You can read a review by Tyler Cowen at the Washington Post here. A short adaptation of the novel is printed here.
In 2015, Geoff Colvin, Senior Editor at Large with Fortune Magazine, published Humans Are Underrated: What High Achievers Know That Brilliant Machines Never Will. The book describes a new economy and the displacement of human jobs by computer software. The most interesting parts of the book were about what skills will be highly valued in the future economy. Colvin emphasizes the human-to-human interactions of empathy, story-telling, and team-building as examples of skills not likely to be automated. Why are schools so focused on teaching kids STEM, science technology engineering and math, not empathy, story-telling, and team-building? The transition from the knowledge-based economy to the human-connections economy will allow workers to focus on human interactions and relationship building. The book is an interesting read, but the sweeping conclusions are a bit idealistic and utopian. When I first read it, I wanted to run out and become a therapist. I can empathize, I thought. But future jobs will likely require both knowledge in STEM and skills in human interaction. It's not one or the other, but rather a need for both. Colvin makes it sounds like empathy, story-telling, and team-building will get you the next fortune 500 CEO job. It's a combination of knowledge-skills and soft-skills. The engineer who can empathize and the lawyer who is a story-teller. Of course, we all want a doctor with a good bedside manner, that's not a new idea. Colvin concludes healing and diagnostic skills will be automated, and the only thing the doctor will be left to do is feel for you, but I think this is an over-simplification. He touches upon team-building and the value of colocation, and highlights the fact that women typically score higher in the soft-skills area. Colvin brings all these human qualities together to underscore the importance of human connections. The broad conclusion on how the economy will function in the future is a bit of a stretch in my opinion. But his argument is completely compelling. Are empathy, story-telling and team-building important? Yes, for sure, but is social worker pay going to jump above software engineer pay anytime soon? I doubt it. It's a thought-provoking, well-written book and worth a read.
You can read a review by Tyler Cowen at the Washington Post here. A short adaptation of the novel is printed here.
Martijn Cremers is a Professor of Finance at the Mendoza College of Business of the University of Notre Dame. He published a research article in the latest Financial Analysts Journal titled, "Active Share and the Three Pillars of Active Management: Skill, Conviction, and Opportunity." The paper, accessible here and here, includes some great research on Active Share, Active Fee, holding period, and market cap. I recommend it to anyone interested in academic research on investment management. Active Share was first introduced by Cremers and Petajisto (2009) as a percentage of a fund's portfolio that is different from the fund's benchmark. One of the primary conclusions of Cremers' research is active managers with low Active Share tend to consistently underperform.
Cremers did NOT found statistically significant evidence that high Active Share led to outperformance or underperformance (although it may be a good starting point in fund selection). He did find strong evidence that low Active Share led to underperformance. These active managers are sometimes called closet indexers because they charge an active management fee for an index-like portfolio. To boil it down, if you are going to invest with an active manager, look for an Active Share north of 70% or even 80%. Cremers also provides Active Share information on mutual funds free of charge via the website activeshare.info. If you would like help looking into this or more information, please contact me.
The Vanguard Europe ETF, $VGK, and the European developed markets may be setup to outperform the U.S. equity market after a decade of underperformance. There are various ways to analyze this trade, and I will walk through a simple thought process to understand the risk and potential return of an overweight Europe versus U.S. equity position. First, I would like to look into the sector breakdown of each region. Below are the sector weightings of $VGK and $VTI:
The largest sector difference is in the technology sector. The U.S. has a much higher technology weighting than Europe, 20.4% versus 4.3%. On the other hand, Europe has higher weightings to materials, defensive, financials, telecom, industrials and energy.
Take a look at the super sectors to get in even higher level breakdown. Here are the super sector weightings:
Europe is overweight the cyclical and defensive super sectors while the U.S. is overweight the sensitive super sector.
Looking at the top holdings, this trade sells $AAPL, $GOOGL, $MSFT, $AMZN, and $FB to buy Nestle, HSBC, British American Tobacco, BASF, and Anheuser-Busch InBev. These American tech stocks have been some of the best performers over the past decade. This trade could be thought of simply as taking some gains on U.S. mega cap tech stocks to double down in Europe.
This trade sounds like a risk-off position, but the historical data clearly shows that Europe has been more volatile than the U.S. over the past 3 years. So Europe has had terrible returns and high volatility. This trade is a contrarian and mean reversion play against this horrible past performance.
The last graph is really the most surprising. The relative performance of the 2 regions is in stark contrast. Europe has been pretty flat for over a decade while the U.S. market has doubled. This return difference has been mainly driven by the earnings outperformance in the U.S. The U.S. valuation premium is between 7-26% which I don't view as excessive.
Which region is likely to have stronger earnings growth in the coming years? My sense of mean-reversion tells me that it will be difficult for the U.S. to continue to grow earnings faster than Europe given the magnitude of the current gap. I think Europe could easily close part of this gap over the next few years given the hurdles are set pretty low.
Europe stocks look to dethrone US counterparts as earnings beats hit 7-year high - CNBC
European Equity Barometer - Blackrock
Europe Earnings Outshine U.S. to Signal Long-Awaited Rebound - Bloomberg
MLP investments involve a higher degree of tax reporting relative to common stock investments in a typical C-corporation. Similar to a REIT, a MLP must distribute at least 90% of it's earnings to it's partners. The attractiveness of the ETF product in the MLP space is greatly reduced by the diversification rule limiting the amount of MLP investments to 25% of ETF assets. Therefore, most MLP ETFs are structured as C-corporations and pay corporate tax on dividends before distribution, greatly reducing the return offered by the MLP structure.
Looking for a MLP focused on renewable energy, and I found an interesting opportunity in NextEra Energy Partners, $NEP, managed by general partner NextEra Energy, $NEE. $NEP owns about 3.3 GW of renewable power producing properties, mostly wind and little solar. $NEP also owns 4 natural gas pipelines. $NEP trades at a yield in the low 4% range which is lower than most MLPs. $NEP does have a robust dropdown pipeline of projects and has guided to increasing the distribution by 12%-15% annually through 2022 off the year end 2016 annualized distribution of $1.41. If you believe management's guidance, the forward distribution and yield table looks like this:
Looking at this table, the current lower-than-MLP-average yield doesn't look so bad. You have to ask yourself how likely management is to achieve their guidance. The high level of dropdown projects makes their guidance look like a good bet. In this light, $NEP looks to me to be a buy.
1Q GDP forecast from Atlanta Fed fell off a cliff last week, dropping to 0.6% from 1.2%.
The market must be looking past the weak 1Q and expecting a bounce back in 2Q growth. If this bounce does not materialize, the market looks increasing vulnerable to a pull-back. Worse yet, the weakness is centered around consumer spending. Real consumer spending growth in 1Q was only 0.6%, down from 1.7% in 4Q, according to the Atlanta Fed. Consumer confidence numbers are heading up, but consumer spending is heading down.
This relationship cannot last forever. Let's hope the weakness is temporary. A good way to describe the American consumer is frugally optimistic. I continue to advocate a more conservative investment stance given the perplexingly optimistic market behavior.
I have concerns over a disappointment in 1Q GDP growth. GDPNow stands at 0.9%, and its next update is Monday, April 3. Given the apparent lack of growth and the market's optimistic pricing of fiscal stimulus and tax cuts, I am inclined to be conservative from an investment perspective. I have been sniffing around for more defensive and yield oriented investments. What came onto my radar is the telecom sector. This is a countercyclical sector and the worst performing sector over the past year.
In addition to countercyclical sectors, I have been focused on sectors which have a relatively low correlation to the S&P 500 Index. Telecom does not have the lowest correlation, which goes to utilities then REITs, but it is lower than most other sectors. The utility sector has had a nice run up, and I might be more interested in utilities after a pullback. I do like the REIT sector, but this post will focus on telecom.
The telecom sector is relatively small at $1.9T market cap, and U.S. telecom is highly concentrated in $VZ and $T. Most of the other large telecom stocks are foreign businesses who issued depository receipts in the U.S. Given the high level of concentration and the low dividend yield of the telecom sector ETFs, I don't see an advantage to buying a sector ETF in this case. I would recommend buying either $VZ or $T directly to overweight the telecom sector. $VZ has not moved much in price for several years while $T has rallied from the low 30's to the low 40's. $VZ is also cheaper on a EV/EBITDA basis at 7.4x.
From a qualitative perspective, I don't view the 'cord-cutting' trend as disastrous to the telecom industry because customers still need to access the internet from either a cellular LTE or broadband service. Much of the weakness in telecom is a result of the 'cord-cutting' trend, and I view this secular shift as priced into the stocks at this point. Furthermore, I believe recent consolidation in the sector has lowered competitive pressures. More consolidation is also a possibility given the merger-friendly Trump administration.
$VZ has been financially levered at over 2x debt to EBITDA following the acquisition of Verizon Wireless in 2014, but the industry median leverage is higher, at over 3x. Although I don't regard telecom as an industry in the best financial health, it has stablity and significant barriers to entry.
Finally, I looked at the dividend yield. $VZ has a much higher yield than the utilities sector, 4.7% versus 3.0%. $VZ is paying out between 50% to 70% of earnings in dividends. I view this payout ratio as sustainable. 2016 was a pretty rough year for $VZ. Revenue was down 4% and eps over 20%. In 2017, revenue is expected to be flat to down a hair. Margin pressures are expected to ease leaving eps flat, good enough to easily maintain the dividend.
Since I am not feeling particularly bullish on the overall market in the short-term given the bleak 1Q GDP outlook, I am searching for stability and yield, not a supercharged growth stock. So $VZ fits the bill, and has some potential upside due to its low valuation and the friendly regulatory environment. I could see $VZ making new ATHs this year, a 16+% upside. That would bring $VZ's valuation in line with $T (8.6x) on a EV/EBITDA basis.
Neel Kashkari is the President of the Minneapolis Federal Reserve Bank. Kashkari was the only dissent at March 15 FOMC meeting, when the fed funds rate was increased by 25 bps to a range of 3/4 to 1 percent. Kashkari published an article, Why I Dissented, a couple days later to explain his decision-making process. This article provides clear insight into the mind of central banker who believes there is more slack in the labor market.
Kashkari first looks at inflation. The Fed's stated inflation target is 2% which Kashkari distinguishes from the ECB's inflation ceiling of 2%. Kashkari goes on the highlight the Fed's inability to accurately forecast inflation, pointing out medium-term inflation forecasts have been too high 100% of the time over the past 5 years.
Kashkari highlights contained inflation expectations.
Kashkari goes on to discount the market-based measures of long-term inflation expectations, because... "financial markets are guessing about what fiscal and regulatory actions the new Congress and the Trump Administration will enact."
Inflation is running low in most developed economies, not just the U.S..
Then Kashkari gets into the employment side of the dual mandate. He highlights the U-6 measure of unemployment which includes people who have given up looking for work or are involuntarily part-time.
Kashkari sees some remaining slack in the labor market from several sources. First, the U-6 unemployment rate is still 1% above the pre-recession level. Second, the recent relative strength in jobs per month (averaging 200,000 versus 80,000-120,000 labor force growth) has not moved the headline unemployment rate much below 5% because more people want to work than are being captured by the employment models and surveys. The employment-population and labor force participation ratios, for ages 25-54, also remain below pre-recession levels.
Kashkari admits the Fed does not know for certain the level of maximum employment and acknowledges this target changes over time. As evidence, Kashkari points to the Fed's own 5.6% estimate of maximum employment from 2012 which we now know was definitively too high. Kashkari sees the labor force continuing to grow, either by workers re-entering or choosing not to leave, which has kept a lid on inflationary pressure so far.
Finally, Kashkari says the current level of the neutral real interest rate is 'around zero'. With inflation at 1.7% and a target range for the real fed funds rate between -0.95 percent and -0.7 percent, Kashkari sees monetary policy as somewhat accommodative.
I like Kashkari's transparency. His opinion is worth a read.
NY Fed Research Article, A Tale of Two States: The Recession's Impact on N.Y. and N.J. School Finances
The Federal Reserve Bank of New York published an interesting research article, A Tale of Two States: The Recession's Impact on N.Y. and N.J. School Finances, by Bhalla, Chakrabarti, and Livingston. As the title suggests, the researchers examine K-12 funding and expenditure changes in N.Y. and N.J. schools following the Great Recession. The article details the effect of the federal stimulus program, the American Recovery and Reinvestment Act (ARRA) of 2009, on school funding. Finally, the article looks at state budgets, and how those impacted school funding.
The change in total funding per pupil is summed up by this graph:
N.Y. had a marginal decline in funding while N.J. had steep cuts of greater than 12% in each school year, 2008-09 and 2009-10. Most public school funding comes from three government sources: federal, state (sales & income tax), and local (property tax). Pre-recession in 2008, school funding in N.Y. and N.J was pretty similar:
After the Great Recession, school funding in both states experienced significant shifts. N.Y. received a much larger increase in federal funding, and N.J. suffered a larger cut in state funding. These charts signify the change in school funding by source.
The two funding channels that showed the greatest change were federal and state.
Federal allocation of ARRA funds to education was $97.8B. N.Y. received $4.4 billion more federal funding than N.J.. Some of this difference can be explained by demographics. First, N.Y. was eligible for more aid through the State Fiscal Stabilization Funds ($53.6B) simply because it was a larger state. N.Y. ($3.8B) had 6.2% of the nation's population in age group 5-24, while N.J. ($1.3B) had 2.7%. Second, Title I funding ($10B) was for low-income schools. N.Y. ($0.9B) had a greater proportion of students from low-income families, 46% vs 31% in N.J. ($0.2B). Third, IDEA Grants ($12.2B) were for special education students. The number of special education students in N.Y. ($0.8B) was greater than N.J. ($0.4B). Finally, N.Y. ($0.7B) qualified second in Race to the Top (RTT), a program designed to reward states with high-performing schools and educational improvements. RTT funding was dispersed to the top 10 states, while N.J. placed eleventh.
State funding also showed major differences. The first major difference is N.J.'s state law which requires the state budget to balance every year. A state budget deficit cannot be carried forward to the next fiscal year like it can be in N.Y.. In addition, N.J. state tax revenues declined much more than state tax revenue in N.Y. following the Great Recession.
In January 2010, Governor Chris Christie, facing a budget deficit, cut $475 million in state aid to N.J. schools.
I find this study interesting for several reasons. First, it quantifies part of the impact of the last federal stimulus package (total ARRA bill was $787B). Today, the federal government is again considering a stimulus program which would look starkly different due to its reliance on tax cuts rather than increased spending. Second, it quantifies the impact the recession had on two state budgets which one might assume at the outset to be quite similarly. Finally, the article shows how school budgets react to severe budgetary change.
A Tale of Two States: The Recession's Impact on N.Y. and N.J. School Finances by New York Federal Reserve Bank
The Atlanta Fed's GDPNow forecast of 1Q growth has fallen to 1.2% from 3.4% on February 1. What is behind this precipitous drop and should we be concerned about a slowdown from 1.9% in 4Q?
The Atlanta Fed publishes a historical breakdown of the contributions to the GDPNow estimates. The total drop in the GDPNow estimate is 2.1% (3.4% - 1.2% does not equal 2.1% due to rounding). The majority of the decrease, 1.4% of 2.1%, stems from PCE, or consumer spending on goods and services. The drop is PCE makes sense since it's the component of GDP. If more of the drop had come from inventory (-0.4%), government spending (-0.3%) or net exports (-0.1%), then it would be less concerning.
The next GDPNow update is March 15 which is 44 days before the GDP report is scheduled to be released on April 28. FRB Atlanta publishes the report below on forecast error over time.
So the current forecast is 1.2% plus/minus 1.4%, a fairly wide band. Upcoming GDPNow updates are scheduled on March 15, 16, 24 and 31.
Are other GDP forecasts also showing weakness? The NY Fed's Nowcast stands at 3.1%, not showing the recent slide in growth GDPNow is picking up. The Cleveland Fed's monthly forecast is 1.8%. Moody's Analytics forecast is 1.0%, and Moody's forecast has come down quite a bit since February, similar to GDPNow.
CNBC Rapid Update is a weekly survey of Wall Street economists' estimates of current quarter GDP growth. The CNBC Rapid Update stands at 1.5%. The WSJ Economic Forecasting Survey polls Wall Street monthly and is currently 2.2%. The Philadelphia Fed publishes a quarterly Survey of Professional Forecasters last updated February 10, which has 1Q GDP growth at 2.2%. One nice element of this report is it shows the change in the forecast from the previous forecast prior to the election.
The change in the current forecast from the previous shows when economists believe the pickup in growth will occur. The growth forecast for 2017 only increased from 2.2% to 2.3%, with 1Q unchanged. The larger increase in growth is in 2018 and 2019 which both increased from 2.1% to 2.4% and 2.6% respectively.
There is a disconnect between the business and consumer surveys and the hard economic data right now. Part of this difference is due to timing because easier financial conditions, improved confidence and expectations for fiscal stimulus take time to feed into the economic data. Therefore, the growth acceleration story remains intact even with a weak 1Q GDP print. The question is how long the market will wait for the strong data to surface. The disconnect between the perception of growth and the actual data must narrow eventually. Either the data will strengthen to confirm the pickup in growth, or the perception of an impending bump in growth will come back to the reality of continued subdued performance.
The stock market has priced in a pickup in economic growth subsequent to the 2016 Presidential election. If this acceleration in growth does not materializing at some point, the market may be vulnerable to a reversal.
I stumbled upon a research article titled, Stuck in Part-Time Employment by Jonathan L. Willis at the Federal Reserve Bank of Kansas City. The analysis is interesting because Willis divides the labor force into 3 skill segments (low-skill, middle-skill, and high-skill) and notes the number of jobs in the middle-skill segment continues to languish below pre-recession levels while both the low-skill and high skill segments have long surpassed pre-recession highs. Willis explains the economic forces behind weak job growth in the middle-skill segment are likely structural, possibly due to advances in technology and increases in globalization.
"... the economy has five million fewer middle-skill jobs than in December 2007. If the employment growth rate over the past four years continues, it would take an additional 13 years for the number of middle-skill jobs to return to December 2007 levels. Given this long-term weakness in labor demand, elevated PTER (Part-Time for Economic Reasons) in middle-skill jobs appears to be a structural issue."
Willis goes on to contrast this with job performance in the low-skilled segment, which surprisingly maintained positive job growth during the recession. Therefore, the weakness in low-skill jobs was likely a cyclical factor, explains Willis. The level of PTER in the low-skill segment has steadily decreased during the recovery. If the labor recovery continues, PTER in the low-skill segment will return to pre-recession levels by mid-2020.
Finally, Willis notes demand for high-skill labor has been the strongest segment.
I thought this analysis was quite insightful into the dynamics of the U.S. labor market, particularly relative to the typical 2 segment breakdown of low-skill versus high-skill.
On Schwab's Kleintop Writeup, The market sees nothing to worry about - that might be about to change
Interesting write-up from Jeffery Kleintop at Charles Schwab titled, The market sees nothing to worry about - that might be about to change. He urges caution and sees investors as overly complacent. His reasoning stems from the upcoming political elections in Europe, mainly the French election. He goes on to explain how the markets sold off prior to the U.K. referendum and the U.S. presidential election in 2016. The following graph illustrates his thinking.
This analysis is particularly concerning to me because the S&P 500 has had a maximum intraday drawdown of only 1.9% since the election during which time the market has rallied 10.6%.
The maximum close-to-close drawdown has been only 1.4%.
A nice article was published in The Financial Analysts Journal titled, Are Cash Flows Better Stock Return Predictors Than Profits? by Stephen Foerster, CFA, John Tsagarelis, CFA, and Grant Wang, CFA. I thought the research was insightful wanted to recap the findings here.
To summarize the conclusion of the article; cash flows are better predictors of stock returns than profits, meaning the statement of cash flows is more useful to forecast returns than the income statement. Furthermore, the cash flow statement constructed using the direct method, as opposed to the conventional indirect method, offers additional explanatory value.
To explain the analysis, the authors provided an example of a statement of cash flows using the direct method and compared this to the indirect method.
The cash flow from operations, using the indirect method, is broken down into more detail when the cash flow statement is constructed via the direct method. Subcategories of operating cash flows using the direct method are: direct business, financing, tax, and one-time items (not shown in example above). This breakdown of operating cash flows allows for an easy elimination one-time items. The authors conclude the more detailed breakdown of operating cash flows offers additional explanatory value of future stock returns not available from the indirect statement of cash flows or the income statement. Definitely worth a read for those who like getting into the details.
The banks are back on top. The financials sector is the best performing sector over the past year up 39.4%, easily surpassing the 22.8% return of the S&P.
Looking at the five industries in the financial sector, the banks rise to the top with a 46.8% return.
Even after the big rally, the S&P 1500 financial sector still sports a pretty low forward P/E ratio of 16x versus 17.6x for the S&P 500 overall. The S&P 1500 bank industry has a slightly lower forward P/E ratio of 15.7x and a healthy dividend yield of 3.3%. Looking at only the large banks, the valuation is even lower. The S&P 500 financials has a 14x forward P/E. Sources: spindicies.com & fidelity.com
The banks are well capitalized, and in a good position to benefit from a pickup in economic activity and lending. The lower valuation of the financial sector is in part due to the lower growth prospects versus the S&P 500. CFRA research puts the long-term growth rate of earnings in the financials sector at 8.1% vs 10.6% for the S&P 500. So the PEG ratios of the financials and the S&P are both right around 1.7x. According to CFRA, banks have historically traded at a 10% discount to the S&P 500 multiple.
The fundamentals for the sector are positive. Deposits are increasing and loan losses are historically low. Net interest margin for the industry is at a historically low level, but this may change as the Fed raises rates and allows its balance sheet to constrict.
Two ETFs in the sector which I would recommend are $XLF and $VFH. I prefer $VFH because it has a lower concentration of top holdings.
The economy appears to be picking up steam. The Atlanta Fed GDP Now forecast for 1Q17 GDP is 3.4%.
Let's assume the Atlanta Fed is right. Economic growth is picking up from 1.9% growth in 4Q16 to 3.4% 1Q17.
Cyclically oriented sectors of the economy may see increasing growth. All but one of cyclical sectors have all outperformed the S&P 500 Index over the past year. The consumer discretionary sector is the only laggard.
The underperformance of the consumer discretionary sector can be seen more clearly in the next chart.
What is the cause of this underperformance and is it likely to reverse? The consumer discretionary sector includes some industries undergoing significant secular shifts. For example, the retail industry has been dealing with a huge shift to online shopping at the expense of brick & mortar stores. The restaurant industry is also dealing with a drop in traffic, similar to traditional retail. The media industry has been shifting to over-the-top content delivery rather than the traditional cable bundle. Although there will be winners and losers as a result of these shifts, I don't see them as negative for the sector overall. Consumer discretionary spending should continue to have a moderately positive outlook based on growing discretionary income and a labor market near full employment. I recommend buying $XLY or $VCR to overweight the sector. Amazon, $AMZN, has the largest market capitalization in the sector, and the allocation to $AMZN is 12.8% and 10.2% for $XLY and $VCR respectively. I prefer $VCR because the concentration of the top 10 holdings is 42% as opposed to 53% for $XLY.
$XLV is the Health Care Select Sector SPDR Fund ETF, and it provides broad exposure to the health care sector: 44% pharma, 21% equipment, 15% providers, and 17% biotech.
The health care sector is the worst performing sector over the past year. The cyclical sectors continued to outperform the past few months as economic growth prospects improved. Since the health care sector is naturally more defensive, it's not surprising health care lagged the recent rally into record territory by the S&P 500. Although health care currently lacks momentum, it does have positive long-term fundamentals in terms of demand growth and scientific innovation. Deloitte sees North American health care spending growing by 4.9% through 2018, and global spending by 4.3% through 2019. According to IMS Health, the global pharmaceuticals market grew 6% in 2015, and U.S. drug sales increased 8.5%.
This graph shows expenditure data on the healthcare sector as a percent of GDP. The The U.S. spends 17% of GDP on health care, Europe & Japan 10%, and China 6%.
This graph normalizes 1996 to 1, so that the rate of change can be easily compared. Although the U.S. has the highest level of spending (first graph), Japan and China have the highest growth rate in health care spending as a percentage of GDP. IMS Health sees U.S. drug expenditure increasing from $425 billion in 2015 to $610-$640 billion in 2020, a CAGR or 8.9%.
With 1996 normalized to 1, the last graph shows the growth of U.S. spending on prescription drugs and healthcare overall. The data here is not a percentage of GDP. The graphs makes it obvious that the growth of spending on prescription drugs is growing much faster than spending on health care overall. The drug segment of the health care sector should continue to see growth above the growth rate of GDP and also above the growth rate of the health care sector. Although political risks are elevated, these trends in health care spending will not be changed easily. Therefore, I see the weakness as a opportunity to overweight to the health care sector through $XLV.
The IBB is the iShares NASDAQ Biotechnology ETF. The IBB's allocation is 66% biotech and 28% pharmaceuticals. The IBB has been ravaged by the political firestorm around drug pricing, and has traded flat for the past year. This may be an interesting sector to overweight since, in time, strong fundamentals should overcome the negative headlines. The weight of the health care sector in the S&P 500 Index is 13.7%, the pharmaceutical industry is 5%, and the biotechnology industry is 2.7%. The fee structure of the fund is 47 bps which isn't particularly cheap, but I don't think it's prohibitive. The IBB is a growth oriented investment as opposed to value oriented. The geographic focus is the United States with over 98% domestic holdings. The IBB is more volatile than the S&P with a beta in the 1.2-1.4 area. Although the beta is high, the correlation to the S&P has not been high relative to may other sectors. The IBB is market cap weighted, and therefore is heavily weighted toward large cap biotech stocks. The top 10 holdings represent 58% of the ETF. The IBB might be attractive to buy below $270 where it has repeatedly found support. Positive long-term fundamentals of an aging population and promising new medicines are strong, and I think the headlines can only hold the sector down temporarily.
The best diversifying assets over the past year have been long-term treasuries and gold. I used bloomberg to look at the correlation between ETFs to get an idea of what goes up when the S&P 500 Index goes down. Over the past year, long-term treasuries (TLT), have had the most negative correlation to the market. Only 2 other ETFs had a negative correlation, GLD and LQD. Gold had a significantly negative correlation, almost as large at treasuries. Investment grade corporate bonds (LQD) had a small negative correlation, so effectively corporate bonds were flat when the market sold off. This check on correlation is a good exercise because different investment only diversify a portfolio if they don't move together. Other sectors with relatively low correlation to the market are utilities and real estate. What had the highest correlation to the market? Financials, technology and industrials. This is not surprising because all 3 sectors are cyclical in nature. Technology is by far the largest sector at 21.1% of the S&P, so by definition, they will be highly correlated. Financials is the second largest sector at 14.7%.
Fed Paper: Volcker Rule Decreases Corporate Bond Liquidity During Stress Events to Financial Crisis Levels
The Federal Reserve has published a paper on the Volcker Rule's impact on corporate bond liquidity.
The paper quantifies a fact most have know to be true: liquidity provided by dealers in the corporate bond market has decreased due to the Volcker Rule. The methodology of the research is to quantify price changes for corporate bonds which have been down graded from investment grade to junk. These downgrade events provide a consistent stream of stress events to measure corporate bond market liquidity.
The conclusion of the paper is that corporate bond liquidity has decreased subsequent to the implementation of the Volcker rule to levels seen during the financial crisis.
"Indeed, we find the disturbing result that illiquidity in stress periods is now approaching levels see(n) during the financial crisis."
So is this significant for financial markets as a whole? Will the next market stress event throw the corporate bond market into a tailspin? Corporate bonds should trade at a liquidity discount compared to its previous, high-liquidity price level. On the margin, this will make the Fed more cautious with regards to tightening financial conditions.
Using the Bloomberg backtester, I looked at the performance of several investing factors during 2016. I found value investing performance outperformed other factors, and the growth factor was the worst performing. I followed the default methodology of the Bloomberg backtester which buckets the universe, the S&P 500 Index in this case, into 5 quintiles, calculates daily quintile returns, geometrically cummulates the annual returns, and calculates q-spreads (top quintile return minus bottom quintile return). The 5 equal-weighted portfolios for each factor are rebalanced daily, and the time period used for the analysis is the calendar year 2016.
To measure the value factor, I used several financial statement measures, but the best performance is from price-to-book. I looked at dividend yield and volatility measures such as historical price volatility and beta. Although these factors performed positively, they clearly underperformed value. The most surprising result of the analysis to me was the underperformance of the growth factor. Revenue growth actually had a negative q-spread. This means stocks with faster growing revenue underperformed stocks with slower or negative revenue growth.
There are going to be qualitative explanations for these results which I am not going to go into here, but it's good to keep the facts in mind when listening to the pundits on TV.
Pending home sales was reported today to be at the highest level in over a decade. The strongest regions are the west and the south. This extremely strong report along with the very strong new home sales report from Tuesday show the housing market is much stronger than previous thought. A strong housing market is very bullish for the economy in general. It shows that buyers are comfortable making a large purchase which reflects positively on just about all other spending categories as well as construction.
The NAR attributes the strength in the housing market to low mortgage rates and a strong job market. Mortgage rates are hovering around all-time lows, below 4%. The job market has been good as far as the number of jobs created, but there are some complaints on a lack of wage growth. This was a very bullish report. My favorite housing plays are Apogee (APOG) and Acuity (AYI). Apogee manufactures glass exteriors for sky scrappers. Acuity makes LED lighting sold at Home Depot ($HD).
A huge jump in new home sales was some really positive data today. New home sales came in way above expectations reversing several months of flat and weaker-than-expected reports. The number of new homes sold in April jumped to 619,000, easily eclipsing the previous post-recession high of 549,000 from February 2015. This report helped the market sentiment overall today and particularly helped the home builder stocks. I still like my two favorite housing-related picks, Apogee (APOG) and Acuity (AYI). Apogee makes sky scrapper windows and Acuity makes lighting sold at Home Depot (HD).
The strongest industry in the April retail sales report is the non-store retailers, Amazon being the largest. The weakest industry being department stores. Although this is making a lot of press recently, this is not a new phenomena, but it seems to have finally come home to roost for the department store stocks. If you look at department store sales, they are the mirror opposite of the e-commerce sales. In fact, the peak for department store sales was January 2001. Back then, department store sales were 33% higher than non-store retailers at $19.9B for the month. If you zoom out in the graphs below, this move to online shopping has been consistent and has been putting the hurt to the department stores for years.
According to the numbers in the April retail sales report, non-store retailer sales are almost 3.5x as large as department store sales at over $45B.
Amazon is reported to be the second largest apparel retailer behind only Wal-Mart. How long before Amazon takes the top spot?
Initial claims had a big increase for the week of April 30, although the level of claims is still historically low. The job market is showing signs of slowing with the lower than expected NFP report and higher initial claims. A few more weak data points are needed to be certain.
Construction spending firmed in March reported the U.S. Department of Commerce today. The strength of the report was in the large upward revision to February's number, revised from -0.5% to 1.0%. March construction spending was up 0.3% from the higher February number. This strong construction spending number is a good sign for APOG, which makes and installs windows for skyscrapers. This positive construction data along with the strong pending home sales data from last week paint a picture of a firming housing market.
Some welcome strong data on the housing market today. The Pending Home Sales Index came out stronger than expected. This leading indicator is particularly welcome given the recent weak numbers in existing and new home sales. The strongest region was the Northeast, which has had the weakest home price appreciation of the 4 regions over the past 3 years, around 10%. The West region was the weakest in the March reading, but this region has had almost 40% price appreciation over the last 3 years, so some hesitation on the part of buyers might be expected. The West has also had the best job gains by far of any region. The low mortgage rates surely helped to get some contracts signed in March!
So I have been out of my housing related stocks, Acuity Brands AYI and Apogee APOG, due to the weak housing data. This Pending Home Sales number could be an outlier or it could be the start of a string of stronger data leading into the spring selling season. I think I am going to take a wait and see approach to find out if it will be followed up by some more strength. AYI has recently made several acquisitions, and these have reduced their ROIC. If I get back in to a housing stock, I'll go with APOG.