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Change is Coming

The stock market is all about earnings.  Corporate earnings and their level in relation to stock prices is the fundamental basis, the keystone, of stock valuation.  US stocks have been enjoying an unprecedented period of earnings growth and price appreciation.  Much of this stems from the stock friendly behavior coming out of Washington DC.  In general, corporate America could not be more pleased with the US corporate tax cuts and the across the board emphasis on de-regulation.

For the month of May, this symbiotic relationship continued to self-reinforce, and stocks responded with a total return of 2.41%.  The solid returns for the month brought the S&P back into the black for the year.  May’s positive returns and moderate volatility (only three of 21 trading days had price moves +/- 1%) were a welcome relief for investors after two stressful months with sharply negative returns in February and March.

While stock returns are modestly positive this year, it’s a shadow of the 8.8% return through May of 2017.   I do not expect the S&P 500 to return 22% again this year.  Signs of trouble are brewing.  Few asset classes are faring well.  Most larger foreign markets are down (Brazil -11.9%, Germany -4.2%, China -4.6%).  Gold and silver, and almost every maturity level across the fixed income spectrum are also down year to date.

It’s a challenge to make forward looking determinations on how best to position the portfolios in the face of so much media noise and misplaced commentary.  In my opinion, there are two overhangs to the market that are threatening to spoil what has been an intoxicating run for stock investors.

One of the supportive backdrops for the upbeat market in 2017 into 2018 has been coordinated global growth.  The idea behind this concept is a stronger global economy supports improving demand for US goods and services, and spurs corporate profits.  The US$ had been low, amplifying the effect.  Suddenly, this growth driver is under assault, and isolationism and protectionism are on the rise.

Further, tension on the Korean peninsula, threats of a trade war with China, tariffs on steel and aluminum imports from Canada, Mexico and the Eurozone, and the US’s withdrawal from the Iran nuclear deal have led to a destabilization of the world political-economic order.  This is thin ice.

Much of the anticipated global growth was fueled by debt.  Now, global debt has reached levels never seen before, equivalent to 225% of global GDP (according to the Economist 4/24/2018). China is guilty of leveraging up to sustain its economic growth.  This is similar to the US tax cuts that will push the US deficit over the $1 trillion mark.  Emerging markets are suffering with many of their obligations issued in US$s (Argentina, Turkey).  Growth, measured by GDP has slowed.  The question here is whether we have come to that point, the tipping point, when things begin to change, while no one wants to believe that is truly the case.

The question isn’t so much if there will be trouble, but when.  I do not think any changes in asset allocation need to be made, yet.  I do expect returns to bonds to be minimal, and stocks to be in the average range.  I am pleased the market continues to reward growth over value.  This is a tailwind for our portfolios.  Our core approach to investing is referred to as GARP or growth at a reasonable price.  Growth stocks continue to outperform value stocks at the large, mid and small cap levels, by notable margins.  The two highest returning sectors are technology and consumer discretionary, both sectors where we hold overweight positions. 

One of the clearest reasons to take a more cautious posture toward stock investing is because many, possibly too many investors and market commentators are overwhelmingly positive.  They tend to tick down the list of supportive economic or consumer data points.  There is a lot of cool-aid being consumed out there.  I’m not a contrarian, but I’m also not one to get sucked into the vortex.  The best course of action today is to avoid getting drawn in to owning too much stock.  We need to stay well invested, while hovering one foot over the break. 

Bruce Hotaling, CFA

Managing Partner

Rock Steady

April was a “backing and filling” month for investors.  This is a stock market term that applies to prices as they attempt to digest a large run up.   After a monstrous 5.6% jump in prices in January, the return to stocks in April, measured by the S&P 500, was a mere 0.27%.  Year to date, returns have fizzled and are now down 0.38%.    These results mask some eye catching day to day price moves.  For example, out of the 21 trading days in the month, 9 involved an up or down move in prices of greater than 1%.

This volatile yet sideways pattern is likely a byproduct of last years extended rally in stock prices that led so many investors to the trough of complacency.  Fifteen months of positive returns will attract a lot of attention – suddenly investors began chasing returns, and taking on more risk.  It had become too easy.  A reflection of this mindset was the craze over bitcoin.  That was an extension of the high risk-taking mentality that consumed investors worldwide.

On January 26th, stock prices hit their 14th record high of the year.  Over the next couple of weeks we experienced a full on reversal of the prior year’s blind optimism and things turned ugly.  By February 9th, stock prices had fallen over 10% on an intra-day basis.  The dust settled, and things seemed ok, until April 2nd when prices went right back down to those uncomfortable levels.       The origins of this sudden shift in market direction initiated a raft of media speculation as to what might have gone wrong.  Was it the US 10-year Treasury nearing 3%, the looming Federal Reserve interest rate hikes or possibly saber-rattling talk from Washington about trade wars?  When market trends change, it is often unclear what precipitated the change.  For us, the more important question is the emerging trend – what does the slope of the developing trend in prices look like?

As an investor, it’s important to focus on and identify investment goals, particularly long term.  The big considerations are, what are we working toward and what is the best path to get there?   Trouble often shows itself in the short term.  While things that come up admittedly do not normally have any bearing on long term goals, or the agreed upon path, they can be un-nerving to the point investors retreat.  There are times when owning stocks is flat out uncomfortable. 

After years advising people how best to position their financial assets, one thing clear to me is how easy it is for investors to become disillusioned.  Admittedly, there is some concern the world at large is sliding down a slippery slope.  This may be true, or it may not.  In my opinion, though we perceive a tenuous backdrop today, there has always been a long list of things that could go wrong.  Often, we did not know there was a monster under the bed.  I suspect our current cautious awareness puts us in a better position to look ahead and acknowledge risk.  Stocks are inherently high risk, high return, and when investors dismiss this we are collectively on thin ice.

Our goal is to guide our investors in a way that allows them to hold quality investments during challenging times.   As active investment managers, this requires our constant attention and a balance of art and science.  We use analytical tools and fundamental analysis, along with a considerable dose of experience.  We also use a risk-on, risk-off approach to profit during the good times and temper the effect of the difficult periods.  This is in stark contrast to passive index strategies or a blind reliance on asset allocation models. 

My expectations are for the recent surge in volatility to continue, though tempered somewhat.  I also expect stock prices to move higher by the end of the year.  Earnings have been strong through the first quarter and analysts’ forecasts through the year-end are high.  I do not expect stocks to deliver anything close to the 20%+ returns we saw in 2017.  Considering the backdrop, we ought to expect it to remain challenging.  We are constantly asking whether the choices we are making today are additive to your long term goals.  At the moment, I am optimistic we are well positioned for the year ahead, but I am also prepared to change course if need be.  I invite you to call if you have concerns.

 

Bruce Hotaling, CFA

Managing Partner

Nor’easter

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

Managing Partner

Nor’easter

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

Managing Partner

Melt Up

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

Managing Partner

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