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Commentary

Appreciation Strategy

Second Quarter 2019

Key Takeaways
  • Stocks recorded strong returns, completing the best first half since 1997, while Treasury yields declined and the inversion of the yield curve indicated real concern about the economy.
  • We still feel that the robust U.S. consumer will keep us out of recession in 2019, and the market’s technical picture is good.
  • In general companies with strong prospects see them reflected in their stock prices. However, valuations alone have a poor record of forecasting future market returns.
Market Overview and Outlook

During the second quarter the stock and bond markets sent very different signals about the health of the world economy. Stocks recorded returns of 4.3%, completing the best first half since 1997, up 18.5%. By contrast the decline in 10-year U.S. Treasury yields from 2.40% to 2.01% and the inversion of the yield curve indicated real concern about the economy. Gold prices echoed bond market worries, spiking from $1,220 to $1,332. Oil prices fell only slightly for the quarter, from $59.3/bbl to $58.5, but prices were volatile, ranging between $51 and $66. Apart from oil and gold, commodity prices were down.

Two themes drove stock performance during the quarter. We saw a safety trade through May caused by economic fears, and then a “don’t fight the Fed” rally in June. The strongest sectors were financials, materials and technology, a bit of an odd mix. Financials stocks were volatile during the quarter, showing strength on first-quarter results, weakness on yield concerns, then a rebound in June. Technology stocks benefited from confidence in continued strong earnings growth, especially in the software sector. Materials stocks with defensive characteristics such as specialty chemicals and gold led that group higher. The commodities portion of materials were some of the worst stocks in the market. The weakest sectors were energy and health care. Health care stocks were hurt by polls indicating that President Trump could be vulnerable in the 2020 election, and discussion of “Medicare for All” by some of the most liberal of the Democratic candidates.

U.S. economic data weakened in the second quarter, with the significant caveat that the most  important component, employment, remained excellent. Consumer data continued to be stronger than manufacturing.

Manufacturing was weak worldwide. Two-thirds of the countries that report Purchasing Managers Indexes (PMIs) showed numbers below 50, indicating shrinking manufacturing sectors. The trade dispute with China and President Trump’s periodic threats of tariffs with numerous countries made it difficult for producers to make capital investment decisions. Companies questioned their supply chains, uncertain what costs would be. The June U.S. ISM manufacturing fell to 51.7, down from the high 50s seen last year. Hurt by the industrial economy, S&P 500 profits are expected to decline in the second quarter and again in the third.

 

"The several-year decline in consumer staples volumes seems to be easing."

 

Consumer numbers saw some very modest fraying at the edges. Employment results remained robust. Payroll employment gains were weak in May at 75,000 but bounced back in June to 224,000. Unemployment claims rose from a 40-year low of 201,000 in early May to 222,000 in late June, but the absolute level is very low. Continued strength in employment will limit Federal Reserve rate cuts going forward. There were sharp declines in the June University of Michigan consumer sentiment survey and the Conference Board’s consumer confidence survey, but the absolute results are still very good. Auto sales of 17.1 million were better than expected. Housing starts and permits were down low single digits versus a year ago. We need to wait until the key months of September and October to see if lower rates will stimulate housing sales.

Stock valuations are full. The Buffett Indicator, the market cap of the S&P 500 divided by U.S. GDP, at 1.3:1, is the second highest in history. In general companies with strong prospects see them reflected in their stock prices. However, valuations alone have a poor record of forecasting future market returns. U.S. bank balance sheets are very strong and the group is one of the few areas of the market with real valuation support. If the U.S. does not go into recession banks will outperform. The risk that a Democrat is elected president next year has hurt health care stocks. Valuations of selected drug and HMO stocks are compelling if a moderate Democrat is elected or if President Trump is re-elected. The several-year decline in consumer staples volumes seems to be easing. Increased inventories at retailers are necessary to support one-day deliveries. Earnings estimates for the group do not yet reflect the improved prospects.

We still feel that the robust U.S. consumer will keep us out of recession in 2019, and the market’s technical picture is good. The market’s advance to all-time highs has been broad. The period after a yield curve inversion usually generates good stock market returns — especially if no recession occurs. However, the deterioration in the worldwide industrial economy must be monitored. The Appreciation strategy of owning large, high-quality stocks is well-suited for today’s market, offering upside participation if the economy continues to grow and preserving capital if global weakness becomes more problematic.

Portfolio Highlights

The ClearBridge Appreciation Strategy had a positive return during the second quarter of 2019, outperforming the Strategy’s S&P 500 Index benchmark.

On an absolute basis, the Strategy had gains in all 11 of the sectors in which it was invested during the quarter. The main contributors to the Strategy’s performance were the information technology (IT), financials and communication services sectors. The industrials and utilities sectors contributed the least.

In relative terms, the Strategy outperformed its benchmark due to stock selection. In particular, stock selection in the energy, IT and consumer staples sectors contributed the most to relative performance. Conversely, stock selection in the industrials sector detracted.

On an individual stock basis, the biggest contributors to absolute returns during the quarter included positions in Microsoft, Walt Disney, Anadarko Petroleum, JPMorgan Chase and Visa. The greatest detractors from absolute returns were positions in 3M, Alphabet, Raytheon, United Parcel Service and Exxon Mobil.

During the quarter, we exited our position in Anadarko Petroleum. The Strategy also received shares of Corteva (CTVA) and Dow (DOW) following their spin-off from holding DowDuPont (DWDP), the remaining segment of which is now called DuPont de Nemours (DD) and is held in the Strategy. Shares of Dow were sold, while shares of Corteva were retained.

Scott Glasser

Co-Chief Investment Officer, Portfolio Manager
28 Years experience
26 Years at ClearBridge

Michael Kagan

Portfolio Manager
34 Years experience
25 Years at ClearBridge

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  • Past performance is no guarantee of future results.

  • All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC  nor its information providers are responsible for any damages or losses arising from any use of this information. 

  • Performance source: Internal. Benchmark source: Standard & Poor’s.