Beyond The Headlines

February 2017 Monthly Letter

March 1, 2017 | Bogumil Baranowski
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Highlights: Higher highs, earnings season, Fed rates unchanged, car loan record delinquencies, political commentary

 Portfolio-specific commentary (12/31/2016-2/22/2017) Year-To-Date

Healthcare (biotech) and selected technology

 Improved sentiment helped our biotech holdings YTD, and our higher-than–the-S&P-500 exposure made a meaningful difference in our performance. We have a long-term view on the sector, and remain optimistic about its prospects, especially for selected holdings with the most attractive positioning.

Some of our technology holdings benefited from an upbeat earnings season (Mobileye), and M&A activity (Ultratech).

On the other hand, we saw weakness in our energy sector, where we have higher-than-the-S&P 500 exposure. We feel comfortable with our picks in the sector, and look forward to their satisfactory performance in the long run.

 Big-picture commentary

 Higher highs for the stock markets

After experiencing an especially nervous market not long ago, when stocks would quickly sell off on any bit of negative news, we are now witnessing what some call the “Teflon market.” Despite all the noise coming from Washington investors remain very optimistic, pouring money into the market and counting on economic growth. Both the Dow Industrial Average and the S&P 500 are up 5-6% YTD (2/23/2017), and recently hit all-time highs. UK, France, Germany, Japan, Brazil are climbing to new highs as well.

Earnings season – encouraging growth, but peak valuations

 With almost all earnings reports for the 4th quarter behind us, we can tell that this will be the first time in 2 years that we have seen two consecutive quarters of earnings growth for the S&P 500. Estimated 12-month forward earnings per share for the index have reached a new high ($133.50 Source: Factset), but the 12-month forward P/E also reached a peak level that we haven’t seen since 2004 (17.6x).

Two thirds of companies beat earnings expectations – with technology and health care leading the pack — while telecom services and utilities had the most disappointing results. Eight sectors reported y/y EPS growth including utilities, real estate and financials, while 3 sectors reported y/y declines with telecom services being the weakest.

 Fed leaves rates unchanged

In February, the Federal Reserve kept the rates unchanged. Remember that in December, we saw a 25-basis point hike, which was only the second increase in more than 10 years. It sets a new trend that shouldn’t be a surprise, but many may have long forgotten the world of normal rates, so it may prove to be a rude awakening for some.

We welcome further rate increases, and the end of easy money policies. We trust it will lead to a long-awaited reset in asset prices, return expectations, and debt levels across consumers, businesses, and governments.

We also believe rates increases may be a bigger determinant of the markets’ direction than new tax and trade policies, or a wave of deregulation. Any further rate increase from such low levels implies a very high percent increase in the cost of debt for all participants. It’s hard to imagine it won’t affect their behavior, and prompt an adjustment in levels of borrowing and spending.

 Car loan record delinquencies

 We like to call out, now and then, an intriguing new market dynamic that deserves more attention. Quartz recently published an interesting article on auto loans – “American car buyers are borrowing like never before—and missing plenty of payments, too” (February 21, 2017). Here are some highlights.

Last year, Americans bought more new cars than ever before. Is that meaningful? Car sales represent a fifth of all retail spending. US outstanding auto loan debt reached a new high, $1.2 trillion, 9% up y/y, and 13% higher than the last peak in 2005 (inflation-adjusted). Wages haven’t gone up much since the Great Recession. Lending has been the main growth driver. Interestingly enough, nearly a quarter of auto loans are subprime loans which carry an average 10% annual interest rate. This may look compelling to investors seeking yield, but around half of auto loan asset-backed securities (ABS) feature subprime collateral. Auto loans are a tiny phenomenon versus mortgages. In 2007, Americans had $10 trillion in mortgages with $7 trillion securitized, compared to $1.2 trillion in auto loans, with under $100 billion securitized.

Forbes (February 17, 2017) recently reported that newly delinquent car loans reached an 8-year peak. This doesn’t go unnoticed. Car makers have been hinting at sales pressures, poor appetite for cars, dwindling demand, seeing sales go from “record to rocky.”

 With rates heading up, and other metrics at peak level (total loans outstanding, percentage of cars bought with financing, average loan amount, average selling price) it’s not hard to envision a turn in that trend.

Will it be contained to only one sector, will it spill over, is it a good indicator of the overstretched consumer? The jury is still out on the subject, but we have an inkling that we might know the answer. Surprisingly enough, the biggest US car maker is trading at a multi-year high.

There is a disconnect there somewhere…

Political commentary

 It’s hard to escape the daily deluge of political headlines. In earlier letters, we listed some of the potential policies that may affect the consumer, the labor market, and businesses. We don’t share the market’s enthusiasm. We are patiently waiting for specifics, and we remain cautious in terms of our expectations. We believe that if some of the earlier-hinted measures do materialize, the beneficial impact, if any, will take time to become more visible.

Lastly, with the US stock market up over 10%% (on top of previous highs) since the presidential election, a lot of that theoretical future growth in profits appears to be more than priced in.

 Looking for opportunities

During periods of new market highs, we may not be big buyers of new positions, and we may not be adding aggressively to existing holdings. We spend this peculiar time reviewing our investments, while carefully and deliberately examining potential future acquisitions.

The process remains especially difficult given that we don’t know where the potential market weakness will come from, or where it will hit the hardest,– thus creating the best buying opportunities. Holding higher-than-usual cash levels keeps us to some extent immune to a market sell-off, and better positioned to act when the prices of securities become more compelling.

We have been generously compensated by the market for our patience before, and we believe this time will be no different.

 

Yours truly,

François Sicart, Allen Huang & Bogumil Baranowski

 

Disclosure

 

This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.