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Patience Here

Stocks prices, measured by the S&P 500 fell 2.9% in August. The S&P 500, trading at 1632.97, is just below the upper boundary of a trading range it’s been in for the last several years. It’s exhibiting good relative strength, for now. While down months always seem to raise doubts in the back of investors’ minds, the evidence is mixed regarding whether we should be “buying on the dip” or “taking some chips off the table.” At a point in time like this, the best course of action is to be patient, and attentive.

The primary concern most investors are wrestling with today is the possibility of military action in Syria. This could be the latest chapter in the Arab Spring saga. It raises the question whether, and to what extent, the U.S. needs to take an active role. While not an ostrich, I prefer we use any resources we have to improve our schools, jobs and environment here at home. And, if we simply feel compelled to spend some money and do a good deed, we don’t have to look further than Detroit to find a place to flex our muscles.

While any action in Syria may be politically charged, it will not likely have any affect on the stock market or the fixed-income markets here in the U.S. There may be some agitation for a short period, but no longer- term effect.

A parallel concern, one that began back in May, is the upward shift in interest rates across the yield curve. The change in rates is a result of the market’s anticipation of the taper Ñ the reduction in the monthly purchases of mortgage bonds by the Federal Reserve. The rise in rates is causing downward pressure on bond prices. The Barclays US Treasury Bellwethers (10Y) is -6.79% ytd, and the BofA Merrill Lynch Municipals Master is -5.46% ytd.

The rise in rates has also led to a general flight from many investments that behave in sympathy with fixed income. This includes high dividend- paying stocks, REITs, and many closed-end mutual funds. Some fixed income investors now extrapolate continued rising rates, but in my opinion, while this could of course be the case, it is not likely.

Markets cycle up and down in relation to short-term news flow. It is clearly impossible to trade in front of these events. While there are some seasonal tendencies in front of us, and while this fall looks as though it will be unusually “noisy,” my suspicion is that the underpinnings of the stock market are still secure. I also think that longer term, the fear of rising interest rates, wreaking havoc in fixed income-related markets, will temper, and these securities will begin to see price stability tied to fundamentals.

From a portfolio management perspective, it is not helpful when fixed income balks, but the growth and wealth creation does not come from this segment of the portfolio Ñ it comes from the stocks. Stock prices are highly correlated with earnings, making earnings a critical market measure. 2Q2013 saw modest 2.1% earnings growth. 3Q2013 is expected to be slightly higher, and hockey stick growth is forecast for 4Q2013. The 12-months forward consensus earnings forecast for the S&P 500 is $117.88. At today’s price level, that means the market is trading at a PE multiple of 13.8x earnings, a reasonable level by historic measures.

There are many variables that will dictate whether or not these earnings estimates become real. Concerns are structural shifts in our economy, some as a result of the “great recession” that we may not fully understand yet. There are well known difficulties in Washington DC. Fiscal policy is non-existent and the market’s strobe light is pointed at the Federal Reserve. There are also changes taking place around the globe (Europe on the upswing, China on the downswing) that impact our economy and make effective forecasting difficult.

At the same time, profit margins are at all-time highs and forecasted higher. Corporate leverage is low and forecasted lower. Based on current FactSet data there is ample room for stock prices to move higher without becoming overheated. So, from a longer-term perspective, I see continued value in holding stocks.

We’ve come to the unofficial end of summer, Labor Day and all things related to back-to-school. For many this marks the unofficial start of the New Year. As I said last month, one of these days, things will change, we should expect that. If September lives up to its billing as the worst month to own stocks, then we may want to reallocate. At the moment, patience is key. As always, please do not hesitate to call if you have any questions or would like to schedule a meeting.

Bruce Hotaling, CFA

Managing Partner

One of These Days

Stocks returned to their winning ways in July with a 4.9% return. June, the month fraught with fears related to Federal Reserve policy, seems like ancient history after July’s robust performance. The S&P 500 has risen 10 of the last 12 months and is now up 19.6% for the year and 25% for the trailing 12-months. Stocks of all types (value, growth, etc.) are making new highs and have now definitively pushed through historical high-water marks set in early 2000 and late 2007. There is a good chance stock prices are in a secular bull market, and will continue to reach higher highs. Rising markets tend to attract investors as no one wants to miss out.
As good as things have been, this bull market is getting a little long in the tooth. All good things seem to come to an end. Bond market investors are nervously weighing the long-anticipated directional change in interest rates. It is not clear whether this will lead to stock market inflows. Investors remain skeptical of stocks, as measured by recent American Association of Individual Investors sentiment surveys.

There are a few other aspects to the current market that are making my job more difficult. First, the market is getting a little pricey. The S&P is now trading at a P/E multiple of approximately 14.6x forward earnings estimates (currently $117.13). This multiple is higher than at the start of the year and higher than the 12.9x 5-year average. The concern is that corporate earnings (and analyst earnings forecasts) are growing, but not nearly at the rate necessary to sustain the growth we have been seeing in stock prices. This is more a macro view and not a trading call, but the bottom line is the market as a whole is becoming expensive.
Second, short-term measures are overbought. A measure we typically review is the percent of S&P 500 stocks that are trading 1 standard deviation above their 50-day moving average. Today, 67% of the S&P is one standard deviation above the 50-day, while only 7% is one standard deviation below. On the whole, 2013 has been difficult. Like they are today, prices have been overbought for the duration of the year. June was the only true opportunity to buy stocks at “cheap” prices. For example, in June, the above percentages were nearly reversed. There were many stocks priced well enough to buy, and we did, but the window closed quickly.

Finally, the market is a hodge-podge of information. Typically, we analyze stocks based on like characteristics (factors) and their recent contribution to returns. Often times, for extended periods, the market will favor stocks exhibiting a certain characteristic (or characteristics). Some of the more common characteristics are measures such as high dividend yield, low P/E ratio, medium market cap and prior month’s returns. We assess how we want to weight our portfolios based on the characteristics of the stocks generating positive returns. At the moment, all stocks are rising and it’s difficult to attribute returns to any one or set of characteristics.
The potential camel in the tent is the market’s anticipation of a change in Fed policy. A true change in the direction of interest rates (shift in the yield curve) will have short and long-term implications. This has already made things difficult for most types of fixed income and also assets priced with some correlation to fixed income. The US 10-year Bond was 1.48% a year ago, 1.76% at year-end, and 2.6% today. The whole yield curve (beyond 1 year) has gapped higher. With no inflation to speak of and limited economic growth it’s difficult to see this continuing. I do not think the fundamentals support higher rates. It looks to me as though the market has priced in the end of QE3.

REITs and higher dividend yielding stocks also came under heavy selling pressure just as the yield on the 10-year made its dramatic surge beginning in May (60% bump in interest rates in a 3 month span). In my opinion, credit quality, and the integrity of the coupon are more important long-term considerations for income investors than near- term price volatility, particularly since the price volatility may be out of context with true fundamentals. I expect we have the option of being patient here. If we are truly entering a macro shift in the direction of interest rates, we will review your fixed income options and put an appropriate plan in place for you.
One of these days, things will change. It’s a matter of when. Until then, let’s review your asset allocation. If we have not spoken recently and you have any questions or would like to review your portfolio. In the meantime, please enjoy these long summer days!

Bruce Hotaling

CFA Managing Partner

Summertime Blues

Here we are at the midpoint of 2013. It’s been a very good year for US stocks, with returns, measured by the S&P 500, up13.8%. In contrast, most categories of fixed income (TIPS, US Treasuries, US Corporates) are down in price, with the longer maturities suffering the most. Other asset classes have performed even worse, especially the BRIC countries (Brazil, Russia, India and China) gold and silver. Global asset allocation strategies have not fared well this year.

For the month of June, stock prices fell 1.5%, the first monthly decline this year. According to Bespoke Investment Group, the recent stock pullback was 5.8% and lasted 34 days. Since the bull market began in March of ’09, this was the 17th such pullback of 5% or more, with the average decline being 8.3% lasting 25 days. The last true rocky patch stocks experienced was May – September 2011 when stocks fell five straight months for a cumulative decline of over 18%.

I have been waiting for a pullback, only to allow us to buy some stocks we like, at somewhat better prices. The S&P is slightly below its 50-day, so we are not backing up the truck, but selectively adding to some favored names. Stock prices are up 10 of the last 12 months — so with the exception of the most recent month, the uptrend remains in place. Price behavior over the coming months will tell if June was a blip or the start of a trend change.

The recent fly in the ointment is investor concern with the long-anticipated change in policy from the Federal Reserve. Beginning with the financial crisis in 2008, Fed policy has been accommodative to repair and rebuild confidence in the financial markets. This project is largely accomplished and the reversal of Fed policy (tapering) and the ultimate change in direction of Fed Funds (short interest rates), is expected.

The recent jump in interest rates pushed the yield on the US 10-Year Treasury over 2.6%. For perspective, it peaked at 15.6% in late 1981, and hit an all-time low of 1.4% June 2012. If rates have in fact begun to turn, it will be a long process and premised more on economic fundamentals (GDP growth and inflation expectations) than traders playing their own game of musical chairs. I expect rates to revert, rather than to continue their recent move, and any upward trend to be gradual.

At the moment, the economy is growing modestly and forecast to pick up speed in 2014. Housing data is compelling, with the Case-Shiller Home Price Indices continuing its advance. The expected inflation levels remain low and non-threatening.

In my opinion, we have been placing too much emphasis on monetary policy and not nearly enough on fiscal policy. Some constructive policy coming out of Washington, DC would go a long way toward promoting job growth and enhancing the competitiveness of US businesses.

Known risks to the stock market include faltering GDP, analyst downward earnings revisions, inflation (suppressing the market P/E ratio), rising commodity (input) costs and rising energy prices. None of these risks are apparent today. Indirect risks could include hot spots such as the Middle East and North Korea, slowing economic growth in China and the re-emergence of financial-fiscal crises in the Euro-zone.

While everyone is on the road to the beach, they can take comfort in the favorable historical behavior of stocks in July. Bespoke data shows positive returns for the month of July 65% of the time over the last 20 years. Bespoke data further shows that in years where the S&P 500 has returned greater than 10% in the first half of the year, the second half of the year has been positive 72% of the time, with average returns of 5%.

Earnings season kicks off with Alcoa scheduled to report on the 8th. Earnings will be critical to stock behavior. In one sense, earnings announcements may re-focus investors away from the yield curve. I am hopeful that some solid results will shore up what has been a trend of declining growth forecasts from analysts. The lowered expectation is for only 0.8% earnings growth over Q12013. Meeting these lowered growth figures and limiting the negative revisions to the second half outlook are pivotal.

Near term, I expect stock prices to remain volatile. There will no doubt be some earnings disappointments that catch investors off-guard. Longer term, I think the outlook for stocks is attractive, based on current estimates and valuation levels. I also anticipate the interest rate concerns that roiled markets recently will taper off, and rates will normalize. Have a great start to your summer, and if we have not spoken recently or if you have any questions, please do not hesitate to call.

Bruce Hotaling

CFA Managing Partner

Shifting Sands

This year, it appears few investors paid any attention to the well-worn adage “sell in May and go away.” The adage is premised on the notion stocks generate the bulk of their annual returns between the months of November and April. Had investors minded the rule, there is every chance stock prices would have declined, in a self-fulfilling way. Just the contrary, measured by the S&P 500, stock prices advanced 2.1% for the month of May. The stock index is now up 15.4% year to date, and an astonishing 27.3% for the trailing twelve months. Stocks have moved higher 11 of the last 12 months. The last down month in the market was a full year ago, May 2012.

This juggernaut stock market is confusing investors, many of whom have not recovered from the emotional trauma of the financial crisis. According to Bespoke Investment Group, June may in fact be the month the May adage takes hold. Data on the Dow Jones Industrial Average shows that over the last 100 years, the index is up less than 50% of the time in June. During the last 20 years, June has been the poorest performing month of the year (up only 40% of the time). In the shadow of months of steady returns, I would not be surprised to see some profit taking in the near term. This does not mean the bull market will end. It does mean that some profit taking and re-orientation of the leadership in the markets is apt to occur, and once it starts it will stir fears.

In my opinion, while stock prices in the U.S. are rising across the board, the foundation of these price moves is somewhat directionless. There has not been a consistent pattern of return to measurable factors. The tides, invisible on the surface, are shifting in ways that can make one fearful of going into the water. Often, stocks with discernible characteristics will lead the market. For example, often a characteristic such as dividend yield, growth, valuation, short-interest (you get the idea) will tend to lead the stocks sharing those characteristics higher (or lower). The recent tendency in stock prices has curbed the effectiveness of this type of analysis. Stocks are herding higher and the leadership changes from month to month.

The natural inclination is to attempt to correlate the behavior of stock and bond markets with news/data. Recent economic data is mixed, and supports the continued, if somewhat lumpy path of improving conditions for stocks. Consumer confidence, housing prices and the price of gas at the pump are a few of a multitude of economic indicators pointing in the

right direction. We are in an interesting place, where the growth figures are not strong enough for us to expect any changes in policy from the Federal Reserve. The Goldilocks economic data is allowing for an extension of quantitative easing. If and when the economy begins to heat up, (remember the Fed’s 3/20/2013 press release has targeted unemployment below 6.5% and inflation of 2%) there will be a period where the markets will likely re-set.

From a fundamental perspective, stocks look fairly priced. According to FactSet Research, the current forward 12-month P/E ratio is 14.4. The 10-year average P/E ratio is 14.1, so the market is in the ball park. Calendar estimates for 2014 are for earnings of $122.55. Extrapolating the price of the S&P 500 forward, using a 14 multiple, we might see the S&P 500 priced in the 1,715 range next year, roughly 5% higher than today’s 1,630 level. One could argue there is not a lot of upside in stocks, but a dividend of 2% and potential appreciation of 5% is more appealing than many alternatives.

The big institutional investors are pressed to direct new funds into stocks immediately. Institutions represent about 67% of stock ownership. They cannot afford the risk of a performance lag. When the gun goes off, they go. While acknowledging the risk of a performance gap, I think it much more prudent to work into the market, to attempt to buy favored assets at favorable prices. The opportunity cost of missing some near-term return is not nearly as great as buying into a heated up market only to see it begin to slide. Bear in mind, the S&P 500 has typically seen an annual pullback of at least 10% from its high. The largest decline this year has been 3.5%.

I expect some turbulence in the markets in the coming months, if for no other reason than the market will need to digest its recent gains. While I do not think there is evidence the bull trend will change course, I see inflated levels of investor greed and fear. This makes me feel this is the wrong time to stray from our established play book. Please do not hesitate to call if you would like to review you asset allocation.

Bruce Hotaling

CFA Managing Partner

Get With the Beat

Stock prices are on the move. Measured by the S&P 500 stock prices advanced 1.8% during the month of April. This lifts the index an impressive 12.7% year-to-date, and 16.9% for the trailing twelve months. Stocks have moved higher 10 of the last 12 months, or 83% of the time, while historically they’ve moved higher 66% of the time. The two down months in the last 12 were May and October 2012 when prices fell 6.3% and 2.0%, respectively, due to economic jitters.

During the prior twelve month period (4/30/11 – 4/30/12) stocks were up only 5 of 12 months, 41% of the time, and the cumulative return for that period was 4.7%. The market we are in today reflects a remarkable shift in frequency and magnitude of returns. On an absolute level, the S&P 500 and the Dow Jones Industrial Average have both broken to new all-time highs, and prices are up well over 100% from the early 2009 low. We are in a bull market for stocks.

There is some evidence the average investor’s sentiment is finally beginning to thaw, after years sitting on the sidelines. The financial crisis and recession scarred investor’s psyches. According to data generated by Credit Suisse, equity mutual funds took in net new cash for 16 consecutive weeks in 2013. Interestingly, flows into bond funds have also remained positive. This is in spite of the widely anticipated flight-from-bonds that has been forecast, as interest rates inevitably begin to rise. The source of these newly invested funds is low yielding money market funds.

At the moment, the stock market is balanced in a Goldilocks-like place. Economic data (housing and jobs) is steadily improving. This is spurring expectations. At the same time, when growth does accelerate the Federal Reserve will pull back on economic stimulus (quantitative easing). It’s not clear how long the porridge can remain “just so” before stock prices show resistance. No doubt, stalling economic growth will bring an end to the party. Conversely, things will likely become more volatile when the Federal Reserve ultimately backs-off its current monetary policy. There are of course multiple other scenarios, one or some of which will ultimately change the markets direction.

Earnings season for Q1’13 is nearly complete and the results have been fair, somewhat reflecting the Goldilocks analogy. To date, 59% of all companies reporting have beaten their earnings estimates and 52% have beaten their revenue or sales estimates. These figures are not what one might expect in light of the buoyant market. Revenue is often considered a better measure,

less susceptible to manipulation. Overall, many companies and their respective Wall Street analysts are projecting positive guidance, but often lower than had been the case. This guarded optimism, some call it sandbagging, is curious. Better to set the bar low and hurdle it cleanly. I wonder if the game will change, ironically, when corporations finally let their hair down and increase their growth forecasts.

At the present time, FactSet consensus earnings estimates for the S&P 500 are for 110.24 and 122.77 per share earnings in 2013 and 2014. With the S&P 500 in the 1,625 range stocks are selling at a 13.2x forward P/E. Generally speaking, that is not an over-priced market. Precisely how high stocks can go from here depends on many things, most of which we can monitor – jobs and housing data, consumer sentiment, the Federal Reserve, interest rates and earnings trends.

As often happens, the underlying current of the stock market has shifted, though largely unnoticed. While on the surface, the market has been heading in one direction, the stocks that are driving it have changed. For the last five months, defensive stocks (health care, consumer staples and utilities) had been the top performing sectors and the energy behind the market’s gains. Recently, technology, telecommunications, and energy stocks, the laggards year to date, have begun to break out and are now driving the bus. This is evidence that stocks more sensitive to the macro economy are emerging, and may indicate, as stock prices often do, growth data supporting the market will persist.

I suggest staying with the bull – but in accord with our targeted allocations. While we are enjoying a strong market for stocks, it is a sensible time to re-visit asset allocations and to take profits where appropriate. It is also an opportunity to re-set our weightings among the defensive stocks that have done so well, and the cyclical stocks that are now on the move. Please feel free to call if you have any questions, something has changed specific to your investment profile, or would like to review your asset allocation.

Bruce Hotaling, CFA

Managing Partner

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