If a casual observer of the stock market glanced at returns for 2014 they’d probably shrug their shoulders. Chances are they’d see nothing out of the ordinary with year-to-date returns of -1.19% and -3.92% on the S&P 500 and NASDAQ respectively, especially after the strong returns of 2012 and 2013.
But there has been a sell-off in stocks the past month that has investors wondering if the bull market is tiring. In fact, since the beginning of April the S&P 500 is down 4% from its high and the NASDAQ is down almost 8% from its March high. Even though we all know stocks don’t move up in a straight line, corrections in the markets always spook us. Let’s examine what’s been going on the past few weeks.
The current sell-off in the market has been led by selling in the high-growth and high-valuation stocks, specifically the healthcare/biotech, and technology/cloud computing stocks. These stocks have been market leaders the past year and their stock prices have moved up a lot. Below are some examples of these “momentum” stocks investors have been taking profits on.
Gilead Sciences (GILD) is down 21% from recent highs (still up 27% the last 12 months)
Netflix (NFLX) is down 27% from recent highs (still up 88% the last 12 months)
Splunk (SPLK) is down 40% from recent highs (still up 39% the last 12 months)
The chart of Splunk (a high growth cloud computing company) exemplifies the intra-market correction that’s been going on. Even though it’s down 40% from its highs, it’s still doubled the S&P 500 the past year, not too shabby! Below, the price of Splunk is in blue and the S&P 500 is in green:
We’re simply having a rotation out of the high-flying momentum stocks of 2013 (think G33 holdings) into more value-driven opportunities (think G50 holdings) recently and this has investors and the financial networks a bit concerned. What are they worried about? Below is a list of current concerns:
- First quarter earnings growth will be flat year over year
- Federal Reserve tapering continues
- Tension between Russia and the Ukraine
- High valuations investors have given the momentum stocks
- Weaker economic numbers out of China
- Strong returns in stocks without a correction since late 2012
Let’s reply to each of these concerns.
- Yes, 1st quarter earnings will be flat year/year. I believe this is due to severe weather and as the nation thaws out earnings growth will accelerate the next 3 quarters
- Yes the Fed is tapering. I endorse this since it implies the Fed feels the economy is strong enough to slow down their bond buying
- Yes, the recent turmoil in the Ukraine and Russia bears monitoring, but there’s always some hot spot across the globe
- Yes, investors have chased high growth stocks and IPO’s. Now they are simply taking some profits. That’s how stocks work
- China has had slower economic data the last year, but the strength out of the U.S. and Europe has picked up the slack around the globe
- Finally, stocks have done well the past two years without a significant correction (one over 10%)
Could equities correct? The quick answer is yes. Corrections are normal in the stock market and we should all be aware of this. Below are some statistics dating back to the year 1900 on how often corrections occur:
- 5% market corrections: 3x per year
- 10% market corrections: Once per year
- 20% market corrections: Once every 3.5 years
Stocks have provided investors with long-term annualized returns of around 10%. The problem is those returns aren’t linear. Some years are up and some are down, with most years having intra-year declines like we’re experiencing now. See the illustration below that highlights these intra-year declines in both up and down years. The green bars are annual returns, with the red percentage figure highlighting that year’s biggest intra-year decline.
Most Gradient Investment portfolios have been immune to the momentum selling in the market. The G50 and Endowment portfolios are down less than 1% for the year. The Fixed Income and Laddered Income portfolios are up 1-2% while the Absolute Yield portfolio is up almost 4%.
The G33 portfolio holds high growth/high valuation stocks. Unfortunately this portfolio has corrected with the momentum stocks and is down 9% on the year. The G33 was up 48% last year and is giving back some of that performance. I believe over time, earnings and sales growth will trump market corrections and provide investors out-sized returns in the G33, but it can be volatile.
I’d like to highlight the chart of a current G33 holding, Jazz Pharmaceuticals, as an example of what’s going on within the G33 right now. Over the past year it’s been a great performer (up 125%). The last month it’s been brutal (down 28%). See the chart below:
Even though the stock has been down a lot recently I still like it. The company is expected to grow earnings 25% and only has a Price to Earnings (PE) multiple of 13X. In other words the fundamentals and valuation are attractive, as are many of the G33 holdings. When the selling subsides, I’d expect the G33 stocks to recover based on their strong fundamentals.
Corrections can test the fortitude of stockholders, but if an investor has a portfolio allocation that matches their investment objectives they should be able to endure the many corrections in the investment markets that will inevitably occur. We don’t see anything ominous on the horizon, but think it may be a little early to commit new money to the equity markets. We’d prefer to let the dust settle first. We are still constructive on the market and believe the economy is improving and U.S. corporations are thriving.
As of April 11th, 2014:
Dow Jones US Moderately Conservative Index is up 1.10% (TR) for the year
S&P 500 closed at 1,858.83 down 1.19% for the year
U.S. 10 year Treasury Futures are yielding 2.62% down 0.35% for the year
WTI Crude Oil futures closed at $103.74 up $5.04 for the year
Gold closed at $1,319 per ounce up $115 for the year
To expand on these market reflections or discuss other portfolio strategies please don’t hesitate to reach out to the Gradient Investment team.