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Bruce Hotaling

Bruce Hotaling

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A Low Bar

Stocks rallied in August, jumping 7.2% for the month as measured by the S&P 500.  This is unusual, as stock prices typically take a bit of a pause while many Wall Street traders close out the summer in the Hamptons.  For the year, stocks are now up 9.7%, a surprising reversal from the -19.5% returns we struggled with at the end of March.  Stocks are up 5 consecutive months now, and a whopping 36.4% from the end of March.

As I’ve mentioned before, stock prices are an important leading indicator.  The stock market is a discounting mechanism, an indicator of investors’ future expectations, which includes the direction of stock prices.  August was a remarkable month; of the 21 trading days, prices moved higher on 17 of those days or 81% of the time.  According to Bespoke Research, since 1993 (the inception of the SPY ETF which tracks the S&P 500) there have only been six other months where prices were up more than 75% of the available trading days.  Interesting for us to bear in mind, after each of those frothy periods, stock prices tended to continue their uptrend for the ensuing six and 12 month periods.

The news flow pertaining to the election, the virus, and shaky economies around the globe has dominated the lens through which many investors view the stock market.  While the news has stirred emotions and created a nearly impossible disconnect between what people perceive and what the stock market does, there is quite a bit of underlying support for what is propelling stock prices upward. 

The primary factor behind the markets remarkable run since the end of March has been the immediate and aggressive response by the Federal Reserve.  The Fed’s moves created liquidity for the markets, backstopping credit and lowering interest rates which restored confidence in the US, and around the world.  The de-risking of credit markets and the expansion of the P/E (the market multiple) through historically low interest rates have catalyzed higher stock prices.  A second critical factor was the quick response by Congress to provide fiscal support, putting money in the hands of those that lost their jobs.  The CARES Act pumped $2.2 trillion into the economy at various levels.  Another $1+ trillion is under consideration.   These figures dwarf the $787 billion American Recovery and Reinvestment Act passed by Congress in early 2009 during the Great Recession.

Wall Street analysts typically over-do it, and with the onset of the virus in March, they began to cut earnings forecasts, only to see them handily beaten by actual 2Q results.  Now analysts are rapidly increasing their estimates, and according to FactSet Research, are forecasting a 29% jump in earnings in ’21 (led by consumer and industrials).  The pattern has been one of weak but improving data.  As lowered expectations are beaten, again and again, the market has been coaxed higher supported by the relative improvement.

Somewhat hidden is the fact that the economy is recovering.  The excessive damage to service, travel, retail and dining has been more than offset by the pull-forward of a massive cloud based digital economy. Work from home, school from home, shop from home are all factors that have “modernized” our economic lives in ways we would never have imagined only a year ago.  The emergence of 5G, the continued expansion of the internet of things, immense cloud infrastructure and the preponderance of the distributed workspace will perpetuate this transformation.

At this point, our portfolios have benefitted from strong weights in consumer and technology growth stocks, many immune to the economic disruption caused by the virus.  We are also continuing to add exposure to more cyclical companies, many heavily impacted by the virus and now clearly recovering.  This balanced, or barbell, strategy will remain in place for the time being.   

As always we look forward to speaking with you, or “Zooming” if that has become a part of your routine.  We are always available to review your portfolios, strategize as we head toward the election and review you year-end tax planning.  Typically, one or two of us are working out of the office, while the rest continue to work remotely.  Please, be safe out there.

 

Bruce Hotaling, CFA

Managing Partner

Siren Song

For the month of July, stock prices measured by the S&P 500 generated a strong 5.6% total return, bringing the index into positive territory for the first time since late February.  As it does, the stock market is pulling more and more investors in from the sidelines, however there are ample risks to this uneasy place we find ourselves. It seems more often than not identifying the risk is relatively straightforward – the difficulty is in determining how one chooses to respond.

The obvious risk is the continued impact of the pandemic.  While ultimately this will be resolved by science, it’s going to take patience on the part of all of us to get there.    Vaccines are under development by quite a number of companies, but it’s unclear when they will be safely available.  A further twist is whether or not enough Americans will be willing to take a vaccine, threatening herd immunity.

We don’t know the full scope of the damage from the virus, beyond the obvious human toll.  According to JPMorgan, the US debt/GDP ratio will exceed 100% this year.  This will be the first time public debt has exceeded the size of the economy.  This is complicated by the fact that Washington must allocate additional funding.  State and municipal governments are desperately attempting to maintain staff to provide essential services while balancing their budgets.  States are also largely responsible for Medicaid, providing health care for over 75M.

The upcoming election is a concern; will we have a fair election, will there be an attempt to delay the election or even an attempt to hijack the office?   At the moment, Wall Street is beginning to absorb the 60% odds of a Biden victory and how this might play out.  It will follow the opportunity to make money. On the heels of a Biden victory, one might expect a greater orientation around climate change, decarbonization, new investment in technology and critical improvements to the country’s infrastructure.  There is good reason to think Wall Street would respond favorably to honest and competent leadership in Washington.

The economy, to which corporate earnings largely correlate, is in a difficult place.  The risk of a prolonged recovery is this: a “v” shape is good, a “w” is not.    In 2Q, GDP dropped 9.5%, (32.9% annualized) the worst drop since 1947.  Virtually every measurable aspect of the economy went into decline, especially the unemployment rate – between March and April 22.1M people lost their jobs.  It will be a long time before these “lost” businesses begin to reestablish and rehire.

Today we are well into 2Q earnings reporting season.  Over 80% of companies have reported earnings beats, far better than feared.  It’s true, analysts lowered expectations in April and May when the extent of the damage became clear.  While just beginning to show some signs of inflecting, it is not expected that operating margins will recover to their pre virus levels until sometime in ’22.  The risk is not another steep drop, but a low slope recovery that drags on and does not produce enough jobs and tax revenue to restore broad economic health.

The market is bifurcated.  Large cap growth stocks have returned 13.8% YTD (as measured by the IVW) while value stocks have returned -13.4% YTD (as measured by the IVE).  In all my years as a growth stock investor I have never seen a spread like this.  The five largest companies make up over 20% of the S&P500’s market cap.  Dividend paying stocks which tend to fall more into the value category, are suffering.  Technology, communication services and healthcare remain the core drivers of current market returns. Eventually, I expect this performance gap to narrow, as the economy begins to regain its footing, though there is no rush to transition away from our big growth names.

Patience is critical at this juncture.  We continue our analytics and fundamental analysis to identify well positioned opportunities.  It is a market of stocks, well suited to thoughtful and well-timed stock picking.  As is typically the case, markets become misaligned, and investors often tend to let their emotions override their analysis.  I’ve found over many years that when it’s uncomfortable, there is opportunity, and when things seem oh-so-easy, there are sharks in the water.   As ever, we are here, albeit remotely.  If and when you need us, please do not hesitate to call – we are happy to arrange a Zoom meeting with you.  Please take good care.  

 

Bruce Hotaling, CFA

Managing Partner

What’d I Miss?

During the first half of 2020, the stock market has shown itself to be every bit as volatile and unpredictable as investors often fear.  As measured by the S&P 500, stocks generated a total return of 1.78% for June, and are now -3.18% for the year; stock prices have staged a truly unprecedented rebound.  According to Bespoke Investment Group (July 2, 2020) by March 23rd, stock prices had fallen 33% in 33 days as the virus brought the worlds’ economy to a sudden stop.  In the 100 days since the March 23rd low, the S&P 500 has rallied nearly 40%, the strongest 100-day return since 1933. 

The pandemic driven swings in stock prices have most investors on edge.  A week ago, investors appeared concerned the rapid spread of the virus across the U.S. would put an end to the stock price rally.  In a blink, investors appear to now not be concerned with the virus data.  The news flow on the virus’ spread and its impact on the economy, jobs and the future reinforces the fact that we are truly flying blind.  Worrying is evidence the virus is actually a vascular disease, effecting many organs of the body.  It also appears to be mutating, becoming more transmissible and less deadly.  Please, wear your mask.

The market is now more clearly than ever made up of haves and have-nots. Large cap growth stocks are the indisputable darlings of the market, as measured by the IVW (iShares S&P 500 Growth ETF), up 7.7% YTD versus the value counterpart IVE (iShares S&P 500 Value ETF)  -15.6%.  That 23.3% spread is big enough to parallel park a Tesla Semi.   This spread has grown to new heights, but is not a new phenomenon.  The performance disparity between growth and value is similar, though not as extreme, to the last 10 years.  Another disturbing fact is the non-participation of both small and mid cap stocks.  The year-to-date top performing sector is technology (14.9%) and on the other end of the spectrum, energy (-34.6%) and financials (-23.6%) bring up the rear.

The mid-point in the year marks the all-important 4th of July holiday.  Happy Independence Day.  I hope you were able to celebrate our country’s declaration of independence from Great Britain, in some physically distanced manner.  My family’s celebration included watching the film version of Lin Manuel Miranda’s Broadway musical Hamilton.  If you have not seen it, I will go out on a limb and strongly recommend you do.  All that is required is a subscription to the Disney+ service and you are on your way. 

The release of Hamilton over the holiday is remarkably pertinent in light of the extraordinary behavior we are seeing out of Washington, D.C. The underpinnings of our constitution and our experiment with a new federal system were under immense pressure then, just as they uncomfortably are today.   The show reminds us that all men are created equal (except for women and African-Americans) and its brilliant multi-ethnic cast highlights the degree to which freedom and equality remain challenges for us.  We also learn that we have Alexander Hamilton to thank for securing a powerful and enduring banking system, and I expect he would be pleased with the way the Federal Reserve has upped its game to rescue us from a second financial crisis.

The fiscal and monetary stimulus in place (with more pending) are likely to be transformative for the economy.  We cannot see the benefits yet, but signs are emerging.  Some recovery in the job market is evident, with the number of workers on temporary layoff beginning to fall, from 11.5% to 6.6% in the last two months.  This improved employment is matching businesses reopening.   How far we can extrapolate forward with the outbreak of the virus widening is unclear.  Earnings season begins next week.  This will be telling as a majority of S&P 500 companies have cut or suspended guidance.  I am optimistic that the companies we own will continue to put up numbers, as we continue to eye opportunities in more economically sensitive businesses that may pick up steam with a re-emergence of economic growth.

Overall, I am pleased with our positioning and how our stock portfolios have performed in a most difficult year.  We are continuing to work remotely, and find it (with the help of Zoom) quite effective.  If you would like to review your accounts or have any questions please do not hesitate to call or email.  We are all available for you.  Please take good care.  

 

Bruce Hotaling, CFA

Managing Partner

What Comes Next?

This year we have watched as the stock market executed a remarkable v-shaped recovery from the traumatic lows it explored March 23rd.  At that point, the S&P 500 was down over 30%.  Since then, prices are up 37.7% (as of June 3) the largest 50-day gain ever, according to FactSet Research.  May saw shares rise 4.7%, and now for the year, prices are down 4.9%.  In a similar manner, the bond market has seen the dramatic cracks that appeared largely remedy themselves.  Investors are breathing a sigh of relief, while asking themselves, what comes next?  

When I assess the investment landscape in an attempt to reconcile where there is opportunity, and excess risk, I am of two minds.  On one hand, the market itself is its own best leading indicator, and it is pointing to continued opportunities.  Recession or not, the vast amounts of financial support from the Federal Reserve and Congress’ fiscal stimulus are unprecedented.  A large component of the market is made up of companies whose fortunes have not been impacted by the virus; many in fact have been unwitting beneficiaries of the new economic order.

On the other hand, while the curve has been flattened and the health care system stabilized, the protracted fallout from the virus is unclear.  There is not a therapeutic or vaccine on the horizon yet.  This means we have the continued threat of infection, and required physical distancing and modified work protocols, which will dull the economy’s rebound.  Unemployment is at record high levels, and our consumer driven economy is dependent on spending.  Recovery may be further hampered by higher taxes, higher default rates on rents/mortgages, and extended periods of recovery particularly for both the service and travel/leisure industries.  

Normally the principal barometer of stock behavior is earnings and forward guidance;  2Q 2020 earnings will likely be the washout of all washouts.  According to FactSet Research, during the period through May, estimates for the full year fell from $177 per share to $128 per share.  Sadly, this is the largest decrease in annual EPS estimates for the index since FactSet began tracking in 1996.  The good news is the cuts to estimates have largely run their course and we have seen a larger than normal number of companies withholding forward guidance.  The difficulty here is the highly uncorrelated behavior of stock prices going up, while earnings forecasts are going down.

The approach that has been working well for us continues to center around growth companies with high free cash flows and strong margins.  These have been the driver of returns for the last few years, and I expect this to continue.  We have also been taking advantage of a surge in interest in more cyclical (economically sensitive) companies, many severely punished in the downturn.  I think we will see a continued snap-back, driven by pent-up demand.  There is a good chance the recovery will usher in a period of secular growth along with some inflation, historically a favorable backdrop for stock prices.

While I think the recovery will be stronger than many fear, I’m not sure which letter of the alphabet it might look like.  I also think we need to brace for fits and starts along the way.  We need to be aware and open minded, as there will be a lot of change; think about public transportation, travel by plane, professional sports and college (according to National Student Clearinghouse, college enrollment since its peak in 2011 has fallen 10.6%).  In a curious way the pandemic has amplified change.

Finally, I am hopeful the most recent crisis over racial injustice will raise critical awareness and allow fairly elected representatives to begin to effect constructive reforms.  At the moment, the market’s only concern is the virus and nothing else.  I view the current protests as a window into the need for attention to far larger concerns, such as the health and sustainability of our social-economic fabric, and the future security of the global environment.  We will work through this pandemic, but we need to attend to more to insure vibrancy of the markets into the future. 

Though we continue to work remotely, please do not hesitate to call or email, as we are all available for you.  Please take good care.  

 

Bruce Hotaling, CFA

Managing Partner

Medical Science

April was a remarkable month in the stock market.  After March delivered one of the worst months in recent memory, stock prices as measured by the S&P 500 recovered dramatically, with a 12.8% total return in April.  Year to date, prices remain down 9.3%, and the trailing twelve-month return for stocks is 0.8%, essentially unchanged

Just to refresh your memory as to what has happened this year, the stock market hit an all-time high February 19th (S&P 500 closed at 3,385).  Prices then plunged over 33% in only 20 trading days and the market hit its low point on March 23rd (S&P 500 closed at 2,237).  Believe it or not, since the March low, prices have surged over 23%.  In prior instances (there have been nine) when the market has risen in excess of 20% in a 25-day window, prices over the ensuing 3 and 6 month periods are all positive (Bespoke).

A lot of people are struggling with the profound disconnect between the economic data and what stock prices have been doing – it is extremely difficult to connect the dots here.  Not that it is ever easy, but more often than not we at least think we can make sense of things.  Q1 GDP was down 4.8% (annualized).  When Q2 GDP comes out, it may well be the worst drop in GDP, ever.  Yet the stock market taken as a whole does not reflect anything as extreme as these figures might portend.

Medical science is the solution, simple as that.  An important distinction is that it matters far less what the people in Washington DC say, as opposed to what the people in the community do.  Curve flattening is working and the number of new cases and mortalities are on the decline.  Just the same, going back to something close to “normal” will require a vaccine.  There is optimistic news from several companies, including Pfizer, which has initiated a trial, and the much appreciated Dr. Anthony Fauci who said he thinks a vaccine will be completed in a historically short time frame. 

On our end, our work hangs on our ability to analyze data, fundamentals, quantitative factors, technical patterns and relationships.  Macro data often sets the table, but we buy stocks based on specific attributes.  As earnings are released, we are seeing patterns emerge: importantly, the earnings of many of the companies we own will not be overly impacted by the economic fallout from the virus.  Industries such as cell towers, social media, online retail, cloud-based businesses, software, med tech and utilities are posting encouraging results.  On the other hand, many companies (airlines, hotels, restaurants) are essentially closed.  Job loss has spiked and unemployment is at levels never seen before.  This is optically a challenge.  We are experiencing the fallout from the virus in ways notably different than how the stock market is pricing in the anticipated earnings disruption.

In my opinion, stock prices at this point in time reflect a cup-half-full outcome.  The Federal Reserve has done an exceptional job steering the financial system clear of another financial crisis.  Congress has delivered firehose fiscal spending that will no doubt give the economy a life sustaining jolt.  Stock investors now appear to be assuming 2020 is simply a wash, and have fixed their attention on the potential earnings outlook for 2021.  I am concerned over the risk of a recurrence in stock market volatility if the goldilocks recovery does not arrive on time, and according to plan.

Our focus is to continue to own high-quality growth stocks which have served us so well over the years.  Large-cap growth stocks were up 14.5% in April, and are off a modest 2.2% year to date. They have held up extremely well as the pandemic has circled the globe.  We are now looking to add in cyclical companies, whose share prices have come under extreme selling pressure, and as the recovery takes hold, I expect there to be considerably greater price appreciation.  As we have discussed in the past, holding adequate cash and other liquid reserves in times like this is critical to riding out the storm.  I’m optimistic that medical science will get us out of this, and a vaccine and effective anti-viral will bring us back to life as we knew it.  To get there, I also think we will need to be even more patient than we are generally accustomed to being.  Please do not hesitate to call – we are working from home but connected, on-line and available.

 

Bruce Hotaling, CFA

Managing Partner

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