Hotaling Investment Management Proudly Sponsors the 12th Annual Plein Air Festival, Wayne Art Center
En plein air is a French expression meaning “in the open air”, and refers to the act of painting outdoors with the artist’s subject in full view. Plein air artists capture the spirit and essence of a landscape or subject by incorporating natural light, color and movement into their works.
The high point of plein air art came with the emergence of Impressionism in the mid-to-late nineteenth century. Artists of that period who painted outdoor landscapes included Monet, Renoir, Pissarro, Cezanne and Van Gogh. Interest in outdoor painting has remained constant since the twentieth century. Today’s artists carry on the traditions of these past masters by capturing light and movement in landscapes that can only come from seeing the subject outdoors in its natural form.
The last twenty years have seen a resurgence of interest in plein air painting in the United States. During this time, groups of plein air painters began gathering together to paint at single locations or within certain geographic boundaries. These “Paint Outs” are now very popular and give artists a chance to share their talents and creativity with the public and with one another.
Let’s hope March of 2018 was an anomaly. Just as signs of spring were beginning to appear, folks living in the northeast and mid-Atlantic encountered what was likely their first ever cyclone bomb. Exhausted from shoveling snow, they were then clobbered by three more nor’easters in a three week span. It could be we need to place more trust in Punxsutawney Phil’s early February predictions.
The unpredictable nature of these storms reflects closely the unsettled activity in Washington, which is becoming so chaotic it looks to be finally having the effect on financial markets many had feared back in November 2016. Stock prices, measured by the S&P 500, have begun to mimic both the unforgiving nature of recent weather – and the chaos inside the beltway. Stocks fell in March by 2.7%. This is on the heels of a 3.9% decline in February. Year to date, stock prices are down 0.76%.
For some context, over the last 30 years, the S&P 500 has produced an average return of 12.2%, with an annual standard deviation of 17.3%. There have been 5 years (17% of the time) when the return to stocks was negative, and in those years, stock prices fell on average 16.6%. After a larger than average 21.8% return in 2017, stock prices may be reverting to the mean.
On a more granular level, the stock market looks to be attempting to assess the potential damage from a trade war. Old school protectionism is the latest contrivance out of Washington in hopes of making America great again. Restrictive trade, whether it leads to a trade war, will put the brakes on the positive effect foreign competition has on holding down price inflation.
The recent stock price volatility highlights the concern that fractured global supply chains may negatively impact US corporate margins. Free trade is proven to stimulate economic growth. Higher tariffs will eliminate the process of comparative advantage that allows all parties to benefit from globalization. If the root of the problem is infringement of intellectual property rights, then that needs to be addressed directly, without the random and damaging effects of trade warfare.
Recent economic data has not been compelling and the nine year expansion is long in the tooth. Employment levels are high, so high investors have been on alert for signs of inflation. The brutal stock sell-off in early February was ignited due to clear signs of inflation based on reports of increasing wages. Stock investors are well aware, if a cycle of higher inflation has begun, the Fed will continue to raise interest rates.
The yield curve has shifted upward, and flattened. This is a mixed signal. It may well be telling us growth expectations have deteriorated. The Federal Reserve has raised rates now for the sixth time since the first 0.25% hike in mid-2015. Expectations are for 3 hikes this year and 3 more in 2019. Ambitious fiscal spending, at this late point in the economic cycle, will support the Fed’s hawkish position. The ballooning deficit, continued deficit spending and higher interest rates will raise the probability of a slowdown (recession) sometime in the near future.
The other curiosity I’ve discussed before is the perpetual weakness in the US$. It has been in a steady decline since the November 2016 election. The higher interest rates available in the US would support buying dollars. On the contrary, global investors have been selling US$s, and buying yen and euros. It’s not clear what is causing this, though it’s likely related to increased tariffs, restrictive immigration and rising deficits. The persistent US current account deficits are spurring talk the US$ may not be the safe-haven it once was.
The current backdrop is mixed. Earnings estimates remain high and stocks are not excessively expensive with the forward P/E multiple in the 16x range. Volatility has risen, making stocks harder to own. From a contrarian perspective, this is constructive. Yet, if the earnings forecasts falter, for whatever reason, this will spell trouble for stock prices. With the high level of volatility, and two successive down months in stock prices, we are taking a more constructive stance, and will become more cautious if conditions persist. Please feel free to call us if you would like to discuss further or if your investment parameters have changed since we last spoke.
Bruce Hotaling, CFA
Stock prices began 2018 right where they left off in 2017 – measured by the S&P 500, stocks recorded a total return of 5.7% in January. The market’s buoyancy is uncharacteristic. The last true down month in the stock market was October 2016, 15 months ago. The steady month over month returns have in effect hypnotized investors into thinking this ongoing melt up is normal. The monthly variability of returns to stocks in 2017 was 1.1%, the lowest measure our research produced in any year dating back to 1982 (the average monthly standard deviation was 4.2% during that time).
While I am uncomfortable with the pattern of returns, I think there is a fundamental basis for the strength in stock prices; the primary factor being earnings. US corporations are delivering parabolic improvements in earnings, not seen in years. According to FactSet Research, 4Q 2017 corporate earnings reports are outstanding, coming in with a blended growth rate of 13.4%. In the last month alone, CY 2018 estimates for the S&P 500 earnings jumped 5.3% (from $147 to $155), representing the largest increase in estimates over the first month of the year since 1996.
Other factors supportive of the earnings inflection are the surprisingly weak US$ and turbo-charged global economic growth rates. The weak US$ is difficult to understand. Given the backdrop (Fed raising rates, wage inflation), one would expect the currency to strengthen. Equally supportive is a healthy global economic revival boosting economic output and trade. The IMF recently revised its global growth forecast to 3.9% – more customers buying more US made goods.
A fly in the ointment will inevitably appear, and the most likely catalyst of more normal behavior (regression to the mean) from stock prices will be higher interest rates. When rates rise, equity risk/returns often do not look as favorable. The yield on the US 10-year Treasury note rose to its highest level in nearly four years recently. Inflation and unemployment data imply the Federal Reserve will remain on track to raise interest rates throughout the year. The old adage, “don’t fight the Fed” may well lead stock investors to take pause.
The next spoiler to emerge will be skyrocketing US deficits. Estimates are the Treasury will have to borrow up to $955 billion to make it to the September 30th fiscal year end, more than twice the year prior. Lower tax receipts means we borrow more. To induce lenders, interest rates will continue to rise. Higher borrowing costs, on more debt with reduced tax receipts is a prescription for trouble. Akin to a gambler or addict, leadership in Washington has opted for economic (and political) bliss today, at the expense of our children and grandchildren. Eventually, someone will have to make hard choices.
Future investment returns are being pulled forward. On the back of the one-time tax cut benefit, consumers and corporate America have their wallets out. This will spur a flash of growth, but not long-term fundamental growth. Further, expectations are lofty, regulations (financial and environmental) are withdrawn, and animal spirits are now alive unlike any time since the late 1920s or 1990s. It’s no longer a fear of the stock market “crashing” or heading into a downward spiral, it’s now the fear of missing out, the age old driver of unbridled human behavior, greed.
Finally, the market place is changing in ways we cannot foresee. For example, the emergence of ETF’s as primary investment vehicles, the emergence of crypto currencies as the next big thing, and the devolution of asset class correlations have made for a “wild west” backdrop. A melt down, or at least some mean reversion is inevitable. Our hope is that any downturn is measured and stair-stepped. With this in mind, our effort is to guard against foolish impulses and focus our work on the investment policy we’ve discussed and put in place for you. We are rebalancing over exposure to stocks and trimming specific over-weight holdings. Changes to the tax code did not affect the favorable 15% long term capital gains rate. Please feel free to give us a call if you would like to discuss our views in more detail or any changes to your profile.
Bruce Hotaling, CFA
R.s.v.p. Valerie-Clark Roden (610)688-0697 or