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Santa is Checking His List

Consider it an early Christmas present.  In the month of November, the S&P 500 rose 1.79% bringing its gains to 5.11% for the year.  The reversal from the prior month was pivotal.  After October’s -6.94% beating, we needed this positive result to avoid having to take an even more cautious stance and raise cash levels.  The stock market has been challenging.

I anticipate that it may take more time for the market to digest the selloff that began in early October. My hope is that we have seen the worst of it, but the 200-day moving average is in a downtrend, and that is not a healthy indicator.  I also expect some earnings revisions to begin to temper investor enthusiasm, possibly spurred by the poorly performing energy stocks and fall-out from the trade war.

There are a handful of disparate circumstances unfolding that may become problematic.  The oil patch is in disarray, and oil prices are in a freefall.  Over the last month, prices have fallen by 25%.  However, according to FactSet Research, the energy sector is expected to report the strongest earnings growth (+24%) for 2018 of the 11 S&P 500 sectors.  That’s an interesting contrast.  Historically, there has been an extremely high correlation between oil prices and earnings estimates from the energy sector. Therefore, oil prices are possibly foreshadowing a notable decline in the earnings forecast from the energy sector.

The housing industry may already be in a recession, with all manner of housing-related data (new home sales, housing starts, buyer traffic) showing signs of weakness.  Housing stocks have done poorly.  The mortgage lending business is now dominated by non-bank lenders, which are responsible for more than 52% of the $1.26 trillion in originations in the first nine months of 2018 (WSJ 11/22/18).  The affordability of certain markets has made buying difficult.  Further, the interest rate increases by the Federal Reserve are causing many potential buyers to take pause.

Corporate debt is another concern. The volume of corporate debt has more than doubled since the financial crisis of a decade ago.  Credit rating agencies (Moody’s and S&P) have been actively downgrading debt issues to low or below investment grade.  The primary concern is the waterfall effect from rising downgrades and defaults.  The recent plight of GE is a poster child for this issue, and this is a problem that could spread like the plague.

While investors have celebrated recent US profits and economic strength, the above-trend growth rates are unsustainable. Growth rates in 2018 (20%+ EPS and 2.8% GDP) are skewed by tax changes, government stimulus, and other non-recurring impacts.  Importantly, a growth reset (5-8% EPS and 2.4% GDP) should be more than sufficient for markets to continue to advance.  In my opinion, 2019 will deliver growth for stock prices, though expectations will need to be tempered.   Dividend yield may become a more important component of the total return than in 2018.  

My thinking is to remain focused on US growth stocks but to pare back some of the higher-growth and higher-priced names.  The style that may be most suitable for a flat or even declining earnings growth environment is referred to as growth at a reasonable price (GARP).  We intend to focus on stocks that have stable growth rates, pay a reasonable dividend, and are not overpriced (on a P/E basis) in relation to both their peers and the market as a whole.

US financial assets have dramatically outperformed the rest of the world in 2018.  Many investors are convinced that investing funds in regions, sectors or asset classes for the sake of diversification is a good thing.  On the contrary, I believe it’s is more important to make investment decisions utilizing reliable information on the companies that we believe have merit and closely monitoring our exposure.

As we close out 2018, we are actively reviewing portfolios to take advantage of tax loss selling.  It has been a challenging year, and we have purposefully taken gains in stocks that have outperformed over the last several years.  We are all available to discuss this with you or to review your portfolio if we have not been in touch recently.  We wish you and your family a wonderful holiday season and best wishes for a prosperous and peaceful new year.

Bruce Hotaling, CFA

Managing Partner

Trick or Treat

October, the month of Halloween and two of the most memorable stock market crashes, can be a scary time.    Fear is often considered the most powerful and uncontrollable human emotion.  When it ignites, the primal human survival instinct takes over and reason and logic go out the window.  This year’s October was no exception, and investor fear levels are clearly on the rise once again.

Stock prices for the month of October fell 6.94%, bringing the year-to-date total return of the S&P 500 down to an unsatisfying 3.01%.  For some context, February (-3.89%) and March (-2.69%) were also difficult months in which to own stocks.  From January 26th to the April 2nd low, stock prices fell over 10%.  The recent drop, from September 20th to the October 29th low, was 9.8%.  Both were uncomfortable drops in price and can be labeled corrections.  Seasoned investors often consider corrections a necessary evil when one chooses to commit financial assets to the stock market for the long run. 

The market’s behavior in October was unusual.  For example, of the 23 trading days in October, 16 saw negative returns.  There were 5 days on which prices rose more than 1%, and 5 days when prices fell more than 1%.  According to Bespoke Research, October 30 marked the end of a 28-day run for the S&P 500 without back-to-back days of positive returns; the preceding occurrence of this phenomenon dates back to World War II.  Stocks have recently struggled mightily and lost ground.  My concern is stock prices themselves are often considered the most telling indicator of future stock prices.

Of course, the stock market is made up of a vast array of companies occupying different sectors of the economy.  Different stocks have characteristics that cause them to respond differently to the same events.  For example, stocks that fared best during October were ones that had the highest dividend yields, the highest level of international revenues, and the poorest Wall Street analysts’ ratings.  Consumer staples and utilities were the only two sectors with positive performance. 

In my opinion, the increased agitation in stock prices may be an early signal of an earnings deceleration. This will likely be coincident with slowing economic growth and possibly even a recession.  For example, expectations are for earnings growth of 10% in 2019.  This is a reduction by 50% of the 20% growth we’ve experienced in 2018.  By mid-2019, investors will fixate on earnings projections for 2020, and those figures will probably be impacted by several factors.   For example, the trade war is causing higher costs for some US companies as a result of higher tariffs, longer lead times, and broken supply chains.  In addition, hints of inflation and indications that wage pressure is building will likely lead the Federal Reserve to continue on its current course of restrictive monetary policy.

Consumer confidence (at the moment) remains extremely high, both historically and in absolute terms.  This is a good thing, at least for now.  The confidence levels reflect the fact that jobs are available and people with jobs are out spending money.   There is still some punch in the proverbial punch bowl, and that could extend what has already been a prolonged economic run.  Given that we live primarily in a service-oriented economy, the historical cycles of older industrial economic cycles do not necessarily work as a barometer.  There may well be more room to run, but according to Bespoke Research, when consumer confidence has peaked historically, we tended to be at the early stages of a recession.

In my opinion, stocks are still the asset class of choice.  The backdrop is the same as when the speed limit on the freeway drops from 75 to 55 and suddenly you feel like you’re crawling along; the freeway still beats the back roads for a long road trip.  We will need to quickly become accustomed to the new rate of economic growth and the new market place and likely pivot to a more value-oriented stock selection approach.  Expected returns from stocks may well be lower going forward than they have been since 2009.  Our work is to choose the best stocks to own as the future characteristics of the market become clearer.  I am happy to discuss this with you in greater detail if we have not spoken recently.  Please feel free to reach out.

 

Bruce Hotaling, CFA

Managing Partner

Casting About

Stock prices, as measured by the S&P 500, rose 7.7% during the third quarter and are now up 10.5% year-to-date.  These returns are generally in line with historical returns.  Stock prices did jump 21.8% in 2017, but over the last 30 years, stocks have averaged 12.1% annually (1988 – 2017) with a standard deviation of 17.2%.  Based on these figures, the stock market is in “business as usual” mode.  It generally produces returns for which investors, at the end of the day, are rewarded for the risk they undertake. 

That said, investing in the stock market (or staying invested) has always been challenging.  For example, in recent memory, stocks fell 37% in 2008, 22% in 2002, 12% in 2001 and 9% in 2000.  The message is that the average returns of the stock market are available, but to capture them requires a willingness to endure some discomfort and avoiding the impulse to completely disinvest.

Many people are anticipating some type of disruption, as the record bull market grows long in the tooth amidst heightened levels of political turmoil.  Some are casting about for the next sign of trouble.  This could be a peripheral economic indicator or an exogenous shock – something unpredicted that ends up influencing the economy and, ultimately, the financial markets.

Unknown risk factors are difficult to identify and can take control of the markets in a blink.   For example, on October 19, 1987, the Dow Jones Industrial Average fell 22 percent in one day!  It may have been the experimental use of portfolio insurance (program trading), inefficient stock market technology, the huge budget deficit, or who knows what else.  These and other factors led to panic on Wall Street.  That was thirty-one years ago, and while the stock market has evolved enormously since then, we are curiously no better equipped to predict a crash today than we were on Black Monday.  

On a macro level, there are valid concerns such as the national debt and student loans.  The national debt is approximately $21 trillion.  Interest on the debt is rising quickly.  A recent report by the Congressional Budget Office shows that the fastest-growing federal government expense is the interest on our debt.  The expected bill for 2019 is $390 billion, which is 50% more than in 2017.  The report projects the US budget deficit to expand from 3.5% of GDP last year to 9.5% by 2048.   Student loans now rank as the second-largest category of consumer debt (behind mortgages) with a total debt of $1.5 trillion, and 10.7% of the 44 million borrowers are 90 days or more delinquent. (Forbes 6/13/18)

On a more fundamental level, the housing and banking sectors typically do well when the markets are healthy and anticipating growth.  Though the stock market continues to trend higher (20 of the last 22 months), these very two sectors are demonstrating notable weakness.   Weakness in the housing market is evidenced by the CaseShiller Index, which has fallen to its lowest level since March 2010. The malaise in the banking stocks may be due to troubles banks are having securing and paying for deposits – which ultimately impacts their future profitability.

On the contrary, the 2017 Tax Cuts and Jobs Act has clearly spurred a robust inflection in corporate earnings, and this is moving stock prices.  Currently, the aggregate CY 2019 earnings estimates for the S&P 500 are $178.  Using an 18x (trailing PE ratio) multiple on $178 in earnings, would put the S&P 500 at $3,200 at the end of 2019.  Investors using these figures (based on the current quarter-end price of $2,914) expect a 10% return from stocks in the coming year, which is on par with historical averages.

In my opinion, the stock market (from a fundamental perspective) is not cheap, but it is certainly not overpriced, either.  According to FactSet Research, the current forward P/E ratio is 16.8x (based on the above earnings forecasts) versus a 5-year average of 16.3x.  The risk is a deceleration in earnings and/or a compressed multiple.  These are not new worries – they simply feel magnified by the remarkably emotional and politicized haze through which we now view and filter news.  Unable to attach market significance to odd behavior and mistruth, we will rely upon fundamental and technical factors and hold a steady course for now.  I am happy to discuss this with you in greater detail if we have not spoken recently.  Please feel free to reach out.

 

Bruce Hotaling, CFA

Managing Partner

Like a Hawk

2018 has been a profitable year to invest in US stocks.  Apart from a sudden drawdown early in the year (stocks fell 3.89% in February and 2.69% in March), stock prices have moved upward at a fairly reliable rate.  August saw prices rise 3.03%, and the S&P 500 has generated a 9.94% total return year to date.  In the 21-month span since the November 2016 election, stock prices have risen in 19 of those months for a cumulative return of 36.59%.   In spite of a record long bull market for stocks, there is a level of discomfort, like we are playing a high-stakes game of musical chairs. 

The discomfort stems from the charged backdrop.  Daily news paints a picture more reminiscent of a reality TV show than what we became accustomed to growing up with Walter Cronkite and David Brinkley.  The tension may only continue to increase.  September is historically the worst performing month of the year and often the most crisis-riddled as well.  Ten years ago, on September 15th, Lehman Brothers declared bankruptcy, setting off a months-long decline in the markets.  Seventeen years ago, on September 11th, four coordinated terrorist attacks on the United States caused the stock market to close until September 17th and when it reopened, the S&P 500 lost 11.6% over the ensuing five trading days.

The strength in US stock prices since the November 2016 election can be attributed to many things, including somewhat remarkable corporate tax cuts, a hands-off regulatory approach, low interest rates, low wage growth and a period of global economic stability.  These factors have all led to a remarkable inflection in corporate earnings.  During the period 2013 through 2016, earnings grew, but at a modest 2.4% rate.  According to FactSet Research, earnings are expected to grow 20% in 2018 and 10% in 2019.  Wall Street analysts who forecast earnings are maintaining their optimistic outlook for the future.

From a fundamental perspective, as impressive as this growth cycle has been, the forward P/E multiple on the market is 16.8x, only slightly higher than the 5-year average of 16.3x.  We have a situation where stock prices are hitting record highs, but stocks are not overly expensive from a fundamental viewpoint.  This, like so many aspects of investing in the stock market, is nuanced.  The relative attractiveness of a stock, or the stock market as a whole, is tied to investors’ subjective interpretation of the marketplace. 

In the shadow of the market’s recent strength, there are some indications change we are watching closely.  The Federal Reserve continues to normalize (raise) interest rates and de-lever its balance sheet.  Often times, a rising rate environment can be challenging for stock prices.  2019 GDP forecasts have fallen.  Much of what caused the recent surge in economic activity has now run its course.  Markets around the world are beginning to show signs of slowing.  The emerging markets have been in a bear market territory for months and a high US dollar will challenge their ability to repay dollar denominated debt.

Some investors have pre-emptively begun to transition to more risk-averse positions in defensive stocks with low valuations and high dividends.  While not unreasonable, the growth stocks that anchor our investment style have led the market in 2018 and I expect this to continue, for the near term.  We will watch closely on September 26th when the industry classifications for many influential stocks will be changed, thus effecting the industry makeup of the S&P 500.  Stocks such as Alphabet and Facebook are leaving the technology sector, and Netflix will leave the consumer sector to become part of the new communications services sector.  Prices may experience some turbulence while the ETFs and mutual funds are rebalanced.

                At this juncture, I think the best course of action is to watch closely and review our target asset allocation.  The atmosphere on Wall Street is a juxtaposition of fear and unconstrained optimism.  This is often referred to as climbing the wall of worry. I suggest we stay close to our target allocations to stocks.  For many this may involve some profit taking, as many of our growth stocks have seen outsized returns over the last few years.  In the meantime, please feel free to call if we have not been in touch recently.

 

Bruce Hotaling, CFA

Managing Partner

The Beat Goes On

Stock prices, as measured by the S&P 500, rose 3.6% in July and are now up 6.5% year to date.  In my opinion, these are reasonable (not too hot, not too cold) considering the backdrop.  Take a look under the hood, and things don’t look too bad.  Market breadth (measure of advancing stocks relative to declining) is fair, with 60% of the S&P 500 above its 50-day moving average.  Strength among the tech stocks has been extraordinary, and they have contributed the lion share of the market’s gains.

Impressive 2Q earnings reports serve as the foundation of these gains.   According to FactSet, 80% of S&P 500 companies have reported earnings surprises and 74% revenue surprises, the highest percentages since FactSet began monitoring them in 2008.  The valuations (P/E ratios) of stocks across the board have been falling as a result, making the fundamental backdrop of the stock market that much stronger.  Results are balanced, with all sectors showing positive earnings growth.

Some of the strength in recent numbers may be due to companies front-ending their sales in order to beat the coming tariffs.  This may lead to a reciprocal slow-down, but that will reveal itself in the coming quarters.  Stock buybacks, when companies retire (buy back) their shares and allocate profits across a smaller number of shares, typically boost share prices.  The recent spate of buy-back announcements led year-end expectations to top the $1T mark for 2018, a nearly 50% increase over 2017.

Apple, for instance, repurchased $43.5B in the first half of the year.  For comparison, Ford’s entire market cap is $40.1B.  This was partly due to the tax overhaul, enabling repatriation of overseas dollars at tax rates between 8% and 15.5%.  Further, chapeau to Apple, the world’s most valuable public company, and the first stock ever to reach $1T in market cap.  A few others nearing the $1T mark, with impressive year-to-date returns are Amazon (59%), Alpahbet (Google) (19%), and Microsoft (27%).

Record earnings, stock buybacks, and buoyant stock prices aside, many investors are walking on eggshells.  This is not surprising, as most would agree that the backdrop is difficult.  The divisive tone of much of the news flow forces investors to soldier on.   Our goal is to rely upon indicators with some degree of measurability to watch for tides that begin to turn.   When that time arrives, we will look to buffer the effects of falling stock prices with higher levels of fixed income and cash.

  We monitor multiple market factors, and any number of them could signal the onset of the next market cycle.  Among them are relative strength and valuation.  Additionally, we monitor interest rate levels, as the Federal Reserve is tightening monetary policy.  Higher rates will eventually stall economic growth.  Home sales have also slowed.   This could be due to rising mortgage rates, a shortage of inventory, or in the US, the recent restriction on deductibility of state and local taxes, and mortgage interest.   Globally, there is rising concern over a bust in the highly speculative Chinese housing market.

The elephant in the room remains the trade war.  The government intends to modify China’s behavior with respect to trade and intellectual property by hitting them with a stick.  Globalization and economic interdependence have positively impacted national economies around the world.  The European Union, initially the Common Market, was formed to establish political end economic stability in an unstable region.  I expect that the impact of the trade war will be greater on consumers’ wallets and US corporate earnings than on anything related to the trade deficit.

One final item, which we will have to confront one day, is the US Congressional Budget Office’s recent forecast for the US annual deficit to exceed $1 trillion in 2020.  In spite of the underlying economic growth, the national debt is soaring and is forecast to exceed $33 trillion by 2028.  Our nation’s leaders do not appear to have considered the negative consequences of too much leverage, and those consequences may unfairly become a political tool.

The market’s strength is enriching investors.  At the moment, Wall Street likes its man in Washington, and that’s that.  We are watching closely for shifts in the indicators and any other clear signs of change, but until then, we march on.  Please feel free to call if we have not been in touch recently.

Bruce Hotaling, CFA

Managing Partner

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