In mid-January, I began writing a series of articles that examined how far some popular large-cap industrial stocks might fall if we were to have a downturn within the next three years. I continued the series into the spring, and during the months of March and April, I wrote about 12 service sector stocks that had high historical price cyclicality. The stocks covered in those articles were: Union Pacific (UNP), Costco (COST), FedEx (FDX), S&P Global (SPGI), CSX (CSX), Carnival (CCL), Southwest Airlines (LUV), Paychex (PAYX), Magna International (MGA), Best Buy (BBY), W.W. Grainger (GWW), and Tiffany (TIF).
While most of the articles were generally bearish in nature and meant to be a warning to current investors that even the stocks of good companies could fall quite far during a bear market, I didn't stop there. In each article, I suggested alternative investment ideas for the stocks in question. For several stocks, I suggested that Berkshire Hathaway (BRK.A) (BRK.B) would be a good defensive alternative. For others, I suggested the Invesco S&P 500 Low Volatility ETF (SPLV), the Vanguard Utilities ETF (VPU) or a split between the two of them. In the case of Union Pacific, I suggested all three.
For May and June, I examined the financial sector. I had some difficulty finding large-cap stocks that were consistently cyclical enough to get me interested in their stocks, but eventually, I found four that I thought investors should rotate out of into more defensive positions. They were: American Express (AXP), State Street (STT), PNC Financial (PNC), and Progressive (PGR). I also introduced another alternative ETF, the Invesco S&P 500 Equal Weight ETF (RSP), and for American Express, I also thought that Fiserv (FISV) should be part of the defensive mix.
This article will examine how those stocks and alternatives are performing so far, and I'll also share some of my observations about the market, as well as some general takeaways or investing lessons we might learn from tracking these results.
I'm going to be posting total return YCharts for each one of these stocks and their suggested alternatives in this article. The dates for the charts are from the day of publication of the article until the end of June for each stock. I think it's important to post the charts for each stock because, while the sum total return is important, it is equally important to see the price relationships between the stocks and their alternatives as they move through time. I'll also include SPY as a reference point as well. The reason for these parameters is to keep me consistent and honest with the tracking of the performance over time so readers know I'm not cherry-picking dates. Even without a PRO-subscription, readers can go to my profile and see the publication dates of the articles if they would like to double-check my work.
First look at the financials
Since I haven't yet followed up on my financial articles and this information is fresh, I figured I would start with them. I had a pretty tough time finding financial stocks that fit within the framework of my investing approach, but I think the ones I did find represent a decent cross-section of the financial sector. I was also able to apply some lessons learned from some stumbles I made in the service sector, and I think that helped me make better decisions in the financial sector. Namely, it helped me avoid purely individual stocks as my defensive alternatives. While I did select one individual stock, Fiserv, for American Express, it was mixed with the Vanguard Utility ETF (VPU).
American Express actually had several pieces of good news come out the past couple months. It had a Supreme Court case rule in its favor, the company announced a co-branded AXP card for Amazon (NASDAQ:AMZN) small business, it boosted its dividend, and received an analyst upgrade. While that was enough for it to do better than most financials the past two months, it still underperformed both defensive alternatives I suggested and SPY:
While AXP has held up fairly well, the same cannot be said for PNC Financial since I wrote about it on May 9th:
An interesting note on PNC is that my historical research noted that it has tended to be a leading indicator of a recession. Here is what I said in that article:
Historically, PNC usually leads the market lower with substantial price drops of 25% or more, then tries to recover before the actual recession hits.
We aren't to that 25% decline mark, yet, but it's worth keeping an eye on. PNC is currently about 17% off its highs.
Next up is State Street, and it is underperforming, too:
And last but not least is Progressive, which I just wrote about a couple weeks ago. The stock has just started a downturn, and I think it has much farther to go. There is still time to rotate out and into something more defensive if you are a shareholder:
The total return of the financial sector stocks I suggested rotating out of through the month of June was -5.03%. The total return of SPY during this time was 0.89%. And the total return of the suggested defensive alternatives was 2.08%. This isn't a particularly large sample size for this sector, but I'm glad to see the ideas I presented are behaving like I expected them to. I attribute at least some of this to lessons I learned from some mistakes I made in the service sector which we'll examine next.
Some service stocks remain strong
About half of the service sector stocks I have written about remain very strong, while Berkshire Hathaway, one of my key defensive alternatives, has remained fairly weak. I've already written a ton about Berkshire on these updates and tried to come up with a good explanation for its weakness, but I've mostly failed to come up with a fully satisfactory one. On a positive note, as long a Berkshire remains above a 1.2 price-to-book value, my thesis is still intact, and it appears to be finding support where it trades right now around 1.3. So, the market may be taking notice of Berkshire's low price down here.
In the case of Union Pacific, I offered up three defensive alternatives, and I'm glad I did because it gives us a chance to compare the ETFs I suggested vs. Berkshire.
While Union Pacific is still leading the way, the average performance of VPU and SPLV is 5.28%, right in between SPY and UNP. This is the type of performance we are trying to achieve with our strategy. I don't expect the defensive positions to do as well as the target stock when the economy and market are doing well, but I do expect them to be positive and to capture some of the upside (while eventually offering some protection to the downside). What they shouldn't do is be negative like Berkshire stock is. I had a similar problem with Johnson & Johnson (JNJ) when I suggested it as an alternative to 3M (MMM) as well, so I think it's more about using individual stocks as defensive alternatives than it is these particular stocks in question, which are both good defensive stocks.
Putting that mistake aside for the moment, even good defensive alternatives would be underperforming these next stocks right now, which have been very strong:
All of the stocks above have remained very strong, but are well within the bounds of the future price appreciation projections that I proposed in the original articles. The one possible exception is Tiffany, which jumped over 30% on a great earnings report. The three-year projection I had for Tiffany was in the 35-36% range, and that is right where stock pulled back from. It might fall back in line with medium-term projections now, but if it goes higher, there is a good chance it won't fall back below its suggested alternative, even during a bear market. We'll have to wait and see.
There are some service sector cracks showing
First, let's take a look at Carnival Cruise Lines:
Since I wrote about Carnival in April, the stock price has fallen over 10% and several SA contributors whom I respect and admire have come out bullish on the stock. Having reread my original article, it was notable that at the time Carnival didn't look all that overvalued. At the time, the stock had already fallen 10%, so now it's over 21% off its high price set earlier this year. The key danger that I noted in my article was that historically Carnival's stock typically begins falling well before we are actually in a bear market or a recession, and that those declines have grown increasingly deeper, in the 50-70% range. Given this information, it is extremely hard for me to say CCL is done falling.
That said, there was an interesting discussion last week between SA editors Daniel Shvartsman and Mike Taylor on Daniel's podcast "Royal Caribbean Pulling Into Rougher Waters" that might have tilted me toward eventually buying CCL, when before I put it in the "too hard" pile. For some context here, it's hard for me to imagine ever taking a cruise. It basically represents everything I dislike when I travel. I like freedom and spontaneity. I like quiet, uncrowded places. I don't like schedules unless I set them, and after two or three days, I don't like to relax. I like to actively be experiencing something at least semi-authentic. And, perhaps surprisingly, I've only gotten more rigid about these preferences as I age.
While I am very aware of my anti-cruising bias, I've always been cognizant that other people like them, and I've gotten reasonably good at pretending that I'm excited for people when they come home from their cruise with smiles on their faces and tell me how great they were. So, if you listen to the podcast and combine Daniel and Mike's thoughts about cruising together, they basically echo mine. However, Mike made a really good point about how millennials are different. And how they don't have the same sort of reservations about an entirely indulgent and pre-arranged pleasurable corporate experience that I might have, especially if they can get that experience at a reasonable price. And, as much as I hate to admit it, I think he's probably right.
Most people nowadays would find it hard to understand how I could prefer to spend a month-and-half staying in an $11 per night unairconditioned hotel room in Honduras, or camping on the beach in a tent the British Virgin Islands, when I could have taken a cruise and had everything pre-planned, catered, and climate-controlled for me. They find it hard to understand why last year, when I took the family to California and drove the Pacific Coast Highway from San Diego to Oregon, why we skipped Disneyland and Hollywood for a trip to the Channel Islands National Park, or skipped Fisherman's Wharf for the Point Reyes National Seashore. While I think my style of travel has probably always been a minority, I think Mike's observations drove the point home that it's a rapidly waning minority.
The investing lesson here is that we have to be careful not to extend our personal preferences to that of the public at large. I'm usually pretty good about not doing that, but I think Mike's observation about these social changes were something that I hadn't specifically thought about in such explicit terms. At any rate, whereas before, I think I might have avoided CCL even near the bottom, now I think when the price is right, I'll probably be a buyer. I just think we have farther to go until we get to that price.
Shifting to some other service stocks that are showing weakness, FedEx has started to roll over and is likely to underperform Berkshire going forward even though it hasn't quite gotten there yet.
Southwest Airlines continues to show weakness even though it's down 20% from its highs, and I expect the spread to widen between it and Berkshire going forward.
Magna International finally began to show some weakness. This is a much more industrial related service sector stock, and there is still time to rotate out of this one near the top of the cycle. I think it has a lot farther to fall.
Best Buy has been interesting. The stock has been extremely volatile near the top of its range. The holiday season might be what it takes to push it one direction or the other. I'm leaning toward lower, but if we have a blockbuster fourth quarter, it could have another leg up. Ultimately, though, when the bear market hits, I think Best Buy will get hit very hard. There's still time to get defensive on this one.
While Grainger still looks strong in this chart, I think it may have peaked out, and I expect over the course of the next couple months for it to be underperforming the defensive alternative.
The service sector stocks are still strong performers on the whole. On average, they returned +5.29% through the month of June. That's a little bit less than the +5.94% they returned through May, and I expect that downward trend to continue. Through June, for the same time period, SPY returned +1.86% if invested at the same time as the target stocks. My defensive alternatives, if invested at the same time, returned on average -2.01%, compared to -1.90% through May. I expect that since Berkshire is approaching what I think will be support, the defensive alternatives should start to close in on the performance of SPY over the next few months.
If we take all 27 stocks that I've written about in the series (including industrials which had their own article), the defensive alternatives have returned +0.51%, SPY has returned +0.71%, and target stocks have returned -3.13%. Given the large sample size, the fact that the market has yet to actually turn negative, and given the underperformance of Berkshire so far, these results are pretty encouraging. If the market as a whole begins to turn negative and Berkshire begins to get some support, I think we'll begin to get some very good outperformance.
As I was reflecting on how I could have improved my performance with regard to the service sector the past couple months, I came up with a few small changes regarding my general strategy. The first, which I mentioned last month, was avoiding using single stocks as defensive alternatives. As a general rule, I plan to stick with that adjustment. However, I think the strategy has a lot more flexibility if I always include a mix of two alternates, and I think as long as one of those alternatives is an ETF, then having the other be a single stock might be okay in some situations. The example of a mix of FISV and VPU, as an alternative for AXP is a good one. FISV offers a lot of upside if the market continues to rise, while VPU is very defensive to the downside. And, if I was wrong on one or the other, it would be mitigated a bit.
Perhaps most importantly, though, is that when I go to repurchase the target stock on the downside, I use two entry points. Having two different defensive positions to choose from when making that first entry could be very useful depending on what type of cycle we are in and what market sentiment is like at the time. For example, it might be the case that the market decides to rush into utilities at the beginning of a bear market, sending them higher, potentially even pushing them into overvalued territory while the rest of the market falters. In this case, it might be that FISV drops 20%, AXP drops 30% and VPU rises 10%. If my goal is own more shares of AXP and it hits my first "buy price," it might make more sense to sell the relatively overvalued VPU and make the first purchase of AXP, and then wait for later in the cycle to see if a wider spread opens up between FISV and AXP. While none of this is guaranteed, having those two options would provide a lot more flexibility for the rotational strategy. So, going forward I'm always going to try to have a 50/50 blend of two defensive alternatives for each stock I write about.
The second change I am going to make is to not lock myself into writing about whole sectors for months at a time, and instead focus on a few different situations. The first will be when a stock is near an all-time high. These articles will be warnings to current investors that they should get defensive. As long as the stock meets my other parameters, I won't take into consideration what sector it belongs in. The second type of article will be like those I have recently written for 3M, Cummins (NYSE:CMI), Campbell Soup (CPB), and Starbucks (SBUX). These articles will be written after a stock has dropped at least 20%, and I'll explain whether I would buy the stock or not, and the prices (or conditions) when I would start buying. And the third type of article will be when I think a stock is a buy at current prices. So, the main change here is that I plan to write on a broader range of high-priced stocks regardless of sector going forward.
Taken as a whole, I think my ideas are well positioned for a general market downturn while not giving up too much opportunity should the market go higher. Thanks for reading, and I'll continue to keep my eye out for good cyclical opportunities in the future.
Disclosure: I am/we are long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.