Bruce Hotaling

Bruce Hotaling


It’s July 4th, 2017, 241 years from the day the Continental Congress adopted the Declaration of Independence, declaring the 13 American colonies to be independent from Great Britain.   For me, I cannot believe both the bravery and the foresight of the men who crafted the Declaration, the Constitution and the Bill of Rights.  So many things could have turned out differently, and yet, here we are, celebrating our independence.   

This year, stock investors can also celebrate what has been an exceptional first half of the year.  Returns to stocks, measured by the S&P 500, have produced a healthy total return of 9.34%.  One prominent aspect of the stock market this year has been the tail-wind for growth stocks, as opposed to value stocks.  This plays to our strength as we have been steadfast growth at a reasonable price investors for years.

Year to date, the technology sector has produced returns nearly double the next best sector, an impressive run.  Prices wavered some in late June, but I expect their leadership to continue.  The sharp end of the technology stick is referred to as FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) – and all have shown sensational returns this year.  Other pockets of strength include financials, where the banks are benefitting from favorable capital requirements, spurred by the heads of the European and US Central banks.  We have also seen attractive returns from healthcare stocks, likely indicating the market anticipates a more favorable business environment.  Bringing up the rear is energy.  In my lay opinion, there is simply too much oil out there, and demand looks suspect. 

On the economic front, growth is ok, but not by much.  Q1 2017 GDP came in at 1.2% annual growth, following a 2.1% reading for 4Q 2016.  My tarot cards do not include an inflation card.  It’s the equivalent of a child’s monster under the bed – scary but not there.  The Federal Reserve is staying with its script, raising rates and unwinding its balance sheet (tightening).  There are plusses and minuses that do not add up.  Energy prices are low, pleasing at the pump but bad for igniting capital spending.  The dollar is low.  This may boost exports, but conversely may raise prices on imported goods.  I am not convinced we will see strong enough economic data to support a steepening in the yield curve.

The market has shown a high degree of complacency since the election.  This will change, eventually.  There is the idea that great athletes have a high tolerance for physical discomfort.  I’m curious if that is a common characteristic for great investors too.  Can they remain even handed in a highly discomforting environment?  And for how long?  An observation of our current society is how uncomfortable with discomfort people are.  When something unpleasant arises, there is often a need to immediately re-direct, to take some medication, or do something to put the discomfort to rest.

Until the complacency lifts, we have a reasonable backdrop: the economy is standing on its own two feet and earnings growth is in the low double digits.  This “just so” scenario is allowing stock prices to rise.  The market seems to have given up any expectation of anything constructive from Washington DC.  In fact, the opposite may be true at this point.  If Washington DC does in fact do something, other than tweet, it may serve to disrupt what has become an acceptable status quo.  There is a watch what you wish for aspect to our current situation.

Looking ahead, my expectation is for the stock market to mark time, and then show some strength later in the year and into 2018.  I am optimistic on the earnings front and believe this will support stock valuations. I do not think we will see a substantive rise in interest rates, and therefore, I am neutral on tax free and corporate bond markets. I think they are relatively safe, and returns will be mediocre. Obviously, if any of these factors change, my opinion as to how best to invest will change and I will relay that to you. In the meantime, please have a peaceful Fourth of July and if you think of it, take a moment to pause and reflect on the amazing movement that began here in Philadelphia, all those years ago.

Bruce Hotaling, CFA

Managing Partner

Connect the Dots

The S&P 500, the popular measure of U.S. stock behavior, remains firmly in bull territory. The month of May saw a total return of 1.4%, and the market is now up 8.6% year to date. Stoic stock investors have been rewarded. It is remarkable we have seen only two days this year when the prices swung down more than 1%.   This highly complacent market has a lot of investors shaking their heads in some bewilderment, unable to make sense of the behavior of stock prices in relation to the often hard to fathom events taking place around the world.

On the positive side of the ledger, the fundamental backdrop is reasonably strong. The powerful earnings recovery we observed in 1Q 2017 will likely continue. Corporate America is on fire and this has been driving stock prices. Earnings have been bolstered by robust manufacturing data at home and surprisingly strong business conditions from around the world, Europe in particular. The US$ has been falling relative to other currencies, and is now back below its pre-election levels. This improves demand for U.S. goods and services. The Federal Reserve is on track to raise the Fed Funds rate, its messaging has been clear, and at the moment the stock market is ok with that.

The stocks behaving the best in this market are in our wheelhouse. Generally referred to as growth stocks, these are stocks showing consistent improvements in revenues, margins and profits. Large cap growth stocks (measured by the ETF IVW) are up 14.9% year to date, head and shoulders above large cap value stocks (measured by the ETF IVE), which are up 3.7% year to date. To a certain extent, large cap technology stocks have been driving the parade. Stocks like Apple, Amazon and Facebook are all up over 30%. Market cap and a high percentage of international revenue have been positive factors. Also, typical of a momentum market, stocks that have been doing well are continuing to do well. Valuation, measured by P/E ratio, has fallen due to robust earnings, leaving the door open to further appreciation.

On the flip side, interest rates and energy prices may be flashing warning signs. Short term rates will rise with the anticipated increase in the Federal Funds Rate. On the long end, the benchmark US 10-year Treasury note is currently yielding 2.1%, its lowest level since the post-election bump. The drop in rates may be signaling a declining growth outlook for corporate America. It is not clear, yet. Worse, a flattening yield curve can precurse an inverted yield curve, which investors typically link with a recession and often a bear market. The energy patch is also worrisome. The horrendous drop in energy prices starting in 2014 led to utter havoc in multiple areas of the market. After largely stabilizing in the $50 bbl range, prices are falling again. Rising rig counts, discord in traditional oil producing countries, and the economic disruption caused by the US fracking industry are all at work here.

Possibly most difficult to read, and interpret in any meaningful way is the narrative. The news flow out of Washington is unsettling. This creates a musical chairs sense of mistrust. Importantly, it also causes greater mistrust among our traditional partners around the world, with respect to economics (trade), defense sharing arrangements, and most importantly, the environment. Wall Street continues to look through the noise. My concern is that when the troubled times inevitably arrive, as they always do, we do not have the strength in leadership required to reassure nervous markets and allow them to re-set.

Though the path forward is never clear, I have the feeling we are tap tapping along like a blind man with a long cane, principally concerned with identifying where not to step. This makes for cautious progress, at best. Defending against the arrival of a black swan is expensive, in money terms, and is purely a guessing game. I suggest the logical way to proceed is to watch for the beginnings of a change in trend, and to pro-actively take profits (sell) if the market begins to trend down. While we take this on, I would like to catch up with you if we have not spoken recently.

Bruce Hotaling, CFA

Managing Partner

Unchartered Water

Returns to investors in both stocks and bonds have been surprisingly positive this year. We are only one third of the way into the year, yet stocks and bonds have already generated returns the equivalent of what many were hoping would be the final result for 2017.  What surprised many, a post-election growth buzz, seems to now have run its course.  It remains altogether unclear whether stock prices moved as they did due to unfounded optimism, or in anticipation of what may be a remarkable upturn in corporate earnings. 

After a slight falter in March, the S&P 500 returned to its winning ways in April, advancing 0.91% for the month.  Through the end of April, the benchmark has generated a total return of 7.16%.  In my opinion, the sturdy year to date returns have mostly to do with earnings (including a tempered US$, stronger exports, steeper yield curve and a normalized $/bbl oil).  There was evidence of an inflection in Q42016, and Q12017 results have been remarkable, to say the least.  The blended earnings growth rate is 13.5%, which if it holds will be the highest year over year earnings growth for stocks since Q3 2011.  According to FactSet Research, as of May 5, 2017, 75% of S&P 500 companies had beaten Wall Street analysts’ mean earnings estimates.

As is typically the case, not all stocks are in favor at the same time.  Since the beginning of the year, companies with growth characteristics have been outperforming companies with value characteristics, largely reversing the value tilt the market adopted early in 2016.  For investors like us, this is a tailwind, as we have traditionally focused on US companies that for various reasons are able to sustain an above trend growth rate.  Sectors reporting the best earnings include information technology, health care and the financials.

The primary drivers of the earnings renaissance, and thus the accelerated returns to stocks, are many.  First is the employment backdrop.  Jobless claims are the lowest they’ve been since the early 1970s.  This in turn may provide a platform for wage growth.  Wage growth is critical, especially in certain segments of the economy, such as improving the ability of millennials to form new households.  An uptick in spending ultimately could light the fuse for some future inflation.  Rising asset prices are “normal” and expected in a growing economy and incent consumers to act.  The Federal Reserve has signaled its intent to continue to hike short term rates, indicating it supports this thesis.  Finally, the tempered strength in the US$ has helped as there is evidence of improved exports to some of the strengthening economies around the globe. 

The other side of the coin is akin to North Atlantic shipping lanes clogged with icebergs.  On a fundamental level, stocks are nearly fully priced.  Earnings must continue to expand.  Expected returns to bond investors, in a rising rate environment, are likely already in hand.  Geo-political risks, though hard to quantify, must be nearing a high water mark.  The typical safety net of leadership and statesmanship is not apparent based on the news flow, an odd place for a country like ours to find itself.  The much manipulated growth narrative is suffering from policy paralysis – there is no game plan – nothing is getting done – and no one knows what to do about it.

I think it is a prudent time to take a more cautious stance, and as I have said before, drive with one foot on the brake.  While I do not think we should re-allocate (as stocks still have the highest expected returns) we ought to take profits in positions with outsized returns.  My preference is to pay some capital gains taxes on realized gains, rather than allow the market to take those gains back.  Our emphasis remains on a more discerning investment management approach, utilizing our fundamental and quantitative tools to help select individual opportunities to make money, versus owning the market, or segments of the market that may, or may not maintain favor. 

I ask that you please call us if we have not spoken recently.  It’s an appropriate time to review your asset allocation and we can take some time to have a more detailed discussion as to the best path for you going forward.


Bruce Hotaling, CFA

Managing Partner

Bear Trap

Stock prices, measured by the S&P 500, generated a meager 0.1% total return for the month of March. After January and February, when prices were clearly punching above their weight, things began to taper off.  The change seems largely due to the relentless circus underway in Washington DC.  At its height, optimistic and often fallacious tweets stoked investors.  Recently, reports of corruption and self-dealing have thrown a wet blanket on the party.  Normally, with the total return to stocks up 6.07% for the first quarter of the year, folks would be heading for the car dealership.  Instead, bullish investor sentiment has dipped to the lowest level since the election. 

Year to date, results have been driven by strong results from the technology sector (+12.4%). Consumer discretionary (+8.2%) also outperformed, but only when the extraordinary performance of Amazon is factored in.  According to Bespoke Investment Group, Amazon was responsible for one-third of the sector’s gain in Q1.  This is astonishing considering 6 of the 10 worst performing stocks in the S&P are from this sector, most of which are retail stores you know.  On the losing side of the equation, energy was -7.2%.  This was a surprise, as crude and especially natural gas prices struggled throughout the quarter.  In 2016, the energy sector returned 42.6%.  If there is a silver lining here, it’s the sky-high incidence of M&A in the energy sector.  According to Deallogic.com, corporate transactions in the oil and gas space totaled $96.7bn through March, the highest level ever.

From a fundamental perspective, not a lot has changed since last month’s letter.  Expected aggregate 2017 earnings for the S&P 500 now stand at $131, and the index is in the 2,350 range.  More importantly, estimates for 2018 are in the mid $140’s, according to data compiled by FactSet Research.  These numbers do not include any upside that might result from either fiscal stimulus or tax cuts.  Until the 2018 estimates become more viable, and unless stimulus comes to pass, the market as a whole is fairly priced.  The complacency that initially lulled investors as stocks began their end of year lift off remains firmly in place.  I recommend buying and owning only a select portfolio of stocks, as opposed to buying the market.  

The macro backdrop is murky, only because more can go wrong than right.  Stocks are clearly the best house on the block and near term, I expect earnings to hold up.  Inflation is modest, and that’s important for stocks since high inflation typically suppresses the market’s P/E ratio.  Keep in mind, the Federal Reserve did raise the Fed Funds Rate for the second time in four months.  Bonds and bond proxies have been under the thumb of a threatened steepening yield curve.  A drag is the continuing high value of the US$.  And, labor markets are at full-employment. It’s difficult for any government to effectively stimulate a full-employment economy, with a limited (or likely shrinking) labor supply and the intention to replace technology (productivity) with good old fashion labor.

The threats to a favorable outcome are many, and highlighted by the illogical talk of reviving the coal industry. The whole idea that this industry is relevant or will produce meaningful jobs is misguided. Coal is a dirty resource in an irreversible state of structural decline.  According to Morgan Stanley Research, coal production from 2014 – 2018 is expected to be down 67% in Central Appalachia and 19% in Northern Appalachia.  Natural gas is the leading source of power generation in the US, and it is transported via pipeline, just imagine that.

I think we need to proceed with caution here.  In Wall Street parlance, a bear trap is a head-fake, an indicator that the bull market has or is about to reverse course. It induces investors to sell, while the market continues its upward trend.  This has sadly been the case for many investors unable to stomach the swamp 2.0.  We’ve become conditioned, with the trauma of 9/11 and the financial crisis clear in our memories.  Fear can often be an unmanageable emotion, and lead to regrettable decisions.  My suggestion, for now, is to wait until the market begins to show us it wants to change course, rather than making premature guesses.  Please feel free to call me if you would like to review your asset allocation and the best path for you going forward.

Bruce Hotaling, CFA

Managing Partner

Spilled Milk

Stock prices have been on the move. Many investors firmly believed that if the election went the wrong way, stock prices were destined to tumble.  Since that infamous day back in November, to the utter exasperation of those same investors, stock prices (measured by the S&P 500) are up a total return of 11.22%.  Year to date, the total return to stocks is 5.94% with February contributing an impressive 3.97%.

The upward move has in fact coincided with a flourish of positive economic data.  According to Empirical Research, much of the recent strength in stock prices can be attributed to improving economic fundamentals, as evidenced by the recent spike in the PMI index.  The PMI is a widely accepted indicator of current business conditions in the manufacturing sector.  In support of the manufacturing data, the employment data is equally strong.  According to Bespoke Research, jobless claims have fallen to their lowest level since 1973.

Although the run in stock prices has coincided with strong economic data, there is more.  Stock prices have also benefitted from a newfound optimism over proposed tax cuts, deregulation and an infrastructure build-out.   Expectations have run amok.  To date, there is nothing that has happened on the fiscal policy front to support the heightened fervor pushing stock prices higher.  There is a notable void of detail and a surfeit of spin.  The timing and ultimate impact of any proposals is either unknown or carries the greater risk of disappointing the markets with a failure to deliver.  True policy is needed to implement any changes and with the degree to which the messages are mixed, one wonders whether there is an intractable void in competence.

Against this disconcerting backdrop, there is some basis for sitting tight.  According to FactSet, earnings estimates look to have stabilized at $130 per share for 2017.  Earnings are perpetually subject to revision by Wall Street analysts, and almost always downward, as initial optimism fades.  For 2018, consensus estimates for the S&P 500 are now a lofty $145 per share, an 11.5% increase over 2017.  This would be the biggest bump in earnings since the 15% leap from 2010 to 2011.  One comment that has attracted some attention is the speculation that these earnings can be obtained without the benefit of any of the planned stimulus. 

Stock prices may well manage to trend for some time, if only due to the fly-wheel effect.  By many measures, stocks are overbought and sadly the alternatives are either overpriced, or don’t offer any substantive return.  Investors are caught between a rock and a hard place.   According to Bespoke Research, the advance decline line has tipped downward, meaning fewer stocks are behaving well, even though the market continues to rise.  This is not a great sign for the bulls.

The present risks include the fact that the Federal Reserve has said it will be raising interest rates.  This has historically made it difficult for both stocks and bonds (don’t’ fight the Fed).  In addition, there is the pervasive tail-risk, the risk of an extra-ordinary event or tweet that leads to an avalanche of unintended consequences.  Finally, the failure to implement on the promised policy agenda, and ongoing political contagion, will begin to disappoint investors.

In my opinion, it’s no time to be a hanger-on.  I think we can take some profits in stocks that have gotten ahead of themselves.  Technology, healthcare and financial stocks all come to mind.  On the other hand, some stocks in the energy and real estate space have been bringing up the rear and look as though we can add to positions.  The level of complacency among market participants has been high, and as once reluctant investors are pulled in, the risk increases.  This sets the table for some challenging times when some selling inevitably begins.

Overall, my expectations run similar to last month: guarded and without window dressing.  For the remainder of the year, I expect average returns from stocks and below average returns from bonds.  My worry is a good portion of these average returns have already arrived, and the rest will be delivered on the back of greater than average volatility and unrest in the financial markets. 


Bruce Hotaling, CFA

Managing Partner