Bruce Hotaling

Bruce Hotaling

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

Change is Good

I am proud to announce, as of November 1, 2012, Hotaling Investment Management, LLC has transitioned to an independent investment advisory firm. All of us would like to thank you for your patience and helpful interaction. We have relocated to downtown Wayne, and invite you to come visit our new offices if you have not already. If that is not possible, please visit our new web site www.hotalingllc.com where you can experience a taste of our new presence in the investment management world.

I want your experience of the change in the structure of our business to be seamless. We will both need to become accustomed to some new aspects to our relationship, and we will help bridge this for you. From our end, transitions typically lead to challenges, new learning and ultimately an improved potential. We want to be open to new capabilities in the investment management world that will ultimately benefit you. My overarching goals are to continue to provide you direct access to us, quality investment management and customized financial planning solutions. We are now better positioned to do this than ever before.

Change can often help us step outside our box. It is often easy to slip into thought habits, or put on someone else’s blinkers. For example, even though we are confronting a list of global and domestic issues and most investors sense a high degree of anxiety, 2012 has been a good year to be an investor. Stocks and bonds have produced attractive returns. The S&P 500 has returned 14.9% through the end of November. To put this year’s results into some context, the average price return for the S&P 500 dating back to 1929 is about 7%. The average for the past 10 years is about 3%. These figures do not include dividends or the re-investment of dividends.

Change is ever present. At the moment, some investors are uncomfortable with what has been dubbed the “fiscal cliff” and it has become a bit obsessive. We owe this to a large degree to the media. The media’s ability to define the issues we face is extraordinary. This is vastly different than simply reporting the news. The choice of language, the nuance and the frequency of the message all have impact on our views.

My opinion is that the policy makers will resolve the tax and budget complications. While it is as politicized as ever, it is solvable. When we are on the other side of the “issue” looking back, like so many times in the past, it will seem so much less than it does at the moment. Markets reflect perpetual uncertainty. This has been the case throughout history. No outcome has ever been comfortably known, in advance. As soon as the most pressing concern of the day is resolved, another will take its place. It never gets “easy.”

Current economic data (home prices, employment, auto sales) shows signs of positive change – and the most important aspect of economic data is its directionally, not its absolute level. Corporate profits and thus earnings remain solid. Stocks look well priced (though not cheap) and are likely the asset category of choice for the next 12-18 months. Board room discussions today have to do with return to shareholder – things such as dividends and share buy-backs. Potential tax law changes will likely not have a dramatic impact on the investment merit of these discussions. Cash on balance sheets is high, and interest rates are low. You will likely hear of companies issuing debt to fund dividends, something unimaginable 4 years ago.

Investment grade corporate and municipal bonds look expensive to me. If you own bonds, by all means hold on to them, but at the moment, its no place to shop. Other sources of income such as higher yielding corporate bonds and certain real estate investment trusts are more attractively priced.

Patience in markets like these is of the utmost importance. As a rule, it is better to “sit on cash” than to over pay for an asset. Warren Buffett, who needs no introduction, commented on owning stocks over the last 100 years, “You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.” (NY Times, October 16, 2008) Though it is extremely difficult, we want to be sure we do not feed into the sentiment of the day.

Please feel free to check in if you have any questions or would like to review you portfolio prior to year end. Valerie, Eileen, Justin and I are always available to take care of you.

Bruce Hotaling, CFA

Managing Partner