Key Points:
•
Many investors expect a repeat of last year’s sell-off.
While the markets always possess that possibility, we believe
that this year is different.
•
If the markets do correct this month, this should provide a
fresh opportunity to “buy the dip” and add to existing
equity positions.
•
Investing in the health care sector might seem unattractive
given all the current headlines and emotions, but the sector’s
expectations have been reduced enough that relative valuations
are now attractive. Don’t run and hide from this sector.
Just over a year ago, my wife and I took our children on vacation
and met our parents in the Black Hills of South Dakota. The
weather was excellent, the crowds and traffic were surprisingly
manageable, and the scenery was even better than I recalled
from my own childhood visits. It was a great trip; at least
it should have been.
At the time it was particularly difficult to truly escape from
work. While that is nearly always the case these days given
the advent of Blackberrys and laptops, last year’s vacation
was saddled with the additional concern of a potentially rough
autumn for the markets. Even though the bear market and earnings
recession were already qualified as mature by historical standards,
and upcoming corporate earnings growth was expected to turn
a corner in late 2008, there was considerable angst in the air,
and for good reason. There was significant concern and chatter
about the financial system, and the market was quickly approaching
its most negative time of the year from a seasonal perspective.
A few weeks later, of course, Lehman Brothers declared bankruptcy
and the panic sell-off of 2008 began in earnest.
One year later, in many respects, it still feels like last
year. At the very least it sounds like last year, depending
on which voice you are listening to. For starters, there is
no avoiding a collision with the month of September, which easily
ranks as the worst performing calendar month of the year. It
seems everyone knows of this seasonal factor these days. Second,
concerns about the financial system still abound. Given these
concerns (and more), and despite the strong gains of the last
6 months (the strongest 6 month rally in nearly 80 years), investor
sentiment is as negative at the end of August this year as it
was at the end of August last year. In fact, to many investors,
there is even more reason for fear now than there was twelve
months ago, and they have positioned their portfolios accordingly.
Nonetheless, while we recognize there are some legitimate concerns,
we think that the worst is behind us, and any potential price
weakness in the stock market should more likely be viewed as
a fresh buying opportunity (“buy the dip”) than
a reason to abandon course.
Some Bad News
Let’s get to some of the bad news first. Historically,
September has been the worst month of the year for the stock
market. Whether one wants to look at the last 20 years, 50 years
or 100 years, September tends to have the highest likelihood
of negativity and has the largest average loss. The Bespoke
Investment Group examined data on the Dow Jones Industrials
Index over the last 100 years and determined that the average
loss has been just under 1% and the market has been negative
58% of the time. Why is September so foul? There are some potential
reasons floating about, though none of them are entirely convincing.
Some just write it off as a market superstition. Either way,
the consistency of the market’s September track record
is something to note.
The offset to this, however, is that the rest of year tends
to be pretty good for stocks. While there have clearly been
some negative Octobers (last year was no exception), the fourth
quarter of the calendar year tends to be the strongest quarter
of the year for the stock market. In other words, September
tends to be a good time to add to stock holdings.
More fundamentally, however, there are still legitimate concerns
about the banking industry. Some of the statistics are indeed
frightening. In 2009 so far, there are already 84 banks that
have failed. This compares to 25 in 2008, and only 3 in 2007.
Some analysts are projecting anywhere from 100 to 300 more banks
to fail in the upcoming years, primarily due to concerns over
commercial real estate.
Indeed, the FDIC has 416 banks (about 5% of all U.S. banks)
on their “problem list,” which is up from 305 from
the first quarter of this year. How does a bank get on the problem
list, and what are the chances that they will fail once they
make that list? To get on the list, banks must be considered
to have significant deficiencies in some aspect of their business
that may threaten their survival. The list is published quarterly,
though names are not actually listed. It is interesting to note
that historically 13% of the banks (according to a 2007 study)
on the list eventually go broke. That would suggest another
50+ banks are in trouble. Not quite as bad as some of the bears
in the press are stating, and perhaps even more evidence that
the worst is actually behind us.
Nonetheless, while another 50 bank failures is still serious,
especially for those communities that they serve, does that
necessarily mean more pressure on the stock market? On this
measure, it’s important to remember that the stock market
is a discounting mechanism that is forward-looking, while headlines
of bankruptcies tend to lag the economy. Even the Federal Deposit
Insurance Corporation (FDIC) Chairman Sheila Bair recently said: "Banking
industry performance is, as always, a lagging indicator."
It is also important to note, that this current pace of financial
institution bankruptcies is still a far cry from the saving
and loans crisis of the early 1990s when thousands of financial
institutions actually closed down. However, the early 1990s
wasn’t a bad time to buy stocks either. Though the S&P
suffered a loss in 1990, if someone had purchased the index
at the end of that year, they would have earned an above-average
stock market return over the following 1, 3, 5 and 10 years.
Some Good News
Given the negative news in banking and September’s ugly
history, it should not be a surprise to know that individual
investor sentiment (according to the American Association of
Individual Investors) at the end of August was back at bearish
extremes. Many investors feel as if they have seen this story
before. As the saying goes, “Fool me once, shame on you;
fool me twice, shame on me.”
This can partly be explained by a concept from the increasingly
popular school of thought in finance called Behavioral Finance
(BF). Essentially, BF is a study of how investors make decisions,
and how those decisions impact security pricing. A key point
of behavioral finance is that investors are human and aren’t
always rational. We all know that feeling!
There are many behavioral biases that have been identified,
but one relevant to the current situation is called the “recency
effect.” This basically states that investors tend to
overemphasize the probability that a recent market event will
repeat itself. Dramatic events, such as sharp bear or bull markets,
tend to stick in investor’s minds. Last year’s panic
sell-off that spilled over into this year is one of those events
that many of us won’t forget for a long time.
As a result of the recent bear market, punctuated by the fright
and price declines of the accelerated sell-off last fall, are
many investors now overstating the likelihood that another dramatic
sell-off could happen? While a sharp correction should always
be considered, we think there are many key differences this
year from last year and that the stock market will likely continue
surprising many investors to the upside before the year is over.
A big difference between this year and last is that we are
now on the other side of the maelstrom of conjecture regarding
what would happen next with major financial firms such as Fannie
Mae, Lehman Brothers, and AIG. A plan was eventually put into
place, and whether or not investors liked the government’s
response (few did), a level of stability was finally achieved.
Other factors point to the differences this year, including
liquidity being restored, instead of removed. The fixed income
markets, which were an early indictor of upcoming financial
market stress last year, are now behaving and have already returned
to pre-Lehman bankruptcy levels. Accounting rules on mark-to-market
accounting, which were implemented in late 2007 and arguably
amplified financial firm’s losses at the worst possible
time, were modified back in March of this year. Also, prices
and valuations are now more attractive; prices are still off
over 20% in the broad market from a year ago, prices in the
financial sector are down over 30% from year-ago levels, and
valuations for the S&P using normalized earnings have contracted
nearly 25%. In addition, short-term interest rates are much
lower, essentially yielding only a bit more than 0%. Economic
and earnings data appear to be on the mend. In sum, many of
the concerns from last year have been alleviated.
Another positive factor for the market is that investor sentiment
and allocations remain quite defensive. There is still a mountain
of cash sitting on the sidelines in money market accounts ---
that is earning virtually nothing. With the economy and markets
behaving better, cash is finally starting to be re-invested,
but it is coming back slowly. In fact, there is still approximately
$3.4 trillion in combined retail and institutional money market
accounts, which isn’t far from the combined $3.6 trillion
that peaked back in March of this year. Not only was this an
absolute record for money market holdings, but it was also the
first time in over 15 years that money market assets exceeded
assets in equity mutual funds (only two years ago, at the peak
of the market, assets in equity funds tripled those in money
market funds). In short, this is an incredible amount of buying
power which should provide a powerful tailwind for the stock
market as it gradually moves out in search of potentially higher
returns.
What About Health Care?
One sector that has generated a lot
of press and emotion of late has been the health care sector.
It is indeed an important
issue and debate.
What is an investor to do? Many feel that simply avoiding the
sector due to political concerns is the best course of action.
Many are avoiding the sector because it has been one of the
worst performing sectors over the last six months. Historically,
health care also tends to be the worst performing sector 6-12
months into a new bull market. Putting it all together, it looks
like an easy decision to underweight (health care makes up a
bit less than 1/8th of the over-all stock market capitalization)
the sector, if not just outright avoid it. However, we wouldn’t
recommend doing so. While we recognize the poor momentum, we
also recognize some attractive fundamental characteristics,
including valuations.
From a valuation standpoint, health care is attractive. Looking
at price/earning ratios, the sector has typically traded at
a 20%+ premium to the S&P the bulk of this decade, but is
now at a 20% discount. Health care also has the lowest price/earnings
ratio among all economic sectors using expected 2009 earnings – and
nearly the lowest (the utility sector has a slightly lower expected
P/E) using expected 2010 earnings.
Political concerns are a big reason why valuations for health
care have become attractive, but not because of earnings. Health
care was one of the few sectors that had earnings growth in
2008 and it is expected to have one of the higher growth rates
in 2009. Additionally, examining expected earnings through the
third quarter of this year, health care is expected to comprise
approximately 26% of the S&P’s total earnings over
the past twelve months. Even factoring in a better economy,
health care is still expected to make up 17% of the S&P’s
earnings in 2010.
In sum, expectations are beat down for the health care sector.
That is not a bad thing, as low expectations usually creates
attractive relative valuations and sets the stage for relative
outperformance moving forward. Once again, we would not avoid
the sector.
Summary
Our bias continues to be better buyers than sellers
of the stock market. While valuations have expanded considerably
since
March, they are still in the ballpark of being “fair” and
in a position to provide returns similar to what stocks have
generated over the last 100 years instead of the last ten. In
addition, stocks are more attractive than usual versus other
asset classes such as Treasury bonds, and particularly relative
to money markets given their current yields. Lastly, on an expected
real return (i.e., after inflation) basis, stocks also look
more attractive than normal given current market-based inflation
expectations.
Still, one may ask, if September is likely to play to historical
form, then why not just make a dramatic move now and significantly
raise cash? In short, it is not that easy to do. If over the
last two decades we sold stocks every time we thought they would
be lower, it is more likely we would have generated lower returns – and
higher tax bills! To re-iterate this point, we quote from Warren
Buffett and his oft-mentioned op-ed in the New York Times last
fall: “Those investors who cling now to cash are betting
they can efficiently time their move away from it later. In
waiting for the comfort of good news, they are ignoring Wayne
Gretzky’s advice: ‘I skate to where the puck is
going to be, not to where it has been.’”
Instead, price weakness may create a fresh opportunity to add
to our stock market positions. Of course, there are always other
variables that we will monitor and evaluate, including the movement
of interest rates and commodity prices, but all else being equal,
lower prices should create more attractive valuations.
Sincerely,
