$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%.
1/5/2017 0 Comments
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.
Michael Grove, CFA