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 five 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). In August, I wrote an additional article on Nike (NKE) before its advertising controversy, and so I will include Nike here as well.
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.
The basic strategy I've been proposing in this series is that when the risk/reward - even for good stocks - becomes tilted too far toward the risk end of the spectrum and the stocks are overvalued once we consider the inclusion of a bear market within the next three years that investors should rotate out of these stocks and into more defensive positions. The ETFs that I have suggested were chosen because I thought that if the market kept rising, the ETFs would likely capture some of the upside that cash wouldn't. But, if the market went down, the ETFs would likely fall a little bit less than the S&P 500. I assumed that investors liked the companies themselves, and would like to own more shares of the companies, and also that if investors could manage it, that they would like to avoid holding through very big price declines that might include drawdowns in excess of 50%.
Given these assumptions, the goal of this strategy is to increase the shares of the target companies one owns without spending any more money to do so. For example, if one rotated out of the target stock and into the defensive ETF while they were both priced at $100 per share, then during a bear market the ETF might drop to $80, and the target company to $40 per share. At that point, you can rotate back into the target company stock and own twice the number of shares at no extra cost. Then when the stock eventually recovers, you have doubled your wealth compared to what it would have been if you held the company through the entire period (minus taxes, of course).
In order for all this to work one needs to 1) identify a quality company, 2) understand when it is overvalued, 3) get somewhat close at identifying the late-stages of the business cycle, 4) correctly identify a more defensive alternative, and 5) have the guts to rotate back into the stock when it looks like the world is ending near the bottom of the cycle.
My goal is to provide research, strategies, and ideas that help investors do this.
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 August 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.
These five stocks have been crushing it
When I first started writing about these service sector stocks in March, the market had just suffered a mini-correction. So, we might expect fairly strong performance given that the S&P 500 and Dow Jones Industrial averages are currently hitting all-time highs. What is really interesting to me is to see the difference between some of these service stocks. Five of them have been absolutely crushing it in terms of their returns since I wrote about them, but for different reasons.
In last month's update, I postulated that cycles for railroads might be different than they have in the past because, with the development of fracking, the railroads are now tied more closely to oil and commodity prices. I don't have any new thoughts on this other than my suggested alternative, Berkshire Hathaway, with its ownership of Burlington Northern Santa Fe, ought to benefit from this trend as well. Berkshire still seems undervalued and likely less volatile than the pure railroad stocks by my account. I think the question now is how high can the railroad stocks go before the next downcycle? If they go high enough (not just on speculation, but on earnings growth), it might turn out that I was too early in my call to rotate out them and get defensive. CSX, in particular, has seen some explosive growth. It will be interesting to see if the stock levels off here and allows Berkshire to catch up. It seemed to cool off a bit in September even while UNP shot up.
Costco has been on a steady climb, too, but it finally got an analyst downgrade on valuation and that caused it to level off for September. Costco might end up being a good candidate for the "slow buy" strategy for high-quality stocks I recently wrote about instead of waiting for a recession to buy the stock, but it still seems expensive to me.
Paychex is a stock we would actually expect to run up until the end of the bull market and that is exactly what it is doing.
I noted in one of my previous updates that I probably shouldn't have offered an alternative for W.W. Grainger because I essentially acknowledged in my original article that Grainger was too hard to forecast in the middle of a turnaround. It's another one that has been doing well, again for its own unique reasons.
And then there is Tiffany. Tiffany was an example where expectations were simply too low for the company and totally surprised Wall Street. Whereas with Grainger, we knew that there was a possibility that earnings could turn around, nobody was really expecting Tiffany to blow out earnings a few months ago.
These five "winners" have all had unique ways of outperforming since spring. Some are making money in new ways, like the railroads. Others are predictably strong late in the economic cycle like Costco and Paychex because people are going to be earning and spending lots of money. Others in Wall Street simply got wrong, like Tiffany and Grainger, and later made up for it with nearly instant pops in the stock prices.
One of the reasons I think it's useful to track performance along the way is because different trends can stand out at different times. We might pick up on something during the top of this cycle that we can use to our advantage during the next cycle. I think that I have certainly learned something about railroads. For example, I've written "buy" articles on four different oil sector stocks the past year because their prices were cheap and I thought oil would rally before the end of the cycle. But if railroad stocks now benefit from high oil prices just as oil company stocks do, then railroad stocks might be the last stocks we want to sell as we approach the peak of the business cycle. I missed that trend this time around, but it will be something I'll pay attention to next time around.
Perhaps the biggest lesson I have learned this year writing about cyclicals is that there are two distinct groups. One group falls in anticipation of the economic cycle turning, while another group doesn't fall until closer to the end of the cycle (even though they might fall deeper than the S&P 500 during the downturn). Since each cycle has unique aspects, it's worth paying attention to details and what factors might be different this time around. Some of those factors are going to be company specific, like what sort of valuation it had going into previous downturns, and others will be more macro-oriented like we've seen with the railroads.
Signs of weakness
As we've seen, some stocks are doing quite well, even relative to a market that's making new all-time highs. Others are showing increasing weakness. FedEx has been showing relative weakness after each earnings report compared to the S&P 500.
This is the first update where S&P Global has performed worse than SPY and Berkshire Hathaway since I wrote about them this spring. Whatever sort of earnings expectations the market had for S&P Global, it doesn't seem to be meeting them anymore.
Carnival, Southwest Airlines, and Magna International have all behaved much more like industrial cyclicals. Even though I didn't write about these stocks close to their peaks (Carnival and Southwest were off their peaks quite a bit, and Magna had yet to make its peak), they are still underperforming the market, but the ones that fell early are rallying just like an industrial stock would. Understanding this dynamic should help us identify two important trends for the stocks during the next cycle. The first is that they tend to fall early, mostly without warning. The second is that if you happen to get caught up in that early sell-off of 20-30%, it's probably wise not to sell at that point if the economy is still doing well, because you'll probably get some kind of bounce off that level which will give you a better selling opportunity before the actual downturn occurs. How big the bounce will be is hard to tell, but at least one could try to get a little bit more out of the stock if they unexpectedly got caught in the initial dip.
Best Buy & Nike
I think Best Buy's and Nike's near-term future is mostly going to be determined by earnings. For both stocks, it seems like a lot of good news is priced in, so I think eventually either individual issues for the company might disappoint before a wider cyclical downturn occurs, or they could each get caught up in a macro-driven downturn. Near-term, the risk is individual, but medium-term, it's macro. In both cases, though, I think the downside risk is greater than that of the overall market.
In Nike's case, in particular, I think the potential benefits of its controversial advertising campaign will be near-term as some customers might go online and make orders as a show of support, while the potential backlash will be revealed over the medium-term, particularly when parents go out to buy back-to-school shoes next year, or as worn-out shoes and sporting equipment need to be replaced or upgraded this year. So, no matter what one thinks of the issue, I wouldn't let the next earnings report fool you if it's good. The downside, if it comes, will likely come later.
The average return of the service sector target stocks including Nike at the end of September was +13.86%, while the defensive alternatives returned +6.13%, and SPY +9.51%. Through the month of August, the numbers were +13.13%, +5.26%, and +8.99%. So, each category performed about the same in September, rising modestly. If interest rates keep rising, I expect Berkshire Hathaway to keep rising relative to the market, while my more conservative alternatives like VPU may underperform since they are considered bond proxies by many. One of the things I'll be keeping an eye on is how the Invesco S&P 500 Equal Weight ETF (RSP) performs in this environment. I've noticed that it has had several days where it has shown some divergence from SPY. I think it could insulate investors somewhat from large-cap tech names like Facebook (FB) if a few of them get disproportionately sold off by the market.
If one includes all of the 28 stocks from my "How Far Could They Fall?" series in which I suggested defensive alternatives, the target stocks have returned +5.58%, the defensive alternatives have returned +6.87%, and SPY +8.44%. These results are about what we would expect given that many of the industrial stocks are recovering right now. In fact, I would expect the target stocks to probably catch up and surpass the defensive alternatives over the next several months if the market continues to move higher. Fortunately, for owners of those stocks, it will be a second opportunity to take profits. I believe that the market has been kind enough to give us a preview of what is to come during the next bear market. For owners of industrials and some of the early-falling service stocks like Carnival, Southwest, and Magna International, the market has certainly tipped its hand on how it plans to treat these stocks during the next downturn.
For other stocks that have held up relatively well, the future isn't so clear, but if they go into a bear market with high valuations, I wouldn't expect the market to be forgiving. There's still time to get defensive and do just fine over the next year or two with a lot less risk while waiting for the bear market to arrive.
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.