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Taxing

It’s been a taxing year in many respects, but clearly not for investors in US stocks.    Year to date, the total return to stocks (measured by the S&P 500) is a robust 20.5%.  With the exception of a modest miss in March, returns have been positive for 13 consecutive months.  This is the longest period of consecutive returns, and with the lowest month over month standard deviation, going all the way back to 1982.

The goodness extends beyond the US.  Year to date, stock markets in most major countries around the world have produced handsome returns.  These markets include traditional economic juggernauts (Germany +27%), old line economies experiencing difficulties with their neighbors (UK +16%) and even economies no one else seems to like all that much (Russia +1%).

In spite of the soap opera in Washington, there are a number of factors propelling our stock market: earnings growth is inflecting upward, oil prices are stable, economies around the world are echoing our economic expansion, central banks around the globe are withdrawing stimulus (inflation trade) and Wall Street’s animal spirits are running wild with anticipation of the benefits from tax-cuts for corporate America.

Seasonal return patterns tell a story.  Since 1982, December is clearly the best month for stocks, with a positive return (batting average) 77% of the time and a net average return of 1.75%.  The next best month is April, with a 72% average and a net average return of 1.64%.

Stock prices have risen, and are no longer cheap.  According to FactSet Research, the trailing P/E ratio for the S&P 500 is 21.  For context, at the apex of the dot com bubble, March 2000, the market’s P/E ratio was a healthy 30.  In contrast, at the low point of the financial crisis, March 2009, the market’s P/E ratio was 10.  So, best of times, worst of times – today we are smack in the middle.

 The overarching issue on everyone’s mind is taxes.  The drama is playing out inside the Beltway, but the repercussions are being felt on Wall Street.  The effort is to spin a new tax code, lowering taxes and simultaneously spurring future growth.  Investors are licking their chops. Income taxes were briefly imposed in 1861 to help pay for the civil war.  The 3% tax was repealed in 1872.  In 1913, the 16th amendment gave Congress the authority to levy a federal tax on income.  At that time, only a small number of people actually paid. 

 Our current progressive system has taxpayers with incomes over $200,000 paying nearly 60% of all federal income taxes.   Based on early analysis of the bill, the majority of tax cuts will benefit folks in this income group, and more so for higher income groups.

 The last time a tax cut was proposed, in 2001, the Congressional Budget Office projected a $5.6 trillion surplus over 10 years.  Today, the budget office forecasts deficits will total $10.1 trillion over the next decade.  The deficit is expected to top $1 trillion a year in 2022.  Federal debt held by the public is at the highest level since shortly after World War II, at 77 percent of GDP. (NYT 9/28/17)  The political imperative to cut taxes has now superseded any view toward fiscal prudence.

 We’ve done some analysis, and a reduction in corporate taxes will boost earnings for stocks.  The puzzle is which stocks, and to what degree.  Our working assumption is that some benefit is already priced into stocks, and there is the potential for more, though this will require clear and well communicated legislation.

 At some point, I expect the market to revert to the mean.  Consumer confidence is high, as is confidence in the stock market.  These can be yellow lights.  Since Thanksgiving, the market has begun to rotate, away from the year’s big gainers, and into “safer” low growth names.  We have been anticipating this shift in leadership from growth to value.  If the rotation persists, we will look to take more profits in our highest performing stocks before the end of December.  If we wait until the new tax year to rebalance, we may be faced with a multitude of investors with the same clever thought.  My preference is to stay in front of the pack, and if we owe capital gains, to pay them from this year’s generous profits.  Please feel free to check in if you have any concerns.

Bruce Hotaling, CFA

Managing Partner

Narrative

October ends with Halloween.  Apart from All Hallows Eve, and the Day of the Dead, there is a distinctly scary tone to the way Americans choose to celebrate the holiday.  It has somehow evolved into something folks just do each year, and it carries a frightening narrative.

Outside of the world of fabricated ghosts and goblins, there is a broader narrative at play, driving strength in the financial markets.  The underpinning of the narrative is the high level of anticipation in improved GDP figures (job growth and higher wages) with stimulus from tax cuts (both personal and corporate) and incentives to capital spending anchored in a renewed emphasis on active fiscal policy.

So far, we have not seen evidence this is anything other than a story.  But the stock market has another view and continues to march on.  Stocks, measured by the S&P 500, returned 2.2% for the month of October, and are now up a cumulative 16.9% year to date.  If we look back to the beginning of 2016 (a 22 month window) stocks have been up 16 of those months (a .727 batting average) and have generated a total return of 30.9%. 

It’s hard to determine how much of this story is already priced into the markets.  Certainly, influential people in the system are perpetuating it, as the Treasury Secretary recently threatened a dramatic drop in stock prices if tax cuts and reforms were not enacted as prescribed.  From my perspective, the strong returns to stocks is principally the result of a remarkable recovery in US corporate earnings.

We are in 3Q17 earnings season, and according to FactSet Research, as of 10/27/17, 76% of S&P 500 companies have reported positive EPS surprises and 67% positive sales surprises.  The blended earnings growth rate for the S&P 500 is 4.7% for the quarter, well up from the previous estimates in the 3% range, and without the hurricane related hit to the insurance industry, the blended earnings growth rate is 7.4%.

As the market is a discounting mechanism, meaning it extrapolates future outcomes, the current behavior of stocks implies a rosy future.  This is supported by the collective outlook of stock analysts’ predictions for future earnings.   Most people do not realize that between CY14 and CY16 S&P 500 earnings ground to a halt.  Mired at 119, earnings were dead flat for a three year span.  Today, according to FactSet Research, analysts are projecting near double-digit bottoms up earnings growth for the S&P 500: 130.8 for CY17, 145.8 for CY18 and 160.3 for CY19.

The underpinnings of this growth inflection are tied to several existent factors.  Synchronized global growth is spurring demand at multi-national companies.  The low value of the dollar is making US exports more affordable.  The continued stabilization in oil prices is allowing the energy industry as a whole to recover.  There is some confidence that the new leadership at the Federal Reserve will continue to prudently manage monetary policy.  All of this is taking place in spite of considerable concern that the tax reform and cuts that will ultimately spur the economy (and thus further corporate earnings growth) may never be implemented. 

Then, there is the scary Halloween narrative.  We collectively keep telling ourselves nothing is the matter – there is not a monster under the bed.  We try and put on a brave face, but the fear is there.  Washington is in disarray, and we often hear the monster either via Twitter, or bombastic claims in news reports.  The level of doubt rises.  This flies in the face of optimistic analyst earnings forecasts and stock returns we do not want to give up.

As we approach year end, we can take satisfaction in an extended period of stock price appreciation.  There will inevitably be an unsettling event that sparks selling.  Over the next few months our effort will be to take some profits in stocks that have outsized positions in portfolios, to lock in returns and raise some cash to allow a degree of comfort going forward.  Please feel free to check in if you would like to discuss further.  We are also taking a close look at realized capital gains, though I have to say there are not many off-setting losses after the period in the markets we have had.

 

Bruce Hotaling, CFA

Managing Partner

Crow’s Nest

In the UK, when you cross the street, there are friendly reminders to “look right” printed on the edge of the road.  The message is to pay attention, but in a direction many of us are not accustomed to looking.  Here in the US, in the world of financial assets, the implicit message today is to “look up”.  While some may think of prayer, I’m not heading in that direction.  As much as any time in recent memory, the imperative today is to keep a sharp watch on the horizon.

Stock prices, measured by the S&P 500, advanced again, 1.9% for the month of September, and are now up a cumulative 14.2% year to date.  It’s been steady going for share prices of US stocks, with March the only down month this year, and then a mere -0.04%.  According to The Bespoke Report, there have been only 8 days this year when the S&P 500 has moved +/- 1%, with only 1963, 1964 and 1972 recording fewer days.  We are deep into a long-running bull market, and at the moment, there are few signs the trend is about to turn.

From a behavioral perspective, it is clear investors are beginning to be lulled in.  While there is no specific reason to believe the slope of the uptrend is about to change, some baseline prudence at this point is warranted.  Anecdotally, we’re coming up on the 30th anniversary of the October 1987 crash – a point in time I remember well.   My concern now is our collective complacency is creating the foundation for people to own a greater percentage of stocks than they would otherwise be comfortable owning.

To be clear, the fundamentals look reasonable.  2Q GDP figures were recently revised to 3.1%.  The US is in the 9th year of an economic expansion.  It is likely growth can continue in spite of the damage inflicted by hurricanes in Florida and Texas and forest fires in California.  It is also hard to foresee higher growth than what we now have without a change in access to labor.  Unemployment, in the 4.4% range, is the lowest since 1960s.  Importantly, inflation is not apparent, yet.  The issue here again, is labor.  The job market is becoming tight and it seems like wage inflation is inevitable.

US 3Q earnings are just beginning to be reported. Expectations are for results better than analysts’ have projected.  The earnings beats will likely be attributed to several things: an unusual period of synchronized global growth, stable oil prices and improved US output, a “constructive” upward shift in the yield curve, and the low value of the US dollar.

I expect a continued resurgence in corporate earnings to support stock prices through 4Q 17 and likely into 1Q 18.  There has been speculation that corporate earnings would benefit from a realignment of the tax code.  In light of the recent disarray in Washington, it seems highly unlikely any real progress will be made.  There is no doubt a repatriation tax holiday would be a tail-wind, but I do not think the market expects it, and will shrug off one more disappointment as more of the “new normal”.  In my opinion, we will see no fiscal stimulus, modest growth and increasing (but not debilitating) inflation.

There is a good argument the most significant risk the markets face is geo-political.  This is a category of market risk that is in many ways not there, until suddenly it is.  So much takes place out of the public eye, surprises (market shocks) can stem from this largely indirect factor.  The greatest effect is the undermining of investor confidence due to extreme price volatility.

In this vein, a clear concern, fanned by the Equifax hack, is both the security of our personal data in an information driven world, and the ongoing attempts to manipulate popular media.  There appears to have been a well-orchestrated, and highly effective campaign by state sponsored Russian hackers to influence popular opinion in the US.  My primary concern is whether the foundation of our democratic process has been compromised. 

Harking back to our communication last month, if you have not frozen your credit, please do so.  We can send you instructions to put a freeze in place.  This time of year, we are busy reviewing portfolios for the year end.  We want to be tax prepared.  If we have not spoken recently, or if you would like to arrange a review, please do not hesitate to reach out.

 

Bruce Hotaling, CFA

Managing Partner

Uneventful August

True or not, August feels like the month most investors are away on holiday.  Oddly, even when summer trading volumes taper, and the weekend begins early on Friday, trouble still seems to crop up.  Over the last few weeks, we’ve navigated an eclipse, a flood, the threat of a government shutdown, and several missile tests.  There are times when there is simply no rest.

For me, the degree to which August’s markets were more or less event agnostic is a complete curiosity.  Stock prices, measured by the S&P 500, rose a mere 0.05%.  Including dividends, stocks generated a total return of 0.31% for the month.  Year to date, the total return for the S&P 500 is 11.93%, a respectable number.  With the exception of a 0.04% dip in March, prices have risen every month since they took a 1.94% hit way back in October 2016.        

One of the more important characteristics of the stock market this year, one highly supportive of our investment style, is the dramatic outperformance of large cap growth stocks.  The S&P 500 Growth benchmark, measured by the IVW, is up 17.85% year-to-date, while the S&P 500 Value benchmark, measured by the IVE, is only up 4.95%.  Other characteristics, such as size, have seen large cap stocks outperform small cap stocks.  And, stocks with greater exposure to foreign revenue sources have performed better than those with predominantly domestic revenue sources.

We are in a stock picker’s market.  Active investment managers are generating above benchmark returns for their clients.  Three key aspects of our more traditional approach to portfolio management are transparency, quality investments (companies from the upper tiers of brand and balance sheet), and ready liquidity.  These characteristics are often forfeit by managers implementing popular passive investment approaches.  These strategies rely on nicely colored pie charts, built around fabricated ETF’s with often opaque holdings, where liquidity has not been tested.

I am confident in our approach to your investment portfolios.  We utilize a combination of a macro assessment, quantitative factor screening, and some roll-your-sleeves-up fundamental analysis.  Certain sectors are suspect, including the consumer discretionary and staples areas.   Others, such as health care, industrials, and technology look attractive at this point.  Strong corporate earnings have propelled prices higher while broad valuation levels remain acceptable. 

In my opinion, near term economic growth, and robust US corporate earnings will continue to benefit from a favorable backdrop.  Two factors are dominant.  The job market has been strong.  The unemployment rate now stands at 4.4%, an impressively low number, with no sign of wage inflation yet.  Equally relevant is the weak US dollar juicing up earnings.  The dollar weakness likely stems from the traditional interest rate parity equation, a flattening yield curve, and a growing global distrust in US policy makers. 

There has been some talk in the press questioning whether we are in the late stages of the business cycle and the bull market.  In my opinion, this is media hype.  A true directional change will require a recession, a major policy failure from inside the Beltway, or some sort of exogenous shock the markets are unable to digest.  Other than raising cash, it is difficult and can be expensive to invest in defense of any of these risks.

With September here, we are now on to the final stretch of 2017, and in my opinion, weathered from what’s been a noisy year.  We have been in a state of perpetual alert, hoping odd tweets and other events manage to remain “uneventful”.  The stock market appears to be pricing in little probability of any meaningful legislation around taxes or infrastructure spending.   The market calm will ultimately change.  The common fear is when, and to what degree.

If we have not been in touch recently and you have some concerns, please feel free to reach out.  Valerie is busy scheduling reviews.   Also, many of you have not had the opportunity to meet the most recent additions to our team, Matthew Mulholland and Ray Masucci.  Please take a look at their bios on our web-site, at www.hotalingllc.com.  I look forward to introducing you at the next opportunity.  Be well.

 

Bruce Hotaling, CFA

Managing Partner

Higher Highs

Stock prices, measured by the S&P 500, continued their upward march, gaining 1.93% for the month of July.  Year to date, the S&P 500 has generated a total return of 11.6%.  These returns are respectable, by most historical measures of stock market behavior.  Certainly some investors may be tempted to “step off” the merry-go-round, end the year right here, and wait around until the game starts up again January 1st, 2018.  

An old Wall Street adage is “the trend is your friend,” and the recent period has been about as friendly as one could hope.  July marked the sixth of seven months this year when prices advanced, an unusually steady winning streak.  Over the trailing twelve month period, stocks rose eight of twelve months (stocks typically rise 66% of the time) for a total return of 16.04%.

During the period just prior to the election, earnings (and stock prices to some extent) tracked sideways.  There was a long stretch, from 2014 to 2016, when oil prices imploded and the S&P 500 aggregate earnings were stuck at $117 per share.  There is no doubt, the election injected a wave of optimism.  But unnoticed, and coincident with this wave of populist fantasticism was a true inflection in corporate earnings growth.  Beginning with Q1 17, corporate earnings leapt by over 14%.   According to FactSet Research, growth for 2Q 17 EPS is expected to be over 10%, and expectations are for $131 per share in 2017 and $145 per share in 2018.

So what’s the fuss?  These are terrific numbers. Stock prices measured by the Dow Jones, the S&P 500 and the tech heavy Nasdaq have been hitting record high after record high.  In my opinion, investors see the earnings, and they see the stock prices, but there is this nagging sensation something awful is just around the corner.  According to sentiment data from the American Association of Individual Investors, bullish sentiment is at 36%, having spent 28 of the last 29 weeks below 38.5%, the historical average.  Another old Wall Street adage is stock prices climb a “wall of worry,” and this is largely what we have going on today.

The spectrum of worry is vast.  Clearly, one dark cloud shading popular sentiment for owning risky stocks is the torrent of noise coming from Washington DC.  Even amidst a period of record earnings, investors cannot take their eyes off the clowns.  The void of leadership has left several investment grade “brides” standing at the altar. Up to this point, nothing has been accomplished with respect to regulatory reforms, infrastructure spending or lower tax rates.  The pro-growth agenda that was going to accelerate corporate America and pacify Joe-the-plumber is gasping.  With no fiscal policy and the Federal Reserve looking to normalize monetary policy, growth hangs in the balance.

Beyond the US, the worries expand.  Constant geopolitical tension has become the new normal, whether it’s related to security, trade or the environment.  It was clear at the recent G20 meetings in Hamburg Germany that the leaders of the developed world do not view the US in the same light they once did, expressing concern that the US is no longer the reliable partner it was in the past.  

Tangible evidence of diminished faith in the US is the constant downward pressure on the US dollar index.  While this is a tailwind for US corporate earnings, it also indicates fewer investors want to own US dollars.  This is happening in the face of Federal Reserve tightening, generally reflective of higher interest rates and growth, something that would normally attract foreign investors to buy US dollars and assets. 

As Mad’s mascot Alfred E. Neuman would ask, “What, Me Worry?”  Stock prices are higher.  It is widely viewed that stocks are the only game in town.  If sentiment ever does take hold, and more investors overweight their allocations to stocks, the table is set for troubled times.  I continue to have confidence in corporate America’s ability to leverage improving global growth and a low US dollar, and look forward to seeing the expected earnings realized.  I am also well aware we have to tread cautiously here, as a lot of folks have their eye on the exit door, and don’t want to be the last one out.  I look forward to catching up with you if we have not been in touch recently.  Please enjoy your August.

 

Bruce Hotaling, CFA

Managing Partner

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