The Days Ahead:
Look for consumer sentiment. It’s been weak.
The market remains resilient hovering around its year to date and all-time highs. Mind you, there’s no visible difference between resilience and torpor. They both don't move but for different reasons. The market is not being tested and holding up, it’s just not moving, as in, there’s no place to go. The NASDAQ and tech corrections look like they were plain old profit taking, so no concerns there. None of our “fear” indicators (Yen, gold, U.S. Treasuries and VIX) are flashing. Put it all down to short-staffed summer trading desks and the absence of a strong narrative.
The healthcare sector had a nice surprise on Thursday with the “Better Care Reconciliation Act of 2017”, which proposes reducing Medicaid coverage, subsidies and credits and repeals things like device excise taxes. Healthcare stocks were up 4% on the week and 16% this year. We would put the three major Trump reflation themes, (tax cuts, infrastructure and deregulation) as no longer driving the market. This bill is more about “no new regulation”, which is not quite the same thing. Healthcare is usually a solid outperforming sector of the market but for the last two years has underperformed by around 10%. This removes some of that uncertainty. We'll refrain from further comment.
1. Active Indexing:
We’re big supporters of the move to indexing. It’s cheaper, simpler and outperforms active management in efficient markets. There are millions (sic) of indexes calculated every day by the big six index providers, S&P, Russell, FTSE, Barclays, CRSP and MSCI. Keep in mind, the number of indices far outnumbers the number of listed stocks, bonds and commodities so there’s an index for any investment theme you can think of.
MSCI made the news last week because it runs the most widely followed Emerging Markets index. So any change they make to the index means that $4.3 trillion must follow suit. And the change was to include more China stocks in the index from 2018 on. Right now China is about 28% of the index. The bulk of that is Hong Kong-listed China shares. The change will be gradual with perhaps only another 2% going into China (MSCI is pretty coy about how they will do this) but this will still understate the importance of China’s market which is the second largest in the world and five times bigger than India, the next largest Emerging Market.
Why do we care? Well, investors want to run ahead of index changes because all the “forced” buyers of the index will have to commit more in coming months. This can distort markets and a good example is what happened on the same day, when MSCI said they may include Saudi Arabia in the Emerging Markets, a promotion from Frontier Markets.
So there you have it. There was no news from Saudi Arabia, whose stock market tends to follow, unsurprisingly, oil. Yet the market shot up 9%. And it was all due to a change in indexing methodology.
We expect more of these kind of changes because indexing has become such a force in investing. We're not sure index providers should have so much market impact but it's something with which we must live. And it’s something we pay a lot of attention to as we build portfolios.
2. Bond Spreads:
There has been some movement in bond spreads recently. Here’s the spread between 10-Year Treasuries and High Yield, CCC and Energy High Yield bonds. The last two (the two top lines in the upper chart) have risen rapidly.
Why? Some is i) concern about raising rates which will hit highly indebted companies first ii) more energy coming online at a time of weak oil prices and iii) some tightening of lending. We've thought for a while that high quality bonds are a better investment, which is another way of saying that we’re not paid enough to take the risk of low quality bonds. The recent retreat in spreads does not change our view.
3. No clear signals and we don't expect one:
Here’s a graph that we used about a year ago because it was signaling that stocks were cheap relative to bonds.
It simply measures stock yields, at about 2.2%, against Treasury yields at about 2.15%. It’s by no means foolproof because inflation and dividend growth can change the signals. But it suggests to us that both stocks and bonds are fairly well valued and there’s no major opportunity to overweight either. It'sanother reason why we would put our marginal dollar into Europe where, on the one-year anniversary of Brexit, indicators like Purchasing Managers’ surveys are hitting six-year highs.
One of our favorite stock market aphorisms is “prices change more often that facts.” Right now, neither are changing. Our screen on market breadth still shows one third of companies in the S&P 500 25% below their 10 year highs. So not much exuberance.
Please check out our 118 Years of the Dow chart.
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--Christian Thwaites, Brouwer & Janachowski, LLC
Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.
All charts from Factset unless otherwise noted.