Tag Archives: utilities

Investing Implications of Trends in Household Wealth

Shifting Wealth

A new study released by the Russell Sage Foundation analyzes trends in household wealth over the last twenty years, with a focus on the years surrounding the ‘great recession’ of 2008.  The study examines changes in household net worth for the median household, as well as for the 95th percentile of households by wealth (the richest 5%), the poorest 25% of households (the 25th percentile) and tiers in between.

7-30-2014

Source: Russell Sage Foundation

The results, adjusted for inflation (values are shown in 2013 dollars), show that the median U.S. household remains substantially poorer in terms of total net worth than it was before the recession and is actually now poorer than it was in the mid 1980’s.  What’s more, median household net worth has not recovered at all since the great recession.  The same trends are evident even for the wealthiest quarter of households (the 75th percentile), although the gains in wealth by this tier of households in the 80’s, 90’s, and early 00’s were sufficiently great that the top quarter of households by wealth is more than 25% wealthier today than in the mid 80’s.

The most striking feature of this chart is the spread in wealth levels.  While the median and 25th percentiles of households by wealth are substantially poorer today than they were twenty years ago, the wealthiest 10% (the 90th percentile) and the wealthiest 5%, in particular, are substantially richer today.  The increasing spread between the percentiles through time is evidence of growing inequality.  The study concludes that much of the divergence between wealthier and poorer households reflects the proportion of their wealth held in homes vs. stocks and bonds.  Housing prices remain well below their previous peaks in 2007, while the equity markets have regained their previous levels.  For poorer households, homes represents the vast majority of their net worth.  This is not the case for wealthier households.  The results of this study are consistent with other analysis—this is confirmation rather than being surprising.  Nonetheless, each new set of results that are consistent adds weight.

Implications for Investors

The implications of the trends in the table above are substantial.  If the median household is seeing declining or stagnant wealth levels—with more extreme declines for poorer households—this will ultimately reduce their capacity to buy and consume goods and services.  Indeed, the Russell Sage study concludes that declining household wealth shows that poorer households, unable to support their current consumption with income, are gradually depleting their assets.  At the other end of the spectrum, the wealthiest 10% of households has seen a substantial decline in net worth as well, even though this tier enjoyed huge gains in the past twenty years.

Aside from the fact that declining household wealth reduces the ability to spend, there is also the problem of the wealth effect.  Households that have disposable income are less likely to spend it if they feel less wealthy and even the 95th percentile of households by wealth is less wealthy than it was just five years ago.

The simplest interpretation of these data are that mid-market retail products and retailers are going to suffer, while the budget products and retailers and the luxury markets will perform relatively better.  So, for example, Family Dollar stores (FDO), WalMart (WMT), Costco (COST) and other discount retailers should do well.  More broadly, however, the declining disposable incomes for the middle tier of investors suggests that the companies that provide the basic products and services that people depend upon are good bets.  Utilities (IDU), oil companies (IGE), and pharmaceutical companies (JNJ, BMY, GSK, PFE) are fairly well insulated from changes in wealth distribution.

The more challenging questions involve discretionary goods and services that are higher-priced and easier to do without or that can be displaced by lower-cost competitors.  Companies like Bed, Bath, and Beyond (BBBY), Whole Foods (WFM), Abercrombie and Fitch (ANF), and Express (EXPR) sell products for which there are cheaper and largely indistinguishable alternatives.  The winners in this mid-market business are those companies that provide fairly low-cost products while retaining brand appeal to wealthier customers (SBUX, CMG, NKE).

Another theme that looks promising is consumer products that are expensive relative to peers but that represent a low-cost substitution as compared to other types of conspicuous consumption.  Apple (AAPL) has successfully capitalized on this trend.  The new iPhone may be expensive compared to other phones, but it is fairly cheap as a prestige object.   Smart phones also provide low-cost entertainment via product offerings such as Facebook (FB).  People who spend their time surfing Facebook or watching Netflix (NFLX) are likely to see cable TV as expensive.  This realization is already expressed in the high prices of these firms relative to their earnings, however.

The Take-Away

The latest data on growing wealth inequality add support to the conclusion that the middle tier of American families is getting squeezed.  The long-term implications for how people spend their money are worth considering.  The ultimate losers will be companies that sell fairly high-cost goods or services to the middle class for which there are low-cost alternatives and for which there are up-market competitors that appeal to wealthier families.  One class of winners will be low-cost ‘prestige’ brands such as smart phones and Starbucks coffee.  It is hard to imagine the average urban millennial substituting his iPhone for generic pay-as-you-go hardware or rushing to the office with a cup of gas station coffee rather than the iconic Starbucks cup.  As discretionary wealth gets tighter for the middle tier, low-cost mobile entertainment looks like a winner at the expense of cable and satellite TV.

The discount retailers and providers of basic goods such as fuels and pharmaceuticals are likely to hold up well simply because changing wealth distributions will have little impact on their businesses.

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Low Beta Market Sectors

With U.S. equity markets near their record highs and a bull market run that is starting its sixth year, the potential for a correction is a growing concern.  In addition, U.S. equity prices look fairly high when viewed in terms of the PE10 ratio.  Another factor that concerns some market watchers is that volatility (as measured by VIX) is at very low levels, reminiscent of 2007.  This type of complacency has historically been followed by increasing volatility, as levels return to their historical average, accompanied by a sell-off in higher-risk assets as investors adjust their portfolios to mitigate the effects of higher volatility.

Investors seeking to remain invested in equities at a target level but who want to reduce their exposure to market swings and to mitigate the impact of a rise in market volatility have historically been well-served by increasing their allocations to low-beta market sectors.  In this article, I will review the defensive value of low-beta allocations as well as examining the consistency of beta over time.

Beta measures the degree to which a security or a portfolio responds to a move in a benchmark index such as the S&P500.  A portfolio with beta equal to 80% (also written as 0.8) tends to go up 0.8% when the market rises 1.0% and vice versa.  Beta may be thought of as showing whether a security amplifies the moves in the benchmark (beta greater than 100%) or damps the moves in the benchmark (beta less than 100%).

How Beta Varies by Sector

The SPDR Select Sector ETFs provide a convenient way to break out the sectors of the U.S. equity markets by dividing the S&P500 into nine sectors.  These sectors illustrate how much beta varies.

Low Beta Market Sectors - 1

Betas and 10-year average annual returns for major sectors and indexes

The S&P500 has a beta of 100%, by definition.  Some readers may be surprised that emerging market stocks have beta of almost 140%, which means that emerging market equities tend to go up (down) 1.4% for every 1% gain (drop) in the S&P500.  Even before the market crash of 2008, emerging market stocks were high beta—this is not a new phenomenon.

There are three U.S. equity sectors with betas well below 100%: consumer staples (XLP), healthcare (XLV), and utilities (XLU).  It is often believed that low-beta equities have very low average returns.  In fact, a well-known but now widely-discounted model of equity returns (the Capital Asset Pricing Model, CAPM) assumes that beta of an equity or asset class corresponds directly to expected return.  High-beta asset classes have high expected return and vice versa.  Low-beta equities have historically substantially out-performed what would be expected on the basis of CAPM, however, and the past ten years is no exception.  These three sectors have all out-performed the S&P500 over the past ten years.  The return numbers shown here are the arithmetic averages, including reinvested dividends.

Low Beta Asset Classes in 2007-2008

The first question that is worth asking about beta is the degree to which beta corresponds to losses in really bad market conditions.  In the table below, I have tabulated beta calculated using three years of data through 2007 for each of the funds above, as well as the returns for each of these in 2008.

Low Beta Market Sectors - 2

Beta calculated through 2007 vs. 2008 returns

The three sectors with the lowest betas going into 2008 (consumer staples, healthcare, and utilities) had an average return of -22.3% in 2008, as compared to -36.8% for the S&P500.  An equity tilt towards these lower beta sectors could have reduced losses in that year.

Consistency of Beta through Time

The astute reader may notice that the betas calculated using ten years of data through May of 2014 (shown in the first table) are, in some cases, quite different from the betas calculated using three years of data through December of 2007 (shown in the second table).  Beta varies through time.  The betas calculated using three years of data through May 2014 provide an interesting contrast to the three-year betas through the end of 2007.

Low Beta Market Sectors - 3

Comparing betas for two 3-year periods

We are looking at two distinct 3-year periods, separated by almost six and a half years and, in general, low-beta sectors at the end of 2007 remain low-beta today and high-beta sectors back then are still high-beta.  The two most notable exceptions are international equities (EFA) and the technology sectors (XLK).  These changes notwithstanding, the three sectors with the lower betas in 2007 also have the lowest betas in 2014.

There are a number of factors that will determine whether any sector will weather a broad market decline better than others.  Beta is one important factor, but there are others.  In 2008, the financial sector suffered disproportionately large losses—well beyond what would have been expected on the basis of beta alone.  The underlying drivers of the 2008 market crash were most severe in the financial sector.  Small-cap stocks, by contrast, fell considerably less than the beta value of this sector would have suggested.

Low-Beta and Asset Allocation

Low-beta asset classes have historically provided some protection from market declines and increasing volatility.  There are a range of other considerations that potential investors should consider, however when creating a portfolio.  The selection of individual asset classes should be made with consideration of the characteristics of the total portfolio, including desired risk level, interest rate exposure, and income generation.  The target for total portfolio beta is primarily determined by an investor’s total risk tolerance.  A target beta level can be achieved both by choosing how to allocate the equity portion of a portfolio among sectors and by varying the balance between equity (stocks) and fixed income (bonds) investments.  Fixed income asset classes tend to have very low—even negative—values of beta.  In my next blog entry, I will explore these two approaches to managing beta at the portfolio level.

History suggests that low-beta sectors can provide some protection from market downturns.  The length of the current equity rally, and the substantial increases in equity valuations in recent years, are motivating some investors to consider their best defensive alternatives to protect against the inevitable reversal.  The question for investors to ask themselves is whether they are best-served by reducing portfolio beta by reducing their exposure to equities, by shifting some portion of assets from high-beta to low-beta sector, or both.

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Being a Weather Contrarian

Every year when the forecasts for the hurricane season are issued, there have been a spate of articles on implications for investors.  This year was no exception.  USA Today reported that U.S. natural gas prices jumped 3% on the basis of a forecast for an active hurricane season in 2013.  It is also common to read that companies are attributing poor earnings to unusual weather. Continue reading

What Are the Core Asset Classes for Income Portfolios?

In a recent post, I presented a list of the ‘core asset classes’ that investors need in order to build portfolios that fully exploit available diversification opportunities.  That article focused on portfolios designed for total return potential, the combined return from price appreciation and income generated by the assets in the portfolio.  For investors focusing on building income-generating portfolios, the core asset classes are somewhat different.  In this article, I present a proposed set of core asset classes for income-focused investors, along with examples of representative funds.  Continue reading

Sector Watch: Spotlight on Utilities

Utility companies are expected to provide fairly stable performance, without too much downside risk.  Utilities are also typically expected to provide lower average returns than the broader market.  In the last decade, however, utilities have out-performed the broader stock market as investors have become increasingly risk-averse and worried about the prospects for sectors that depend largely on robust economic growth in order to meet their earnings targets. Continue reading