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
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
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
Summer is here, and the heat is on. A quick glance at the weather map shows vast portions of the country shaded dark red reflecting temperatures north of 95 degrees. The National Weather Service is expecting temperatures in New York to top 90 degrees for the next seven days, something that apparently happens only once every 30 years.Extreme temperatures in Chicago led to hosing down the Michigan Avenue bridge in order to cool it to the point the expanded steel would once again lift to allow boats to pass. In a replay of last fall, raging wild fires have struck in California, Colorado, Utah and New Mexico.
Communities in the west are mandating water restrictions due to the eerily low snow pack from the past winter and low rain fall. Climate change and the associated heat is compounding the existing water crisis. The High Plains Aquifer in eastern Colorado is drying up. The Denver Post reviewed federal data showing the aquifer shrank twice as fast over the past six years compared with the past 60 (Denver Post, 8/10/17).The problems associated with agricultural over-pumping, farming drought-prone prairie land, increasing development and demand for natural foods is overwhelming the limited water supply. If all pumping stopped immediately, it would still take hundreds of years for rain-fed streams and rivers to recharge the aquifer.
Theatmosphere surrounding the stock market is tense and selling bouts are sharp. While year to date returnsremain positive at 2.65%, measured by the S&P 500, its becomingever more uncomfortable. There has been pronounced selling, particularly by fund and ETF holders. To date, this has been more than offset by companies repurchasing their own shares. There were $433.6 billion in share repurchases during the period, nearly doubling the previous record of $242.1 billion in the first quarter, according to market research firm TrimTabs. The buying has supported returns, but it cannot last.
The stock market continues to favor high growth stocks over dividend or value plays. We pay close attention to these trends and it has been favorable for our style of investing. According to Bloomberg, more than 100% of the S&P 500’s year to date total return is attributable to just 10 stocks, including Amazon, Microsoft, Apple, Facebook, Visa, Adobe and Nvidia. These are all large cap growth stocks we have owned for a number of years and our positioning has provided us with an attractive tail-wind.
The key questionis, how credible is the threat to the current $175 per share in earnings forecast for 2019. As the trade war continues to escalate, expected earnings figures will inevitably begin to be talked down by analysts. We may encounter this as early as the 2Q reporting season beginning later in July. U.S. corporate tax receipts, according the U.S. Bureau of Economic Analysis, have fallen by over 30% since the same time last year. Will our ballooning debt lead to higher interest rates, and a rate induced deceleration?
Another important measure is the yield curve. The economy is heated up, with slackening regulations, reduced taxes and a frothy mindset on Wall Street. The Federal Reserve has been steadily raising rates, and this has flattened the yield curve. The spread between the U.S. 10-year and the 2-year is now a mere 0.28%. An inverted yield curve is a widely accepted (and often self-fulfilling) indicator of a recession. A recession is a period when both economic activity and trade are in decline. This leads to declining corporate earnings, which in turn pulls stock prices down.
So here we are, in the hot-seat. Atsome point the winds will change and we will have to make some tactical adjustments to the portfolios. It’s not at all clear when, but things will change, as they always do. Until then I suggest we try to become more comfortable with the heat, the volatility and the seemingly incessant flow of fiction dressed as news. I may look in the attic for the old Ouija board to see if we can derive any clearer signals (just kidding). In the mean time I hope you have found a cool and comfortable place to enjoy some fireworks, in the true sense. Happy 4th of July. Please feel free to call if we have not been in touch recently.
Bruce Hotaling, CFA
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