While there has been quite a bit of market related noise, stock prices were relatively quiet in April. Measured by the S&P 500, stock prices rose a modest 0.62% in April and are up 2.56% for the first third of the calendar year. Much of the “noise” has come from a flurry of commentary suggesting there is a new stock market bubble. Solid contrary evidence is reflected in investor confidence measures. They are not high by any means, so the recent returns from stocks have come at quite an emotional cost to the average investor.
The talking heads fussing over whether or not the stock market is in a bubble has been cross pollinated by some dramatic style shift. Returns from value stocks have far outstripped those from growth stocks for the last six weeks. Suddenly, investors are attracted to more defensive (versus cyclical) stocks, the refuge investors seek when they want to own stocks representing lower risk (and expected return). We have also seen a marked sector rotation. The dominant sectors in 2013 were health care, consumer discretionary and industrial. Thus far this year, not surprisingly, these are the three worst performing sectors. In my opinion, this is protracted profit taking by portfolio managers playing musical chairs. While these sectors have been under selling pressure, and are now trading below their 50 day moving averages, I think they will recover more quickly than not. The only sector I think will continue to limp along is telecom, which is decisively below its 200 day moving average and has dropped into a low single-digit growth phase.
More noise has come from large corporations, flexing their muscles and proposing mergers and acquisitions. Some of this activity has been footprint expanding. For example Comcast purchasing Time Warner and Excelon purchasing Pepco would simply create size. AT&T’s proposed purchase of DirecTV would transform it from primarily a wireless company into a direct competitor with Comcast. Then there is the Valeant purchase of Allergan and more remarkable, the Pfizer purchase of AstraZeneca. These are largely tax inversion schemes, where the resulting company locates its tax domicile in the non-U.S. location to avoid the higher U.S. corporate taxes. This is sand in the bed of a lot of elected officials in Washington DC and I can assure you we have not heard the last of this. Finally, the muscle transaction, GE and Siemens climbed into the ring in a slug fest to buy Alstom Energy.
The market has been trading with little regard for the very strong earnings season we’ve just seen. As reported by FactSet, 74% of the S&P 500 companies have reported earnings above the mean estimates, and 52% have reported above revenue estimates. The earnings beats are above the historical figures, and the revenue percentage is below average. The earnings are impressive considering the crazy winter most of the Midwest and Northeast suffered. Both below average temperatures and above average precipitation made this past winter one to forget for a range of different types of companies, from retail to shipping/transportation to the food industry.
The high percentage of earnings beats, impressive as it was, only tallied to earnings growth in the 1.5% range for the first quarter. This is not an impressive number. Expectations are for much stronger, hockey stick shaped earnings growth later in the year. Double digit earnings growth is projected for both the third and fourth quarters. Backend loaded forecasts are always suspect, and earnings frequently tend to get revised downward as the year progresses. Time will tell. Considering the anemic 0.1% GDP figure reported for Q1, it is a little surprising the earnings growth figures even had a plus sign in front of the number.
The valuation of stock prices is not nearly as bubbly as some would have you believe. Certain stocks do carry high valuations and/or post minimal earnings, though they are not typically the type of company we are interested in owning. The forward earnings for the S&P 500 are in the $124 per share range. At the market’s current price level, stocks are trading at a P/E ratio of 15.3x. This is not an excessively high number, though higher than the 5-year (13.2x) and the 10-year (13.8x) averages.[i]
One sector I remain quite interested in is housing, a significant component of GDP. Though I’m not a big fan of housing manufacturers, many other stocks that are derivatives of the housing industry are appealing. Stocks that focus on flooring, appliances, and furniture, for example will thrive with the improving economic backdrop as it impacts the housing industry, whether construction or rental. Data provided by the Department for Housing and Urban Development shows that the median U.S. home is now 37 years old, versus 21 years old in 1985. There is likely a freshening-up trade here, as homes are rebuilt, remodeled and refurnished.
With our newfound Spring and weather more suited to human habitation, I think focus will return to stocks exhibiting core, above-average growth rates, with reasonable valuations. While dividends are important valuation methodology, I do not think they will be as important as they are when markets head into secular downturns. I don’t think we’re there. I also think there are returns and portfolio application for short to medium laddered bond portfolios, which will throw off more income with limited price fluctuation, if in fact we see a protracted move upward in interest rates.
As usual, I am available to review your asset allocation or discuss the market backdrop in greater detail if you like. Please do not hesitate to call me. Enjoy the May flowers, at long last.
Bruce Hotaling, CFA
[i] FactSet, Earnings Insight, May 2, 2014.