After a very strong 2013 it was reasonable to expect there would be some period of consolidation in 2014. Stocks gave back about 5.7% through February 3rd before rallying to new highs by the end of that month. March saw choppy sideways trading for the most part, but at quarter’s end the S&P 500 was standing 1.8% higher. This gain occurred despite a looming crisis in Ukraine, much cooler than expected weather here in the United States, and economic disappointment in both China and Japan. The silver lining for investors was that despite the fact that the Federal Reserve did begin to taper bond purchases, the bond market performed very well. In fact, bonds slightly out-performed stocks over the quarter.
Until the very end of the February, it seemed like the same market sectors that drove the market in 2013 would continue to do so in 2014. Biotechnology stocks rocketed up close to 30% in the first eight weeks of the year, on top of a 50% gain in 2013. At some point, however, all speculative rallies end. Almost all of that 30% gain was gone by the end of the quarter, and as this is being written the sector is down 6% year-to-date. Many social media stocks could tell a similar story, as could market darlings like Tesla. As the high fliers began to falter, however, income-oriented sectors came back into favor. Real estate and utilities, two sectors that really struggled when the Fed announced tapering back in May 2013, posted gains of more than 9% last quarter. Other higher yielding sectors – telecommunications, financial services, and energy – also benefited in March from the rotation out of high momentum growth stocks.
International stocks struggled early in the quarter, and that trend got even worse when Russia grabbed the Crimean peninsula. In March, however, emerging market stocks reversed to the upside as very cheap valuations drew in money leaving hot sectors in the United States. Brazil and India were some of the bigger countries that got a boost, but the Middle East, Indonesia, and Vietnam also scored double-digit gains. On the whole international markets gained a little over half a percent on the quarter, but the performance varied greatly. Japan, which seemed poised to end its two-decade-plus economic slide, lost 5.4% last quarter. Russia, for obvious reasons, was the worst performing market (-15%).
All categories of bonds gained last quarter, with the average being about 1.8%. That said, the dynamics of the bond market swung wildly. The first two months were a continuation of 2013 for high yield corporate bonds, which tend to do well when stocks do. This sector cooled off by quarters end. Longer maturity, investment grade debt (both taxable and municipal) rebounded sharply from a horrendous 2013. Emerging market debt surged in March just like emerging market equities. Overall, interest rate sensitivity was a good thing as rates declined during the quarter.
A very strong trend is a wonderful and dangerous thing. The long term outlook for health care seems very bright with average ages in the developed world continuing to rise. Early in the quarter the concern was whether we were capturing enough of that trend. We added funds like PRIMECAP to more aggressive portfolios to get more exposure to healthcare than we would get from T. Rowe Price alone. By the end of the quarter the correction in that sector was in full swing, and we looked to trim positions in the T. Rowe Price fund that had grown from say 4% to 6% or more.
We also saw the chance to add to our existing international bond positions, as that neglected sector finally began to show some life in March. Lastly, we built up our international stock positions by increasing our holdings in VEU, a low cost foreign stock ETF that includes emerging markets.
At the risk of extending the zebras and lions metaphor past its “best if used by” date, it would seem that the lions are back. We have moved into a higher risk environment now, because we have had a taste of the factors that are likely to eventually end this bull market:
- The tapering has begun. The Fed is still friendly, but it is gradually becoming less friendly;
- China is slowing. The biggest global engine of demand is sputtering;
- Geo-political strife. The upside of reducing our commitments in Iraq and Afghanistan is an improvement in our national balance sheet. The downside appears to be emboldened adversaries (Syria, Russia).
It would seem that investors are taking the classic zebra approach, namely moving to less economically sensitive areas such as utilities, real estate, gold, and treasury bonds. Last year’s leaders have fallen from grace recently, leaving markets more volatile. At this moment, it remains to be seen whether investors will be content to rotate (move money from one area of the market to another) as opposed to selling outright. It should be noted, however, that the market “traffic signals” very frequently go from green to yellow and then back to green. Red lights are thankfully uncommon.
Last quarter’s Commentary, entitled “Come On Stocky”, tried to convey that stocks had risen to a level where even if everything was to go right in 2014 it still would be very unlikely to see another 30% gain. Obviously, everything isn’t going right and stocks are struggling a bit. I am not too concerned because most of the current activity should be seen as volatility. Stocks fluctuate. Every investor who contemplates a stock investment should be aware of this. Risk, on the other hand, is the possibility you will buy something at a price that once lost will never be recovered. In the parlance of finance we call that phenomenon a permanent impairment of capital. In a diversified, un-levered mutual fund or ETF, you are almost always dealing with volatility rather than risk. Risk comes in when you buy into a situation where valuation and expectations reach a level that economic reality cannot justify (like technology stocks in 1999 or real estate in 2006). Social media and biotech stocks were beginning to look that way back in late February. We always try to limit exposure in any area of the market where the risk of permanent impairment of capital is present.
Commentary – Party Time!
One of the keys to understanding stock market movements is that sentiment changes drive prices. Let me explain. If I polled all stock market investors and discovered that 80% said they were long the stock market and 20% said they were short, you might assume that stock prices were heading higher. You are probably going to be wrong. In fact, given those results, there are vastly more potential sellers than potential buyers. Put another way, the expectation of higher prices is too great. Stocks will only go higher if the ratio gets more lopsided. The fact is, markets cannot accommodate everybody being right. They can accommodate a majority but not a consensus. Once confidence levels in any market event get above 70%, the risk of reversal becomes statistically greater than the potential for further profit. This is why experienced professionals become very uncomfortable when their position becomes the consensus.
Perhaps the best analogy is to think of investors as party goers. Every party has a “cover charge”, or a cost to get in, but in return you get a little piece of the cover charge that every subsequent party goer pays. Therefore the cover charge rises for every new party goer. If you get there early the cover charge is low but it may turn out that very few party goers show up. In that case, you don’t recover the cost of entry and you miss out on a better party. At least when the party ends (as all parties invariable do) the cost of the cleanup will be minor.
As you can see, investors do well when they get to a big party before a substantial amount of other investors. If you are the last to arrive, you will pay a lot to get in, collect nothing from those that come after you, and bear a huge cleanup cost. This is where strategy and nerve enter in. Do you have enough confidence to be the first person to show up? Most people don’t. They fear no one else will show up, and they don’t want to miss out on a big party somewhere else. Ultimately, every asset class is going to host a party. The difference is, some of these parties get a lot bigger and some parties last a lot longer than others.
The Biotechnology “party” has really taken off since mid-2012. Figure 1 shows the Biotech sector’s performance since that time. New product introductions had soared, and earnings exceeded expectations. By this past January it became a blow-out. Everybody wanted in. It was just too hard for the investors over in financial services or home construction or emerging markets to see that big party across the street. At first they resisted because they didn’t want to pay the cover and they feared maybe that party was about to end and the party goers just might come over here. But you can only watch other people have a great time for so long – “They sound like they are having so much fun. More people keep showing up – I’m sure that more will come after I get there”. When sentiment gets that strong, you know the end is near.
What makes a great party is a narrative, or a reason why the party should last a long time. That is how you get people to leave other parties to come to yours. Growth investors have an ear for narrative. They seek to determine which parties are going to turn into all-night bashes. Value investors will only go to parties if they can get there early and pay a low cover. That way they can still come out ahead if only some of the parties turn out to be big successes. Indexers try to attend every party for at least a little while. It is more important to them to avoid having the worst results than it is to try to have the best results.
No party going strategy always works. This just makes sense – if any one strategy always worked everyone would practice it and everyone would earn above average returns (which is impossible). If it were possible to show up when you knew the party was already a smash but pay the same entrance fee as the first one there, everybody would try to be fashionably late (again, by definition, impossible). That said, the strategy of going to the biggest party and paying the highest price of admission is one that almost never does.
We try to diversify all our approaches because again, no one strategy works in all environments. We participate in the big parties to some extent, but only moderately with medium risk investors and not at all with low risk ones. We pay a lot of attention in all portfolios to what we might lose (our cleanup costs, if you will) if the party we are at should immediately end. To that end, we strive to determine whether our market beliefs are becoming consensus (in which case there are too few left to come to the party). It is important to understand the trends and narratives that drive the market, but even more so to know to what extent those things are already priced in.
We appreciate your continued trust in our management program,
Mark A. Carlton, CFA