The views and opinions stated herein are those of Bruce Hotaling, are of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S & P500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation.
Stock prices, measured by the S&P 500, fell 7.48% in February. This leaves them down 7.52% year to date. While a difficult start to the year, these figures mask the true story. On February 19th stocks set a record high and by month end had dropped nearly 13%. According to Bespoke Research, the S&P 500 fell over 12% in the six sessions ending on Thursday February 27th, its fastest drop from all-time highs, ever. The selling volume was the highest since August 2011, when Standard & Poor’s rating agency cut the U.S’s credit rating to AA+ partly due to dysfunctional policymaking in Washington.
As you know, the panic in the markets is tied to the coronavirus. A dozen epidemics have struck, dating back to the HIV/AIDs crisis in June 1981. All induced immense fear and reciprocal selling on Wall Street, but within 6-months the stock-related implications of the epidemics had been resolved. What we saw in February is a market that had gotten ahead of itself, largely through ignoring bad news, forced to re-price as the fear of the epidemic to both the supply side and the demand side of the economic equation began to pencil out.
It is interesting that over the last two years, stock prices have produced some alarming volatility. Back in the early days of 2018, prices fell roughly 10% due to the imposition of Trump’s tariffs. Beginning that fall, prices began an extended downslide, falling nearly 19% by Christmas. This was primarily attributable to the Federal Reserve as it was attempting to normalizing interest rates. Then, just last week, prices fell nearly 13% in less than a two week span over fears of the global spread of the coronavirus. The volatility does not seem as though it will abate any time soon, and investors will likely begin to lower stock exposure, or demand higher returns, if these dramatic price swings remain this challenging.
The recent price swings are investor’s attempts to price in the longer-term impact of the virus. Investors overcome with fear are using worst case assumptions. On Wall Street, fear is contagious. There are several things we can observe from the market’s recent behavior. First, stock prices tend to rise gradually and fall quickly. We are in a computer driven world and much of the trading that takes place on Wall Street is handled by algorithms, versus pencils and green eyeshades. Also, the recent prevalence of ETF’s creates a flywheel effect and both selling and buying become accentuated well beyond what the market might normally dictate. It’s impossible to accurately link the potential severity of the coronavirus with future stock market levels.
I expect the fear factor will crest and countries will better implement mechanisms to defend their populations. Sadly, this may exacerbate the already anti-globalist tendencies. There will be an impact on the stock market, separate from the recent emotional rash of selling; analysts’ earnings forecasts will come down as expectations are lowered. This will be due to supply chain disruption and demand reduction (airlines, for example), putting a fundamental cap on expected returns from stocks in 2020.
Going forward, we should anticipate increased pressure on the Federal Reserve to lower interest rates in an attempt to spur economic growth –primarily by boosting stock prices. As we saw in 2019, forced liquidity can artificially lift the market multiple, pulling prices up, without any underlying change in business economics. Investors had been hoping a 10% surge in corporate earnings would drive stock prices to new highs. Now, with the unknown scope of the virus weighing on investors, the market is discounting low to no growth and the focus will shift outward to 2021.
Our efforts are focused on identifying and owning companies that can thrive in the current investment landscape. The strength and momentum of US high growth, high free cash flow companies has been impressive. Further, the gap in returns to growth stocks over value stocks supports our work going back years. We are also seeing strong market interest in ESG-type stocks which includes certain utilities, and stocks of companies in pursuit of global environmental sustainability. We are pleased to see this evolution of the application of technology finally beginning to take hold.
Please do not hesitate to check in if we have not been in touch recently.
Bruce Hotaling, CFA
Talk of the “new normal” developed several years back, in the wake of the financial crisis. Mohamed A. El-Erain, a widely regarded voice in the world of finance and investments, is often given credit for originating the idea. He began using the term to describe the then struggling low growth economy, the resultant quantitative easing (monetary policy enacted by the Federal Reserve), and the persistent low interest rate environment.
Today, we are thankfully well beyond the financial crisis. One important point El-Erain made was there were limitations, and notable downside risk, to perpetual reliance on central bank intervention. Traditionally, monetary policy was intended to either stimulate economic growth or tamp down inflation. My concern is that the new “new normal” is the politicization of the Federal Reserve. What we are seeing is Washington commanding monetary policy intending to influence stock prices. The downside of this new normal is the risk that stimulus stops working to spur economic growth. Higher stock prices allow politicians to lay claim, but they do not correlate with the general economic well-being.
The question on my mind is how long can the party last? We are in the late stages of an economic upcycle and Wall Street seems to be on a liquidity driven sugar high. There are many investors who hope an extension of the current demagogic regime in Washington will perpetuate the good times. And, the flip side of that coin is that if reasonable adults are brought into the nation’s capital once again, there will be a huge let down as all the excess will have to be accounted for. In my opinion, either scenario ultimately gets us to the same place, just passing across vastly different landscapes.
At the moment, a wave of complacency is dominating investor behavior. After a robust 2019, stocks have taken a breather in the first month of the new year – prices ended down 0.2% to start the year. Stocks had been over-bought, so this down blip is not overly important. For some context, this was only the third down month in the last 12 (fourth in the last 14). At one point in January, stocks were up over 3%. The long-term uptrend remains in place, and most investors are uncritically deflecting any bad news that comes along.
The coronavirus is the most recent speed-bump for the stock market. Uncertainty over the virus and its potential negative impact on travel, tourism, trade, supply-chains and retail sales (Apple stores, for example) is causing investors to take pause. The worry is that economic growth will suffer, and thus earnings will come down. If the SAARs outbreak in 2002 is any indicator, the impact of the coronavirus will hopefully be only temporary.
One of the byproducts of episodes such as the coronavirus is that it led investors to take safe haven in US Treasury bonds. This buying has pushed the yield on the benchmark 10-Year US Treasury bond down near its lows, in the 1.5% range. A temporary move like this will only invite political pressure on the Federal Reserve to lower the Federal Funds rate. This in turn will likely perpetuate the liquidity driven stock market rally.
We are roughly half way through 4Q 2019 earnings -the reports and outlooks for the coming year are pivotal. Thus far, the spectrum of results has been dramatic, with some clear disappointments (Caterpillar) and some surpassing already high expectations (Amazon). The potential for a true inflection in earnings this year remains firmly in place. From the beginning of each year, analysts typically lower their earnings forecast as we move deeper into the year. For now, the call is for a nearly 10% jump in earnings in 2020.
Looking ahead, we need to see some robust earnings. The market’s multiple is in the high end of a range. Strong earnings will allow stock prices to move higher for more fundamental reasons, those which provide greater staying power and are more reliable than external factors. There are other cautionary signs which may cause trouble but nothing clearly imminent. My expectation is that improved earnings reconnect stock prices to their fundamentals. This will enable our growth oriented domestic stocks to continue to generate returns. Please look for a call from us to schedule a review if we have not been in touch recently.
Bruce Hotaling, CFA
In 2019, U.S. based large cap stocks, as measured by the S&P 500, produced a generous total return of 31.49%. Over the last 30 years, the S&P 500 has returned more than 30% only five times or 17% of the time. The average annual return for stocks in the last decade, beginning January 1, 2010 was a heady 14.1%, the only down year being 2018. The average for the prior decade, beginning January 1, 2000 was only 1.2%, with four down years and staggering price drops in 2002 and 2008.
Last year at this time, stocks had just taken a precipitous year-end nose-dive to end the year down 4.4%. Stocks were oversold and the PE multiple was relatively low; the Federal Reserve had raised interest rates the fourth and final time December 20th. A lot of investors were disheartened by the rate hikes and on their heels when the market sentiment turned in early 2019, causing them to miss some of the upturn.
Today, the market is regularly making new highs. The Federal Reserve opted to reverse its 2018 rate hikes with three cuts in 2019. This drove animal spirits that were wrestling with negative fallout from the trade war and slowing growth around the globe. One argument is that the Federal Reserve, bullied or not, became the only adult in the room.
Now, at 18.2x expected 2020 earnings, stocks are more expensive than a year ago. According to JP Morgan, the 25-year average is 16.3x. Just how pricy the market is, of course, is contingent on multiple factors – during those 25 years, stocks have sold for over 24x, and below 10x. FactSet currently estimates $178 per share in earnings for 2020, a nice 9% bump from the $162 companies in the S&P 500 managed for 2019.
My biggest concern for the coming year is a protracted deterioration in our economic relations with China. The U.S.’s self-declared war on trade is now two years old and the loser in the trade war has been the American consumer, forking over billions of dollars in tariffs to no effect. Trade wars are clearly not good or easy. The economy and the stock market will both be better off once there is resolution. In my opinion, the U.S. has been busy wasting time and money in the Middle East, while China has been investing, and building diplomatic and economic relationships around the world. Bullying the Chinese will not help the American economy.
Earnings will prove key to stock prices this year. This may seem obvious, but last year earnings were flat, while stock prices skyrocketed. This jump was due entirely to PE multiple expansion, which in turn was driven by the reduction in interest rates. The Federal Reserve cut rates three times in 2019, and that is unlikely to happen again in 2020. So, if stock prices are to rise this year, it will hinge on improved corporate profit margins and earnings per share.
Our energy is directed at selecting quality U.S. stocks and bonds where we have reliable information. We make active bets on companies we believe from a fundamental and a quantitative perspective are positioned for price appreciation. Stocks and bonds, our asset classes of choice, are reliably non-correlating, counter-balancing each other’s volatility. We manage our bets, and the overall exposure to risk, in each portfolio. This is in distinct contrasts to the use of multiple asset classes, deployed via mutual funds and ETFs, as is the common practice among many investors.
For 2020, I expect the markets will likely behave a lot like they did in 2019, until November. Then, we shall see. In the meantime, we will continue with our emphasis on growth stocks. This tilt has enabled strong performances from our primary equity models over the last several years. If it begins to look as though the expected 9% bump in earnings is not going to come to fruition, we will re-assess and modify our approach. Until then, stocks (even slightly more expensive stocks) remain the best bet. We look forward to getting together with you in the New Year.
Bruce Hotaling, CFA
One of the more newsworthy things about November was the surge in Wall Street transactions. Approximately $70bn in deals were announced, including Charles Schwab & Co.’s purchase of TD Ameritrade, LVMH’s agreement to buy Tiffany & Co. and Novartis’ acquisition of The Medicines Company. In the spirit of the moment, Xerox made an attempt to buy the much larger HP Inc. (the old Hewlett-Packard), but was swatted away by the board.
This flurry of deals came on the heels of what had already been a busy year, particularly among some of Wall Street’s financial titans. For example, JP Morgan Chase bought InstaMed Inc., BB&T purchased SunTrust Banks and both Morgan Stanley and Goldman Sachs got in on a wave of corporate deal making. It’s not perfectly clear what is driving the move toward more deals. We can speculate it represents the last gasps of the bull-run in stocks, or possibly more worrisome, the current administration’s lax oversight and dismissive view toward financial regulation.
You may remember that some misaligned interests, both in Congress and in the savings and loan sector, led to aggressive deregulation of the S&Ls in 1982. Within a few years, this led to a collapse of over 1000 banks, and a tax payer bailout in excess of $130bn. It was a disaster second only to the thousands of banks that closed in the Great Depression. While a lot of people bristle at the Dodd-Frank Act implemented in the shadow of the 2008 housing crisis and the Great Recession, we may be entering the next chapter of low/no regulation.
The surge in deals may also be a product of the low interest rate backdrop. It’s inexpensive to borrow money today. The Federal Reserve’s decision to lower the Fed Funds rate three times (for a total of 0.75%) this year, after it raised rates four times in 2018, may have sparked a borrowing spree. After rate cuts in July, September and October, animal spirits are running high.
Also key to the current merger boom are the record high stock prices. Companies often use their stock as currency when they look to make acquisitions. Companies with high P/E ratios seek out companies with lower P/E ratios, as this can be accretive to earnings, an instant way for management to shine.
Amidst the flurry of corporate activity on Wall Street this November, stock prices, as measured by the S&P 500, rose a smart 3.6%, and are now up 27.6% for the year. The last year with returns this big was 2013. The last three years have produced 14.8% annualized returns, and during that span, stock prices fell in only 6 of 36 months. That’s an extremely high batting average (percentage of positive months). One of my concerns is that the down months have been dramatic, dropping by an average of 5%. That is a jarring number. Sharp drops in stock prices tend to freeze investors – as they hope for prices to rebound or struggle to recalibrate their expectations. There is a touch of complacency with the market’s recent strength, and I don’t want our accumulated gains to be snatched away due to the deer in the headlights effect.
Sensational headlines day after day desensitize us to the nuance of the information being reported. In my opinion, a trade war with China cannot be won; the global market place is interdependent and isolationism does not work. Though fear of recession has receded, forward earnings forecasts are only modest. The view from the c-suite is cautious as measured by recent capital spending surveys. Fundamentals are stagnant and the change in stock prices this year has been driven by higher valuations (P/E’s). The deal is, we are on thin ice; the economy is not nearly as robust as stock prices would like us to believe. I expect we will see consistently higher volatility (making stocks more challenging to hold) which means next year may require more effort, for less return.
Investors have banked some nice returns this year, and in my opinion it is a good time to take some profits. We find it’s always more attractive paying capital gains taxes with realized investment gains. In relation to historical levels, current capital gains tax rates are a gift we want to take full advantage of. Stocks remain the best game in town, but we have to anticipate lower expected rates of return going forward. Please don’t hesitate to call if we have not spoken recently.
Bruce Hotaling, CFA
A year ago, most investment markets were experiencing freefall. The Federal Reserve, intent on normalizing interest rates, had raised the Fed Funds rate eight times since 2016. By late 2018, markets in general were beginning to exhibit their collective displeasure. The Fed then announced it would ease up on its tightening program, and stock prices have been rising ever since. Stocks, measured by the S&P 500, rose 2.17% in October 2019 and are making new highs. They are now up 23.16% year to date after a dismal -4.75% in 2018.
The stock market has been deftly climbing a wall of worry. This somewhat dated reference alludes to the ability of stock prices to continue to rise in the face of factors or issues that one generally would consider a deterrent to that growth. This backdrop makes it extremely difficult to put fresh money to work – there never seems to be a clear green light. Many investors have experienced this hesitation since November 2016. The worry is in fact the market’s risk premium: the risk of loss investors must embrace in order to receive equity-like returns.
One month ago, many investors and market pundits were expecting corporate earnings to continue on their recessionary track. The trade war was wreaking havoc in multiple ways on US business overseas, supply chains and access to markets; and global economic growth was stalling in China, Europe and the US. There was also the inverted yield curve, a tell-all indicator that the US economy was on the brink of a recession. There was not much to look forward to.
Today, it seems all that has changed. Whether true or not, the administration via popular media outlets is feeding the public optimistic soundbites regarding the eventual resolution of the trade war. The “seasonal effect” which tends to see stock prices perform well during this period of the year may be influencing investor thinking. The global economic backdrop suddenly appears brighter too, based on more recent economic data points.
In my opinion, more central than the above is the fact that 3Q earnings were more or less on target. This was immensely reassuring to investors. Over 70% of companies reporting earnings have done better than expected, a stark reversal from 2Q where the earnings beat rate was the lowest in over a decade. Investors were poised for disappointing earnings, and surprised with the outcome.
Two factors have produced a nice bump in stock prices: the PE ratio has increased about 20%, largely due to falling interest rates and earnings for 2020 are anticipated to increase in the high single digits above their expected 2019 level. The key now is whether forward earnings forecasts can hold up as we move into 2020.
In my opinion, US stocks remain the best game in town. We can more accurately assess the intrinsic value of US companies based on reliable and transparent data. So even at somewhat elevated levels, the expected return from US stocks still remains more attractive than other asset classes, bonds in particular. While we consider the valuation of the market as a whole, we do not buy the market – we focus on specific investment opportunities inherent in individual names, their unique merits in relation to their peer companies, growth rates, strength of their management, and other factors.
Lastly, I have some news to report on changes here at Hotaling. First, we have added another advisor, Gretchen Regan. I’ve known Gretchen for some time. She is a talented analyst and immediately adds value to our work for you on a number of fronts. You can read about her at www.hotalingllc.com. Second, after years of working together, Valerie has decided to move on to the next big thing and retire. She intends to spend important time with her family. We will all miss her here, as I’m sure you will too. In our attempt to fill that void, we have brought Jennie Wilber on board. Jennie is young and energetic and will do everything Valerie had done for you, and then some. I’m sure you will have the opportunity to meet her, at least over the phone, before year end. We have been doing a lot of outreach to make sure you are informed, but please do not hesitate to call if we have not been in touch recently.
Bruce Hotaling, CFA