The New Defensive Sector

Utilities, real estate, consumer staples. Long considered the defensive play in equities when uncertainty rises.  Looking back on 2020, though, and for several years prior, we see a very different pattern.  Year to date, utilities and real estate have logged negative returns of 7-8%, while consumer staples, which everyone flocked to at the onset of the pandemic, are up a mere 5.3%.  

Moreover, the utility ETF XLU fell precipitously following news of the Coronavirus, dropping 36% from late February to late March.  The recovery that followed from the March 23 lows, still places XLU at  14.8% below its pre-Covid highs. The story in no better in real estate, with the IYR falling 57% peak to trough and currently down 10.24% on the year.  Even the consumer staples ETF (XLP) following not-so-distant memories of store shelves emptied of paper products, cereal, pasta and cleaning supplies, fell 16% at the outset of the crisis and stands just 5.5% up on the year.

So if the traditional defensive sectors were not where investors were hiding in troubled times, where did they go?  In a word, technology.  The XLK towers above other sectors this year, with a total return to date of 35.8%.  But what's most interesting is that the XLK actually fell less than traditional defensive sectors like utilities and real estate, during the early days of the crisis, before rallying back hard in the ensuing months.

Here's what has been driving tech equity performance and why it's still relevant to investors today. Large tech companies showed their resilience to the crisis, with many companies posting solid revenue and earnings growth in Q1 and Q2 vs similar periods in 2019.  Investors now increasingly believe that Amazon, Netflix, Apple and Microsoft, among others, are impervious to cyclical employment and broad measures of consumer demand.  With interest rates on hold, the discounted present value of tech earnings creates considerable value to support earnings multiples and valuations.

While diversification is essential to portfolio management, tech very likely will continue to outperform amidst growing uncertainty around the election, vaccine development and the restart of the economy.

A Fresh Start

Wow.  It's been a while since I last posted.  Looking at the date of my last article, like four years!  It's time to reengage.  I'll try to keep the blog postings coming, with at least two per week, so there will be something new to read if you return to the site as often as you like. Some posts may be short, some much longer.  As in the past, I'll keep the focus on business and economics, but will also include more posts on the human experience in an increasingly harsh and contentious society.  

Something has changed in America that threatens our connectedness and our respect for one another. No doubt, the discord has been amplified over the past four years of the Trump administration, but it started long before in a bitter and divisive congress and an anachronistic two-party political system.  America has drawn sides, liberal, conservative, Democrat, Republican and all the news of the day is somehow politicized.  As you might have guessed, I'd like to keep this site free of politics, as best as can be done.  There's plenty of that on the internet. It's my hope that we can look at issues on this site fresh, unburdened by political ideology.

I welcome and encourage your comments, although I ask that postings be civil and respectful. No one should be so naïve as to expect a world without controversy or where there is universal agreement on all issues.  But the world needs to restore intelligent, well mannered conflict.  Let's find it here, together.

2017 Stock and Bond Market Predictions - Part Two

The period following the November presidential election was, by many measures, extraordinary. Equities soared, bonds and interest rate sensitive stocks declined, while Dow leader Goldman Sachs saw its share price climb by 30% in just six weeks. By now, we're all familiar with the thesis: less regulation, lower taxes, greater fiscal spending on infrastructure, higher inflation and more rapid growth will all contribute to earnings growth in 2017. The ability of the new Trump administration to rapidly advance each of these themes, however, is at best uncertain. Nonetheless, each issue has likely contributed to the equity rally and bond market decline. 

Of these factors, the most likely new policy of the administration out of the box is widely believed to be some sort of a tax cut. And therein lies the rub, as we turn to 2017. In post-election 2016, higher stock prices were driven by greatly expanding p/e multiples. Whether new policies, if enacted, may contribute to earnings growth and thus, lower multiples over time, we can only guess. 

But one thing appears all but certain. The market is convinced that lower tax rates will prevail in 2017. In fact, this one single factor may have contributed the most to the post-election rally, and may now pose the greatest risk to 2017: a lack of selling in November-December if capital gains were deferred to 2017. With the New Year just days away, we'll soon find out whether this is in fact what has happened. That being said, it might be well worth putting stops in place, just in case.

The New Year will also see the ability of scheduled OPEC cuts to restore balance to the oil markets. The first quarter is typically a period of scaled-back production for Saudi Arabia and many other OPEC producers. It will be critical for oil markets to see some cuts in production over and above the normal seasonality to instill the confidence necessary to support prices. OPEC member production will also be monitored closely for cheating, as has been the case with prior OPEC agreements. To this, we add scaled up production by US shale producers and potential demand saturation in China as inventories, ramped by lower prices, are expected to fill. If the market loses confidence in the ability of OPEC to manage the oil glut, prices could fall swiftly and dramatically.

With the December Fed meeting now behind us, it's unlikely the Fed will do much for the next several months, as they await new information. Thus, bond markets will be driven by hard economic data, in short supply over the past several weeks. The strong dollar has already negatively impacted exports, raising the trade deficit, and thus weakening projected GDP. If fourth quarter consumer spending data is weak, bond yields will accelerate their descent of the past few sessions. In this environment, interest rate sensitive stocks will gradually rise, as we're now beginning to see in telcos, utilities and select REITs. 

The first quarter of 2016, following the Fed's December 2015 rate hike saw bank stocks decline, utility stocks rally, bond yields fall and gold rise. That was against the backdrop of a sharp selloff in stocks early in Q1. Nonetheless, gold, bonds, utilities are now all higher following the Fed's December 2016 rate hike. Financials are lower. Caution is advised.

2017 Stock and Bond Market Predictions

Regrets for taking so long between posts. I plan to be better about posting next year...get more exercise...and more sleep.

Before moving on to the 2017 forecast, let's take a look at what took place in various segments of the markets in 2016, including the impact of major political developments on those markets. The S&P currently stands at 2265, up 10.8% year to date. Fully 8.7% of these gains, however, occurred in the last five weeks following the US Presidential election. 

Equity markets fell sharply early in 2016, largely on China worries, falling commodity prices, a collapse in oil prices and record low bond yields. By mid-February, the S&P 500 would fall by nearly 10%, before snapping back to rally to new highs in mid-April. But by July the market was up just 5% on the year, and with some volatility, stayed in this range pretty much up until the November election. 

Major political events, unexpected and shocking to many like Brexit, the Trump victory and the Italian referendum would disrupt markets, but with ever shorter periods of recovery, before pushing to new highs. It's been said that the stock market took three days to recover from Brexit, three hours to recover from the Trump victory and three minutes following the Italian referendum. Amidst these recent, post-election gains, however, and with new infrastructure spending still years away (if at all) the rise in stock prices has been entirely attributable to price/earnings multiple expansion. The S&P 500 now stands at 26x 12-month trailing earnings, second only to historic peaks in 2000 and 2008.

Oil played a major role in markets in 2016, with WTI falling below $27 per barrel in January. Soon thereafter rumors of planned price collusion of OPEC began to swirl, first at Doha, then Algiers and finally Vienna. By the time a deal had been struck, it was early December, with oil prices artfully manipulated for the entire year. Despite the recovery in prices and the alleged OPEC deal, however, oil remains vastly oversupplied.  US EIA data indicates that average daily global oil storage builds in 2016 are expected to average 700 million barrels, dropping to 400 million barrels per day in 2017 (presumably on the OPEC cuts). Oil in storage in the US is just below 500 million barrels (and well above five-year historical averages for this time of year) while oil stored at Cushing, Oklahoma is rapidly nearing capacity.

The UST 10-year bond yield would begin the year at 2.27%, approximately 26 basis below its current level. For all the drama about soaring bond yields, the 10-year is at levels of June 2015 and 50 basis points below its levels of January 2014. That being said, the sell-off in bonds in the latter part of this year, was swift and severe. The 10-year hit a low of 1.46% in July 2016. While yields crept higher thereafter, the 10-year would still be trading at just 1.56% at the end of September. 

What followed for bonds was increasing concern about the Fed, on hold for the entirety of 2016, but widely expected to hike the fed funds rate this past fall. After numerous false starts in June, July, August and September, the Fed would finally hike, but not until mid-December (and then, by just 0.25%). In it's forecast for 2017, the Fed indicated that it would likely hike rates another three times, which spooked a market that had been predicting two hikes for 2017. Turns out, the Fed actually dialed back its hawkishness from the four rate hikes it predicted for 2016 (again, only to raise just once).

But it was the Trump victory in November that greatly accelerated the sell-off in bonds, and with it, interest rate sensitive stocks like utilities, REITs, Telcos and other dividend plays. In moments following the election, investors became rapidly convinced that a Trump Administration, supported by a Republican House and Senate would move swiftly to implement tax cuts, infrastructure spending and financial deregulation. Markets quickly concluded that lowered tax revenue, coupled with greater fiscal spending could only mean greater deficits and, with them, a rapid acceleration of inflation. Long-term interest rates promptly reacted. Yields on the UST 10-year would jump by 70 basis points in just five weeks. But what does all this imply for 2017? Perhaps not what many are thinking.

Part 2, a forecast for 2017 will follow in the next few days...I promise.

Bank Earnings Blowout (Reprise)

JP Morgan, Citi and the tarnished Wells Fargo all reported third quarter earnings this morning. The press was ecstatic. CNBC's original headline "J P Morgan Crushes Expectations", was quickly revised to read "JP Morgan Profit and Revenue Easily Tops Forecasts". At Business Insider, the headline was even more bold: "JP Morgan Smashed it out of the Park". The headline for Citigroup's release at CNBC was "Citigroup Tops Wall Street Expectations for Earnings and Revenue".  

But none of these titles accurately captures what is going on with bank top line revenue or profits. Reading past the headline, here's what we actually learn. JP Morgan saw its earnings decline by 7.5% year over year and its top line revenue climb back to just above where it was in the third quarter of 2014, two years earlier. And this is the report from the nation's top performing bank. The news at Citibank was no better, with top line revenue falling 4.8 % year over year and profits falling by 5.3%. 

These results confirm a trend of now greater than four years of declining bank revenue and earnings, as previously reported here for 2016 Q2. The major US banks are effectively shrinking, based upon poor top line revenue growth and profitability.

The Trump Campaign Struggles with the Real America

Poor, poor Trump. As successful as he may have been in the business world, he’s clearly out of his league when it comes to Washington. Try as he might, he’ll never be as polished, his record never as scrubbed, his views never as focus-group tested as it takes to win a major election. He’ll fail to cut the back room deals that build support within his own party, fail to carefully cultivate the media that so expertly shapes public opinion, nor will he promise the favors of access sought by powerful special interest donors. 

His campaign will struggle with finances, raising only $94 million by July 1, 2016, versus the $386 million raised by his Democratic opponent. A pathetic $5 million of his funding will come from Super-PACs, compared with the $121 million raised by Hillary Clinton. He won’t get the $1 million donations given each by JP Morgan, Citigroup, Goldman Sachs and Morgan Stanley to Clinton, nor the $1.2 million given by the taxpayer-funded institution, the University of California (note, Obama’s former head of Homeland Security, Janet Napolitano, is now the President of UC). His paltry $2,000 in funding from the hedge fund industry will be dwarfed by the $25 million received by Ms. Clinton’s campaign. He’ll lack the two-faced, deceptive, partisan skills of successful members of the US Congress, a body that now enjoys an approval rating by the American people of just 11%.

In the end, he’ll likely be returned by the electorate to his role as real estate developer, never to amass the 400% gain in personal wealth of Barack Obama during his tenure in the White House, nor the $111 million fortune built by the Clintons through their public service. Washington will go on as it has, an ever escalating arms race of special interest donations, with never a serious effort at campaign reform. We’ll fail to meaningfully attack the federal deficit, perhaps allowing the US national debt to double once again, as it has over the past eight years. We’ll fail to fix social security, disability insurance and medicare, leaving a ticking time bomb at the doorstep of an aging population. We’ll continue to shift the ever-increasing burden of health care costs to middle and upper-middle income consumers, compromising the quality of their health care while devastating disposable incomes. We’ll become even more polarized in our wealth as a society, as we have undeniably become over the past eight years. All the while, Congress’ day to day activities will stall in senseless, immature partisan bickering to form, what President Obama so aptly characterized in 2014 as, “the least productive Congress in modern history.” And, we the American people will be left wondering, is this really all we can expect from government?

No one can defend Trump. All the same, it would be interesting to see someone who thumbs their nose at both the Republican and Democratic parties stumble their way into the White House. Paul Ryan would suffer irritable bowel syndrome for four years. But here's the real concern: a binary political system we Americans have somehow come to accept. If it it's not this, then it's that. If you're not a liberal, then you're a tee-bagger. If you oppose illegal immigration, then you're a racist (by the way, notice the word "illegal" in that sentence). We demonize the opposition. And it's all designed to foster the interests of the two parities who only fein attention to what benefits our country when focus groups show voter support. Once that nonsense is out of the way, the politicians can return to the actual business of government, addressing the concerns of special interests and Super-PACs. Sorry Mr. Trump, but we live in a post-democratic technocracy, where the parties only exist to perpetuate their incumbency.

Understanding Dividend Yields

The search for high dividend yielding stocks continues as investors seek alternatives to the abysmal yields on fixed income securities. A stock yielding 3% in the context of a US Treasury 10-year yield of 1.55%, definitely looks attractive. Well, maybe.

Dividend yield is the projected annual dividend per share of a particular stock, divided by the price. So if General Motors, for instance, is paying an annual dividend of $1.52 per share and the stock is trading at $32, the dividend yield is 4.75%. Far better than the 10 year Treasury.

But there are three important points to remember for those investors buying high dividend yielding stocks. The first consideration is that dividends are declared each quarter by the board of directors and, therefore, can be cut or suspended at any time. We've all seen this happen to stocks like Conocophillips (COP) that announce a dividend cut earlier this year. After entering 2016 with a dividend rate of $0.95, the company cut its dividend in Q2 to $0.79, and in Q3 to $0.49.  The stock now trades at $41, fully 25% off its recent November 2015 high of $55.  Meanwhile, other large integrated oils, not cutting their dividends, have risen considerably over this period.

Second, the dividend yield is an annual number. In other words, if you purchase the stock, hold it for a year and the dividend rate does not change you earn a dividend yield, in the case of GM, above, of 4.75%. Now, of course, what is important to investors is not the annual dividend yield, but rather the total return in holding the stock. For instance, taking this same example, if you buy GM today at $32 and it closes one year from today at $30.5, just one and one-half point lower, your total return for the year is exactly zero - quite a bit less than the yield on that US Treasury.

These two considerations are fairly obvious, but there is one more point for dividend investors that's often overlooked. The dividend yield when you purchase a stock is only the projected yield you are to receive (assuming no cut to the dividend rate) at the price at which you acquire the stock. In the example above, the dividend yield for GM purchased at a share price of $32 today is projected to be 4.75%. 

But what happens to your yield over time, is of equal importance. Let's say that you find GM an attractive investment at the prices and yields mentioned. Now, let's say that you hold GM for a year and the price rises to $35. Well, you've done quite well on the investment. Your total return for the year would be $14.12% (9.375% in price, plus a 4.75% dividend). But at this point, assuming no increase in dividend rate, your projected dividend yield has fallen to 4.34%. Still a very impressive yield. But for stocks that have risen appreciably, the current estimated dividend yield may be far less than when the investor purchased the stock. As such, investors should periodically reconsider why they are holding the stock and its estimated dividend yield on capital currently deployed.

Is a Fed Rate Hike Good for Bank Stocks?

With talk of a Fed rate hike at its September meeting increasing, following comments of Stanley Fischer and other Fed governors at Jackson Hole, bank stocks are enjoying quite a run. Bank of America is currently trading at $16.14, a nearly 45% gain from its February 2016 lows.  Citigroup is up 38% and JP Morgan +28.5% (a nice game for Mr. Dimon who publicly purchased $26 million of its shares on February 12). The financial services ETF, "XLF" is up an impressive 27.5%.

Some of this gain was a bounce off the February lows, but a healthy share of the return has been produced over the past 30 days as focus turned toward the Fed's Jackson Hole Symposium. Rightly or wrongly, the market thoroughly believes that higher rates are good for banks, as long-suffering bank net interest margins profit by a higher interest rate lending environment.

Truth be known, a hike in the Fed funds rate, in and of itself, is negative for bank earnings. Such a rise in short term rates has to be accompanied by a far larger increase in term lending rates to produce net interest income benefit to the banks. Part of this disconnect has to do with the mystery surrounding the Fed. Despite the Fed's noble efforts at transparency, market participants remain convinced that the Fed has secret data insights, not otherwise available to the markets at large. If the Fed is moving on rates, the economy must be heating up and with it the UST 10-year, or so the thinking goes.

Of course, the Fed is not privy to some covert set of data, but rather is looking at the same economic data as everyone else. In fact, their prolonged hesitation over the most minor of (and nearly insignificant) rate increases should be ample evidence that the data on the economy is more confusing than it is compelling. Nonetheless, as the chatter rises, bank stocks head higher while utility stocks, bonds and gold - each of which thrive in a low interest rate environment - drift lower.

This being said, it's probably worth taking a look at how markets actually reacted in the days and weeks following the Fed's 25 basis point rate hike last December.  As discussed in a previous post, in the several weeks following the Fed's December 15, 2015 rate hike, the 10-year UST actually fell in yield (bad for bank earnings, by the way) while utility stocks and gold posted some of their best gains in recent memory. 

The XLF shows a similar phenomena, rising to a close of $24.44 on the day following the Fed decision, up nearly 32% from its August 2015 lows. But in the days that followed, the XLF quickly began to fade, falling nearly 5% the very next day. By the time of the February 2016 lows, the XLF had fallen nearly 20%. Eerily, the XLF today, as we approach the September Fed meeting stands at precisely the same level, $24.56, as it did on the day prior to the December Fed meeting. 

The Fed, Bonds, REITs and Utility Stocks

The Fed is hosting its 2016 annual academic conference in Jackson Hole, Wyoming this weekend.  Fed Chair, Janet Yellen is scheduled to speak. While no interest rate decision will be announced, markets nonetheless are fixated on developments. With little real economic data or interest to move stock and bond prices, traders eagerly await some insight into future rate policy, in hopes of gaining some direction for markets.

We see the impact of Jackson Hole on bond and utility stock prices, and prices for REITs.  Each of these instruments trade as fixed income securities and are, therefore, rightly influenced by trends in interest rates. But, it's actually long term interest rates that impact these instruments over time, not the short end of the curve that the Fed sets.

Utility stocks have performed extraordinarily well over the past six months, as we first pointed out in this blog in April 2016, Investing in Utility Stocks.  Utility stocks as measured by the return on the ETF, XLU, were up 18.8% through August 10 of this year (see Returns on Selected Assets Year to Date).  It's also worth reading our 2016 market predications posted on December 30, 2015 and What's Working in this Market Correction from January 7, 2016.

Over the past few weeks, though, bonds, REITs and utility stocks have given back some of their gains as investors eye a potential rate hike by the Fed.  Let's take a look at how bonds are priced and why I treat utility stocks as the equivalent. Utility stocks generally trade with a high level of dividend yield. Because utility revenues are quite stable, the dividend is therefore predictable and protected, as much as possible, from swings in the economy.  Therefore, as with bonds that pay a fixed level of interest, the value of the utility stock is tied to the discounted future value of the dividend stream. If the dividend is stable, the stock value will rise as the discount rate falls and decline as the discount rate rises.

Markets, of course, are forward looking, which explains why utility stocks are weakening, while no interest hike has actually been scheduled. The Fed also does not directly impact longer term interest rates that are the basis by which utility dividend and bond interest would be discounted. Nonetheless, the markets are fragile and investors anxious.  

If we look at the last Fed hike on December 15, 2015, however, we see a very different picture emerge. The US 10-year rose by 2 basis points to 2.30% in the day following the announcement, eventually rising to a high of 2.32% on December 29.  But the yield began immediate falling thereafter, to 2.00% on January 28, and 1.63% by February 11, 2016. The 10-year yield now sits at 1.55%. The XLU utility ETF, by the way closed on the day of the December Fed hike at 42.33, climbing to 53 on July 6, 2016 (a gain of 25%).

This points to the most interesting aspect of how bonds and utility stocks trade, not on forecasted Federal Funds rates, or perhaps even the US 10-year, but on the forecast of inflation in the economy, as inflation erodes the value of fixed income securities. The point of all this is that if a Fed hike acts to curb growth (and therefore inflation) a rise in the Fed Funds rate could actually act to lower the US-10 year and raise, not lower, the price of bonds and utility stocks. This is precisely what happened following the Fed's December rate hike. There's no reason to believe that this would play out any differently in the months following the next rate increase.

Wall of Worry

We've all heard this expression, to refer to stocks clawing gains to new highs amidst a market of doubters. It's contrarian logic. Buy when others are selling, when skies are at their most foreboding.

Recent reports have highlighted significant equity mutual fund and ETF outflows of both domestic and international equities, suggesting at least retail investors may be worried indeed. An article in Barron's indicates that fund outflows from U. S. equities in July deepened to a six-year low. International stocks followed suit. ISI Evercore Research reports that fund flows out of equity mutual fund and ETFs last week alone totalled $6 billion, bringing the year to date fund flows to negative $95 billion, a near record.

Now, to those of the contrarian view, the data argues for bullishness with the market soon to drive ever higher. Well, maybe. While markets have been known to climb a wall of worry, just as often investor uneasiness plays out as expected in future events. The herd isn't always wrong.

Take a look at the chart above. It shows the historical pattern of U.S. domestic equity fund flows paired with the S&P 500. While retail investors were seemingly caught off guard in the 2001 tech wreck, only to pull money from equity funds as the market fell to new lows, the stock market crash of 2008 paints a very different picture. While markets pushed ever higher throughout the fall of 2007, equities began to see negative fund flows as early as April, with money being pulled out of the market in increasing volume throughout the year, before the market began to topple in early 2008.

Today's negative fund flows from US domestic and international equities could be just the contrary signal that bulls are looking for, or this time, the herd could simply be right.