April finished on a mildly positive note. Earnings season has been generally upbeat but with some high profile fallen angels. Yesterday’s fallen angel was Alphabet#, whose shares declined by more than 10% after reporting lower than expected revenues and offering guidance that was less positive than expected.
So far this year, stocks have risen each month. Year to date, markets resemble 2017 much more than 2018. There has been much less volatility as equity markets grind higher. This morning, 10-year Treasury yields have slipped back under 2.5%, an indication that even with better than expected growth and continued solid monthly employment gains, inflation is missing in action. Wages are climbing steadily, leading to real gains in income adjusted for inflation. But productivity is higher, muting the inflationary impact of higher wages.
Aside from wages, commodity prices have generally been weak, although there has been a bit of a rally in oil. If you consume breakfast, however, you know for instance that orange juice and coffee futures are near multi-year lows. You did know that, didn’t you?
As we enter a new month, it is interesting to look back and reflect on trends so far this year. Let me briefly make a few observations.
FAANG – Facebook#, Apple#, Amazon, Netflix and Google (now Alphabet) dominated markets in 2017 through much of 2018. If you didn’t own them in size, you weren’t likely to beat the S&P performance. But over the past six months, the performance of these five stocks has been uneven. The real winners have been Apple and Facebook, companies trashed by investors last year. Apple, which reported better than expected earnings late yesterday and set to open up another 5% this morning, is a maturing company. The iPhone is no longer the must-have Christmas gift. Unit sales are going to grow with population growth. You get a new phone because the old one is broken, works badly or is lost. But Apple has evolved from a hardware company selling phones and computers to one that now gets a third of its profits from services. As more profits come from subscriptions and services, Wall Street will begin to treat this as a company with a growth stream of annuitized revenues. Despite the fact the phone sales may have peaked, it still has a bright future. Facebook gets bashed daily in the war over privacy. When you operate an open platform, controlling how it is used and what gets posted isn’t easy. The company is spending a lot of effort to satisfy the regulators but, frankly, its user base simply doesn’t care. It wants to share stories and pictures. Advertisers still flock to its sites in ever larger numbers. Wall Street has figured out to watch the numbers and ignore the media rhetoric. The others, which seemed so perfect 18 months ago, have issues. Yes, they are still growing at very handsome paces, but they were priced to perfection. Amazon is seeing growth headwinds in the U.S., its most mature market. Netflix faces increased competition as well as slowing growth at home. The law of large numbers seems to be catching up with Google as well. To make matters worse, Google’s management gave very few details to explain the slowdown. Uncertainty is an investor’s worst enemy. Hence the oversized decline yesterday.
Consumer Staples – These are companies like Coca Cola#, PepsiCo#, and Procter and Gamble#. They have been solid performers so far this year after lagging big time early in 2018. Simply put, organic growth among the leaders is rising. Stocks are priced for a certain combination of growth in earnings and dividends. If a stock, for instance, is priced to pay a 3% yield while generating a persistent compound growth rate of 5% gets repriced to a 6% growth rate, the necessary yield would fall toward 2%. Repricing a stock from a 3% yield toward a 2% yield would lead to huge gains. That helps to explain the much better than expected performance of PepsiCo and Procter & Gamble, for instance.
Health Care – The darlings of the stock market for several years is lagging this year. There are two obvious explanations. The first is pressure from Washington, particularly on the drug firms to cut prices. Second, the drug companies so far this year have gotten very few blockbuster new drug approvals. There has been some rebound in recent weeks as stocks got oversold and Trump tweets have concentrated on other news stories. The Mueller Report was the drug industries best friend in that regard. But I don’t think the war on drug prices is over. It is far from certain whether we will see any actual legislation that will serve to limit drug pricing. Generic drug prices have been in decline for several years. The headline prices of some new drugs to treat rare diseases capture the attention of progressives, but that isn’t the real story. The real problem, which is being addressed in a multitude of ways, is that the retail pricing for both drugs and health care services (e.g. a hospital stay) are nowhere near what the provider actually gets paid. As a result, pricing in the health care industry is far more opaque than it needs to be. There are plenty of obvious solutions but, as Warren Buffett often points out, if we as a nation are going to pay less for quality health care, every company and doctor in the supply chain is destined to take a cut somehow. Contrast that with deep pocketed lobbyists trying to maintain as much of the status quo as possible. The trick is to find a good solution fair to all that doesn’t stifle innovation. Possible? Yes. Possible in this partisan governmental atmosphere? Problematic.
Technology – As always, there isn’t one clear picture. Change and disruption brings a large list of winners and losers. Generalizing, the winners today are cloud companies and software enterprises that make users more productive and collaborative at a lower cost with greater ease of use. Winners are growing like a weed and, in general, are overpriced but destined to go higher until their growth rates start to level off. Losers are those being replaced. Intel still dominates the microprocessor world but isn’t making great headway elsewhere. Its stock took a big hit this earnings season. IBM# continues to grow and is actually meeting lowered expectations. A pending merger with Red Hat may help, but clearly it is growing much slower in a cloud-based world than Microsoft# or Amazon. Just as a horse race only pays off bets on the top three horses, in technology you are either a winner, an also-ran, or a has been. In our daily world, a 2015 low-mileage used car will get you around just as well as a brand new Toyota. But a 2015 computer or a 4-year old version of software probably wouldn’t be very appealing. Sometimes, getting there first in technology is a whole lot easier than staying on top. As an investor, one has to buy companies, not products. That means management is everything. Coke and Procter & Gamble both had short-term CEOs that floundered, only to rebound with subsequent management. Tech companies rarely have that luxury. Because of the speed of change, falling too far behind is often fatal.
Today, country singer Tim McGraw is 52.
James M. Meyer, CFA 610-260-2220