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Tariffs and Taxes

Stock struggled in May.  As measured by the S&P 500, prices fell 6.58%, and the year-to-date return to the benchmark now totals 10.74%.  This comes as something of a shock after four successive months of hefty   returns.  The market’s historical pattern of giving steadily, and taking-away quickly, is clearly evident.  Since the November 2016 election, on three occasions, stocks have somewhat violently taken back virtually all the prior period’s gains.  Stocks were routed in February 2018, in December 2018, and again in May of 2019.  On one hand, this could be considered normal volatility in the market place.  On the other hand, this “triple top” formation is considered a warning sign by technical analysts. 

The 800 pound gorilla investors around the world are now contending with are tariffs.  Since the 1930s era Reciprocal Tariff Act, successive administrations have used their authority to liberalize trade, promote economic growth and strategically de-risk regions and relations.  This has all changed.  The justification now being distributed is that increased tariffs will help the US win, they are a counter to national security threats, and they will force our foes to the bargaining table. 

The consequences for the American consumer is they either forego buying certain products, or pay more for them.  Tariffs are a burden on US businesses in multiple respects, through higher input costs, loss of market share, or the elimination of businesses as the tariffs make them unprofitable to continue.  Farmers, particularly soy beans, pork and cotton, have seen their businesses stall.  The sad truth is that the bounty from the Tax Cuts and Jobs Act of 2017 is now lost, as Americans are being taxed, indirectly, to support a global war on free trade.

It’s not at all clear the trade overhang will lift.  This will require cooperation and agreement with trade partners, as opposed to standing on their dog leashes.  We ought to expect this to be a lingering presence in the marketplace, until at least November 2020.  The White House will game, talking up economic growth and stock prices while whirling the politically potent trade stick.  Some of our research providers project the damage from the tariffs could be as much as 5% of earnings.  This would ostensibly wipe out the forecasted earnings growth for the current year.  A valid question, in the face of this degree of uncertainty, is how much can investors continue to digest?

Separately, market fundamentals are not alarming, but they are also a long way from anchoring confidence.  Several April economic data points were down.  Q22019 GDP is now expected in the 0.6% range, the weakest since Q42015, the last time we had an earnings recession.  The slowdown in growth began in advance of the recent trade news with respect to China, Mexico and Canada.  Interest rates and inflation look to me as though they will remain low and range bound well into the future.

Today, based on current earnings expectations for the S&P 500 of roughly $180 per share (12 months forward) stocks are selling for a little over 15x earnings.  This is slightly below the 25 year average.  Expected returns, from this valuation level, are roughly 10%, which is also in line with historical averages.  The Goldilocks outlook is that barring any surprises, these earnings levels can be attained, and the multiple does not erode any further.

On our end we are pleased the market continues to favor growth stocks over values stocks.  The S&P 500 Growth index (IVV) is up 13.32% ytd versus the S&P Value index (IVE) up 8.18% ytd.  We are concerned with the recent anti-trust talk directed at stocks such as Google, Amazon, Apple and Facebook.  Other factors investors use to assess stocks such as size, valuation, dividend yield, etc., are not additive at this time.  We are taking a much more idiosyncratic approach and are targeting stocks with strong secular growth, innovative management teams and limited supply chain exposure to foreign trade. 

I expect the tension we see in the markets to continue, and it will remain challenging to own stocks.  I also think the best opportunities for investment gains remain in select stocks, versus owning the market or making sector bets.  This makes good quality stocks the best game in town and one we pursue with vigor.  Please feel free to check in in if we have not spoken recently.

Bruce Hotaling, CFA 

Managing Partner

Wait For It

Stock prices, measured by the S&P 500, rose an impressive 3.93% in April, boosting the total return to stocks to 18.25% year to date.  These returns are among the best ever for the first four months of the year.  The month was notable in that prices rose in all but five of the 21 trading days, a 76% batting average.  Also notable is the low volatility, or daily price movement.  With the exception of April 1st, when prices rose 1.16%, the average daily price change (up or down) was only .25%.  This compares to December 2018, when the market was in free-fall.  The average daily price change was 1.38%.

Stock prices are behaving as though they are intent on setting a new high water mark.  The last time the S&P 500 hit an all-time high, September 20, 2018, it closed at 2,930.75.  At that point, prices were comfortably up 13.07% for the year.   Few investors would ever have guessed their returns would be negative by year-end.  Between September 20 and December 24, stock prices fell 19.36%.  One of the most universally unwelcomed Christmas presents ever – a bear market. 

A strong start to the year for stock prices cannot necessarily be extrapolated forward.   As we saw last year, the strong behavior of stocks can turn on a dime.  In the past, there have been years such as 1995, when stocks did continue higher after a strong start to the year.  Then, other years with strong starts, such as 1930, infamously saw the complete implosion of stock prices by year end.   More often than not, after a big start, the market tends to saw-tooth for the remainder of the year, challenging investor’s resolve against giving back precious gains with each subsequent downswing.

In an effort to gauge where things stand, investors often try and establish a point of reference based on the duration of the economic cycle.  The current expansion has been in place since early 2009.  The average expansion over the last 70 years has been roughly 5 years.  By these simple terms we ought to prepare for a contraction in the fundamentals and stock prices.  Some have pointed to the more services oriented nature of the economy, and the general low intensity of the expansion.  Questions revolve around the degree of pent up demand, the fact wages have been suppressed, and changes in the structure of the labor force.  The recovery has been going on since 2009, but not all segments of the economy have responded equally.

Currently, the fundamentals are mixed.  Economic growth is challenged.  The tax cut was a one-time thing and will not spur any further corporate spending.  1Q earnings reports have been alright, but only in relation to reduced estimates.  Revenues have underwhelmed.  It’s harder to mask underlying issues with revenues, than with earnings.  The US posture toward China, and other trading partners, will not likely be resolved anytime soon.  The risk here is for unintended consequences.  Finally, and likely a positive consideration, the Federal Reserve is seemingly on hold for a number of months.

We are seeing some positive signals.  While we find stocks with secular growth trends attractive, we are also paying more attention to defensive businesses.  Utilities and staples have been two of the best performing sectors over the last 6 months.  We are also seeing the beginnings of recovery in housing related stocks likely due to the lower interest rates and in spite of the SALT limitations, and some interesting support from semiconductors.

In conclusion, we do not want to give away our shot.  Stocks are fully priced and we are in the midst of a global stock price rally.  We are jointly committed to our secular growth stocks, and looking at select opportunities to take profits and put some $ onto the sidelines.  We are also beginning to see the first signs of value stocks attracting interest.  In many ways this is a signal long investors are beginning to lose their conviction.  If this continues, we will address some of our holdings appropriately.

In the immediate term, we look forward to speaking to you about keeping equity exposures in check.  Complacency is high and with this backdrop, things will be ok until all of a sudden they are not.  We don’t want to be looking at one another wondering “what did we miss.”  Please feel free to call if we have not spoken recently.


Bruce Hotaling, CFA

Managing Partner


Charlotte’s Web

Terrific is the only way one can describe the performance of the stock market through the first quarter of 2019. Prices rose for the third consecutive month, adding on 1.79% in March. Year-to-date, the total return to stocks, measured by the S&P 500, is 13.65%. The remarkable surge in prices nearly perfectly matches (reverses) the utter devastation stock prices faced in 4Q18 when prices fell a cumulative 13.52%. In 4Q18, stock prices fell more than 1% on 16 occasions, while in 1Q19 prices fell more than 1% only three times. This was some change.

From my perspective, I am somewhat surprised by the sudden rebound, and also suspicious that eventually some less-good news is going to let the air out of the market. As much fear as there was in investor’s eyes last December, there is a renewed sense of urgency to own stocks again. Wall Street clearly favors Washington’s policy agenda. Possibly the single largest change agent was the more dovish stance by the Federal Reserve.
The headwinds I’ve discussed in prior letters remain firmly in place. In addition, the yield curve has inverted, with short term interest rates now higher than long. This has historically been a caution sign and is highly correlated with recessions and often challenging stock markets. We’re faced with a chicken and the egg scenario. Does an inverted yield curve signal a recession? Or, does the early phase of an economic slowdown cause the yield curve to invert? This is the first time the yield curve has inverted since 2007.

The short-term economic boost from the 2017 Tax Cuts and Jobs Act has petered out. What we are left with is a $1.5B increase to the federal deficit. Contrary to the plan, there is no economic growth to spur deficit reducing tax revenue. Normally, the intention during good times is to use the excess wealth to deleverage or repay borrowings taken on during the tough times. The increases to the federal deficit are not sustainable and will ultimately have to be corrected. The self-imposed trade war is hurting domestic profits, according to recent earnings calls.

1Q19 earnings season is just about to be begin. According to FactSet Research, earnings estimates for the S&P 500 are expected to decline 3.9% for the first quarter 2019, which would be the first year over year decline in earnings since 2Q 2016. Stocks, at the moment, seem to be looking through these numbers. In fact, it’s not uncommon for the value of the index to increase while the S&P 500 earnings estimates are decreasing.
If companies miss earnings or are forced to reduce guidance, their response will be a key indicator for us. Companies that miss earnings estimates could respond by cutting spending on capital improvements and labor, further strangling economic growth and possibly igniting a stock-market selloff. Earnings misses tend to force companies to rethink their priorities.

Amidst this challenging backdrop, investors are radiant. Prices are rising like its 1999, again. That was a long time ago, but one of the most remarkable periods in stock market history. While 1999 receives all the popular acclaim, (stocks were up 19.5% in 1999), in the four preceding years, prices rose 26.6%, 31%, 20.2% and 34%. While we are clearly in the business of pursuing investment gains, I think a more humble posture is appropriate. Let’s hope we do not repeat the fear of missing out syndrome that owned Wall Street in the late ‘90s.

My take on the way forward is to buy (and sell) stocks selectively. Stocks overall are not that cheap, but individually, some are attractively priced, and others have high growth rates that are unrecognized. Patience in putting funds into the market is key. As the market saw-tooths, we want to buy the dips. We are also watching closely the emergence of new companies, new business models, that may prove to be the next transformative move in the market’s life-cycle. I’m confident that our keen eye and years of active investment experience will allow us to work through this odd hodgepodge of factors.

Please do not hesitate to give us a call if we have not spoken recently. We are happy to work closely with you to asset allocate your portfolio and answer any questions you may have as to the best way forward. All the best, and enjoy the emerging spring time.

Bruce Hotaling, CFA
Managing Partner

Seventh-inning Stretch

Baseball fans in Philadelphia are hoping this is their year. The off-season signing of multiple superstar players has raised expectations. As a group, fans remain stubbornly buoyant from back to back World Series appearances in 2008 and 2009. Baseball and investing have some common traits. The baseball season is long, carrying on for 162 games, and of course, investing is a long term undertaking. It’s equally challenging to pick winners and often unclear whether skill or luck made the difference. Finally, both tend to be emotional to the extent rational decision making often goes out the window.

Turning more directly to recent activity in the stock market, February saw stock prices rise 2.9%, as measured by the S&P 500. Prices are now up a healthy 10.8% year to date. This rebound in prices is remarkable in light of the 14.3% drop in stock prices in 2018’s fourth quarter. The S&P 500 is now in the 2800 range, just below the 2900 level of late September 2018.

At the moment, there are a handful of dominant influences on the market. First, the Federal Reserve has taken a more dovish stance toward future interest rate increases. Second, investors are largely betting the US trade war with China (and other parts of the world) will ultimately cause less damage than had been feared. These are largely factored into prices today. The third influence is that the earnings forecasts are coming down, especially for companies with a greater portion of their revenue originating from outside the U.S. This is not priced into stocks today.

Declining earnings are difficult for stock prices to overcome. There is the possibility we are on the cusp of an earnings recession. The last one we lived through, from 2014-2016, saw stock prices struggle though most investors did not pay it much mind. Today, I think investors will care. The factors threatening earnings today include the tariffs, rising costs (wages and commodities), stagnant oil prices, the end of the corporate tax cut tailwind, and an economic malaise across parts of the globe, including the Eurozone. Slowing growth and rising costs spells trouble.

Another flashing yellow is the record high level of corporate stock repurchases that have been fueling the stock prices. Reported EPS (earnings per share) are the critical measure of corporate health. If for whatever reason, a company cannot increase its earnings, it can reduce its share count. This mathematically creates the same result. Sadly, one recent trend has been for companies to borrow money in order to raise necessary cash to buy back stock. According to research by Goldman Sachs, S&P 500 company buybacks will rise 22% to $940 billion in 2019, while capital expenditures (business investment) is expected to grow a more subdued 9% to $780 billion.

The greater issue here is near term gain as opposed to long term gain. In the near term, stock repurchases boost share prices and executives and shareholders are happy. In the long term, investments in technology, innovation and human capital all play an immense role in the companies’ ability to evolve and thrive. Thoughtful investments will lead to new innovation and greater competitiveness by U.S. companies in an increasingly competitive world. In my opinion, now is the time to take a more progressive view to lay the foundation for the success of future generations.

In my opinion, there remains good value in and a strong case for holding quality stocks. The timing of success can be fickle, so a long-term outlook is important. Our work is to continuously screen for investment opportunities the market will reward in the future. At the same time, I think a more tactical approach with an eye toward judiciously harvesting gains is important. Complacency often prevails. Then, when change does come, it’s a shock, and it turns out the catalyst was unforeseen. With the market, just like our beloved baseball team, expectations can be high (priced in). Predicting a drop in expectations, whether due to earnings guidance or another event is not easy. This is where our challenge lies.

Please feel free to reach out to us if we have not spoken recently. We are happy to review your asset allocation in light of the current backdrop. All the best, and enjoy the coming spring.

Bruce Hotaling, CFA
Managing Partner

The Party’s Over

Stocks, as measured by the S&P 500 rose a surprising 7.87% for the month of January.  This was the best start to the year since 1987, according to the Wall Street Journal.   January’s remarkable stock returns were a generous “bounce” that largely offset the disastrous 9.18% loss that stocks suffered in December to close out last year.  Now, with 4Q18 earnings season underway, we’re faced with the difficult task of assessing stocks, with an eye toward determining which ones will do the most work for us this year. 

On a macro level, the forces that had been driving stock prices have shifted.  After the November 2016 election, stocks went on a manic run; 15 months of positive returns.  Wall Street suddenly had a man in the White House that was going to give it just what it wanted.  From November 2016 through January 2018, stocks returned 31.4%.  Then things changed.  Starting in February 2018 the market stumbled.  Over the ensuing 12 months (through January 2019), stocks fell 1.23%.  During that span of time, stocks fell in four of those months for a total of -22.1%.  These sharp drops in price radically changed the tenor of the market.  They reflect the market’s foreboding of change on the horizon. 

Near term expectations are for more of the same.  There is little prospect of Washington acting in any constructive way with respect to fiscal policy.  More to the point, my hope is Washington will refrain from causing further harm.  The trade war, for instance, is clearly hurting the bottom line of many US corporate and agricultural businesses, based on recent earnings reports.  According to the IMF, the US led trade war with China and the related protectionist tactics may lower global GDP in 2019 by as much as 0.5%.  The threat of another government shutdown looms.  The 35 day shutdown that began late last year damaged the economy and will show up in lower economic growth rates.  FactSet Research’s review of earnings transcripts shows 33% of the companies that   reported to date have made mention of the shutdown.

The elephant in the room, as always, is earnings.  More than any other factor, stock prices reflect forward earnings.  At the moment, 2019 earnings expectations are being revised downward.  While not uncommon, the fear of course, is that continued downward earnings revisions will potentially lead to lower stock prices.  Current FactSet estimates for CY 2019 project earnings growth of 6.3%, but that may be fleeting, and some analysts are quietly suggesting 0% growth for the coming year.  Whether the forecasts hold up or deteriorate further, it will be a huge deceleration from the 19.9% earnings growth in 2018.

Though it’s a stock market, from our perspective, it’s a market of stocks.  In 2018 our style and technique for selecting stocks worked extremely well.  Of course, every year the backdrop and the factors influencing stocks and stock prices changes unpredictably.  We are stock pickers, and we do not subscribe to the suggestion that a low-cost ETF is as good as one can do.  In fact, we strongly believe in the value of thoughtful analysis, tactical buying and selling, and full utilization of the vast technical and analytical tools available to us today.  Our focus remains anchored on the unique potential of each of the stocks we choose to own. 

Finally, the roller-coaster start to the year was so distracting I nearly missed Groundhog Day.  I’m glad to report Punxsutawney Phil did not see his shadow early on February 2nd, which means we ought to expect a shortened winter.  This is good news though there is some concern with the reliability of Phil’s predictions.  In fact, the NOAA says that Phil is right about 40% of the time and does not have any predictive value.  This all leads me to Michael Lewis’ most recent book, The Fifth Risk.  In it he discusses many of the valuable aspects of the federal government, including its immense ability to collect and store various forms of data (economic, weather, census, seismic, soil temperatures, etc.).  With all this information now on the cloud, and vast computing capabilities at our fingertips, one of our most challenging tasks is to thoughtfully begin to ask the right questions to which we want answers. 

Please feel free to reach out if we have not spoken recently.   We are happy to discuss our expectations for the coming year in more detail, or any of your life circumstances that may have changed since we last met. 


Bruce Hotaling, CFA

Managing Partner

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