Why Oil Prices Will Take Center Stage For The Stock Market In The Coming Weeks, Outperformance Of The Healthcare Sector And Why You Must Be Diversified To Stay In The Game.
Saturday, 12 Mar 2022 4:30 PM GMT+07
By Mike Le
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The major averages pulled back again this week, for a fifth straight week of declines, as the Russia-Ukraine conflict continued to be the main point of discussion. Oil prices touched decade-high levels, stayed above $100 per barrel — a key economic reading pointed to ongoing inflation.
With earnings season now behind us, the focus on macroeconomic and geopolitical updates will only be more front and center. When this is the case, only focusing on individual company's fundamentals will prove to be difficult. That's why in our portfolio management process, we also take a top-down approach - choosing the sectors that can outperform given where the economy is heading ("selecting the neighborhood").
Given the move in oil, we want to take a moment to review some of the dynamics at play and why it is causing so much concern — not only on Wall Street but on Main Street as well.
First, energy (gas or oil) is a key input for all production activities. As a result, companies are forced to either push that cost through to customers, or eat the cost at the expense of profit margins. Companies with pricing power (retailers such as Walmart, Costco or Amazon, healthcare companies such as Pfizer or Eli Lilly, or tech companies such as Microsoft) can easily pass on higher costs to customers: did you notice your Amazon Prime subscription has gone up about 15% since last month? Even if you did notice, did the price increase make you stop your subscription? Probably mostly the answer is no; that's what we call pricing power. On the other hand, sellers of non-essential products (we call consumer discretionary - from cars to airplane tickets to clothes) need to keep prices down in order to compete with other players in the market. Higher production costs will hurt their profit margins because they are unable/ unwilling to raise selling prices.
While some industries are more directly impacted than others, the ripple effects of higher oil eventually hit every sector of the economy. While some costs can successfully be passed through, eventually, high prices will lead to demand destruction. While the silver lining is that a little demand destruction can help bring down prices by bringing supply and demand more into balance, it also means that economic growth will slow. This in turn leads to fears of a recession. That’s not our call by any means but don’t be surprised if you hear the “R” word thrown around a bit more these days — especially by the bears that are finally getting their moment after years of calling for doomsdays that never came — should energy prices remain elevated or worse, continue to climb.
Second, there is the dynamic of what higher energy costs do to consumer spending. As energy demand at the consumer level is largely inelastic, when those costs rise, be it to fill up the tank or heat your house, it takes up a greater portion of disposable income. This results in less money available for the more elastic purchases, such as purchases of clothing or family outings. This means we should expect some pressure on these sectors should energy take up a larger and larger portion of disposable income.
The caveat this time around, and something that is certainly working to the economy’s advantage, is that the consumer is actually in pretty good shape. In fact, Morgan Stanley recently released a brief report commenting “that rising incomes, record levels of household wealth and healthy personal balance sheets could drive a consumer spending boom that powers stocks for years to come.”
So what’s the takeaway?
The elevated cost of energy is problematic and something we must continue to monitor closely. It can certainly get worse, but it could also get better. In this report, we don't want to tell you which side to take, but rather, present you the facts, analyses, and prepare you for both outcomes.
With the S&P 500 index in correction territory, the Dow Jones nearing that level and the Nasdaq in bear market territory, we think now is not the right time to be so negative on the entire market. The time to prepare your portfolio for a recession was probably end of last year, with the markets were at the highs, certainly not now, when the "R" word has already been thrown around. In other words, with everyone talking about a recession, it has probably already been priced into the market. Everyone is clearly fearful, so this is time to be selectively greedy.
Earnings season for portfolio companies still show above-trend growth, no sign of slowing on both their reported numbers and outlook (we will be writing an earnings report card for all portfolio companies in the coming days). The consumer is still strong (according to credit card data from banks). Therefore, at the moment, we simply do not have enough evidence to call a recession. However, remember that the stock market is a forward-looking mechanism, therefore, it is currently fearful of a recession.
What should you do to your portfolio?
As we've said above, the situation can go both ways. On the bad side, the Russia - Ukraine war could go on forever, oil prices and general inflation remain persistently high, the Federal Reserve would be forced to aggressively raise interest rates and conduct quantitative tightening into an economic slowdown; a scenario that could result in a 20 - 30% market decline (we're now a little bit more than 10%). On the good side, the war could be soon ending, oil prices go back down, inflation expectations get back in line, the Federal Reserve can be nimble with monetary policy, the economy is left to remain above trend; a scenario that would reverse the current 10% decline.
The good news is, we believe you don't have to bet on any one scenario. At WIC, we stand that there is a 70% chance that the war will eventually resolve, the economy will still grow above-trend; a 30% chance that recession - or perception of recession - will occur. Therefore, we try to structure our portfolio to reflect that way:
In an economic upturn, cyclical sectors outperform (financials, industrials, energy, consumer discretionary, technology). In an economic slowdown, defensive sectors outperform (healthcare, utilities, consumer staples, select technology).
Prior to 2022, we felt something like this would happen, and we discussed our portfolio line-up here and discussed what sectors to play/ avoid here. In one post, we wrote:
"Healthcare is a group we continue to emphasize. They are defensive and can grow earnings even in an economic slowdown. Also, drug stocks are winners from the potential blocking of the Build Back Better plan because one of the provisions would have allowed the government to negotiate directly with pharmaceutical companies on the price of certain drugs.
In the portfolio, we love Eli Lilly (LLY) at the current price more. The stock has fallen about 6% from its post-Investor Meeting high, and we continue to favor this pharma name for its volume-driven growth, blockbuster-rich pipeline, and continual operating margin expansion."
If you look at the stock of LLY, it has strongly outperformed the broader markets. In the chart below, blue line represents LLY, while orange line represents the S&P500. Note that while the S&P 500 lost 10% in the past 3 months, Eli Lilly has gained 7% (17% outperformance).
The significance of this demonstration is that you need to be diversified to stay in the game. We are not entering a nuclear winter or another untreatable pandemic, therefore, we believe there's always a bull market somewhere: you just need to know where to find it. Currently, healthcare stocks are in a bull market because investors fear a recession will come, and healthcare companies do well regardless of economic conditions. This is at the expense of cyclical stocks such as financials or industrials.
But again, you can't just own a portfolio full of healthcare companies. What happens if the Russia-Ukraine situation is resolved, prices go down and the economy comes roaring stronger? Healthcare gets sold, people bid for cyclicals again. That's why you want to be diversified.
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