Summary
- The Health Care Select Sector SPDR was a safe haven in 2022.
- XLV has also outperformed over the longer term.
- Demographic trends make reining in U.S. health care expenditures unlikely.
- The market-implied outlook (calculated using options on XLV) continues to be bullish.
Healthcare stocks were one of the best safe havens in 2022, with the Health Care Select SPDR ETF ( XLV ) returning a total of -2.1% , as compared to -18.2% for the S&P 500 ( SPY ) and -32.6% for the NASDAQ 100 ( QQQ ). What is even more notable, however, is that XLV has outperformed SPY over the past decade. XLV's 10-year annualized total return is 13.8% per year vs. 12.6% for the S&P 500.
12-Month price history and basic statistics for XLV (Seeking Alpha)
The Sector SPDRs are created by sorting S&P 500 components into 11 sectors. Over the past 12 months, XLV has delivered the 2nd highest return out of the Sector SPDRs, behind the Energy Sector SPDR ( XLE ). Over the past 5 years, XLV has the 2nd highest return as well, with the highest returns coming from tech stocks ( XLK ). Over this 5-year period, XLE has annualized return that is less than ½ that of XLV.
Looking at a factor analysis of the performance of the Sector SPDRs also highlights the notable performance of XLV. I ran a 3-factor Fama-French analysis of the 11 Sector SPDRs, with the data history limited to a maximum of 54 months (XLC was launched in June 2018 ). Over the last 54 months, XLV has the highest 3-factor alpha of any of the 11 Sector SPDRs. XLV's annualized alpha exceeds that of the Technology Sector SPDR ( XLK ), with 2nd-highest alpha, by 1.1%. XLV has the 2nd-lowest Beta, behind Utilities (XLU), which reflects the defensive nature of health care stocks. It is interesting that XLK has a slight growth tilt (negative loading on the Value factor), albeit not large enough to be statistically significant. This suggests that XLK will tend to perform okay when the market shifts back to favoring growth.
Fama-French 3-Factor analysis of Sector SPDRs (PortfolioVisualizer.com)
The narrative supporting the performance of health care stocks is straightforward. First, U.S. real expenditures on health care have been rising for 50 years , with the rate of increase going up over time. Second, the U.S. population is graying , and older people tend to consume much more health care than younger people. Third, older voters tend to be more active voters and have historically been resistant to any proposals to reform Medicare. There does seem to be increasing movement in support of regulations to limit increases in pharmaceutical costs, however.
I last wrote about XLV on March 2, 2022, at which time I assigned a buy rating. Along with considering the broad economic outlook, I relied on a probabilistic price forecast called the market-implied outlook . In this approach, I analyzed the prices of call and put options on XLV and used these prices to infer the consensus outlook from the options market. The market-implied outlook was bullish to the middle of 2022 and into January of 2023. In the 11 months since this post, XLV has returned 3.1%, including dividends, vs. -4.6% for the S&P 500.
Previous post on XLV and subsequent performance vs. the S&P 500 (Seeking Alpha)
For readers who are unfamiliar with the market-implied outlook, a brief explanation is needed. The price of an option on a stock reflects the market's consensus estimate of the probability that the stock price will rise above (call option) or fall below (put option) a specific level (the option strike price) between now and when the option expires. By analyzing the prices of call and put options at a range of strike prices, all with the same expiration date, it is possible to calculate the probable price forecast that reconciles the options prices. This is the market-implied outlook. For a deeper discussion than is provided here and in the previous link, I recommend this outstanding monograph published by the CFA Institute.
Readers may be interested in my analysis of the top holdings in XLV using the market-implied outlook, including [[UNH]] (the largest holding ), [[JNJ]] (the 2nd-largest holding), and [[MRK]] (the 3rd-largest holding):
My analyses of these stocks supports a positive view of XLV.
Market-Implied Outlook for XLV
I have calculated updated market-implied outlooks for XLV for the 4.4-month period from now until June 16, 2023 and for the 11.5-month period from now until January 19, 2024, using the prices of call and put options that expire on these dates. I selected these specific expiration dates to provide a view to the middle of 2023 and through the entire year.
The standard presentation of the market-implied outlook is a probability distribution of price return, with probability on the vertical axis and return on the horizontal.
Market-implied price return probabilities for XLV for the 4.4-month period from now until June 16, 2023 (Geoff Considine)
The outlook for XLV is tilted to favor positive returns, with the maximum probability corresponding to a price return of 5.25% over the next 4.4 months. The shape of this distribution, with the flattened peak and shifted to favor positive returns, is very similar to the outlook to the middle of 2022 that I calculated at the start of March of 2022.
The expected volatility calculated from this outlook is 9.8% (16.2% annualized). For comparison, ETrade calculates 15% implied volatility for the options expiring on June 16, 2023. The expected volatility to the middle of June of 2022 from my previous analysis was higher, at 22.2% . For context, the annualized historical volatility for XLV over the past 3-, 5-, and 10-year periods is 16.9%, 15.9%, and 13.9%.
A diversified equity portfolio is expected to have a general form like this, negatively skewed with a positive peak in probability and a longer negative return tail. I judge the relative attractiveness of an equity ETF by comparing the maximum probability return to the expected volatility. Adding the expected dividends between now and June 16th ( 1 payment that adds approximately 0.37% in return), the maximum probability total return is 5.6%. The ratio of this return to the volatility is 57% (5.6% / 9.8%). As a rule of thumb for a buy rating, I want to see this ratio at or above 50%, so I interpret this outlook as bullish.
At the time of my previous analysis , I compared the peak probability price return to the standard deviation (i.e. without including dividends). This ratio for the outlook to mid-June of 2022 (a 3.4-month period) was 41% as compared to 54% for the current outlook to June 16, 2023. Statistically, we expect this ratio to be higher as the time horizon increases, so these values are more equivalent than they appear.
To make it easier to compare the relative probabilities of positive and negative returns of the same size, I rotate the negative return side of the distribution about the vertical axis (see chart below).
Market-implied price return probabilities for XLV for the 4.4-month period from now until June 16, 2023. The negative return side of the distribution has been rotated about the vertical axis (Geoff Considine)
Theory indicates that the market-implied outlook is expected to have a negative bias because investors, in aggregate, are risk averse and thus tend to pay more than fair value for downside protection. There is no way to measure the magnitude of this bias, or whether it is even present, however. The expectation of a negative bias reinforces the bullishness of the market-implied outlook to the middle of 2023.
The market-implied outlook for XLV to January 19, 2024, a period of 11.5 months, has a peak in probability that corresponds to a price return of 7.9% and an expected volatility of 16.8% (17.1% annualized). We can expect to receive the full year's dividend payments between now and January 19, 2024, so the maximum-probability outcome is a total return of 9.4%. The ratio of this return to the volatility is 56% (0.47% without dividends). This bullish outlook is consistent with the view to the middle of 2023.
Market-implied price return probabilities for XLV for the 11.5-month period from now until January 19, 2024. The negative return side of the distribution has been rotated about the vertical axis (Geoff Considine)
The market-implied outlooks for XLV to mid-2023 and into the start of 2024 are consistently bullish and indicate an attractive risk-return proposition.
Summary
The Health Care Select SPDR has consistently delivered attractive risk-adjusted returns with relatively low volatility. The fund also has low beta, providing diversification benefits when added to a broadly-diversified portfolio. Health care stocks got a boost from COVID-19 and its aftermath, and this was a (hopefully) one-time event, but the long term outlook for health care companies is encouraging. While reducing costs is often discussed in policy circles, the United States appears not to have the collective political will to address our runaway expenses. As our population becomes even more skewed towards the aged, demand for care inevitably grows. The market-implied outlook for XLV continues to be bullish and suggests good potential for attractive returns relative to risk. I am maintaining a buy / bullish rating on XLV.
For further details see:
XLV: Continued Positive Outlook For Healthcare Stocks In 2023