Utilities, Still on Defense?

The JP Morgan Guide to the Markets is out for Q2 and is always a good place to find some fun charts and a recap of the prior quarter.  I usually peruse through it when it arrives in my inbox.  This quarter, something in particular caught my eye – in Q12013 Utilities are up more than the S&P 500 (SPX). 

The sector was up 13% and the index was up 10.6%.  This is odd as Utilities are typically defensive so when SPX rallies hard like it did in Q1 you would expect Utilities to lag.  Over the last 10 years the beta (how Utilities move relative to a move in SPX) is .52, which means since SPX was up 10.6% Utilities should have been up roughly 5.50% based on the last 10 years of historical moves.  So why did this happen?  I have two thoughts:

• Search for yield.  The 10-Year Treasury floats around 1.75% with SPX around 2.00%.  Utilities yield about 4.00%.  This feeds into…
• Capital Protection.  Investors are still nervous from 2008 and 2009.  Given the low yields, investors feel more compelled to reach for yield and return in less volatile equities.  This is evidenced by large moves in other low beta, defensive sectors – Health Care, Staples, Telecom – in Q12013.

This presents two questions.  The first is will these conditions persist?  I think yes given QE (Fed won’t let rates rise) and investor psychology being extremely sticky.

The second is what happens if the market reverses?  Utilities are roughly 30% overvalued to their historical norms.  Thus, the risk is that if the market starts trending negatively, the downside protection Utilities provided in the past may not hold this time around.  Though if the market moves higher and Utilities lag this could correct itself before an overall market correction. 

Thus, the conclusion I draw is that while the conditions driving Utilities higher are still in place, I am concerned their upside potential does not compensate for the downside risk.  This kind of market disconnect can have great bearing if there is a sudden increase in downside market volatility as the investor could be subject to more risk than initially thought.

If decent yield with a defensive posture is a prime goal, an investor may be better served looking at alternatives to this sector or, at the very least, understand the risk.

Past performance is no guarantee of future results. An investment concentrated in sectors and industries may involve greater risk and volatility than a more diversified investment.  The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

Draft Weekend

The NFL Draft was last weekend.  We now have the absurd post-draft grades, where despite these players never having played a down, teams are given an evaluation based on perceived value of the picks.

While not as absurd, I do find it silly that NFL GMs are considered great or horrible based on a handful of picks.  Think about it, if roughly 60% of picks pan out a GM is considered “good”.  That’s a bit better than a coin flip.

For simplicity, let’s assume the first two rounds present the only chance of producing legit starters, and assume a GM has about three years to show results.  Thus, in three years a GM must count on roughly 3.6 picks in the first two rounds to become good, if not great, starters.  If only two succeed he is a total failure, three he’s average, and four plus he is probably a success/genius. 

The sample size is extraordinary small, the success or failure probability is essentially even, and the margin of error is narrow; so the results of the pick are not a good indication of a GM’s skill or luck, at least over the course of a few years.  Thus, it’s the process that matters – how do GMs evaluate players?  The success of a player is probabilistic and therefore there is always a chance of failure.  A GM can do everything right in terms of his process, yet ultimately have a poor result. 

No, I haven’t started a sports blog, but I do see many parallels between a portfolio manager (PM) and a GM.  A PM can have years of underperformance, but have a strong process and will ultimately show skill and subsequent outperformance over the long-term (i.e. the skill of coming to solid probabilistic conclusion is born over a large sample size).  Therefore, it is how they invest, not the short-term returns, which are of concern to me.  Investors typically make the mistake of selling a manager early or passing on one altogether because of terrible one or three year returns, when qualitatively the same process is in place the has led to exceptional long-run performance.

For NFL GMs, unfortunately they aren’t graded on the same curve as I grade PMs.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

The Inflation Concern

I am still not terribly worried about near-term inflation; although, I am paying more attention to the intermediate-term.  Many of the disinflation/deflation prognosticators I read regularly, who have been right, are changing their tune slightly, and this is causing me pause. Eventually we will transition from this disinflationary secular bear/range bound market to an inflationary secular bull. 

However, here is why nothing is imminent: until wages move, we won’t have inflation, and wages have been stagnant:

Second, if inflation does get out of hand an equity allocation should do quite nicely:

The charts indicate basically that inflation doesn’t appear to be a threat now, but if it does become one then stocks should help weather that storm.  One caveat is that inflation is the only thing in my opinion that will cause interest rates to rise (via the Fed), so that could have a near-term negative impact on stocks.

The views and opinions expressed in this blog are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  04/13

Blog Note Update

Posting has been slow of late, and for that I apologize.  I have re-tooled the message for three main reasons:

1. To give the blog a more distinct and personal feel
2. To make posts timelier and more scheduled
3. To tie the blog into other social media

Here is what I came up with:

1. Posts will now exclusively cover how various things impact someone’s portfolio, and how to capitalize on them or how to mitigate risk. It could be a macro event, a theory, or just something which occurred to me from reviewing countless research.  Regardless, it will focus on possible impact on the markets.
2. I will post twice a week on Tuesday and Thursday with a more precise message.
3. I will tie in a Twitter account and link it to other platforms, like Linkedin.  When this happens I will outline where to follow.

So, look for regular posting as outlined above starting Thursday.  And if you have any questions, comments, want me to touch on something, or anything else please email me – zabrams@capitalavisorsltd.com. 

Election, Fiscal Cliff, Europe… But Earnings were also Weak.

So right after the election equity markets got a bit shaky; although, have now perked up a bit.  Fears that the President will raise taxes and sink the economy, the Fiscal Cliff is right around the corner, and more negative news out of Europe seemed to “drive” equity markets lower.

So what did move equity markets?  Anyone who professes to have an idea is guessing.  Take your pick of the above if you want to rationalize whatever it is you want to rationalize about changes in the stock market; however, you should consider this – QE3 earnings were bad and forward guidance was weak…

1.  Looking ahead, assuming markets discount the future, once again future guidance was poor.

2.  The earnings beat was up from the last few quarters, but nothing spectacular.

3.  The revenue beat rate was much worse, in fact we've now had consecutive two quarters where revenue beat was below 50% and that hasn't happened since Q4 '08 and Q1 '09.

Remember, earnings  are the ultimate drivers of stock markets, so when you hear various noise it’s important to keep that in mind.