What To Do in a Rebuilding Year

Sports fans can relate to the painful realization that 2008 has quickly become a market “rebuilding year.” Though the S&P 500 had a bit of a rough start during the first quarter, stocks did rally 11% from early March to mid-May. Since then, however, the market has declined 18% amidst financial industry uncertainty, volatile commodity prices, slower global economic growth, and horrendous sector rotation. Year-to-date, no sector has been able to produce a positive return; at best, Consumer Staples stocks are off “just” -1%; at worst, Financials are down 28%. Even Health Care and Utilities, known for their defensive growth & income characteristics, have declined by -10% and -13%, respectively. In short, there has been nowhere to hide.

Energy stocks are off -24% this quarter (-18% year-to-date.), making the sector the worst performing group. Oil reached an all-time high of $147 on July 15th, and retreated to $101 yesterday. Naturally, this decline started a stampede out of oil-sensitive companies, as conventional wisdom assumed that if oil isn’t hitting new highs, companies in the sector can’t grow.

The truth is that oil sector profits are much less elastic above $60/barrel (bbl.) than they are below $60/bbl. In other words, the huge fixed-cost investments needed to get oil out of the earth and sold in its various forms are prohibitive, and incredibly volatile, to profits when oil is trading below $60, given the per-barrel costs of extraction, refining and marketing. That all changes, however, once the $60/bbl. barrier is broken, as evidenced by the ROE progression of leading offshore drillers from 2005-2007: while oil averaged just above $60 (range of $50 to $78), return on equity increased by 500%. Yet Wednesday, just eight weeks after the high oil tick, global leaders involved in exploration, production, drilling and services are trading at 25-year low valuations, while their earnings growth outlook, despite the drop in oil, remains solid.

Materials stocks have also been hit hard, off -15% since the end of June and off 15% YTD. While the Materials sector is widely diversified, the companies within the sector, overall, were squeezed through August by input costs—think energy and labor—that were rising faster than the end-market prices for their goods (e.g. lumber, aluminum, wheat). Though the juggernauts earlier in the year were the steel and agricultural fertilizer players, those stocks have come off hard as wholesale prices have retreated.

Within Materials, you either invest in the companies or in the commodities themselves, which has been made much easier over the last five or ten years with the proliferation of Exchange Traded Funds, or ETFs. As we have been more comfortable with the directional prospects of certain hard assets than the ability of companies to efficiently pass through price gains, we would consider precious metals. Gold bullion has been a great inflation, uncertainty and dollar hedge over time, which proved true again throughout the recent demise of the U.S. banking system and expansionary monetary policies deflating the U.S. dollar.

The Industrial sector is off just -1% this quarter but down -15% for the year. Though a diverse sector, which includes aerospace/defense, building/construction/ engineering, electrical equipment and machinery, the heaviest weightings include macroeconomic bellwether conglomerates and aerospace/defense companies. Most of the pain was felt earlier in the year as awareness of a global economic slowdown sunk in and oil prices hit new highs, which has created excellent buying opportunities with decent yields. Just check the largest companies in this sector by market cap, and you’ll see the values.

Consumer goods companies have fared well this quarter, with Staples up 8% (down -1% YTD) and Discretionary up 7% (off -7% YTD). Consumer staples stocks are the year’s top performers, though negative for the year, given their classic defensive characteristics of relative stability and low earnings volatility. Earnings estimates have declined faster for consumer discretionary stocks than for any other sector (save Financials) given their leverage to consumer spending whims amidst a disastrous housing market, slowing economy and rising unemployment. However, sentiment changed for the positive in mid-July, coincident with falling oil prices. We believe that this is an opportune time to add positions in the consumer sector, given depressed prices and valuations that appear to fully reflect a recession scenario. At this point, we believe any whiff of marginal economic improvement should send discretionary stocks higher.

Health Care, the other classically defensive sector, is off -10% for the year despite a slight 4% gain so far this quarter. Earnings estimates have been adjusted downward following slight negative earnings surprises during the first half, lackluster new product pipelines in general, strong FDA corrective actions and the anticipation of a falling Medicare reimbursement hammer next year, regardless of which candidate makes it to the Show. However, what has also become apparent is that these stocks, as a group, are trading at P/E and P/BV ratios not seen since the nationalized health scare of 1993-1994 – giving us confidence that some pricing and/or regulatory changes are pretty well reflected in current stock prices. The drug industry continues to mature, but there is also a tidal wave of demographic catalysts forming on the horizon and whether it be AIDS, cancer or diabetes, these companies have the best solutions to date.

The Financial sector continues its bi-polar activity, up 4% for the quarter but off -28% YTD. Stocks in this sector experienced a huge drop in July, rebounded by late in the month, and have since been trading sideways in a 10%-15% cycle. Earnings are expected to fall by another -25% this year, and hopes are high for a much-improved 2009. However, the housing market continues to show signs of weakness, Fannie Mae (FNM) and Freddie Mac (FRE) were taken over by the Feds, and Lehman Brothers (LEH) is desperately trying to raise capital. Overall, deposit growth is hard to come by and there is a credit crunch on….but other than that, the Financial sector looks great. The one bright spot we have seen is that the sector as a whole has been able to shrug off a continual stream of bad news, giving us more confidence that financials established a very strong support level on July 15th.

The Technology & Telecom sectors are off -7% so far in Q3 and -22% YTD. Though earnings are still expected to grow 24% this year, estimates have been dropping alongside expectations for economic growth. All of the bellwether stocks in the sector are in negative territory for the year, even the juggernauts Google (GOOG) and Apple (AAPL).

Overall, we recognize that there has been nowhere to hide this year as far as equities are concerned – every sector is negative. Given that this has become a rebuilding year, consider your positions in high-quality companies that are expected to benefit from more stable macroeconomic trends, or cyclical recoveries in their respective industries. When possible, look at companies that pay above-market, stable dividends, which provides the advantage of receiving income while being patient for the eventual economic recovery.

Comments

[buyitcheap:]

Good article - but I'd broaden the time range to perhaps rebuilding decade - this market has been a complete disaster for the last 8 years for the passive investor. Ibelieve I've seen this period referred to as the "lost decade."

2008 Sep 27 04:05 PM

[Larry House:]

Eleven paragraphs of fluff. You could have saved yourself a lot of trouble (and for the reader) by just saying "go for quality." That's your simple answer to your big buildup. Your article is actually about what the sectors have done. That is rather common knowledge. Sorry. I am a former English teacher, and you are guilty of false advertising. Not good in an essay.

2008 Sep 27 11:07 PM

[Alan von Al...:]

So, 1929 was a rebuilding year?

2008 Sep 28 01:35 AM

[Agcapita:]

The equity and bond markets have benefited from a long period of low inflation, but ongoing and massive central bank liquidity injections point to a far less benign environment of elevated inflation ahead. Research by our firm, Agcapita Farmland Investment Partnership (Calgary, Canada based agriculture private equity firm – farmlandinvestmentpart...) shows investors must be prepared to rotate into asset classes with different characteristics. During the last commodity bull market & high inflation period in the 1970’s, equities materially underperformed farmland.
- Western Canadian farmland went from around $100/acre to $550/acre (550% total return and 176% in inflation adjusted terms);
- Cash held in a money market account barely kept ahead of inflation (6% inflation adjusted return); and the
- S&P 500 index returned less than 2% per year (a loss of almost 50% in inflation in adjusted terms)

We believe the world is still in the early stages of this current commodity bull market. When agriculture commodities prices are compared against their previous inflation adjusted highs they are significantly discounted implying scope for further increases:
- Corn is US$ 5/bushel currently compared to US$16/bushel in 1974,
- Wheat is US$ 7/bushel currently compared to US$27/bushel in 1974
- Canadian farmland is C$ 660/acre currently compared to C$1,100/acre in 1981

Another interesting metric is the long-term average ratio of the Commodities Research Bureau Index versus the S&P 500 which is currently around 1.5 times. Simplistically, this ratio indicates how much S&P 500 stock you can buy with a fixed basket of commodities. Some important points:
• During the commodity bull market of the 1970s, the ratio was consistently higher than 2 times for over 10 years – it peaked at almost 4 times.
• The ratio is currently at around 0.5 times - significantly below the 1.5 times long-term average, just slightly above the 0.15 all time low reached in 1999/2000 and still very far below the almost 4 times multiple reached in the last commodity bull market. We still appear to be at an all time low relative valuation between “hard assets" versus "stocks.”
• If history is a guide, the ratio of hard assets to stocks will have moved much higher before this commodity bull market is over.
• How? Stocks will continue to fall and/or commodities will continue to climb – most likely a serious combination of both as investors, fearing inflation, rotate out of stocks into commodities – the cycle of “inflation, rotation, hard assets”.
Agcapita is a Calgary based, agriculture private equity firm that allows investors to cost effectively allocate a portion of their portfolios to hard assets in the form of Canadian farmland via its professionally managed Agcapita Farmland Investment Partnership. Agcapita Farmland Investment Partnership is the third in a family of private equity funds which has grown to almost $100 million in assets under management. Agcapita’s investment team has over 40 years private equity and fund management experience and over $1 billion in total career transactions and previously managed a group of emerging market funds with almost C$500 million in assets for one of the largest banks in Europe.

2008 Oct 05 01:18 AM