By Ron Muhlenkamp and Jeff Muhlenkamp, Portfolio Managers
During the second quarter, we earned an average return of -1.35%. For comparison, over the same time period, the S&P 500 Index returned 2.46%, the Nikkei (Japanese stock market index) returned -6.95%, the Euro Stoxx 50 (a European stock market index) returned -1.90%, and the Shanghai Index (China) returned -1.64%. The S&P 500 Index was the best of the bunch even before the United Kingdom voted to leave the European Union on 23 June, and it widened the gap with the rest of the world after that event.
In general, our holdings with exposure to the business or credit cycle did poorly in the second quarter, as did drug companies. Our technology companies have done well, and the money we put to work in select energy and healthcare companies in the first quarter has generally done quite well for us. We are pleased to own no financials, which have performed poorly this year and were hit particularly hard in the aftermath of the British referendum.
Most of the second quarter was marked by rising stock and crude oil prices as both markets rebounded off of their February lows. The S&P 500 Index hit 2119 on 8 June, 2016, just short of the 2126 level it achieved in both May and July of 2015, before declining into quarter’s end. The price of crude oil crested just above $50 per barrel late in June, before similarly declining into quarter’s end. The Federal Reserve kept short-term interest rates unchanged during the quarter (citing the risk of volatility due to the Britain vote; they sure got that one right!), and long-term interest rates declined during the quarter with the yield on the 30-year Treasury moving from 2.6% in April to 2.43% at the end of June. The spread between high-yield (junk) bond yields and Treasury yields continued to narrow throughout most of the second quarter, continuing the move we saw at the end of the first quarter. That remains a positive development. First quarter company earnings (which were reported during the second quarter) were generally in line with expectations, but, again, both aggregate revenues and earnings declined on a year-over-year basis. By our count, that’s four straight quarters of declining year-over-year revenues and three quarters of declining year-over-year earnings. As in the previous quarter, declines were worst in the energy sector, but fully half of the 10 sectors saw declining earnings and revenues—it’s not just energy that’s experiencing weakness. The weakness in much of the industrial part of our economy that we identified in late 2015 remains and has neither improved nor worsened noticeably.
It seems like every quarter something big happens for us to talk about, this quarter was no exception. The UK voted itself out of the European Union on 23 June. The markets (currency markets, equity markets, commodity markets) reacted violently to the development on 24 June—a bunch of market participants must have been caught by surprise. We believe that this is a great big sign that the previously unthinkable can no longer be dismissed and must now be considered possible, that the range of possible outcomes as we look at the future is now broader than it was a month ago and our ability to see clearly has diminished. We think other market participants will come to the same conclusion and adjust their actions accordingly. In other words, we think investor psychology has probably changed, which will probably change the markets. We’re keeping an open mind as we think about the impact.
Our expectations going forward are for negative interest rates in Europe and Japan to continue, encouraging investors in those countries to leave home and invest in the United States (tending to support U.S. stock prices and keep Treasury rates low), while simultaneously damaging their banks. We expect U.S. economic growth to be less than 2% with inflation below 2%, and think it is unlikely that the Federal Reserve will raise interest rates in the near future. A recession in the near future is quite possible. We’ll be watching to see if the spread between high-yield (junk) bonds and Treasury bonds widens back out, and to see if the Treasury yield curve, which has flattened quite a bit, flattens more or inverts. We’re also keeping a sharp eye out for effects from the exit of the UK from the European Union.
We continue to hold a large cash reserve and look for good opportunities to put that cash to work. We know those opportunities are coming, we just don’t know when.
Until next quarter,
The comments made in this commentary are opinions and are not intended to be investment advice or a forecast of future events.
Refer to the SMA All-Cap Value Fact Sheet for the Top 20 Holdings and performance data as of the most recent quarter-end.
The S&P 500 Index is a widely recognized unmanaged index of common stock prices. The S&P 500 Index is weighted by market value and its performance is thought to be representative of the stock market as a whole. One cannot invest directly in an index. The S&P 500 is a widely recognized, unmanaged index of common stock prices. The figures for the S&P 500 reflect all dividends reinvested but does not reflect any deductions for fees, expenses, or taxes. It is not possible to invest directly in an index.
Nikkei is short for Japan’s Nikkei 225 Stock Average, the leading and most-respected index of Japanese stocks. It is a price-weighted index comprising Japan’s top 225 blue-chip companies traded on the Tokyo Stock Exchange. The Nikkei is equivalent to the Dow Jones Industrial Average (DJIA) Index in the United States Euro Stoxx 50 is a market capitalization-weighted stock index of 50 large, blue-chip European companies operating within Eurozone nations.
The Shanghai Stock Exchange (SSE) is the largest stock exchange in mainland China, run by the China Securities Regulatory Commission (CSRC). Stocks, funds, and bonds are all traded on the Exchange, which has listing requirements including that a company must be in business and earning a profit for at least three years before joining the exchange.