Topic Tags: U.S. Equity

Booming Biotech Still a Buy?

The Nasdaq Biotech Index enjoyed another great run in 2014, returning 34% for the year and over 220% since 2011. By comparison, the Nasdaq Index has gained 13% and 75%, respectively, over the same time periods. Currently, the Nasdaq Biotech Index is nearly 60% above its long-term average price-to-book (“P/B”) ratio, and while there’s an argument that most U.S. equities are currently overvalued, the Nasdaq Index is only about 13% above its long-term average P/B ratio.

The Nasdaq Biotech Index enjoyed another great run in 2014, returning 34% for the year and over 220% since 2011. By comparison, the Nasdaq Index has gained 13% and 75%, respectively, over the same time periods. Currently, the Nasdaq Biotech Index is nearly 60% above its long-term average price-to-book (“P/B”) ratio, and while there’s an argument that most U.S. equities are currently overvalued, the Nasdaq Index is only about 13% above its long-term average P/B ratio. As a comparison, the S&P Biotech Index is about 36% above its long-term average P/B ratio, while the S&P Index is only 23% higher.

These elevated valuation metrics even have biotech bulls questioning if a bubble is emerging in response to so much growth. Though these fundamentals alone may indicate that biotech is on the verge of a correction, there is still hope for the sector. Healthcare spending is a large portion of U.S. GDP and is expected to grow with our substantial aging population. As technologies and research methodologies improve, so do drug research possibilities and opportunities. Some of the prior rises in price may be explained by positive news that is not yet quantifiable or on positive trial data that is not yet able to be capitalized. Because of the lengthy trial and FDA approval processes, along with the current maturation of the sector, many revenue-generating drugs and technologies should come to fruition in the coming years, thus providing optimism for further positive returns from biotechs.

Fundamentals suggest that biotech has already experienced the majority of its run, is overvalued, and would not be an ideal investment for the faint of heart. However, the sector bears watching in the coming year as investors keep an eye out for progressing FDA phase data or new drug releases. Ultimately, in spite of current valuation data, biotechs should continue to deserve a healthy allocation within a well diversified U.S. equity portfolio.

Lower Oil Prices a Tailwind for Airline Stocks

Our chart of the week examines how the fall in the price of oil – despite its recent impact on the overall stock market – has benefitted the airline industry and should continue to do so in the near future.

Our chart of the week examines how the fall in the price of oil – despite its recent impact on the overall stock market – has benefitted the airline industry and should continue to do so in the near future.

The chart shows how oil prices have steadily declined since June to roughly $56/barrel as of December 16th. Over the same period, U.S. equities — as represented by the S&P 500 — have marched higher, led by stronger than expected earnings and an increasingly favorable jobs market. Given the drop in oil prices, it may not be entirely surprising that airline stocks as a group have been one of the strongest performers in 2014, gaining 34% so far this year. Since one of the largest expenses for any airline is fuel, the recent decline in prices coupled with both the large volume of travelers in the fourth quarter and rise in airline ticket prices should translate to one of the most profitable quarters for a sector already flying high. The nosedive in oil prices may not be the best news for the overall market (seen at the very end of the graph) but should bode well for airlines and the managers who choose to invest in this soaring sector.

Currency Effects on International Equity Returns

One of the most significant challenges that international equity investors have faced this year is the impact of a stronger dollar. From many perspectives, a stronger dollar signals improved economic growth in the U.S. Unfortunately, a stronger dollar also acts as a headwind for U.S.-based investors purchasing international equities.

One of the most significant challenges that international equity investors have faced this year is the impact of a stronger dollar. From many perspectives, a stronger dollar signals improved economic growth in the U.S. Unfortunately, a stronger dollar also acts as a headwind for U.S.-based investors purchasing international equities. In some instances, the impact of the stronger dollar has flipped positive returns denominated in local currency to negative returns when translated to U.S. dollars. In fact, this phenomenon has occurred year to date in 2014: the local currency return for a primary international equity index (MSCI EAFE) is positive (red bar; 4.2%), but becomes negative when denominated in dollars (blue bar; -2.4%).

In our Chart of the Week, we examine the retrospective returns of the MSCI index, denominated in both local currency and U.S. dollars. Based on the chart, two conclusions seem straightforward:

  • The “winner” each year will vary over time, which is not surprising since the U.S. dollar strengthens in some years and weakens in others.
  • Over the long term, the relative strengthening or weakening of the U.S. dollar is more or less balanced out, as the cumulative returns of each index – local and dollar – suggest, shown by the convergence of the two cumulative return streams.

If nothing else, this week’s chart should provide some comfort to investors whose returns have been negatively impacted by a stronger dollar: although the dollar acted as a drag on international returns this year, it is highly unlikely this will be a consistent pattern in the coming years, and should certainly not serve as a worry for long-term international equity investors.

Improving Diversification Profile for Commodities?

As they are driven more by supply and demand and less by macroeconomic factors, commodities have historically enjoyed low correlations to other asset classes in an investment portfolio, and are often utilized as a source of diversification. However, the correlations between commodities and other asset classes, such as equities, fixed income, and hedge funds tend to be fluid over time and can change significantly over a market cycle.

As they are driven more by supply and demand and less by macroeconomic factors, commodities have historically enjoyed low correlations to other asset classes in an investment portfolio, and are often utilized as a source of diversification. However, the correlations between commodities and other asset classes, such as equities, fixed income, and hedge funds tend to be fluid over time and can change significantly over a market cycle. Our Chart of the Week examines the recent movement in correlations between commodities and the most common constituents of an institutional portfolio: U.S. equities, international equities, bonds, and hedge funds.

The chart above illustrates that in the years leading up to the summer of 2007, rolling 5-year correlations between commodities and other asset classes ranged from as low as -0.07 for fixed income to as high as 0.36 for hedge funds. Correlations spiked after the collapse of Lehman Brothers in September 2008, as macroeconomic conditions took the driver’s seat and pushed correlations to equities and hedge fund strategies upwards over the following years. Recently, though, these correlations have started to retreat towards pre-recession levels, with correlations generally decreasing since July 2013. Given this downward trend, the correlations between commodities and other asset classes make a better case for the asset class and its diversification benefits now than it did a few years ago.

Investing in MLPs: Which Vehicle is Right for You?

October 2014 Investment Perspectives

Since our last Master Limited Partnership (“MLP”) newsletter in 2011, the MLP market has grown from $220 billion to $437 billion as of September 2014. Investors have been on a “search for yield” over the past few years and the MLP space has proven to be an attractive investment with high yields and attractive growth opportunities. In the past, investing in MLPs has traditionally come with complicated tax related issues, which have often deterred institutional investors. As institutional interest continues to expand into the MLP space, however, institutional-friendly products have emerged. This newsletter takes a look at some of the recent developments in the MLP space and examines the channels by which investors can access MLPs in a tax efficient manner.

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Impact of Profit Margins on Stock Market Valuations

This week’s Chart of the Week looks at U.S. (measured by the S&P 500) and Developed International (measured by the MSCI EAFE) equity market valuations. Over the last five years U.S. equity markets have outperformed their developed market peers by almost 10% on an annualized basis (14% vs. 5.3%).

This week’s Chart of the Week looks at U.S. (measured by the S&P 500) and Developed International (measured by the MSCI EAFE) equity market valuations. Over the last five years U.S. equity markets have outperformed their developed market peers by almost 10% on an annualized basis (14% vs. 5.3%). Perhaps most surprising is that, as this week’s chart shows, U.S. markets trade at only a modest premium to other developed market peers (16.5 price to earnings ratio for U.S. stocks versus 14.9 for developed market international stocks). However, non-U.S. stocks are actually much cheaper when normalized for profit margins. Profit margins have a strong tendency to mean revert over time (high profits attract competition which drives down profit margins) and U.S. profit margins, at 9.5%, are at an all-time high. Conversely, non-U.S. developed market profit margins are just 6.6%, below their long-term average. Not since 2009 have international profit margins exceeded U.S. profit margins.1 Investors should be aware that as profit margins revert to their long-term averages it could leave U.S. stocks looking pricy, and their developed market peers looking cheap.

1This is shown in the graph when the red area (EAFE profit margins) completely covers the blue area (S&P 500 profit margins).

Support for the U.S. Equity Market

In this week’s Chart of the Week we look at the recent volatility of the U.S. equity market. Since the fourth quarter began, the S&P 500 index fell as much as 4%, but has recently rebounded, thus bringing its YTD gains to approximately 6%.

In this week’s Chart of the Week, we look at the recent volatility of the U.S. equity market. Since the fourth quarter began, the S&P 500 index (green line in chart) fell as much as 4%, but has recently rebounded, thus bringing its YTD gains to approximately 6%. Issues such as Ebola, ISIS, the Ukrainian Crisis, and a possible recession in the Eurozone have all contributed to the pullback.

However, it is worth noting that U.S. companies traded on the S&P 500 index are reporting strong third quarter earnings. So far this month, a total of 293 companies have released third quarter earnings that can be compared to Wall Street estimates. An overwhelming majority, 218, either met or beat Wall Street earnings per share estimates. As the chart illustrates, the continued good news from U.S. corporate earnings has positively contributed to the S&P’s recent rebound. Any continued volatility should be watched closely for prolonged effects on portfolios, but continued strong U.S. corporate earnings should calm investors’ worries about an elongated retreat for the U.S. equity market.

Speed Bump or Something More?

Over the past couple weeks financial markets have suffered steep declines, with the Dow Jones Industrial Average falling over 800 points, leaving investors to wonder if this is simply the pullback that we have been waiting for or if larger losses loom on the horizon.

Over the past couple weeks, financial markets have suffered steep declines with the Dow Jones Industrial Average falling over 800 points, leaving investors to wonder if this is simply the pullback that we have been waiting for or if larger losses loom on the horizon. While some may be pointing to underlying fundamentals or economic data, one could simply point to history as an indicator. This week’s chart looks at the maximum intra-year drawdown for the S&P 5001 Index for the last 30 years.

Since 1984, the S&P 500 Index has only had five negative calendar years. Despite this fact, 25 out of the last 30 calendar years have had an intra-year drawdown of more than -7%, and the median calendar year maximum drawdown over the last 30 years was just over -10%. Year to date in 2014, the maximum drawdown is what we are currently experiencing, a drop of 7.4%. Based on this data our present drawdown, while significant, is not out of the ordinary. Though it is impossible to precisely predict the length and magnitude of the current market slide, investors can derive some comfort knowing that an intra-year drawdown like this is not uncommon. Additionally – at the time of writing – the S&P 500 index is still positive year to date, and bond returns are also in positive territory for the year.

1We use the S&P 500 instead of the Dow Jones Industrial Average because it is a more commonly used benchmark by institutional investors.

Hedge Funds vs. the Equity Market

Recently, the California Public Employees’ Retirement System (CalPERS) announced its decision to completely shutter its hedge fund program. As a result of this news, investors have been asking whether hedge funds still deserve a spot in their portfolios.

Recently, the California Public Employees’ Retirement System (CalPERS) announced its decision to completely shutter its hedge fund program. As a result of this news, investors have been asking whether hedge funds still deserve a spot in their portfolios. In this week’s Chart of the Week, we examine the efficacy of hedge funds compared to equity markets over the last 25 years. To do this, we compare the rolling 3-year Sharpe ratios of hedge funds (using the HFRI Fund Weighted Composite as a proxy) and equity markets (using the S&P 500 as a proxy). As a reminder, Sharpe ratios are a measure of risk-adjusted return, so a higher score represents a more attractive risk profile.

A comparison of the two indices suggests that recent hedge fund performance has been disappointing as the S&P 500 has delivered higher risk-adjusted returns over the last few years. However, most investors who have added hedge funds to their portfolios have done so to add diversification and new sources of alpha to their portfolios, so a comparison based on returns may not be entirely fair when comparing the equity market to hedge funds. Moreover, it is critical to note that the last five years have featured an impressive bull market that will naturally outpace hedge funds, which endeavor to create more attractive risk-adjusted returns by utilizing various strategies designed to limit downside risk, but also limit upside potential in times of bull markets.

So while hedge funds may surrender some return in times of significant market rallies, they can be expected to offer protection from market corrections, which are a part of every market cycle. Over the long term, the graph shows that hedge funds have indeed delivered higher risk-adjusted returns, in spite of the recent dip. Given the long-term cyclical nature of the market, when equities exhibit a correction, hedge funds should see a shift in relative performance, and once again demonstrate their utility to investors.

S&P 500 Dividends and Stock Buybacks Hit Record Levels

This week’s Chart of the Week examines increases in dividends and stock buybacks for companies within the S&P 500 index during the prior six years. Following a recession low of $71.8 billion during the second quarter of 2009, combined dividend and buyback expenditures established a record high of $241.2 billion in the first quarter of 2014.

This week’s Chart of the Week examines increases in dividends and stock buybacks for companies within the S&P 500 index during the prior six years. Following a recession low of $71.8 billion during the second quarter of 2009, combined dividend and buyback expenditures established a record high of $241.2 billion in the first quarter of 2014. The previous record occurred during the third quarter of 2007 when companies spent a combined $233.2 billion on dividends and buybacks.

Stock buybacks reduce the amount of shares outstanding for a company which causes earnings per share (EPS) to increase since the same amount of earnings over fewer shares outstanding creates a higher EPS value. EPS is a metric used in the determination of stock price, so a higher EPS value provides support for the stock price to appreciate in the near term.

A significant source of funding for stock buybacks in recent years came from the ability to borrow at short-term rates near zero. As interest rates are set to eventually rise, companies will be less inclined to fund buybacks in this manner. Compared to dividends which typically don’t experience large changes from period to period, stock buybacks are more dynamic in nature and can be quickly reduced if needed. Going forward, a potential concern for future stock market returns is that if buybacks are scaled back significantly, returns will likely be adversely impacted by such a contraction in buybacks.