last six months, something not usually associated with market tops. Also not typical of market tops is one that has allowed investors ample time to exit around the top, as the current environment has. Markets are rarely so hospitable.
Once we move beyond the Greece event, we would look for a visible improvement in economic activity and company results in order to justify any meaningful move higher from today’s levels. And we would be more circumspect of such a move if it is simply an expansion of valuation multiples. Given our more modest expectation regarding economic growth, we foresee a more moderate return trajectory from what we would otherwise expect from the longer-term averages. Still, we are encouraged by the market’s increasing differentiation between company fundamentals and the resulting opportunity to add value through stock selection.