market perspective-may 2015

Market Perspectives – May 2015

Experience Insight Impact

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Overview: During market downturns, investors will often seek out defensive areas of the market in search of “safety.” This month we investigate “safe” sectors of the market which have been traditionally used for conservative equity exposure: healthcare and utilities.

How safe is conservative equity?


Defensive Equity Allocation

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• It’s generally accepted that investors can improve their equity portfolio’s performance during down markets by being defensive. Defensive actions during tumultuous times typically involve shifting equity exposure toward less cyclical and less volatile (lower beta) sectors.

• Defensive sectors typically consist of firms that produce goods and services with relatively inelastic

demand curves. In other words, the demand of these goods is not impacted by price increases. Economics professors use cigarettes as a prime example of inelasticity (people who smoke are still going to smoke with relatively little regard for cost). In the stock market the least cyclical sectors have been healthcare, water and electric utilities, food processors and other consumer staples.

• However, this relationship is not true during all periods. We believe some traditionally defensive areas

have greater risk in today’s market due to certain circumstances specific to the current environment.

• There are many reasons why a sector might perform differently from one bear market or recession to the next. We examine why we believe the general utilities and healthcare sectors may not provide the same defensive characteristics currently as in prior cycles.


Are Utilities Defensive in a Low Yield Environment?

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• Utility stocks are often considered the ultimate risk-averse investment. They boast reliable dividends, inelastic demand, and regulated monopolies.

• This chart tracks utility dividend yields over 25 years. While its dividend yield is relatively attractive in today’s near zero interest rate environment, global demand for income has created a price rally and pushed utilities’ yields close to historical lows, limiting its defensive characteristics.

• Perhaps as a precursor of what lies ahead, utility stocks have traded poorly during the brief interest rate rallies we’ve seen over the past few years.


Utilities – Defensive or Not?

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• Further limiting utility sector’s safety is valuation. This is a chart of S&P Utilities Index earnings multiple, or P/E ratio.

• At its peak, the P/E multiple increased 62% off of its 2011 lows. At 17x earnings vs. its long term historical average of 14.8x, it’s difficult to consider utilities defensive.

• Further, US utilities have traded at an average discount of roughly 25% to the S&P 500. Even after the sectors’ correction this year, US utilities are only trading at a 20% discount.


Is Healthcare Defensive?

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• Healthcare is a mainstay of defensive equity exposure. It’s inelasticity is evident – people continue to get sick no matter what the economy does. However, the drivers of an industry can change dramatically over time. “Health care” is in fact composed of many different segments with a variety of characteristics. While we do still find many areas attractive based on growth and sustainability of earnings, the current investment landscape leads to the conclusion that many areas of healthcare are no longer defensive.

• Today, healthcare indices are heavily influenced by major secular themes which are driving up valuations. It is no longer dominated by big pharma trading at low earnings multiples and paying large dividends. Biotechnology companies and interest rate driven merger activity have driven up valuations and substantially increased this sector’s correlation to the broad equity market.

• For example, the S&P Healthcare Index is has a dividend yield of 1.41% and a P/E of 23.6x trailing earnings. This is a substantial premium to the broader equity market. As of April 29th the S&P 500 has a dividend yield of 1.97% and is trading for 18.43x.

• In addition, healthcare has been equally as volatile as the broad stock market. The sector’s beta – a measure of risk which tracks correlation to the S&P 500 – is 0.97 over the last two years. Note: A beta of 1.0 is 100% correlated to the S&P 500.


Healthcare Valuations

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• The chart represents the earnings multiple of the S&P Healthcare index. Over four years, the P/E multiple has increased by 131% or 26% per year on average.

• The index moved from trading at a discount to the S&P 500 to a 28% premium today.

• While there are attractive and conservative individual securities within the sector, in aggregate we consider it less defensive than it has demonstrated historically.


Why is this Important for Clients?

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• Its important to constantly test rules of thumb for reasonability and validity. The security prices are constantly changing due to changing market conditions and secular changes in sector dynamics.

• Individual stock selection and active management versus blind indexing can protect investors from risky areas of the market by incorporating the impact of changing industry dynamics into the investment thesis.

• The global search for yield and global central bank activities are affecting security prices for many assets with income characteristics.

• When the US Federal Reserve changes its interest rate policy, it could result in increased volatility in areas of the market where volatility has been historically lower.

Market Perspectives – May 2015


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Conclusion: “Defense” to some degree is an important part of the investment process for the vast majority of investors. Regarding equities, it is not sufficient to simply look at history. It is important to frame an investment in the context of valuations, current economic and market conditions and critical thought in order to achieve the desired risk adjusted returns.

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Opinions expressed in this commentary may change as conditions warrant and is for informational purposes only. Information contained herein is not intended to be personal investment advice for any specific person for any particular purpose. We utilize information sources believed to be reliable, but cannot guarantee the accuracy of those sources. Past performance is no guarantee of future performance; investing involves risk and may result in loss of capital. Consider seeking advice from a professional before implementing any investing strategy.


Disclaimer

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market perspective-may 2015

Economy & Finance