Bruce Hotaling

Bruce Hotaling

Spring Fever

The bull market rumbled on in February. Measured by the S&P 500 stock prices ended the month 1.36% higher and are now up 6.6% as of February month end. Over the last twelve months, stocks have returned 13.5%, slightly higher than the long-term averages and stocks have been positive for 9 of those twelve months. From a practical point of view, the month was important in that it worked off much of what analysts refer to as “over-bought” levels, following January’s surge. Many stocks had become too expensive to buy.

Such a long stretch of positive stock returns can eventually have a constructive influence on investor market outlook and behavior. It can be stressful and unprofitable, to continually struggle with fear of an imminent meltdown. What better than to be riding a bull market and to be able to enjoy the ride? My concern is there may be a bout of spring fever working its way into Wall Street’s view of stocks.

According to Bespoke Investment Group, although the 4Q2012 earnings figures were generally above expectations, analysts have been revising their earnings expectations for 2013 downward. In my opinion, while important to monitor, this is evidence of spring fever. It’s not at all clear what it is going to take to make analysts more positive, but for now at least the market doesn’t seem to care. Maybe once analysts turn positive, it will be time to sell. (Bespoke Earnings Estimate Revisions, 3/1/13). Earnings revisions may be an accurate indicator and a sign to lower exposure to stocks. These analysts’ views may also be symptomatic, as I suspect, of spring fever, and likely to remedy itself in short order.

The economic data that Wall Street media pundits fuss over has been encouraging. The general assumption is that there is a natural positive correlation between stock prices and economic data. Assuming that is the case, we can take some comfort in recently reported auto sales, the strongest manufacturing data in 20 months, improving consumer sentiment, job growth and housing data. The sequestration is likely to have some negative impact on the economy, though no one knows precisely to what degree. The elephant still lingering in the room is the federal borrowing limit that has been pushed out until some point later in the year. Persistent economic strength will dampen the impact of the automatic spending cuts, making for a softer landing. We shall see.

If you would like some interesting free reading in support of the positive long-term market outlook, you can go to berkshirehathaway.com and read Warren Buffett’s 2012 shareholder letter. As usual he is full of practical and easy to understand advice. He did us all a favor purchasing Heinz and resetting the valuation bar on most food stocks. He also remains optimistic on rails, an area I have felt strongly about for some time. Lastly, I’m happy to review his assessment of dividends. His view is straight out of the CFA curriculum, where the favored approach is for the investor to choose to sell shares to realize a “cash” return, versus receiving a dividend.

I think dividends are important. The dividend discount model is the gold standard for stock valuation. Dividend yield is an important relative measure and income is real. This is largely different than investing for growth, over time. The appreciation potential from good investments held over extended periods of time is one of the hallmark principals of Berkshire’s market beating results over the years.

An interesting anomaly, revealed by analysis from Bespoke Investment Group, was the dramatic outperformance of “appreciation” over “income” in 2012. The S&P 500 stocks (by decile), with the highest PE ratios were up an average of 29.25%. The worst performing stocks were those with the highest dividend yields, which declined an average of 0.63%. While investors were clamoring for the safety net of dividends, as a defense against uncertainty, they were unknowingly tying one hand behind their back.

Spring fever or not (particularly among the analyst community) my sense is corporate earnings will maintain their positive slope, and PE ratios will continue to rise from their below average levels. I’m a buyer, on the dips.

Finally, we are holding several Pop-Up classes in our Wayne office, in conjunction with the Main Line School Night. Please join us for these educational opportunities and to see our new space. Call Valerie for more details and to reserve your place.

Bruce Hotaling, CFA

Managing Partner

The Bull

Stocks are in a bull market. Measured by the S&P 500 stock prices ended January up 5.04%. The index, at 1498.11, hit its sixth highest month-end close, ever. The five other instances the market closed higher all took place in 2000 and 2007. The highest month-end close for the S&P ever was October 2007 when it closed at 1549.37. So, from today’s level, we are a mere 3.4% from a new high water mark. This bull began running in March of 2009, the low point in the stock market’s response to the 2008 financial crisis. According to Bespoke Investment Group, comparing all the bull markets since 1928, this one has run for 1,425 days (ranking eighth) and the S&P has risen 123.6% (ranking seventh among all bull markets in percent return).

The fundamentals support the market. Recent earnings reports (and importantly, revenue) for 4Q2012 have been well above expectations and recent quarters. FactSet consensus earnings forecasts are $111.6 and $124.1 for 2013 and 2014. The 2014 numbers are quite a ways out and subject to revision, but they set the table for the current bull market to continue on into next year.

If recent money flows into stock mutual funds are to be trusted, popular sentiment toward stocks is in fact beginning to shift. Stock prices (similar to consumer confidence or non-farm payrolls) are a leading indicator. The stock market does an efficient job discounting multiple factors into stock prices. Rising stock prices indicate the investment backdrop is improving and we can look forward to a stronger economy, better corporate revenues and earnings, and ultimately higher stock prices.

While this ought to push prices higher over the long term, in the near term stocks are somewhat overbought. With stocks hitting new highs, it can be difficult to put new money into the market. Under these circumstances, both art and science come into play and patience is of the utmost importance. My conviction for stocks remains high, but I think a good bit of caution is due when approaching the market.

With high hopes that we have finally closed the book on the ill effects of the financial crisis, and with markets poised to hit all-time highs, there are a number of issues worth our attention. One is a persistent level of distrust in the banks (the banking system), particularly in the US and among developed countries. This was reported on recently at the World Economic Forum

in Davos, Switzerland, and in the lead article in The Atlantic (January 2013) “What’s Inside America’s Banks? How Wall Street Could Blow Up the Economy –Again”. This issue has the potential to flair, either from attempts to re-regulate (reinstate Glass Steagall) or worse, another round of negative disclosure and write-downs due to mismanagement of financial derivatives.

On a more business-as-usual level, there are several other things that could shock the stock market 1) the withdraw of accommodative policy from the Federal Reserve, 2) the inability of Congress to implement effective fiscal policy needed to replace the Fed’s stimulus, 3) a reversal in the current improving trend of economic data or 4) some unknown, unforeseen series of events (a black swan) that is impossible for us to attach any probability to, at all. This would include the recent rising trend in natural disasters.

The most critical role, from an investment management point of view is to pay close attention, and to question herd-think. My goal is to determine as quickly as possible whether or not new information merits some asset re-allocation. At a more granular level, we closely monitor the characteristics of our stock holdings and the behavior of their respective sectors. Currently, we are watching a changing of the guard – low dividend and small market cap stocks have outperformed recently, a reversal of what we observed in 2012. On the sector level, health care, energy and financial stocks have become the new market leaders.

After a snappy start to the new year, it’s a good time to take a breath and dial in our focus. I contend this will be a good year for stocks, with new high water marks, and a return of the sentiment lost in the financial crisis. I also think the tendency of the market to become overbought and oversold on a short term basis should be respected. Please feel free to call if we have not spoken or if you have any other questions. Finally, keep your hopes high, as Punxsutawney Phil did not see his shadow today, so we are expecting a shortened winter, at least here in Pennsylvania.

Bruce Hotaling, CFA

Managing Partner

The Picture or the Frame

Welcome to 2013. We here at Hotaling Investment Management, LLC wish you and your family a safe and prosperous new year! We will do our best to work with you to obtain these goals.

By most measures, 2012 was quite a good year for investors. Stocks, measured by the S&P 500 generated a total return of 16%. Bonds, measured by Barclay’s US Intermediate Government/Credit, returned 3.89%. This is a broad look at fixed income returns – and the simple takeaway is that most fixed income sectors did alright last year.

The numbers are now in the books. When the calendar ticked over into 2013, good as the returns were, they no longer matter. Now, by convention, we are collectively focused on what our returns will be for the calendar year 2013.

I am not a big believer in forecasts, so I will not produce a top ten list of prognostications for the coming year. You can find some of the more prominent views (Barron’s Roundtable, Byron Wien or Bill Gross) on-line. Most seers, over time, only generate 50/50 results. Their opinions, while interesting, have limited “investability.”

What I can do is point out certain observations, constraints or opportunities as I perceive them. In my opinion, it is often difficult for investors to hone in on the important stuff, and look through the noise. It is not new information or strategies that make the difference, rather it is seeing and acting on what is already apparent.

  1. Volatility is here to stay. Uncertainty is inherent in investment markets and always has been. Without it, there would be no return potential to investors. When the commentator on CNBC says “markets dislike uncertainty” feel free to turn off the television.
  2. Try not to “love” your investments. As Tom Hanks said in A League of Their Own, “there’s no crying in baseball.” Emotions will only cause problems.
  3. Herd thinking. 2012 produced strong equity returns while in fact most investors were moving money from stock funds into bond funds. The overwhelming tendency is to do what everyone else does. Think about becoming a contrarian.
  4. Taxes are going up. The payroll tax, a new Medicare tax and the new Net Investment Income Tax. They will impact nearly everyone, but will not have any noticeable impact on the investment markets. These are separate from the tax increases/deduction limits agreed to by Obama and Congress in avoiding the fiscal cliff.
  1. Earnings Estimates. Stock prices and earnings are reasonably well correlated over time. Current estimates for the S&P 500 are $113.15 (2013) and $125.11 (2014) per share. Any revision to these numbers is a critical factor to watch relating to the direction of stock prices.
  2. Valuation. The market is trading at 12.8x 2013 earnings estimates, below the 10 year average of 14.2x. A 14.2x on $113.15 implies a $1,600 price level for the S&P 500 or an approximate 10% return from today’s level.
  3. Economic Data. There remains a lot of economic wood to chop. Job growth is stubbornly slow, real income growth is low (declining), and income inequality is growing.
  4. Low Interest Rates. The Federal Reserve has stated its intention to keep rates lower, longer, until true economic growth takes hold.
  5. Marginal Inflation. Labor costs are low. Energy (oil and gas) prices are expected to continue to fall. That’s it.
  6. Cost is critical. Do not overpay. The key sentiment when purchasing an asset is caution, not urgency.

While I am optimistic about the coming year, I think a good measure of patience is in order. Sitting still is OK. Few made their investment riches in one or two trades. We will follow the same tried and true investment process and guidelines we have in the past.

One aspect of our investment process we are improving is our transparency. We are implementing a new portfolio accounting and reporting system called Tamarac that I am confident you will find to your liking. You will be able to view the same reports and analyses we view (if you wish). It will also be available through a client “portal”, allowing you to log in any time you like. This will be in place by March.

In the meantime, please feel free to check in if you have any questions. Valerie, Eileen, Justin and I are always available to take care of you.

Bruce Hotaling, CFA

Managing Partner