Friday, July 22, 2016

Weak Investor Sentiment Yet New Equity Market Highs

Today the S&P 500 Index closed at another all time record high. This higher advance in the market is becoming a regular occurrence as this is the fourth consecutive week for the market to close higher on a weekly basis. From the market's intraday low on February 11th, the S&P has advanced over 20% on a price only basis.

The magnitude and trajectory of the move higher is seen more clearly on the daily chart below.

Somewhat interesting is the fact individual investor bullish sentiment as reported by the American Association of Individual Investors is far from indicating excess optimism. This week's bullishness reading of 35.43% was a decline from the prior week's reading of 36.87%.  The long term average bullishness level is 38.5% and bullish sentiment has not exceeded this level since early November of last year.

So given the strength of this move in the market since February, and reviewing some of the technical market indicators, a pullback would not be surprising. However, in a June 2nd article I posted, Is It Right To Be Bullish Near A Record Market High?, I noted:
"Being bullish after a double digit market decline seems a lot easier than being bullish near market tops. Knowing the market does not move up or down in a straight line, are there factors we see that would support higher equity prices? In the intermediate and long run, we believe fundamental company and economic factors are key drivers of stock price returns."
Our view that company and economic data will continue to remain favorable is unchanged from early June.

Lastly, Ryan Detrick, a strategist at LPL Financial, provided a link to one of his firm's recent research reports, Is an Overbought Condition Necessarily Bad for the Stock Market?. This research article is a worthwhile read for investors. The conclusion might surprise some readers. In the end, the market will not move higher in a straight line; however, this longer term trend seems to be a friendly one for investors at the moment.

Wednesday, July 20, 2016

Summer 2016 Investor Letter: Searching For Yield

In our just published Summer 2016 Investor Letter, we explore the investor's pursuit of income generating investments. In our view this has led to extended valuations in some of the income yield segments of the equity market, for example, utility stocks. If interest rates do remain lower for longer then the extended valuations in the income yielding sectors could remain elevated. The Investor Letter contains broader commentary on this topic.

Our last newsletter mentioned the potential issues surrounding the U.K.'s potential withdraw from the European Union (Brexit). Just a few weeks ago the voters in the U.K. spoke at the ballot box and voted to leave the EU. We wrote separate commentary on Brexit in the days following the vote; however, we include additional highlights in the Summer 2016 Investor Letter on the Brexit topic and more.

For additional insight into our views for the market and economy, see our Investor Letter accessible at the below link.

A Look At Projected Sales And Earnings Growth

In spite of the S&P 500 Index trading sideways for most of the last 18 months until very recently, the advance from the financial crisis low has been strong. A part of the return generated from equities has been the fact the forward P/E multiple has expanded from low double digits to just over 17 times earnings.

In a low interest rate environment stocks tend to trade at higher P/E multiples. The current forward multiple on the S&P 500 Index is certainly not low; however, the current forward P/E level is not giving off a signal of overvaluation either. Importantly, going forward, we believe growth in stocks will need to be driven by growth in earnings since a large part of the return from multiple expansion is behind us.

Not only is earnings growth obviously important, company revenues need to see growth as well. As the below chart shows, expectations are pointing to stronger earnings growth as one looks one year into the future and top line sales are expected to grow as well. We believe the equity market's strong recovery from the February low earlier this year is partly due to the improved outlook for corporate earnings and revenue growth. The equity markets seem to be anticipating this better environment.

In a post written a few days ago, Value Stock Outperformance May Indicate Stronger Economy Ahead, I highlighted the fact analysts are projecting Q2 2017 (one year forward) earnings growth of 15.3% for the S&P 500. Equally important, the top line is anticipated to return to growth as well.

Lastly, the market recently broke out of its 18-month trading range on a near parabolic move to the upside. It would be nice, and expected, to see the market consolidate some of these gains, but positively, selling volume does not seem to be taking hold.

Sunday, July 17, 2016

Value Stock Outperformance May Indicate Stronger Economy Ahead

Over the course of the past few years several times I have touched on the significance of the value versus growth stock performance cycle. A couple of the earlier articles contain useful information for investors that provides insight into the economic cycle being telegraphed by the value/growth cycle. In short, in a slowing economic environment, growth tends to outperform value and the opposite tends to occur when the economy is strengthening. Value has been outperforming growth this year.

In the March 2014 article, Why It Matters That Value Stocks Are Outperforming Growth Stocks, value's outperformance peaked around April of that year and growth went on a nearly two year run of beating value. The backdrop for this reversal from value to growth is provided in the just noted article, but economic data began to rollover. In an article early this year, Is The Value Style Outperformance Sustainable?, detail is provided on the trend reversal in 2014 from value back to growth as well as value's strength now.

Fast forward to today and the iShare equivalent of the S&P 500 Value Index is outperforming the S&P 500 Growth Index, 9.21% versus 4.79%, respectively. A significant factor contributing to value's strength is the investor focus on income producing equities in a world where bond rates are low, near zero and in some cases below zero. The below graphic compares the sector weights of the S&P 500 Value and Growth indices. The two top performing sectors this year are telecoms, up 24% and utilities, up 22%. Combining these two sectors, telecoms plus utilities, they have a weighting of 11.2% in the value index and only 1.3% in the growth index. Additionally, in each of the six top performing sectors, value's sector weighting is greater than in growth's.

Positively, the next three best performing sectors, energy, materials and industrials, tend to be economically sensitive ones. And, if one believes the equity market serves a bit like a weighing machine, the better performance in these three sectors may just be anticipating a better economic environment ahead.

Friday's industrial production report for June of .6% was better than the high end consensus expectation. The report contained many positives signalling an improving manufacturing sector, retail sales exceeded expectations (.6% vs .1% consensus) and jobless claims of 254,000 were lower than the 265,000 consensus.

With earnings projected to improve as one looks one year forward and economic activity just maybe swinging more positive, there remains the possibility that value's outperformance might last more than just a few quarters this time around. The one concern is the overvaluation of some of the income yielding sectors like utilities; however, investors may still find attractive values in the the more economically sensitive sectors.

Saturday, July 16, 2016

Market Breaks From Trading Range While Sentiment Measures Remain Mixed

The S&P 500 Index has recovered all that was lost in the two day selloff following the Brexit vote. Since the Brexit low, the S&P 500 Index is up over 8.5% and this has taken the index out of its 18+ month trading range. As the below chart shows, the trading range goes back to the end of 2014 and up until this week, the only breakout from the range had been to the downside.

With this strong recovery and range breakout, some of the technical indicators are indicating the market looks overbought. The next two charts show the percentage of NYSE stocks trading above their 50 and 200 day moving average. In the case of the 50 day moving average percentage of 80.9%, this is approaching levels that historically coincide with market tops. Although the percentage of stocks trading above the 200 day moving average is also high, it is not at peak levels that necessarily are indicative of a market high.

Our best case view is the market will trade higher over the course of the next twelve months; however, a near term pullback and test of the prior range resistance level around 2,134 is likely and would be healthy for the market.

Sentiment readings from individuals and active managers are somewhat mixed. For active managers, one can review the NAAIM Exposure Index and see active managers are nearly 100% long the market with a reading of 96.5%. Also included on the below chart is the 8-period moving average of AAII's individual investor bullish sentiment. This is calculated from AAII's weekly Sentiment Survey. The bullish sentiment average has begun to turn higher; however, it remains at a very low level. The low level of the sentiment reading average is an indication individual investors remain skeptical of the recent market advance. The more volatile weekly sentiment reading has increased to 36.9%, but remains below the long run average of 38.5%

For the market to continue to move higher, corporate earnings will need to continue showing improvement. As we have noted in a couple of earlier posts, this seems to be occurring. To date Thomson Reuters reports, 36 companies in the S&P 500 Index have reported Q2 2016 earnings and the beat rate of 64% is slightly better than the long term average beat rate. Also, the negative guidance to positive guidance ratio of 2.2:1 is better than the 2.7:1 ratio that goes back to 1995. We believe earnings have bottomed and are beginning to return to growth. However, the speed and magnitude of the market's recovery from the Brexit is such that some consolidation/pullback is likely, but would be a healthy occurrence.

Saturday, July 09, 2016

Dividend Payers And Dividend Focused ETFs Post Strong Returns YTD

A few prior posts have provided detail and potential consequences facing dividend focused equities given their extended valuations. Of course, in a low (and going lower?) interest rate world it seems the simple approach an investor can pursue is just buying a stock that has a higher yield than the 10-year U.S. Treasury. S&P Dow Jones Indices recently reported on the average performance of the dividend and non dividend paying stocks in the S&P 500 Index. Maybe no surprise, but the payers are swamping the non payers this year and over the last twelve months as of June 30, 2016. As the below table details, the payers have outperformed the non payers by 728 basis points year to date and by 1,142 basis points over the prior twelve months.

Also, the strong performance of the dividend payers is evident in several of the dividend focused ETFs. Below is a chart of the SPDR S&P Dividend ETF (SDY) and the iShares Select Dividend ETF (DVY) plotted with the S&P 500 Index.
  • SDY seeks to replicate the performance of the S&P High Yield Dividend Aristocrats. SDY's projected income yield is 2.3%. Notable sector weights in SDY are Utilities (31%) and Financials 14%.
  • DVY's performance is focused on replicating the Dow Jones Select Dividend Index and has a projected yield of 3.0%. Notable sector weights for DVY are Financials at 24% and Utilities at 15%.
Both of these ETFs are up by mid teen percentages this year through Friday's close as can be seen in the below chart.

A Look At The PEG Ratio: Earnings Growth Versus Valuation

In an article I wrote about a week ago, I reviewed the current P/E (price earnings ratio) of the sectors that comprise the S&P 500 Index. The article included the below chart which compared the current sector P/Es to the respective sector's average P/E and minimum P/E over the past ten years. the article noted some of the income or yield producing sectors were trading at elevated valuations.

Simply because the P/E for a sector is high, and the same applies to individual stocks, this does not necessarily mean the sector or stock is overvalued. Importantly, the P/E should be compared to the earnings growth rate for each sector or company. By dividing the P/E by the earnings growth rate, one obtains the PEG ratio (PE to growth rate.) A good discussion on this is contained in an article on the CFA Institute's Inside Investing blog, Is It Overvalued? Look at the PEG Ratio. When evaluating the PEG, a PEG of 1.0 is an indication a sector or company is fairly valued. If the PEG is less than 1.0, this is an indication the sector or company may be undervalued. Conversely, PEGs greater than 1.0 are indications of overvaluation relative to fair value.

As can be seen in the above chart, the energy sector is trading at a P/E of greater than 40, but what is the PEG? Below is a chart comparing the sector P/Es to each sector's PEG ratio. The growth rate used in the denominator is Thomson Reuters' I/B/E/S earnings growth rate for Q2 2017, or one year forward.

Below is the table detailing the earnings growth rates for each sector as reported in Thomson Reuters' 7/8/2016 This Week In Earnings report.

Clearly, the PEG for the utility sector shows investors that are buying utility stocks are paying up for the single digit earnings growth. As discussed in last week's post, one reason this has occurred is investors are purchasing dividend yielding investments in part because they are unable to get that yield in bonds. This reach for yield appears to have pushed some of these yielding sectors and stocks to elevated valuation levels. The first chart in this article does show the forward P/E for utilities is higher than the 10-year average P/E for the sector as well.

The other factor to note is some stocks/sectors trade at higher PEs. Looking at the telecommunications sector for example, the current forward P/E is lower than the sectors 10-year average P/E. As a result, comparing each individual sector's P/E and earnings growth rate with its respective historical data is also important.

And finally, P/E and earnings growth rates are only a couple of factors investors should use in evaluating equity investment opportunities; however, the PEG ratio can be useful as a starting point. In the end, just because a company appears to be great, does not mean it is a great investment at all points in time. Recently, investors have pursued income yielding investments for their safety characteristics. However, many of these income investments are priced, as we call 'for perfection'. In other words, the slightest bit of negative news for some of these yield plays could result in strong price declines.

Sunday, July 03, 2016

An In Depth Look At The Extended Valuation Of Defensive And Income Yielding Equity Sectors

Early last week I highlighted the extended valuation of the utility sector in part due to investor demand for income yielding stocks. Not only are the income sectors attracting investor dollars, defensive sectors like consumer staples are as well. A result of this investor demand for defensive and income producing equities is these sectors have produced market beating returns so far in 2016. As the below sector return chart shows, the defensive consumer staples sector and the income yielding sectors like utilities and telecommunications have generated strong returns this year.

However, the strong return in these sectors has pushed the sector valuation beyond the average longer term valuation for each respective sector itself. The better performing sectors, utilities and staples are some of the most extended compared to the other sectors. Energy sector valuations are at extremes, largely due to earnings headwinds resulting from lower oil prices.

Of note is the fact the telecommunications sector is the second best performing sector this year, yet, its current valuation or P/E remains below its 10-year average.

For utilities, the forward 12-month expected sector earnings growth rate is only 3.4%. In Q1 2016, although earnings were positive for the utility sector, earnings fell 4.3% as compared to the same quarter last year. Consequently, with utilities trading at a forward P/E of 17.9 times and expected earnings growth of 3.4%, this leaves little margin for error.

The consumer staples sector valuation is as stretch as the utility sector as can be seen in the below chart. In Q1 2016 staples did generate a small positive in earnings growth, i.e., up 1.5% versus Q1 2015. The 12-month forward earnings growth rate for the staples sector is 7.9%.

Investors will note, higher stock valuations can be supported at a lower level of interest rates like the environment we are in today. However, when the market begins to price in a move to higher interest rates, higher yielding stocks will act like bonds and be subject to a downward price move. Specifically, the income yielding sectors trading at extended valuations could be particularly hard hit.

Saturday, July 02, 2016

The Pursuit Of Yield Continues To Benefit Return For 2016 Dogs Of The Dow

Investors' continued pursuit of income in this low bond interest rate environment has led them to higher yielding stocks. Partial evidence of this can be found in the total return of the Dogs of the Dow basket of stocks this year. As noted in earlier posts, the Dogs of the Dow strategy is one where investors select the ten stocks that have the highest dividend yield from the stocks in the Dow Jones Industrial Index (DJIA) after the close of business on the last trading day of the year. Once the ten stocks are determined, an investor invests an equal dollar amount in each of the ten stocks and holds them for the entire next year.

The average YTD total return through July 1, 2016 of the ten 2016 Dogs of the Dow equals 15.4%. This compares to the Dow SPDR and S&P 500 SPDR returns of 4.4% and 4.0%, respectively. The top performing Dow Dog this year is Verizon (VZ), returning 24.5%. Of course, it was also the highest yielding Dow Dog at the beginning of 2016. Below is a table containing various metrics on the 2016 Dogs of the Dow.

A full list of the Dow stocks with return and yield data can be found at the Dogs of the Dow website.

Monday, June 27, 2016

Income Yielding Equity Sector Valuations Near Historical Highs

Towards the end of 2015 and far ahead of the BREXIT induced market downturn, investors began to seek the apparent safety of income yielding equities. The initial motivation for this seems to have been investors seeking yield outside of fixed income where yield seems hard to find in this low interest rate environment. The consequence of this pursuit of yield is the valuation of some of the defensive, income yielding sectors has been pushed to extremes. This move towards higher valuations has been exacerbated by the BREXIT outcome. One example of this is the utility sector.

The below chart displays the performance of the S&P 500 Index sectors for the year to date period through June 27, 2016. Three of the top performing sectors are viewed as defensive ones and tend to be comprised of companies that pay and grow their dividends, i.e., utilities, telecom and consumer staples sectors. The top performing sector is utilities garnering a return of 19.8% so far this year.

Of importance, investors should keep in mind the utility sector is trading at a near record valuation based on the sector's forward price to earnings ratio of 17.8 times (blue line.)

Other sectors such as consumer staples and energy also trade at higher valuations or P/E multiples as well. Yardeni Research ($$) updates sector valuations on a periodic basis and their most recent report can be read here. Sectors, and for that matter specific stocks, can remain elevated from a valuation perspective for an extended period of time. However, when rates rise and/or a more risk on equity environment returns, these defensive sectors are likely to underperform.

S&P Dow Jones Indices and Factset recently highlighted the continued growth in cash balances for S&P 500 companies. A part of this cash growth has gone towards dividend payments and stock buybacks as I noted in a post yesterday, Stock Buybacks Up Double Digits In First Quarter, In Factset's report released today, they acknowledge the growth in cash levels; however, they also note the Cash to Debt Ratio for S&P 500 companies (ex-financials) has fallen to its lowest level since the second quarter of 2009. And back to utilities, six of the top ten companies with the lowest cash to debt ratios are utilities as can be seen in the below table.

There is more to valuation than simply looking at cash/debt ratios, and utility rates are regulated and maybe more sustainable from that point of view, but higher demands on cash due to debt payments can become an issue for utility companies. Just last month Moody's downgraded the long-term senior unsecured rating of The Southern Company (SO)to Baa2 from Baa1 due to increased debt levels and lower cash flow coverage resulting from an acquisition.

For investors pursuing investments in higher dividend yielding equity sectors, paying attention to valuations and coverage ratios is important. Additionally, not if, but when a risk on equity environment returns, these defensive, income yielding stocks could come under pressure.

Sunday, June 26, 2016

Stock Buybacks Up Double Digits In First Quarter

S&P Dow Jones Indices reports first quarter stock buybacks for the S&P 500 Index were higher by 12% on a year over year basis. On a quarter over quarter basis buybacks were higher by 10.6%. The increase in buyback activity was supported by a quarter over quarter 15.8% increase in as reported earnings. Disappointingly though was the fact QOQ dividend payments declined 3.1%. Additionally, the combination of dividends and buybacks equaled $257.65 billion and was in excess of reported earnings of $189.11 billion. This is the six straight quarter buybacks plus dividends exceeded reported earnings.

Data source: S&P Dow Jones Indices

Several highlights from S&P's report:

  • The Health care sector increased 86.1% to $30.6 billion for the quarter, up from the prior quarter’s $16.5 billion, as Gilead Sciences (GILD) spent $8 billion (ranking as the 18th largest in S&P 500 history).
  • The Energy sector conducted only minor buybacks ($2.1 billion), as it posted a 20.6% decline for the quarter and a 62.9% decline from Q1 2015.
  • For the ninth consecutive quarter, more than 20% of the S&P 500 issues reduced their year-over-year diluted share count by at least 4%, therefore boosting their earnings-per-share (EPS) by at least 4%. The participation rate for significant EPS impact rose to 28.2% for Q1 2016, up from 25.8% in Q4 2015.
  • Total shareholder return, dividends plus buybacks, set a quarterly record of $257.6 billion in Q1 2016 and a 12-month record of $974.6 billion for the period ending in March 2016.
Howard Silverblatt, Senior Index Analyst at S&P Dow Jones Indices. said, "The Q4 2015 uptick in buybacks was a surprise to many in the market, but it continued in Q1 2016. The pace of buybacks was partially driven by companies supporting their stock during the opening downturn of the year, which coincidentally started in early February when many earnings lock-ups ended. The upswing in both expenditures and participation appears to persist in the market, meaning that the upturn in Q4 was not single-shot. Looking at Q2 2016, the share count reduction trend is already baked in, as more than 20% of the issues have reduced their share count by at least 4% from Q2 2015."

Silverblatt also noted in the report cash reserves set a new record and increased 1.6% to $1.347 trillion. "Shareholder returns continue to increase, as companies remain awash with cash and have access to low-cost financing – especially in Europe and Asia," said Silverblatt. "The rate of dividend increases has slowed, as commodity-based issues remain a major uncertainty. Given the current cash-flow, projections, and an expected slow and measured pace of interest rate increases in the U.S. by the FOMC, companies have the ability to increase returns, as they remain under continued pressure from outside investors."

From an investor perspective, at HORAN, we prefer to see companies commit to higher dividend payments versus just an increase in buybacks. Dividends tend to be a more permanent commitment on a company's part and an indication of more consistent expected earnings 'growth', where buybacks can be turned off and on at will.


S&P Dow Jones Indices
By: Howard Silverblatt, Senior Index Analyst
June 22, 2016

Saturday, June 25, 2016

BREXIT Inspired Equity Pullback: The World Is Not Coming To An End

Much is being written regarding the impact of the United Kingdom's exit from the European Union and all the conclusions lead to uncertainty. It is the uncertainty equity markets do not handle well, thus, the sell off on Friday. One conclusion I believe is certain is the world will not come to an end and business will continue to be conducted between EU and non-EU countries. This is a wakeup call for the EU and its seemingly unending promulgation of rules and regulations that seem to favor some EU member countries over others. On paper the formation of the EU seemed like a good idea; however, a monetary union without a fiscal union has led to a lack of spending discipline by some countries. And, no real spending discipline is a symptom not only of EU countries, but with non-EU countries as well. The United States can be included in the 'no discipline' crowd too. Our firm will have more commentary on the Brexit outcome later.

The damage done to global equity markets on Friday is pretty clear. The Nikkei was down 7.9%, S&P 500 Index down 3.6%, the Dow down 3.4%, the French CAC Index down 8.0%, Spain's IBEX 35 Index down 12.35% and the UK's FTSE 100 Index was down 3.2%. The unknown is what additional weakness can be expected in global equity markets over the next weeks and months ahead. In earlier blog articles, I have noted past crisis events and their duration and time to recover. Below is a chart from a June 28, 2015 post.

From The Blog of HORAN Capital Advisors

Some of the crisis influenced market declines bottomed after one day while other declines took place over a longer period of time. The average decline in terms of days was six with an average return of -5.3%.

The sentiment technicals for the S&P 500 Index are indicating fear is elevated. Historically, when the fear measure like the VIX is elevated or the equity put/call ratio is above one, these levels have coincided with near market bottoms. The first chart below shows the CBOE Equity Put/Call ratio spiked above 1.0 on Friday.

The VIX futures went into backwardation on Friday as well. VIX backwardation refers to the situation when the near-term VIX futures are more expensive than longer-term 3-month VIX futures (VXV). This is an indication traders expect volatility in the future to be lower than it is now. Historically, when this occurs, short term market rallies tend to result from this technical event.

The other sentiment measure that is indicative of an oversold market is the ratio of the VIX to the 10-year U.S. Treasury yield. The low level of the denominator of this ratio, the 10-year Treasury yield, is indicative of a slow growth economic environment and investors' propensity for risk off assets; hence, driving the yield lower. The numerator, the VIX, is elevated thus, an indication of investors' fear of the equity markets.

An expected certainty in this Brexit inspired uncertainty is the fact the markets will continue to be volatile. Of importance is whether or not this event pushes Europe into a recession and drags the U.S. into one along with it. What makes this a heightened issue is the slow, bump along growth, of the U.S. economy and the slow economic growth globally. The added uncertainty is whether or not Brexit leads to additional EU countries taking steps like the UK's and then the ultimate breakup of the EU. The world is not coming to an end and this Brexit induced equity market pullback will likely provide investors with a buying opportunity in equities that have been unduly punished.