BITK - Episode 5 - Quarters & Sense Q2

In this episode of BITK, Paul and Mark highlight their review of the market performance for Q2. They call it Quarters & Sense. Tune in and learn how the second quarter performed and how that will guide them through the next quarter and throughout the rest of the year. 

Transcript

00;00;07;24 - 00;00;39;29
Paul
All right. We might as well get started. I'm Paul Tichy with Stiles Financial, joined again by Mark Gierach. We're both PM’s here at Stiles Financial. And, in keeping with our promise a quarter ago, we are going to, deliver our second installment or second, edition of "Quarters and Sense", where we talk about what's happened in the quarter, some things that surfaced that are interesting to talk about and try to make sense of them for our audience.

00;00;40;02 - 00;01;05;08
Paul
Like last quarter, I will kind of lead off with some conversation about, the second quarter performance, maybe even integrate some comments about the first half in general. What may have influenced some of that or just some interesting anecdotes that came about in the second quarter in terms of, asset class performances? Marc will spend some time talking about, earnings growth.

00;01;05;11 - 00;01;31;00
Paul
And valuations and valuation multiples and kind of the interesting dynamics happening there. I'll add some commentary about inflation. We'll talk about inflation a little bit. Between the two of us. And then, we'll conclude with some comments about the high yield bond market as well. So to get started, the, by the way, welcome, Mark.

00;01;31;02 - 00;02;02;09
Mark
Thanks, Paul. To get things started, I will kind of preface by saying that the, the quarter was good enough for, equity markets as a whole, but the whole market didn't participate. So as confusing as that sounds, it'll make sense when we, when we discuss this, but, you know, first of all, on the first half, the results in the first half, and I mean, literally like through June 30th was very similar to last year's first half, with the S&P up about 15 or 16%.

00;02;02;09 - 00;02;25;09
Unknown
Great start to the year. Anybody who's kind of seen what's been going on since June 30th and more specifically since about July 18th, markets have have definitely, given back some of that gain. But more importantly, what we saw in the second quarter was, a, S&P 500 that was up about 4 or 5%.

00;02;25;11 - 00;02;52;19
Unknown
The problem is, and we wish you could see it, but there's an interesting kind of dissection of, the markets by the, by decile. And if you look at the market caps of the overall market by decile, meaning the top decile being the top 10% of the companies by market cap in the S&P, and so on, there was really only one decile that was positive and that was the top ten percentile.

00;02;52;19 - 00;03;18;06
Unknown
The the biggest companies in the market. And and that wasn't up even as much as the overall market. So what that's even signaling is that there was just a few of those biggest companies that were driving that performance in the market. And if that sounds like a repeat of what we talked about a lot last year, with clients, it is, where there was kind of that very high concentration of, of, specific stocks that performed well.

00;03;18;06 - 00;03;44;06
Unknown
And much of the market did not participate as well. You know, and to the to that point, you know, large cap, in general, when we talk about large cap, meaning what would you say, Mark, north of 50 billion in market cap or north of 100 billion and market cap. To put it in perspective, you know, the biggest ten are, you know, closer to a, you know, a half a trillion in market cap and some even north of a trillion in market cap.

00;03;44;06 - 00;04;07;02
Unknown
So those are very, very large or mega cap companies. Those specifically on the second quarter, returns, large caps were up about 4.4%. And in, the year to date, nearly 15%. So you can see that the first quarter was fantastic, but we would never sneeze at a 4.5% return, in a quarter by by large caps.

00;04;07;04 - 00;04;34;06
Unknown
But on the flip side, in that same second quarter, small caps were negative. They were down 3.3%. So you get much smaller in size of companies and you start to see a difference in returns. And then getting into some other asset classes. If you look at international, actually emerging markets had a very good second quarter. They were about on par with large cap, and developed markets.

00;04;34;09 - 00;04;59;10
Unknown
Also, you know, they didn't quite participate the same way. So you had this again, bifurcation or difference in returns, whereas developed markets, meaning the you know, more developed companies was actually down or slightly down and maybe arguably flat in the second quarter. So we've had a very kind of diverse type of return profile out of not just domestic markets, but international markets as well.

00;04;59;12 - 00;05;21;19
Unknown
And we look at when we look at bonds, in the second quarter, they also, it was a mixed bag, you know, high yield performed well. High yield was up about, 2 or 3% in the second quarter. But investment grade corporate bonds were actually slightly negative by 1%. So you again, you saw this difference in the overall bond market as well.

00;05;21;21 - 00;05;41;28
Unknown
But you also saw an overall aggregate bond market. You know, slightly negative and not surprising given that the yield curve, moved up a bit. Interest rates moved up a bit at the long end of the curve, meaning kind of in the five year duration and longer. Whereas the short end of the curve actually went down a little bit.

00;05;42;00 - 00;06;03;18
Unknown
And, you know, some can argue that that might be a good sign for the economy. We're still in an inverted yield curve. But when we start to get to a more normal, slope of the yield curve, meaning short end is lower than the long end of the curve. That can be a good forecaster of of, good things to come in the economy, but we're not quite there.

00;06;03;20 - 00;06;30;20
Unknown
And so I don't want to jump ahead to the inflation or talking about the economy. I want Mark first to kind of give us some, some thoughts around multiples evaluations of the market. Thanks, Paul. So I guess first thing first off is, you know, as we get further into the year here, you have more and more Wall Street analysts were putting out their projections for, 2025 earnings and all the numbers I'm going to talk about are in relation to the S&P 500.

00;06;30;22 - 00;06;58;05
Unknown
But as it stands right now, analyst estimates are, looking for greater than 10% earnings growth in 2025, compared to 2024 after the year's all over with. So that's that is a pretty aggressive growth number. And I guess, you know, along with that is that market multiples are back up to 20 times, which is quite high.

00;06;58;05 - 00;07;30;16
Unknown
If you look back over the last 15 to 20 years, we're right near the high again. So that's kind of it's a little worrisome from a valuation standpoint. Given that we're still forecasting really high growth and that that multiple is going to stay high. So I guess, you know, to put some numbers to that, the current estimate, in dollar terms for 2025 is, you know, right around 270, $280 share.

00;07;30;19 - 00;08;04;20
Unknown
If the market is able to hold at 20 times multiple, we're, you know, puts it right at about 55, 50, 600, which is only a couple hundred points higher than where the S&P is right now. So if at the end, if at the end of 2025 that say, $280 a share is is achieved and the market's trading at 20 times trailing earnings, we're only going to be 200 points higher than today, which is, you know, roughly what, 3 to 4%.

00;08;04;22 - 00;08;29;18
Unknown
So not much. Yeah. Not much at all. So that's, you know, like I said, that just saying that that implies a little bit of earnings risk, or a little bit of risk to valuations and that if earnings don't come in as expected, you could have a little bit of a bumpy ride here. Also not saying that earnings couldn't accelerate more than what's expected to because that that has happened from time to time.

00;08;29;20 - 00;08;55;29
Unknown
But in your experience, the opposite, right. In other words, early expectations usually are higher than what it ends up being true. Initial estimates tend to be a little more optimistic than, than what gets realized. So, yeah. Let's see, in terms of valuations, there's couple a couple sectors that we see as you know, that do have some compelling companies.

00;08;56;02 - 00;09;16;00
Unknown
Some of the basic materials companies, some of the health care names that have gotten beaten up over the last year. So, they look compelling with rather rather cheap multiples in that low double digit, even high single digit range. A lot of the industrial names tend to stick around that, that type of, earnings multiple as well.

00;09;16;00 - 00;09;34;17
Unknown
And, we think there's some good companies there. But, given that there's some potential headwinds to the market in terms of the valuations, bond yields are still around 5%. It's kind of you it might be a good time to take a little bit of risk off, and we'll be a little bit more on the fixed income side of things.

00;09;34;17 - 00;09;48;29
Unknown
And waiting for the wait for this market to cheapen up a little bit. You know, one thing, I guess, to, to, stick to on this part.

00;09;49;01 - 00;10;11;24
Unknown
So along with that, if you're investing in the market, investing in the whole S&P 500, you have 500 companies. Well, with active management you can avoid some of those earning pitfalls. And that's what we do here at style. So as far as earnings growth and value valuation multiples go we are seeing you know, a couple of headwinds.

00;10;11;26 - 00;10;37;13
Unknown
Doesn't mean the market needs to go down. But, you know, we really don't expect things to be super rosy going, 4 or 5% per quarter. For the short term or at least even the mid-term. So yeah, no, that's good. And, you know, you brought up a good point is that we think about valuations and we think about, you know, the growth associated with those, valuations.

00;10;37;13 - 00;11;00;04
Unknown
So yes, basic materials, some health care some industrials look attractive. We also sometimes they come attached with some lower growth rates. But you also get to that diversification a little bit smoother ride overall too. We had a lot of conversations. I felt like in the last couple of weeks talking about why do we own, you know, certain names that really don't grow that fast.

00;11;00;04 - 00;11;23;09
Unknown
Well, the reason is because they when things are rough, they don't go down as fast either. Yeah. And so you, you get sort of that smoothing of, of overall returns through a diversified portfolio. But your point about active management means we're not owning the whole S&P 500. Hopefully we're choosing the names that are delivering the right, returns for the amount the amount of risk taking.

00;11;23;11 - 00;11;47;22
Unknown
Absolutely. And and with those lower growth weights, the lower growth rates tend to not be as great of change or range from quarter to quarter either. So you're not going to go from company that has revenue growth of 4 or 5%. Go to 12%. And then, you know, go -5%. It's usually going to hang around that five, 6%.

00;11;47;22 - 00;12;09;13
Unknown
That's a good point. So that's what smooths out the ride. And actually that lower, lower variability in revenue or earnings growth usually leads to where you think it should lead to a little bit higher multiple because there's less risk in it, more predictability. Correct. You would think yeah. So the quarter was mixed. It did have some some good news.

00;12;09;15 - 00;12;48;11
Unknown
Mixed with some, you know, kind of not so good news for certain parts of the market. But what's interesting is during that second quarter and really throughout the first half of 2024, we've seen very, very little, volatility of the markets. And not to steal away from our conversation in our next quarters. And since we have seen in the last month volatility return and to some extent, pretty dramatic fashion and, and even just the most recent week or two and I don't know, Mark, if you want to address volatility or anything that you've seen just in the last couple of weeks, because this quarter's in a sense, is happening, you know,

00;12;48;11 - 00;13;08;20
Unknown
almost in the middle of the quarter. So it's not out of the realm to talk a little bit about what's happened so far since June 30th. Yeah. So volatility we we have seen a pretty big spike in volatility, as tech stocks started to sell off. I guess it was probably about two, three weeks ago at this point.

00;13;08;23 - 00;13;31;07
Unknown
We did see there's one day that S&P 500 the volatility index for this 500, it did spike, I believe, up to 65 in the middle of the day, which is, you know, just to put it in general directional terms like that's that's really pretty high. I haven't seen anything that high in the volatility index since, back in March.

00;13;31;10 - 00;13;58;13
Unknown
Yeah. March 2020. Right. So yeah. It was it was a pretty big, pretty big move. It's been slowly coming down over the last couple weeks. Again here. And there's still we've seen tech stocks rebound. So there still is an appetite for risk. That leads me to believe it was just the valuation concern. And we can we'll get into that to, you know, move along here in the, in the, quarters and cents.

00;13;58;15 - 00;14;20;00
Unknown
But, there was also a fairly sharp intraday decline in volatility on the same day. Actually, it just did read an article this morning that it was the largest intraday drop ever ever. Oh okay. So it wasn't just you know it wasn't just you. It was it it was big. It was you know roughly anywhere from 65 back down to 41.

00;14;20;05 - 00;14;44;29
Unknown
So 2424 points. So yeah. So I, I used to, I used to work in the volatility markets and it was there were all institutional trading portfolios and that would be the day that if your position correctly, it was a career day for you and your firm. Right. If you got it right, if you got it wrong, you're probably ending day.

00;14;45;05 - 00;15;09;14
Unknown
You're probably polishing up your resume. Yeah, it was a career ending day. That's that's so interesting. Yeah. So so we've had a taste of volatility as, the quarter, you know, the new quarter has started our third quarter. And with those, you know, that kind of deep dive or deep drop in technology stocks in particular, but really a lot of the market participated in that decline.

00;15;09;16 - 00;15;33;13
Unknown
That's had some impact obviously on valuations. So that's why, you know, we we wanted to just kind of set aside some time, on this call for Mark to talk about, you know, multiples of the market, and valuations in general and where he's seeing some opportunities when it comes to valuation. So another factor because you talked about valuations adding some risk.

00;15;33;18 - 00;15;55;10
Unknown
You know we also talk about you know economic risk right. And what's happening with the economy. And inflation has been a big, you know, piece of the puzzle or part of the conversation over the last two years. And, you know, inflation has come down. I mean, I think we're seeing some evidence that it's coming down, you know, kind of into that 3 to 3.5% range.

00;15;55;12 - 00;16;22;22
Unknown
But some of that might be fueled by, you know, certain parts of, the inflation numbers that that is contributing to that. In other words, there's also there's areas like shelter are actually in negative, growth. So by that happening in you're bringing inflation down, I'm not so sure that's saying that the rest of measured, prices are really coming down the same amount.

00;16;22;24 - 00;16;40;15
Unknown
So what are you talking about? The, the implied rent, numbers that so that that has gone negative for housing. It went negative. Wow. Okay. And so there hasn't been a lot that's gone negative. Right. And in other words things the inflation rate has come down. But what does that mean. It just means it's not going up best.

00;16;40;21 - 00;17;05;23
Unknown
Right. Whereas shelter and that implied rent has come down. And so that's contributing to that lower inflation number. But is that saying that maybe the rest of those inflation, components maybe aren't quite coming down as fast? And we've talked about that and how, just that stickiness, you know, in that mid range, because we talked about it in the last quarter.

00;17;05;25 - 00;17;29;11
Unknown
Well, you know, the move from 9% down to, you know, five, 4.5% was the easy part. That kind of going from four and a half down to their target. The Fed's target of 2%, it's really been a struggle. We've had some as it relates to the economy, some recent bad, some recent bad job data. That sounded the alarm on, you know, kind of a ten, a pending recession possibility.

00;17;29;14 - 00;17;50;02
Unknown
Some market forecasters are are, you know, wanting to see some rate cuts. We think that there is probably a good chance at least the, the fed futures, the fed funds futures are pricing in at least 75 basis points. You know, in what and what order that comes. We're not exactly sure. You know, that there's basically three more meetings.

00;17;50;02 - 00;18;12;10
Unknown
So theoretically it might be a quarter point each meeting. Or maybe they go, you know, pretty heavy. The first, the first quarter in and say, let's, let's, cut by 50 basis points. But right now what's being priced in is about 75 basis points. And you know, so that would be, you know, that that would imply that they feel one inflation's under control.

00;18;12;10 - 00;18;31;23
Unknown
But also it might imply that there's some other, some other economic issues lurking. And we know that the fed targets really just a couple mandates target inflation and they target unemployment. Well that's let's let that's what they're supposed to target. Right? That's correct. There there are some other things that they pay attention to and opinon. But you're right.

00;18;31;23 - 00;18;53;29
Unknown
And sometimes even just the markets get them thinking about about where rates should be as well. But you know, right now, you know, the, the, the, the issue is, you know, previous high inflation continues to hurt consumers because the previous high inflation is still being compounded by that current positive inflation. And that's the point we made earlier is that yes, inflation has come down.

00;18;53;29 - 00;19;13;06
Unknown
But that doesn't mean prices have gone down. It just means they're not going up. And you know, the question now becomes, as long as we're talking about the fed and their, capabilities or I don't know if I want to use a different word, but the, you know, are they cutting rates too early or are they too late?

00;19;13;09 - 00;19;31;11
Unknown
And, you know, I, I don't know that I could dial that in any better. So I don't mean the, kind of imply that we don't think that they're doing a great job, but this is the tricky part. They were a little slow. I think in their last, in our last podcast, you were, I think, really critical.

00;19;31;11 - 00;19;54;11
Unknown
I think I gave them an F for giving us for their timing. Yeah. So now what kind of a grade are they going to get? You know, on the, on the back end of, you know, cutting rates, meaning let's not drive us into recession. Ideally, kind of we would think the worst case scenario would be a soft landing if they can avoid even a soft landing meaning, or we don't see any negative growth.

00;19;54;13 - 00;20;20;13
Unknown
That would be, that would be a, a, well, orchestrated feat. I feel like it would make up. Let's, let's say it'll make up a little bit for being slow to, to raising rates. But as it relates to interest rates and the bond market, I think you want to talk a little bit about the High-yield bond market, and I alluded to it having a pretty decent second quarter relative to investment grade.

00;20;20;13 - 00;20;38;26
Unknown
But what are your thoughts about the high yield market right now? You know, before we move on to the point, or on to the high yield bond market? Yeah, there's one other point to, talk about with inflation and and cutting a rates. What did I miss? Well, no, it's just the, how the market would imply any move.

00;20;38;28 - 00;21;05;13
Unknown
Oh, excellent. Going into the, election, 100% our cuts being, you know, is there some Partizan politics, you know, coming into play with how much the fed, cuts, you know, or how quickly would they go 50 basis points for the election or, you know, or even frontload it so that it. It takes action. Yeah. So it takes it takes action.

00;21;05;14 - 00;21;29;07
Unknown
Helps out the economy. The fed says that they're nonpartisan. And for the most part, I, you know, I, I would believe that, but like we said, sometimes they, they expand their mandate and the, do things, a little bit outside of what they're supposed to be doing so well. And you bring up an important point, just about the magnitude of the cuts.

00;21;29;09 - 00;21;59;22
Unknown
And when they happen, but more important about just cuts in general. And why is that necessarily good for the economy? Why is it good for the market? For the economy? It helps stimulate growth if there's some concerns that growth is slowing. As far as the markets, we know that long assets like stocks, like long duration bonds, in a, in a, in a rate environment that's decreasing, that's increasing the value of those assets, it's by which they're discounted.

00;21;59;24 - 00;22;24;01
Unknown
And so having lower rates, is, is typically good news for long assets and maybe even more specifically in equities growth asset. I don't know if you agree with that or you have any other thoughts about that. Oh yeah. Definitely. I mean, if you have pure, discounting long term cash flows by a much smaller number, yeah, the valuation can increase considerably.

00;22;24;01 - 00;22;44;08
Unknown
So. Right. So we can go into the math on that some other time, but, we'll, we'll again, we'll we want to finish talking a little bit about, the bond market, but specifically the high yield bond market. Mark, what do you what are your thoughts there? Yeah. So one interesting, factor, the high yield bond market.

00;22;44;11 - 00;23;11;19
Unknown
As of right now, so there's a, there's a high yield bond ETF, managed by Blackrock. Ticker on is HEG. The only 2% of the bonds in that ETF will mature in 2025. So from a high yield standpoint, you'd think that the companies issuing those bonds. Well, if there's not going to be a bunch of bonds maturing, there's really no like a re yeah.

00;23;11;20 - 00;23;41;29
Unknown
Not real. That reinvestment risk, the, ability to refinance. There we go. There. That's that's what we want to say. So let's pretend like we just started all over and said that again. Yeah. So, we're going to start over with the high yield bond market take do. All right. So, so yeah. And in terms of the high yield bond market, the iShares High Yield Bond ETF, HYG, they only have, 2% of the bonds in that ETF that are going to mature in 2025.

00;23;42;02 - 00;24;20;08
Unknown
So as far as refinance risk, it's actually pretty low within the high yield companies. Now this doesn't take into consideration. This doesn't take into consideration, the fact that you could have some covenant defaults with within some of these bonds. You know, there's a, there's a term, that goes along with that. If a, if a company, defaults on one of the covenants in their bonds or the terms of how the money was originally loaned to them, the refinancing of those bonds, when that, when that happens is called the pretending land.

00;24;20;08 - 00;24;41;02
Unknown
If they pretend that didn't happen, change the terms and then just re lend to the company rather than allowing it to default. True. Okay. And usually it comes with a little bit higher rate, but, and it's also there's also the extended loan. So they say it was a five year bond. The company violates covenant.

00;24;41;04 - 00;25;00;10
Unknown
They're like, well, all right, if we just move it from a five year bond to a ten year bond, all of a sudden it works out for you in your long term viability. So, so there's two new terms. There's the pretend and land or the extended land, like, so. Yeah, we learn something new every day either.

00;25;00;13 - 00;25;40;21
Unknown
That's right. But yeah. So that so the covenant default isn't, isn't captured in that, 2% maturity. So there's not a whole lot we don't see a whole lot of risk there. The bigger part is that we just don't feel like you're you'd be getting paid for high yield bonds right now. So the the current yield on the, Bank of America high yield index is around 8%, investment grade bonds, even even higher grade bonds like A-rated investment grade bonds, you can still get four and a half to five, on probably like a 5 to 10 year bond.

00;25;40;23 - 00;26;03;26
Unknown
I mean, it's only 3% for the types of companies that have a lot more credit risk built in. So before we get interested in high yield bonds, we would we would want to see a much, much wider, spread between investment grade and high yield bonds. So yeah, I don't know. Do you have do you have any views on that?

00;26;03;29 - 00;26;30;09
Unknown
No. I mean, I think you're right. I think as we, that spread described expands, I think it might become more interesting. And that's kind of our role is to keep an eye on those markets, you know, and determine are they becoming are we getting paid for that risk? Because that's a big part of how we think about, and what what is what is the gain we're getting from or the risk taking.

00;26;30;12 - 00;26;56;25
Unknown
And, that should be part of any decision within a portfolio, even down to the individual stocks we own. It happens even at the level of the individual bonds. And we went through a long period, not terribly long period, but we went through almost a year and a half, two years where the most, you know, the highest credit worthy bonds in the market, or in other words, treasuries and, agency bonds were paying us very well.

00;26;56;27 - 00;27;26;05
Unknown
And we were we said, well, for that, virtually no risk. We were getting paid as if we were taking risk in a corporate bond. And that was investment grade. So we, we try to assess that, all the time. And to your point about the spread not wide enough to pay us for that risk, because that's essentially what you're taking is, I think it's, you know, one thing to say, high yield is just the lower, you know, it gives us a higher yield, but it's also because it's a lower credit rating.

00;27;26;09 - 00;27;43;27
Unknown
And while we haven't had default risk, it seems in that market for, going on longer than a decade that could return. And we want to keep an eye on the well that spread my widen and it sounds good from an investment standpoint. We also have to be cognizant of the fact, well, maybe those that that credit is at risk.

00;27;43;28 - 00;28;02;15
Unknown
Well, so we'll keep an eye on that as well. Yeah. So it also depends upon what what point you are in, in the in the business cycle. Right. Correct. So you know, some of the, some of the economic data that's been coming out lately has been a little soft. There was, some not great jobs information a couple weeks ago here.

00;28;02;18 - 00;28;34;12
Unknown
So it's one thing to be invested in, like a compressed, high yield bond, so, you know, low spread to investment grade bonds when the economy's growing at 3 to 4%, corporate profitability looks good. You can you know you can. You're still getting paid a reasonable amount to take that risk. But as you see the economy starting to maybe falter a little bit or slow down often or just, yeah, just in general soften, that's not good for high yield bonds.

00;28;34;12 - 00;28;59;23
Unknown
And that's not the time necessarily to be, you know, yield bonds. Because when you realize that you shouldn't be in high yield bonds, it's usually too too late. That's right. Right. You're you're taking a different kind of risk. So we'll finish with that. I don't want to get too much deeper into, you know, any other conversations we'll leave some of this for, future, “Quarters and Sense.”

00;28;59;23 - 00;29;32;09
Unknown
But, thanks for joining us this month or this quarter. I should say, in our second edition of “Quarters and Sense.” Thanks, Mark, for your insights. And we'll talk to you guys next quarter. All right. Have a good day. Starts financial services SEC. For you only Ryan. And so the information presented is for educational purposes only. No listener should assume that any discussion or information presented serves as receipt of, or the substitute for personalized device announcement and or any other investment professional and is not intended as an offer, solicitation with sale or purchase of any specific securities, investments or investment strategies.

00;29;32;11 - 00;29;52;16
Unknown
Stocks and services is not a law firm or accounting firm. A portion of this program should be interpreted as legal accounting for tax advice. Information expressed does not take into account your specific situation or objectives. It is not intended as recommendations appropriate for any individual. Listeners are encouraged to seek advice from a qualified tax law investment to determine whether any information presented being suitable for their specific needs.