Market Update: January 2013
I am going to make a bold statement here: I declare 2012 the least interesting year since 2006 – at least from a markets perspective. The stock market went up. The bond market went up. Commodities went up, a little. And more importantly, there were no market calamities. We have had a financial disaster every year since 2006: the sub-prime collapse in 2007, the banking collapse in 2008, the market collapse in 2009, the flash crash and Greek collapse in 2010, a political collapse in the United States and Greek collapse (again) in 2011. This year was actually pretty calm: markets generated rather steady gains, and we didn’t reach the brink of collapse. The only exception was the Fiscal Cliff political drama in the last weeks of 2012, and we won’t know how that plays out for a while longer.
A relatively sleepy year notwithstanding, I don’t believe that we are out of the woods yet. In fact, I’m still holding onto some concerns and worries that have affected our decision-making and strengthened our belief that Vodia’s commitment to stable, conservative investment strategies that manage risk effectively is what’s most needed as we make our way in an uncertain future. America, along with other developed economies in the world, is going through one of the deepest set of challenges we have faced as a nation. How we fare, and how the next generation thrives, is dependent on what we all do now.
Market Performance and Apple
The year’s equity market performance was remarkably steady. The market went up for the first three quarters of the year, despite some volatility in the spring. The fourth quarter was a lot bumpier. With a decline of several percent in Q4, the largest companies in the market indices led these declines.
The Q4 decline settled in immediately following the election in early November. With Obama’s re-election, it was clear that capital gains tax rates would rise. With this certainty, there was a large impetus for institutions and folks to realize their larger long-term gains, namely in stocks that have done exceedingly well in the past year such as Apple, Intel, and also Merck.
S&P 500 index performance for 2012: While there was a bounce down in May, it was relatively calm compared to the past five years. The post-election drop was largely driven by uncertainty around tax rates and locking-in long-term gains.
I want to focus on Apple for a few moments, not only because it has become a permanent fixture in the media, but also because it has been a longterm holding at Vodia. The tax selling is not the only reason for Apple’s decline, but it was a large part of it initially. With Apple being the largest company in the stock market at the time, it represented a significant part of the market’s daily movement. In fact, institutional portfolios are saturated with Apple and have no further room to allocate to the stock. Hence, any type of short-term aberration, whether it be tax selling or a slow down in growth, has the propensity for a dramatic movement in Apple’s market value. But that was not the entire picture.
Over the past twelve years, Apple created several new markets around portable devices and the software-based ecosystem to support those devices. The devices (iPod, iPhone, iPad or MacBook), the services (iTunes, Apps Store, iCloud or the support services to these offerings), and their operating software (OSX and iOS) all work together in an intuitive and seamless manner. And let me emphasize the intuitive user experience aspect here – whether it is my father or a toddler, nearly everyone can use Apple products. This level of ubiquitous access to technology is unprecedented, and the ramifications for everything from corporate productivity to education are enormous.
This unprecedented accessibility has been reflected in the company’s financial performance. Apple generates over $50 billion in operating cash flow each year – after all expenses are paid (for comparison, this is the equal to HP, Microsoft and Google’s operating cash flow combined). And they continue to grow at impressive rates. This past quarter saw revenue grow at 18% over the prior quarter, with the realization that they could not make enough of their hot products to meet demand. Put simply, they sold nearly everything they could make.
But there are glitches in the story. The cost of making the products has gone up. As a result, Apple profit this past quarter was roughly the same as a year ago, even though sales were up. They are also facing significant competition for the iPhone as knock-off and competitive products have matured. And of course, with the passing of Steve Jobs, we don’t know what markets Apple will reinvent next; one possibility is television, and Tim Cook’s drive to redesign the entire experience.
Although these threats exist, they don’t change the overall picture of Apple’s position in the markets – they are still growing extensively and globally. We have managed the Apple position accordingly, moving from an overweight risky equity at the beginning of the year to a neutral/underweight in the fall. The market decline, however, has placed Apple’s value far out of line with the fundamentals, and with near hysteria surrounding their recent decline we are again viewing them as a potential overweight.
Getting back to the equity markets, Apple’s impact was felt far and wide. Noting that Apple was still up 33% for the year, the S&P 500 with Apple in the index was up 16% for the year, while the Dow Industrials, which does not include Apple, was up by only 10.2%. That is a fairly wide disparity, and one worth tracking. Alternatively, the international markets performed even better, with the MS EAFE developed markets index up 17%. With far less volatility than we have seen in the past five years, it was a decent showing all around.
My overall assessment of equities remains cautious. I still hear the chatter from equity managers to “just stay the course” with the stock market. If you have twenty years to invest and wait, that has usually been a safe and wise way to go. But the pursuant returns (9% per annum for the past twenty years) do not justify the ridiculous volatility from a repeated cycle of price bubble and collapse. And the reality is that few investors have the ability to wait another twenty years. If markets collapse again, waiting to see what happens could prove to be a devastating experiment.
The Economy
What might happen in the next few years is not so clear. Equity performance depends on the ability for companies to grow profits, speculative bubbles aside. Profit growth in a broad sense can only occur with a growing economy. Our economic growth used to be around 4% per annum – a healthy and vigorous pace for a developed nation. But that was back in the 1960s and 70s. Today the pace has dropped to 2% or less when we are not in a recession. It used to take six months to recover lost jobs after a recession; we now are sixty months past the last recession and there is no jobs restoration horizon in sight.
Our economy is still strong – the largest for any single nation in the world. But it is not strong enough to sustain repeated blows: the financial crisis, sub-prime real estate disintegration, financial market dislocations, or political infighting and potentially devastating partisan divisiveness. Each and every one of these has happened in the past five years, and the debt- ceiling debate is still getting postponed. It won’t take too much to cause another recession, or further job loss.
While our growth has slowed considerably, we are still the largest single economy in the world. Sources: CIA Fact Book, Bloomberg
I am optimistic that we will be able to continue growth, but it will have to come with change. Overall, we are witnessing the change from an industrial economy to a digital one. This has generated a level of income and wealth inequality that hasn’t existed since the end of the 19th century. And with changing geopolitical dynamics, we have become a nation driven by fear: not only do we see terrorism as a threat from without, but some believe we must arm every citizen with assault weapons to protect themselves from within. Change is scary.
But change can also be good.
With that change, we must look beyond the trends of the past for new valuation techniques and investment opportunities. It has been five years of disruption as change takes hold, and will at least five more years until we can find some certainty in the economy. To respond to this dynamic in the portfolios, flexibility will be key; awareness is critical.
Change and Disruption
This change is creating vast disruption and opportunity in society and the economy. As we refine our investment strategy, we see at least five primary dynamics to watch in the coming year:
- Political histrionics – whatever the crisis du jour may be, it can do severe damage to the economy and our prospects. Manipulating the tax system in a haphazard way, for example, created the decline we saw in markets in November and December. The partisan entrenchment needs to stop before it leads to devastating self-inflicted wounds.
- Investment in infrastructure –there is a need for a coordinated and concerted effort by government (state or Federal) to support and invest in an educated, skilled workforce and new technologies. Without these changes, the US economy will have dismal prospects for accelerated growth in a changing global economy. But Obama’s administration does have an eye towards investing in the workforce, as witnessed by his support of state-run education systems and the community college system. Even such a small change can point to bigger economic gains down the line.
- Inequality and fairness – we have again reached income and wealth disparity reminiscent of the dawn of the Industrial Age. Moral implications of wealth and economic disparities aside, the economic impact of increasing inequality can be insidious. Income disparity at this level results in a concentration of power in the business and political realms. Witness the past election: the fractious debate over taxes for the highest income brackets and the “47%” was almost comical if it were not so real. Despite widespread fraud during the last financial crisis, all escaped punishment. This gets noticed, people get upset, and they lose confidence in the system.
- Reshoring – the movement of our manufacturing sector overseas represented a gross misunderstanding of the importance of manufacturing know-how and innovation. There has been a trend to bring it back over the past two years, and it appears to be growing (witness Apple’s announcement to invest $100mm into a new US manufacturing base). It will only help to improve our trade imbalance and create job growth. Our service economy is not strong enough to provide the jobs growth alone – we need to be a manufacturing exporter again.
- Debt – at all levels we have binged for decades on cheap money and skyrocketing debt. The Federal debt is a minor issue, but the current levels are sustainable if and only if the annual deficits are tempered. The bigger problem is educational and municipal debt. Both are growing enormously, and neither is being correctly measured. Municipal debt could cause a dislocated bond market; educational debt could squash an entire generation of income earners and consumers. Both need serious attention now.
All of these dynamics can be turned into positive change, but the systems are challenged and there is no deus ex machina in the wings. The underlying tension is the consumption cycle; with nearly three-quarters of our economy based on the ability of our citizens to consume, the economy will remain highly volatile and growth will be elusive. We need to get back to consumption levels in the 60% range, and addressing the dynamics above could advance that aim.
The US does have tremendous prospects for the coming years, despite political machinations. Driven by cheaper energy in the form of natural gas and our cultural propensity to innovation and entrepreneurship, I believe the economy will mend to again create sustained growth above 2% per annum. This could take several years, however, given the current trajectory of the factors above.
The rest of the developed markets are a problem, however. With Europe’s outrageous debt levels, socialist policies creating an unsustainable tax burden, and political dysfunction that makes the US look tame, their recession will likely continue for several years.
Emerging markets, with their population expansion, growing middle class, and unabashed theft of advanced technologies, are going to continue to drive global growth. Investing in any one of these markets is going to be a volatile endeavor as dislocating regional trends resolve, while finding companies such as Apple and CAT that sell into these markets mitigates much of that volatility.
Stocks are likely to continue for another positive year simply from the amount of global monetary easing in the markets. In some cases, the valuations will be strong, with high risk premiums assigned to stocks in general. In other cases, bubbles will continue to emerge and deflate – both on the upside and downside. For this reason, we will cautiously look to increase our stock exposure by 5-10% of overall portfolio allocation. Keep in mind, however, that we are still less than half equities in our managed accounts. Some of this increase might be expressed through the use of stock options rather than the actual underlying stock, giving us a little leverage with a capped downside.
Fixed income, the perennial highlight of our portfolios, is where the coming year will be trickiest. Risk premiums are at their lowest in a long time, on top of a yield curve that is historically low. Both of these factors indicate a bond market top. But unlike equities, there is a known floor on bond values (maturity value), providing a natural mitigation to any bond market volatility – as long as we hold individual bonds and not bond indices. As a result, our bond exposure will come down to fund the increase in stock exposure.
Our ability to hold individual assets (bonds or stocks) allows us to manage the systemic risks I’ve outlined. As a result, in our managed accounts we can make up for a lower-than-average stock exposure through strategies such as call options. The individual bonds also give us a natural hedge against bond market volatility. In accounts where we are limited to using exchange-traded funds, the allocations will vary this year to account for higher levels of systemic risk.
We are maintaining roughly the same commodities exposure as this past year – 10-15% of portfolios – but shying away from energy and focusing more on gold and agriculture. The reasoning in simple: inflation. I don’t see inflation on the immediate horizon, but I do see it as a sizeable risk in this era of unprecedented monetary easing.
And finally we will continue to hold larger cash reserves (10-20%) to buffer against systemic volatility and allow us buying opportunities in deeply stressed markets.
Please don’t hesitate to call or write, and I wish you all the best for a manageable winter.
David B. Matias, CPA Managing Principal
