Friday, April 29th came on the heels of the worst day for stocks since mid-February; U.S. shares were under pressure Friday as investors reacted to a mixed earnings season, the latest moves or lack of moves from the world’s central bankers and fresh incoming economic data.
In spite of the final two days of April with the Dow Jones industrial average tumbling 211 points Thursday, its worst one-day point drop since Feb. 11, and falling 56 points, or 0.3% to close Friday at 17,775 the Dow ended up 0.5% in April. The Standard & Poor’s 500 stock index ended April with small gains, of 0.3%. The Nasdaq did not fare nearly as well, falling 1.9% for the month.
The first quarter of 2016 was a tale of two quarters. In Part 1, from the start of the year to February 11, markets plummeted. Oil prices bottomed at $26.21 a barrel, a 13-year low and the S&P 500 index was at its lowest level in two years. Then in Part 2, things turned: markets rallied broadly and the S&P 500 recovered more than 12 percent over the following six weeks.
What’s in store for Q2?
As we head into the second quarter, the big questions are: Will we see a repeat of Part 1 or Part 2? And what sectors may be best positioned for the next three months? Here’s a quick look at some of the most notable winners and losers from Q1.
Defensives
According to Bloomberg, the best performing sectors in the first part of Q1 were telecom and utilities. This should come as no surprise, as those so-called defensives historically tend to perform best when the broader market is falling. Then, in Part 2, riskier sectors had their moment. Materials, tech and consumer discretionary returned 15 percent or more and financials, industrials and energy were close behind, all according to Bloomberg data for Q1. All 10 sectors showed strong performance, including the defensives.
Going forward don’t forget the ingredients for geopolitical risks: The continued uncertainty surrounding the U.S. election, a potential “Brexit” of Britain from the European Union and a possible yuan devaluation in China, just to name a few. Now is a time when quality could be important. Bottom line: The defensive sectors — telecom, utilities, staples and real estate investment trusts (REITs), have the potential to continue to perform well.
Energy and materials
Both of these sectors rebounded in Part 2 of the first quarter as oil prices appeared to stabilize — for now. It seems very unlikely these sectors can continue to perform well without a sustained rally in the price of oil, which is dependent on reducing the supply glut.
Multiple expansion, which we have written about in the past, explains a lot of the gains in the energy sector. Here, the picture seems far worse. At the start of the year, energy earnings were projected to be down 44 percent. Now that number reads a 99 percent decline in earnings. Despite this, the P/E ratio for the sector is up over 7 percent. Energy trades at the highest 12 month forward P/E relative to all other S&P 500 sectors: 51x earnings. The expectations for 2017 earnings growth are at 83 percent, as of Bloomberg Consensus Estimates at the end of Q1.
Bottom line: I’d be cautious about expecting oil prices to double through 2017. Meanwhile, the earnings picture for energy and materials does not look encouraging.
Technology and healthcare
It’s very surprising that two sectors with some of the strongest balance sheets, revenue growth and stable earnings according to Bloomberg data, are the two worst performing sectors year to date. The two sectors are technology and healthcare. Both were favorites of hedge funds and long-only managers for years, because they led the pack during the period of overall earnings growth for the entire market.
However, when sectors become “crowded”, they also become prone to unwinds when investors pull their positions. Many areas of tech and healthcare have suffered from this phenomenon recently.
Bottom line: Over time, higher earnings typically lead to higher stock prices, so as long as technology and healthcare maintain their track records of revenue growth and headline earnings growth, they could become top performers again.
A final note: Whether the second quarter looks more like Part 1 or Part 2 of the first quarter, the most sensible approach is diversify — but be selective about where to seek opportunities.
As the bull market gets long in the tooth and earnings have disappointed, some shareholder friendly policies have slowed—namely M&A activity and share buybacks. A company’s commitment to paying a dividend has remained a priority and those growing their dividends are likely to continue to attract investor attention. Even as markets have been relatively calm as of late, investors should be prepared for volatility to return.
Now: a little on portfolio design and reasonable expectations.
The last few months have been tough on most investors. Not only have most asset classes, and long-only-related strategies, been in negative territory, but stories abound about the top names in the hedge fund world struggling in this environment. From Ray Dalio of Bridgewater to Bill Ackman of Pershing Square, and to David Einhorn of Greenlight Capital to John Paulson of Paulson & Co., investors have reacted. Hedge fund assets have been declining and most liquid alternative categories have likewise experienced net outflows. Our observation is that these outflows are often times a function of unrealistic expectations. Investors routinely mistake “low correlation” or “uncorrelated” with “negatively correlated.” Only negatively correlated assets rise in a falling market.
A portfolio is a collection of assets assembled to achieve a certain goal that is almost certainly not measured over days or weeks. As Yale’s David Swensen has said, “Casual commitments invite casual reversals.” The purpose of a robust due diligence process must be to avoid making such an error. The due diligence process has to ensure that investors know what they are buying, what the return drivers are, and what embedded risk factors exist. Investors must acknowledge that the dips in the growth of a dollar chart may be painful in that moment, but are to be expected. If the initial reaction is to sell when a strategy prints a negative return we’d suggest re-thinking the diligence process itself, rather than the strategy selected.
One problem that becomes clear every time market volatility rises is that investors expect “uncorrelated” to be negatively correlated. In other words they are really looking for a direct hedge. The problem with direct hedges is that they are rather expensive when you don’t need them. The pain of holding those positions for months or years before they payoff often leads to abandoning such positions prior to the time when they would in fact become useful. The simplest example would be the iShares VIX Short Term Futures ETN (VXX). Had you held VXX during August and September, you would have made a staggering 60% gain — certainly an effective hedge during a horrible time for the rest of your portfolio! However, there’s much more to this story. This same investment, if purchased at the end of 2014 and held through the end of September, would have been down nearly 19% during the same timeframe that the S&P 500 Index lost only 5.3%. Maybe not such a good hedge after all…
So what’s the point of beating up on VXX? It’s that direct hedges are costly and that positive returns to such hedges are usually produced over very short time frames, requiring deft timing skills if they are going to be captured. Alternatively, prudent investors should probably rely on indirect hedges or uncorrelated assets that over longer timeframes produce returns that are independent of the market, knowing that at any given point these investments may behave similarly to the market. You build a portfolio for the long haul. Getting too focused on day-to-day movement can only undermine the hard work you have already done.
When evaluating your portfolio, you must ask yourself: “What do I really want?”
Have a question? Let us know! Email us at info@wsmtexas.com.