The end of the year tends to bring some odd movements in the markets. These can occur for a handful of reasons but most are driven by funds with short-term incentive policies and year-end bonuses. Fortunately, their short-sighted foolishness can be our gain since we’re in the position of investing for the long-term.
Many funds will dump losers and chase the big winners on the year to goose the appearance of their book since holdings are reported as of year-end. They certainly don’t want to look like a fool for owning some of the year’s biggest losers but do want to “look smart” by showing big allocation to big winners. You’ll also see managers that have underperformed thus far chase the winners in the hopes of improving their return before the end of the year to hit bonuses and hopefully attract new investment dollars. This means we tend to see the year’s losers continue lower and winners continue higher all the way into the close of December.
Often times though, things will reverse on a dime with the first day of trading in January. What seemed like an invincible stock (or entire sector) becomes chopped liver and significantly underperforms the following year. The same is often true for losers in one year to reverse and become big winners the next. This is usually the case because longer-term “value” investors begin to step in to pick-up beaten down losers that may now be undervalued and to sell some big winners that may be overvalued – which is the way we look at things.
Here’s a look at the 30-year Treasury bond over the last few years to illustrate the point. After a really rough 2013, T-bonds reversed course with the start of January and have been climbing all year. My guess is that they’ll continue to rally or at least hold their strength into the end of the year and then see some weakness in January.
30-year Treasury bond – 3 years (weekly)
So what has been knocked down the most in 2014 that might offer nice opportunities for the year ahead? The most hated sector has certainly been energy. With the price of oil in an outright collapse, most companies in the sector are off at least 25% over the past few months alone. There are most certainly some great buys in this area for the income side of portfolios – like large pipeline companies with little exposure the actual price of oil/gas. Most energy companies on the growth side are the Exploration & Production (E&P) names. I’ve haven’t been a big fan of these for a little while and don’t think now is time to jump in either. I think we’ll see oil remain lower for a few months at least so there’s probably more pain to come, especially for the smaller E&P companies.
Surprisingly, a lot of big tech names have also underperformed this year. Companies like Google, Amazon, Netflix, etc. are actually down on the year while the S&P 500 is up about 10% so far. There’s a strong chance we see this trend flip with the new year but I’m not willing to pay the price at which most of these companies are trading. Two that I do have my eye on right now are Google and Twitter, but haven’t bought any just yet. I see both pros and cons but I’ll keep everyone posted if I do decide to buy some.
The Industrial sector still offers the best valuations in my opinion so I’ve been adding to a few names here over the past few weeks. The problem is that the industrials are highly tied to the economy and thus are very cyclical. Falling oil, slowing growth in China and a dire situation in Europe have really hit a lot of these stocks this year but I think it’s all about finding the specific companies in the right position. As a whole, I think we’ll see continued weakness here too as long as energy prices remain low, but weakness from the sector as a whole creates opportunities within for the best companies. It’s also a possibility we see the entire sector reverse course after January 1st.
The Emerging Markets (both stocks and bonds) have also been hit hard over the past few months – mainly because of the rise in the US dollar but also from oil moving lower since energy is a main export for a handful of EM countries. One example that comes to mind is Russia, which has been hit by the perfect storm of sanctions, capital flight and lower oil to the tune of a 50% drop in the Russia ETF (RSX). I’m still contemplating whether I want to stick my neck out there on this one, and if I do it will be a rather small position within our allocation to Emerging Markets, but I wouldn’t be surprised to see the trend reverse beginning in January. For the EM’s in general, I would typically be adding after a drop like this, but not this time. While we’ll probably see a bounce for a short while, I’m still very bearish over the next few years (see here and here for why).
On the flip side, one area that the contrarian in me is starting to become nervous about is the biotech sector. After 3 really strong years in a row, we’re bound to see a pause in the rally and it could begin January 1. However, these companies are still posting great numbers so I don’t want to be out completely. I’ve been trimming most of our biotech holdings but still adding to Gilead as I think it offers the best valuations (I don’t think the market is even giving them credit for their pipeline) and the amount of cash the company is going to generate over the next two years is mind-boggling. I think we’ll see Gilead go on a buying spree with this cash to add to the pipeline so a drop in the biotechs as a whole would be a welcome opportunity for Gilead.
A final note on the overall stock market – Things got pretty roughed up last week with the S&P 500 falling nearly 4%! I think this is just a preview of the volatility in the year(s) to come which is why we made the decision to begin incorporating options in everyone’s portfolio. For any followers that aren’t clients, please feel welcome to contact me if you’d like to discuss how options can benefit your portfolio (especially in volatile markets!).
Thanks for following!
-Nick