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Bruce Hotaling

Bruce Hotaling

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Take A Breather

Stock prices are now up an impressive 12.6% year to date. After eye-opening results in February, March and April, prices were more muted in May: up only 0.5%. The push and pull taking place behind the scenes is between those investors buoyed by the stimulus and high growth expectations, and those concerned with the threat of runaway inflation. Of course time will tell but I am in the growth camp until evidence mounts to show that excessive inflation is here to stay.

Since mid-April, the stock market has been moving in a sideways pattern and interest rates have stabilized. This period of consolidation is a good sign and supports favorable expectations going forward, while I think stronger economic growth over the next few years will both steepen and shift the yield curve higher. Yield curve shifts can result from either increased inflation expectations or increasing rates of real GDP growth. Markets have a long history of generating healthy returns in both rising and falling rate environments.

From a more fundamental perspective, the current backdrop supports attractive earnings forecasts. Q1 ‘21 earnings data from FactSet Research indicate the highest percentage of companies reporting positive EPS surprises and the highest net profit margins (12.8%) since FactSet began recording this data in 2008. The forward P/E ratio is 21 (5 year average is 16). FactSet bottom-up EPS estimates for CY22 are $210 per share (and recent J.P Morgan research indicates $225 for CY22 and introduces $245 for CY23). These earnings estimates are the foundation of today’s stock prices.

There are concerns brewing with respect to peak earnings and peak margins, causing some rotation in investor focus, though it is not a threat to the broader outlook (it’s more akin to a head-fake than a true deceleration or change in the directionality of the market). There is also the concern that the Federal Reserve will modify its guidance with respect to interest rates. This is a question of when, not if. As long as any policy changes are well communicated and incremental, rising rates may have a short-term impact on stock prices but should not produce a long-term effect.

Inflation is a natural occurrence in a growing economy. When a tariff war and then a global pandemic cause breaks in supply chains, and shuttered businesses come back online, there is reason to expect a period of adjustment before production, distribution and pricing realign. It is premature to label the global economic restart as the onset of systemic inflation and I think it will prove to be less of an issue than many, on Wall Street and off, are postulating.

The meme-trading frenzy continues, making it difficult for many investors to keep their eye on the ball. Skyrocketing stock prices and energized news reports are quick to catch investors’ attention, however this type of stock trading is not investing. It is no more grounded than playing the tables at your local casino; not many beat the casino and being lucky once is no assurance of winning again. In the stock market, making informed bets, managing risk and managing one’s emotions are critical to producing long term investment results.

In a similar vein, Crypto has reared up again with a related conversation over digitized central bank currencies. Institutional investors are getting on board, and I expect the regulators will initiate some oversight. I think the many crypto currencies are akin to an emerging market – an asset class with expanding influences, particularly in fin tech. The narrative is compelling (similar to the dot.com era) and participation is broadening. We are centering our attention on businesses that can thrive from the continued establishment of crypto assets and blockchain technology.

Our focus in this market remains on owning a full weighting in quality stocks well positioned in their respective markets. We are focusing on a mix of big growth and technology stocks, as well as more economically cyclical value stocks. We are less incentivized to buy fixed income with interest rates as low as they are, though a nice positive to the low-rate backdrop has been the enhanced interest in high dividend yielding stocks and REITs.

Take good care and please be safe out there.

Bruce Hotaling, CFA
Managing Partner

Stimmies

Stocks continued their impressive behavior of the previous few months, advancing 5.2% in April, and are now up an impressive 11.8% year to date, as measured by the S&P 500. According to Bespoke, the S&P 500 has posted 25 record closing highs this year, with records on nearly 1/3 of all trading days. The behavior of the market as a whole has been almost too good, lulling some investors into complacency. For the last 12 months, prices have marched steadily higher, empowering investors to take on ever more risk. This will change at some point, however, leading to an inevitable shakeout.

The market backdrop this year has fostered change that, in my opinion, reflects a cultural shift in the underlying fabric of the “markets.” $1400 stimulus checks, people working from home, social media and commission-free stock trading have leveled the playing field and invited many to invest in stocks who never before had access. On the opposite end of the wealth spectrum the SPAC fervor, where investors give over their money to a yet-to-be-identified company, erupted. This celebrity-sponsored mania is funneling volumes of money to companies that most likely would not be able to access the traditional IPO market.

From a more fundamental perspective, the underpinnings of the strong start to the year have been widely discussed. Fiscal stimulus has been unprecedented: Congress passed a $900 billion coronavirus relief program in December 2020, and the American Rescue Plan at $1.9 trillion in March this year. The effort is clearly to bridge the sweeping economic effects of the pandemic on millions of American. Interest rates remain at or near historic lows continuing to fuel business development and home buying. Global trade is rebounding with the easing of the trade backdrop and the diminishment of the impact of the virus.

There is a reasonable probability that the bottom-up economic stimulus now taking place will have both a dramatic and long-lasting effect on the future welfare of households across the U.S. This is the opposite of the supply-side dogma advancing since the days of Ronald Reagan: if you give a few people a lot of money, it’s good for everyone. I think some seeds of change have been sown that will lead us to a new path. This approach, a lifting of all boats, is just what we need to bolster a consumer-led economy, and critically align it with current spotlights on racial equality, true economic opportunity, education, and environmental awareness.

Closer to the bottom line, we have seen nothing short of stunning Q1 ’21 earnings reports. The FAANGMN (Facebook, Apple, Amazon, Google, Microsoft and Netflix) all posted remarkable earnings growth this quarter. Collectively, they make up well over 20% of the S&P 500’s total market capitalization. Their profit margins are at or near all-time highs, they are establishing new plants and investments in the U.S. and importantly, increasing both hiring and wages. They are thriving. My hope here is that their success is not more than some in Congress can stomach.

One trend we are seeing on earnings calls is the tendency for log jams in the logistics for many companies. The availability of some components, as varied as microchips, and wood, is also slowing production. My suspicion is that we do not face secular inflation, as is often cited. I think the benefits of the efficiencies and innovations realized during WFH and the pandemic shift lead to a fly-wheel acceleration of margins and earnings once these dislocations are resolved.

On the investment front, I think we need to patiently hold high quality growth stocks that are reasonably priced. Some cash reserves are useful here as I think we do see some volatility, and I think interest rates are on the rise. The coming wave of growth and higher earnings will support stock prices even with a higher rate backdrop. The breadth of the economic surge will prove to be deeply seeded across our society, reversing some of the inequity that has been promoted.

In my view, now is the moment to be attentive, but optimistic at the same time – cautiously bullish. If you would like to discuss further or review your accounts we are more than happy to catch up with you. Take good care.

Bruce Hotaling, CFA
Managing Partner

Expansion

A lot can change in a year. Looking back at the stock market on April 1, 2020, the S&P 500 began the month by falling 4.4% to 2470. This was in the immediate shadow of March 2020, one of the most volatile months in my lifetime, anchored by March 16 when stock prices fell 12% in one day. Today, the S&P 500 is over 4000 (62% higher than the March ’20 low) and shows no outward signs of slowing down. Last month saw a buoyant trend continue, as stock prices rose 4.2% (as measured by the S&P 500) and are now up a sturdy 6.2% year to date.

Many investors are being caught wrong-footed by the regular shifts in the types of stocks the market is rewarding. When the potential for robust economic expansion began to take shape late last year, investors bought value stocks, which benefit most as the economic tide comes in. They also began to buy small cap over large cap, and low quality over high quality. My concern with many of these shifts is whether or not the trades have legs – and my suspicion is they do not.

The backdrop is challenging. Prominent concerns for the future months include higher interest rates, higher taxes, higher inflation, commodity costs and of course, new and emerging strains of the virus. None of these have derailed stock prices as many investors pre-emptively anticipated, which has led to numerous directional shifts in the market.

In my opinion, we need to pay attention to a number of emerging trends and events which could be early warning signs of more significant change brewing. The meme trading of stocks like Game Stop, reflects reckless group risk taking, as the stock trades at over $170 a share and has not earned a dime since 2017, according to FactSet estimates. The implosion of the family office Archegos Capital and the complicit behavior of multiple global banks writing swaps blind to the illiquidity and the systemic threat, harks back to the near melt down of the system in 1998 when Long-Term Capital Management suddenly failed. When they do, things tend to go wrong quickly.

We have also seen unexpected stresses on the supply chain. When the container ship the Ever Given became stuck and blocked the Suez Canal, it was reported that as much as 10% of the world’s trade was on hold. Another current crisis is the chip shortage. This is not something we think of often, but largely attributed to crypto currency mining, we now face a shortage of chips for the production of new cars and other consumer products.

Yet, there is a lot to support the current bout of optimism on Wall Street. Interest rates remain near historic lows. The pending fiscal spending from the American Jobs Plan is long overdue, and will begin to make up for decades of underspending on critical infrastructure that benefits everyone. The development of vaccines has been nothing short of remarkable, as is their effectiveness, and with the new administration their dissemination has increased to the current 4 million doses a day. Immunity is broadening and expectations are that greater than 80% of the US population will have been vaccinated by early summer.

My sense is the coming wave of economic growth will be eye-opening and with it, we should expect an extended period of outsized earnings growth. Current bottom-up EPS estimates by FactSet indicate over $175 a share in earnings for CY ’21 and over $202 for CY ’22. Both of these figures are record highs and imply growth rates of over 25% and 14% respectively. These figures are enormous in relation to S&P 500 historical earnings numbers and the market today is placing a 20x PE ratio on these high expectations.

The last year has been a true challenge, something few of us have ever experienced in such scale. People have saved a lot of money, not doing many of the things they had in their pre-covid lives. The new normal will be a blend of the adopted digital lifestyle with a more live-now vibe that germinated during the lockdowns. The financial markets are anticipating this and, as a discounting mechanism, are already reflecting how things are expected to be 12 months from now.

I hope you have your vaccine or, if not, will in the near future. In the meantime, please be safe out there, and don’t hesitate to check in if we have not been in touch.

Bruce Hotaling, CFA
Managing Partner

A Jumble

Here we are, two months into 2021, and there is already a long list of fears facing investors.  Many are not new, but since the elephant left the room on January 20th, it may be that the media and investors now have more mundane things in their minds.  The pending stimulus, the recent spike in interest rates, rising inflation expectations, meme-trading on Robinhood, commodity price spikes and supply chain fractures, chip shortages, and SPACs (Special Purpose Acquisition Corp) are all now cause for concern.  With that as a backdrop, the market jumped into action in February with stocks increasing 2.7% for the month and raising the return of the S&P 500 to 1.7% year to date. 

The main event in February that touched so many households was the winter storm that swept across the country.  Texas seemed to bear the brunt: the unprecedented storm hit with record low temperatures and led to the failure of the electric supply grid causing widespread blackouts and clean water crises.  This will protract the recovery process, amidst the pandemic and an economy struggling to put millions of people back to work.

Whether it’s the virus, the economy, the weather or politics, people across the country are beginning to reach their limits.  While more vaccines are rolling out each day and there is positive news of collaboration between Merck and J&J, the virus persists; new case counts are similar to where they were last October.  The end of the pandemic, and springtime, cannot come soon enough.

While possibly a by-product of the pandemic, certain aspects of investor behavior are cause for worry and are a troubling echo of the late 1990’s.  After an immense 150% return in 2020, ARK Innovation’s fly-wheel-like ETF has taken in more assets than any fund besides Vanguard S&P 500 ETF, according to Barron’s.  Robinhood offers investors an app-based free trading platform and many of its users gather on Reddit to both promote trading schemes and, curiously, to bait one another.  Herd behavior is not unfamiliar on Wall Street.  A recent and shocking instance was after Hertz filed for bankruptcy in May of 2020. Robinhood investors herded in.  Hertz leapt on this and issued more of the hyped shares to the public.  The investors that did not sell were ravaged when the stock was delisted by the exchange on October 30.    

More fundamentally, the Federal Reserve says it remains committed to low interest rates for the foreseeable future. Yet, as the yield curve has shifted, the interest rate markets apparently are not taking the Fed at its word.  In my opinion, while there may be some disturbances, I do not think rates are headed appreciably higher, nor do I think ‘70’s style inflation is brewing.  There may be temporary dislocations (used cars, appliances) and yes, certain commodity prices (copper, oil) have risen, but I do not think these are longer cycle issues. 

I am encouraged to see impressive 4Q 2020 earnings and revenue growth.  Forward guidance, something many companies suspended, is generally strong, and forward S&P 500 estimates are trending higher.  Stocks in general are expensive.  According to Ned Davis research, the total market cap of all stocks, as a % of GDP (similar to the Buffett Indicator) is over 200%, well above its historic range.  I’ve said this before but we are stock pickers – and expect to continue to be able outperform, in any variety of market backdrops. 

While we are growth investors, we also are well aware of the market’s tendency to re-orient itself now and then.  It’s not often, but value stocks (measured by the Russell 3000 Value and Growth indices) did outperform growth stocks in 2007, 2014 and 2016.  In each of these instances, our patience staying with our core growth names paid off handsomely in the subsequent periods.  Our focus is on both quality stocks and stocks that stand to benefit the most as the recovery continues to unfold.  Quality often lags when investors become starry eyed (greedy) but it stands tall when fear and uncertainty are driving the market.

We always look forward to catching up with you.  If we have not been in touch recently, or it you need some help accessing your tax information, please do not hesitate to reach out.  In the meantime, please be safe out there.

 

Bruce Hotaling, CFA

Managing Partner

A Fresh Start

After a robust 2020, stocks measured by the S&P 500) began the New Year on a mixed note, returning -1.01% for January.  However, there is no need to read a lot into this.  Stock prices, for the most part, are still attached to the conditions that prevailed in December of last year.  Not much has changed: the stock market is expecting another stimulus package to be passed, and the Federal Reserve continues to signal it has no intentions of raising interest rates anytime soon.   Stock prices are remarkably interest rate sensitive, and with rates at rock bottom, any upward move will pressure the market’s P/E ratio and bring prices down.  This is not on the horizon yet but talk of higher inflation and higher levels of GDP will spur concern.

As we lap the first anniversary of the date the WHO declared the COVID-19 outbreak a global health emergency, news on the virus is finally, marginally improving.  Johnson & Johnson is applying to the FDA for emergency use authorization for its single shot vaccine.  AstraZeneca and Novax also have vaccines on the cusp of approval by the FDA.  23M Americans have received the vaccine, and over 26M Americans have confirmed cases, according to the WHO Coronavirus Disease Dashboard.  With the total population of the US @ 330M, it remains unclear what needs to have had the vaccine or the virus in order to establish herd immunity.  It is possible the virus becomes endemic and vaccinations and re-vaccination to sustain immunity become the norm.

The popular news this past week echoed the roaring ‘20s.  Techniques akin to the “pump and dump” schemes popularized by Jesse Livermore over 100 years ago took hold of trading in GameStop shares.  In today’s world of social media, “meme trading” has become a thing on Robinhood Markets Inc. free, app-based trading platform and the surge in trading caused Robinhood to raise $2.4B as collateral for clearing requirements. The episode is largely a distraction and shows the capital sensitivity of small broker-dealers.  It’s not clear whether or what type of regulation the SEC may need to bring as the use of message boards, AI and social media scraping appear to have been used to knowingly manipulate the price of a stock, which is a violation of securities laws.  

There is a vast difference between trading and investing – clearly to make an investment, you must trade (buy or sell) a stock,  but short term, spontaneous and uninformed bets on short term price movement have nothing in common with investing.  The issue is not likely to threaten the underpinnings of the broader market, which is organized to allow for the creation of and access to capital. There is considerable evidence that only a tiny percentage of people involved in day trading make money and this type of activity in today’s social media world begs for some updated regulations.  Sadly, one trait of stock market behavior is that those who can least afford a loss (those with fewest resources) are the most likely to take outsized risks.

For us, the basics of fundamental investing remain in place.  Quality, transparency and liquidity are primary criteria in all our investment models.  When prices move without any fundamental reason/underpinning there may well be a profit opportunity, but it is not tied in any way to earnings or other measurable fundamentals.  The earnings outlook for the S&P 500 remains strong, and the market is beginning to look forward into 2022.  According to FactSet, S&P 500 companies are reporting 4Q ‘20 earnings well above expectations, and are producing the highest level of positive surprises for any quarter since 2008.  We view our opportunity set as a market of stocks with attractive themes, such as clean energy, emerging technology, EV technology and stocks still in the recovery phase from the pandemic induced recession. 

It’s that time of year, and taxes are upon us.  Unlike last year, we are back on a regular tax filing cycle.  You will receive your 1099s in the mail, and you can also access them from the Schwab web site. Please let us know if we can help, and as always, we look forward to hearing from you.  Please do not hesitate to call us if we have not been in touch recently.

Be safe out there.

 

Bruce Hotaling, CFA

Managing Partner

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