An 8% Return is Not Guaranteed
As reported in several media outlets in the past month, U.S. pension funds are headed for catastrophe. Consulting firm Mercer published a report that found the total deficit of U.S. pension liabilities increased by $134 billion to $512 billion as of the end of the third quarter of 2011. The funded ratio (assets divided by liabilities) for these plans is now at 72 percent, down from 81 percent at year-end 2010. Mercer indicated this deficit is the largest since the end of World War II. Don’t dare inform pension fund committees of this growing albatross as it might upset the long term funding requirements that pension funds maintain. According to Milliman, a large independent actuarial and consulting firm, large public U.S. companies currently maintain an expected rate of return of 8% for their firm’s pension funds, a slight decrease compared with 8.1% for 2009. The annual Milliman study covers 100 U.S. public companies with the largest defined benefit pension plan assets. Although the expected return has steady declined over the past decade from a gaudy 9.4% in 2001, an 8% return expectation is still above the long-term averages. High net worth investors are equally optimistic. Family Office Exchange (FOX), a leading provider of research and education to the wealthy and their advisors, released survey results in early 2011 that indicated wealthy investors still believe high returns are a rite of passage. For 2011, wealthy families also anticipated a median long-term return of 8% from their investments, consistent with previous years’ studies. The question of all questions is will the optimists earn the 8% expected return with traditional allocations between stocks and bonds? A historical examination indicates the folly of expecting such a high rate of return.
Bond returns are most dependent on the starting interest rate and the changes in general interest rates over time. The most similar period in U.S. history in regard to low yields is the 1940s. Over the decade of the 1940’s, 10-year Treasury yields averaged only 2.33%. However, the total return from bonds during the 1940s was a mere 1.82% as bond yields slowly climbed throughout the decade. Given that our own government bond yields today are at historical lows, the opportunity for price appreciation is limited. More likely, the collection of interest payments will provide most, if not all, of market returns. Additionally, interest rates could also trend up over the ensuing decade. This would result in capital losses as bond prices rise, reducing total return further. Much like the decade of the 1940s, total returns from bonds will most likely be subdued or perhaps even negative if interest rates climb substantially higher. Most certainly pension funds and individual investors cannot expect an average long term return of 5.72% that intermediate U.S. Treasury bonds have delivered. A 3 to 4% total return for Treasuries over the ensuing decade would be a generous estimate. Look to purchase non-government bonds to potentially earn a higher return.
Although future prospects for the bond market are low, stock returns should be more constructive. The ultimate drivers of stock returns are impacted from four primary components; starting P/E ratio, future earnings growth, dividend yield, and corporate profit margins. The current starting P/E ratio (based on trailing earnings) of the S&P 500 Index in mid-2011 is approximately 15. The average P/E ratio of the S&P 500 Index over the past 80 years has been approximately 16 based upon 12 month trailing earnings. Thus today’s P/E ratio is slightly below the historical average. If you take the 8 closest starting P/E ratios (chart) to today’s 15 value, the resulting 10-yr average return is 13%, above the long term averages. However, these returns are highly variable, including a 19.18% annualized ten-year return starting in 1989 to a more muted 3.16% return from 1969 onward. The return is thus very dependent on other conditions, including average profit margins, earnings growth, and dividend yields.
| Period | P/E |
Net Profit |
Forward 10-yr Return | |
|
Margin Avg. |
||||
|
12/31/1987 |
14.12 |
4.4 |
15.28% |
|
|
12/31/1985 |
14.46 |
5.2 |
14.40% |
|
|
12/31/1966 |
14.47 |
8.9 |
3.27% |
|
|
12/31/1994 |
15.01 |
5.5 |
11.06% |
|
|
12/31/1989 |
15.45 |
6.1 |
19.18% |
|
|
12/31/1990 |
15.47 |
4.3 |
18.20% |
|
|
12/31/1969 |
15.93 |
6.8 |
3.16% |
|
|
12/31/1986 |
16.72 |
4.8 |
14.84% |
|
|
Averages |
15.03 |
5.7 |
13.04% |
|
Since 1948, net corporate profit margins for the S&P 500 corporations have ranged from just above 4 to nearly 10 percent . In those periods where the average corporate net profit margin was at the highest levels (late 1960s), forward 10-yr returns were muted. The current net profit margin of the S&P 500 is 7.5, near the highest levels in the past half century. Therefore, based upon historical precedent, a discount should be applied to future returns based upon a higher starting net profit margin. Dividends are also a critical component of projecting future returns. Dividends have accounted for 45% of the total return of stocks since 1930. Thus, of the 9.37% annual return investors have garnered, 4.2% have been generated by dividends. Academic studies have also consistently demonstrated that the average dividend yield of the market impacts future returns of the market. Studies done by prominent researchers such as Eugene Fama and Kenneth French have concluded that the market’s current dividend yield has the capacity to predict multi-year stock market returns. Professor John Cochrane from the University of Chicago found that when market prices are low relative to dividends, subsequent 7-year returns are likely to be higher than average. As the average dividend yield of the S&P 500 is now just above 2%, expectations of a higher than average total return from stocks should be low. The outcome for a ten year forward expected average rate of return given the current P/E, current net profit margin, and low average dividend yield could vary widely. At the low end of the scale, stocks could appreciate 3 to 5% if corporate net margins contract to the historical mean and dividend increases remain dormant. A higher range of 9 to 13% is possible if corporate earnings remain high or accelerate towards the higher end of the spectrum. This was the case in 1989 as corporate profit margins remain elevated throughout the go-go 1990s. With the structural issues and high debt ratios of developed markets as future headwinds, a return to the rapid fire GDP growth of the last century is no sure bet. Given the low historic yields of bonds, high historic profit margins of corporations, low average dividend yields, a portfolio consisting of 50% stocks and 50% bonds will most likely deliver total returns in the mid single digits.
Given the expectation for an 8% total return, both institutional and high net worth investors must come up with a better strategic allocation in-order to meet return assumptions. This includes shunning government bonds. Higher yielding corporate and emerging market bonds offer investors a greater return, with a historically low default rate. On stocks, concentrate your holdings on the sectors of the economy that offer the most compelling growth including technology, healthcare, and energy. Additionally, consider those stocks with above market dividend yields. Examine alternative asset classes such as precious metals and commodities. One thing an investor cannot do, is to keep to the tried and true philosophy of buying the typical asset classes and holding out hope for an 8% return. As Benjamin Franklin once eloquently commented, “He that lives upon hope will die fasting”.
Playing Defense through Healthcare
The healthcare sector has historically been one of the most defensive places to park investment dollars over the past three decades. Since 1986, the healthcare sector has only suffered five losing years (table).
|
1987 |
-1.16% |
|
1992 |
-6.65% |
|
2001 |
-12.55% |
|
2002 |
-18.85% |
|
2008 |
-23.43% |
This is the lowest number of negative return years of any of the major sectors within the S&P 500 stock index. The sector also fared well in 1990, 1994, and 2000 — losing years in the general market. Healthcare stocks generally outperform the market when the economy is heading into recession and many other stocks are losing value.
Healthcare struggled in 2010 with the fallout of Obamacare and poor earnings guidance. With the Republicans gaining the house back in last year’s November elections, the political cloud over the sector was lifted while surprisingly earnings have begun to pick up. In the third quarter, a wide swath of large healthcare firms posted higher than expected earnings including Pfizer, Merck, Wellpoint, Novartis, and Cardinal Health. As the sector was beaten down and expectations were very low last year, many healthcare companies had an easy time jumping over 2011 analysts estimates.
Healthcare generally outperforms late in the economic cycle or when growth in GDP is slowing. This is the case in 2011, as the quarterly U.S. GDP estimates have been coming down all year. Today, the Commerce Department said gross domestic product climbed at a 2 percent annual rate from July through September, less than projected. Europe is most likely ahead of the U.S. and a mild recession is almost a certainty. The European composite purchasing managers’ index dropped from 50.7 in August to 49.2 in September, falling below the 50 level for the first time since the summer of 2009. The European Central Bank’s October lending survey showed that banks cut net credit to businesses by 16 percent in the July-September quarter. Germany and France, the only economies with growth in Europe, now are looking to be stagnating. A recession in Europe could easily carry over to our shores as approximately 23 percent, or $412 billion worth, of U.S. exports in goods and services went to the European Union last year. Investors are sensing the increasing odds of a recession and more turmoil from Europe. This is one reason why 10-Year Treasury yields in the U.S. have dropped from a high of 3.72% earlier this year to back under 2%.
With the political deadlock in Washington and world growth slowing, playing defense in your portfolio makes sense. 2011 is proving healthcare’s defensive case once again, up 2.3% on a year-to-date basis. Despite this gain, many stocks within the sector are still priced at very attractive leve;s. So within healthcare where should you look? With the rapid price rise in the sector during 2011, certain industries such as the HMOs look overextended. Within pharmaceuticals, several firms look like long term winners including Novartis, GlaxoSmithKline, and Merck. Novartis (NVS) is my favorite among the bunch. The pharmaceutical firm has the most diversified operating platform which includes branded pharmaceuticals, generics, vaccines, diagnostics, and consumer products. The generic segment offers exposure to the billions of dollars in branded pharmaceuticals going off-patent during the next several years while the company’s acquisition of Alcon in 2011 will increase its exposure to the higher margin and growing eye care business. The stock trades at only 10 times earnings, a discount of 30% to the market. I put fair value at $75.
Another compelling area is within the medical distribution arena. My top pick here is Cardinal Health (CAH). Its principal business is to act as a middleman between drugmakers and pharmacies. Three recent acquisitions – Healthcare Solutions, an oncology services firm; Kinray, a drug distributor serving over 2,000 independent retail pharmacies in the NYC metropolitan area; and Yong Yu, a leading pharmaceutical distributor in China – should lead to continued expansion of earnings and share price. If you are looking to have some portfolio protection against an economic slowdown, buy these defensive stalwarts. It will be good for your portfolio’s health.
Disclosure: The author, Timothy McIntosh, SIPCO, and/or clients may hold positions in securities mentioned in this article at time of writing. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.
A Christmas Rally – Unlikely
The S&P 500 has rallied strongly off the 1100 level tested in early October. Company earnings have continued to be strong, which has offset the news flow from Europe. Historically, November is one of the best months to be in the stock market, even producing better returns than January. The average return in November is 1.41%. December is even better and has been the No. 1 month for stock returns for the S&P 500 index since 1950. The large-company stock index has posted average gains of 1.65% in December. The consistency of the gains in December is also impressive, with gains 77% of the time since World War II. With such a strong seasonality record, odds favor continued gains despite the negative economic environment. The largest sector gainers during the past two months historically have been technology and financials. Thus for the short term, we have increased our positions in those sectors. In the past 30 days, we have added Cisco to our large cap value portfolio and Charles Schwab to the large cap growth portfolio. Although our short term outlook is positive as long as the S&P 500 can break through the 1270 level, the longer term outlook will most likely offer investors more disappointment. There is a tremendous amount of resistance at the May price highs. If we approach this level, investors will need a further improvement in the economic environment to push stocks to new highs. However, we feel the sideline money has already moved very quickly back into stocks. According to the Hulbert Financial Digest, the average recommended exposure level among market timing newsletter writers is now 106 percentage points higher than where it stood a month ago. This is in sharp contrast to past market rallies, where the same market timers were cautious early on in previous rallies. The fear of missing out on the upside obviously has obfuscated the downside risk. Corporate insiders are also not ebullient on the prospects of their own firms. Insiders are selling nearly 4 shares for every share purchased, above the long term averages as well. Our view is that this rally is much akin to the rallies of 2001 and 2002. Rallies that were strong and produced easy double digit gains, but that also proved elusive. Bear market rallies they were. I advise caution, stay with the defensive areas of the market such as healthcare and consumer staples, and higher than average weight in cash.
Staying Defensive
One of our favored indicators, copper, broke to new 2011 low today. This is in stark contrast to 2010, where the price of copper advanced before the market. Today, Dr. Copper is indicating the global economy is continuing to contract. Weakness in copper is only one symptom of the economic malaise. Treasury bond yields are also informing us that economic growth is not accelerating, but decelerating. The 10-yr Treasury Bond once again cascaded below the Mendoza line today. Interest rates have been trending down since the latest job report virtually showed no job growth while the unemployment rate stayed above 9%. Although our Federal Reserve Bank, led by Ben Bernanke, is keeping interest rates aggressively low for the next two years, it is not helping heal our job market. Our economy has a high level of structural problems and high debt levels, which are not soothed by lower interest rates. We are rapidly entering a liquidity trap as witnessed by an article in the L.A. Times about surging bank deposits. Investors are holding out hope that as in 2010, Mr. Bernanke will announce a quantitative easing (QE3) or the newly mentioned “twist” very soon. However, members of his committee are very conflicted, as three of them voted against lower interest rate language last month. Thus there is dissension among the committee and a positive vote for any of these remedies is no sure bet in our mind. Congress is also against such a continued ‘bailout’ policy. The new jobs plan by President Obama will never get brought to the house floor. With fiscal debt a major concern of the public, another round of spending for infrastructure or jobs will be difficult to muster support for. We had initially reduced stock exposure last month as the stock market had advanced by 12% in a matter of two weeks. Today, we remain defensive with hedges to protect against future declines in the market based upon our lack of confidence in a sustained job recovery and also continuing problems in Europe. Two weeks ago the European purchasing managers index (PMI) for all of the continent hit a two year low, which was much worse than expected. Inventory of goods in Europe is now at a two year high as well, the largest inventory build since the abyss of 2008. Europe’s banks are also very strained with the debts of the lower half countries including Greece, Italy, Spain, and Portugal. Greece will be lucky to get further funding. We are concerned we could see several further attempts to run on the banks in Europe as we witnessed last week. A Lehman Brothers 2008 scenario for Europe is a possibility. With all these heightened concerns, it is more prudent to protect capital than hold out hope for equity market gains.
Reducing Exposure
This morning we reduced our equity exposure in the markets as we feel the rise in the S&P 500 stock index from 1105 to 1225 discounts improvement in the economy. Risks within the financial markets are still elevated and we feel that third quarter earnings expectations still need to come down to more realistic levels. We also believe that Europe’s banks still present risks to the downside. The most likely outcome is a retest of the lows set on August 9th.
Buying Travelers (TRV)
We added to our position in Travelers last week in SIPCO’s large cap value portfolio. Travelers (TRV) stock has been hindered by the poor stock market and recent hurricane warnings season. The price of the shares had dropped from $64 to the high $40s. We think there is tremendous value in TRV at the present time. The company is a strict underwriter and has a very conservative balance sheet. Its combined ratio is nearly 95%, one of the best in the industry. The firm trades at only 7.7x our 2011 earnings estimate of $6.55 We think the damage from Hurricane Irene will be limited and we have not reduced our expectation for second half earnings. TRV also pays an annual dividend of $1.64, resulting in a healthy 3.25% dividend yield. Although our market forecast is tempered for the fall, this offers a good opportunity to pick up a long-term position in a solid financial company with a high dividend. Our target price is $70 a share by the end of 2012.
Disclosure: The author,Timothy McIntosh, SIPCO and/or clients may hold positions in securities mentioned in this article at time of writing. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.
August Review – It never pays to panic
The S&P 500 blue-chip stock index has fallen below the 1230 level. The index is now in full correction territory, down over 10% from the May highs. The market fallout is much similar to last year’s decline. During the summer of 2010, the S&P 500 index fell from 1210 to 1030.
As in 2010, we think the current sell-off is overdone, at least in the short-term.
Our Key Observations:
1. Less than 10% of all stocks within the index are trading above the 50 day moving average. This statistic cannot last for more than a few days.
2. Copper is holding up extremely well as the JJC fund is still trading above the $55 level.
3. Investor sentiment has once again become too bearish, with individual investors selling stocks in mass. For the week ended Wednesday, stock mutual funds had outflows of over $10 billion. To put this in perspective, last year investors pulled $8.7 billion after the infamous flash crash. 50% of all individual investors as measured by the AAII survey are now bearish.
4. Where is all the money going? Gold. Gold had inflows of over $4 billion in July. Does anyone remember that Gold moved to $800 an ounce in 1980 and stayed there for only a few of weeks before dropping into the $300-500 range for most of the next two decades. Gold is overowned and now trading in a mania phase, just as the internet stocks in the late 1990s.
5. The put/call ratio has exploded to the upside, a good indicator of the panic in the markets.
6. Earnings reports for U.S. corporations have been very good. Over 70% of all firms within the S&P 500 have matched or exceeded quarterly estimates. Costco today came out with great earnings and a solid outlook. If we were heading for a double dip recession, would Costco be so ebullient?
7. 10 year Treasury yields have collapsed to under 2.5%. Long term Treasury bond are the most overvalued of any major asset class. Lower interest rates will assist both U.S. consumer and corporations. Coca Cola just issued a new 5 year notes at 1.8% Who is smarter? The institutions buying these “safe” bonds, or Coca Cola jumping in while yields are collapsing and for paying out an interest rate just above Treasuries.
8. Price of copper and steel are still high. Yield curve is still very steep as well. We are simply in a slow patch, exasperated by the media and pundits.
Conclusion: Don’t sell the market today with the oscillator trading off the charts. Expect a strong oversold bounce taking the S&P 500 back to 1300. Then sell the rally if we do not break through this level on high volume. Await a retest as there has been a significant amount of technical damage done to this market.
Selling UNH
We have sold out of one of our largest HMO positions in our value portfolio. Since purchasing United Health in the summer of 2010 for just under $30 a share, the stock has doubled in value. The firm’s stock traded at a low 0.20 price to sales ratio during the abyss of 2008. It now trades at 0.60 price/sales, towards the high end of its historical range. Additionally, the stock is approaching its all time high of $60. With the lack of clarity with Obamacare and with medical loss ratios at very favorable levels, it is time to take profits.
June Review – A correction period is starting
The Dow Jones Industrial Average blue-chip index tumbled 173 points today, dropping below the key 12,000 level and falling 1.6% for the week. This marks the sixth consecutive losing week for the Dow. As for the major sectors, technology was the worst performer, down just over 3%. Utilities had the most relative strength, to no surprise, falling by only half a percent.
Key Observations:
1. According to Bespoke, it is only the 17th time the S&P 500 has had a six-week losing streak. There have only been three times in history where we have gone seven consecutive weeks of losses. This puts the odds in favor of a rally next week.
2. Investor sentiment became very bearish, with individual investors selling stocks in mass. Sentiment down to 22% bulls. This normally leads to a rally, at least short term.
3. Copper, as measured by the JJC fund, held up well this week and has not dropped below its May low, creating a positive divergence. The transportation average is also holding above the 5000 level.
4. Emerging markets stocks are still above the May lows as well. If China, India, and Brazil were decelerating fast, these stocks would have foretold the abyss. And, if the risk trade was off, these stocks should have broken down to new lows this week as investors rushed for the exits.
5. Very oversold oscillator
6. 10 year Treasury yields have most likely bottomed below 3%. This week everyone is jumping on the bond bandwagon predicting a return to recession, quite the opposite of last February. We sold our LT treasuries this week. I think that Bill Gross might be right yet!
7. A double dip recession is still a longshot in my mind. However a period of slow growth will continue through the summer.
Conclusion: A rally next week, and perhaps some follow through that mirrors the market pattern of 2010. June is up from here. July and August could be more treacherous.
Overweighting; Energy, Healthcare, Materials, Financials Favorite Names; Exxon, Transocean, Mosaic, Novartis, BankNY
