Blue Skies

Stock prices rebounded nicely in February with a 4.3% return, as measured by the S&P 500. This bump came on the heels of a worrisome -3.6% start to the year in January. For the trailing 12 month period, stocks have risen 9 of 12 months and are up a cumulative 25%. While the S&P 500 continues to make new highs, the number of stocks hitting 52 week highs is declining. A falling rate of participation (market breadth) is a warning sign the bull market may be weakening.

According to the Bespoke Investment Group, a bull market is any period where the S&P 500 gains 20% or more without a decline of 20% in between. Our current bull market began on March 9, 2009. During that period of 1,817 days, the market has risen 175%. We experienced one extended pull-back. It began in May of 2011 and the market dropped by just over 19% before finally hitting a trough in early October[i]. The scare ended, and the bull market rumbled on.

Large cap growth stocks are out-performing value stocks and this is helpful to our growth at a reasonable price approach. Of the sectors we own, healthcare and technology are doing well while telecom, staples and energy are lagging. In addition to style selection and sector weightings, good stock selection remains the most significant return driver for our portfolios.

I would expect sharper pull-backs in stock prices as the market cycle ages. The dip in stock prices in January looks to have been an excellent buying opportunity, in hind sight. Of course, at that time, many investors were anticipating a larger drop and had their eye on the emergency door. I think the market looks like it wants to go higher, and yet it also wants to make it more difficult for investors to remain invested. Some refer to this as climbing the wall of worry.

Economic data has generally been trending up. Home sales and prices are moving in the right direction. Real estate brokers will tell you there is not enough inventory, that construction shut down during the financial crisis and is only just coming back on line. This will take some time and prices are likely to continue upward.

The jobs data is improving. While encouraging, on one hand, there is critical work to be done here. Many of the positions being created are low paying. We ultimately need a strong job market with better access to education, skills training and technology to build a better foundation for economic growth well into the future.

Earnings have been encouraging. According to FactSet’s John Butters, 71% of companies reported Q4 2013 earnings above the mean estimate and 63% reported sales above the mean estimate. Technology companies have shown the highest incidence of reporting above estimates. The other side of the earnings coin is Wall Street analysts have been downgrading their earnings forecasts for the coming year at a pace. This may be largely due to recent weather, and if so, should reverse itself later in the year.

Valuation appears reasonable. Earnings growth, a critical metric, is Goldilocks, in the 8-9% range. The forward P/E ratio for the S&P 500 is 15.3. This is in relation to the 10-year average of 13.9[i]. The P/E to growth (PEG ratio) is not outside an historical range. In this context, there is ample opportunity to find well priced stocks

Stock price seasonality may be a near term factor in support of owning stocks. While the weather has wreaked some havoc, the good news is Spring is in sight. And, according to Bespoke, March and April are historically the two best months of the year, when combined. Then of course comes May, when investors are supposed to “go away”. We’ll cross that bridge when we get there.

Fixed income is performing markedly better than last year, with most sectors and maturities showing positive returns year to date. US 10-year Treasury is parked at a 2.6% yield. The long prognosticated run-up in interest rates is just not happening. GDP growth will of course prompt higher rates, but with no fiscal stimulus in sight, this will not be the case any time soon. Credit spreads are tightening, municipal balance sheets are improving, and bonds are playing a viable role in many portfolios.

As he does each year, Warren Buffett has written an interesting shareholder letter posted on the Berkshire Hathaway web site. In 2013, Buffett missed his benchmark by the widest margin since 1999. He is curious. For example, he refuses to own technology stocks, Coke may be going the way of the pay phone and last year he bought Philadelphia’s Fox & Roach. At the same time, I admire his focus and his perspective on value. Quoting from his 2013 letter, the Oracle says, “Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)”. Finally, it’s his blue sky optimism I admire more than any of his remarkable attributes, as he states, “Indeed, who has ever benefited during the past 237 years by betting against America?”

As usual, I am available to discuss the market backdrop in greater detail if you like. Please feel free to call

Bruce Hotaling, CFA

Managing Partner

[i] FactSet Earnings Insight, February 28, 2014 [i] The Bespoke Report, February 28, 2014

Weathering Stocks

Stocks prices have started 2014 with a wobbly move into negative territory.  Prices, fell for 12 of 21 days in January, and as measured by the S&P 500 fell 3.52% for the month.  Looking back, the last down month for stock prices was August 2013.  Otherwise, returns in 2013 were hypnotically positive (10 of 12 months) so the rocky start to the year has been all the more jarring.

The most likely source of the recent selling is profit taking without any capital gains constraints and an as-yet unclear economic outlook.  Last year, investing in stocks was akin to driving on the New Jersey Turnpike.  This year, even hardened travelers are pulling into the right hand lane to avoid the dreaded speeding ticket.

In my opinion, the outlook is “goldilocks” with nothing particularly scary or inspiring to direct investors.  Economic reports are mixed.  We should expect a continued positive slope to most data.  Contrary to many forecasters, interest rates have gently fallen, since the Federal Reserve announced the beginning of its taper on December 18th.  Earnings reports for S&P 500 companies are coming in nicely above estimates on both the revenue and the EPS lines.

Fundamentals support owning stocks.  Earnings forecasts for the S&P500 companies are currently forecast $120 for 2014 and $133 for 2015 (FactSet Data).  With the S&P currently trading at $1,782 stocks are trading at 14.7x 2014 earnings.  This is slightly above the 13.1x average multiple of the last five years, but certainly not inflated to a degree that should generate concern.  In fact, with inflation rates as low as they are, there is the distinct possibility the market multiple will trend higher in 2014.

One factor brewing uncertainty and certain to impact estimate revisions is the weather.  The polar vortex aside, this has been a very cold year across much of the country.  On the east coast, the cold and snow have likely kept shoppers at home instead of the malls, or buying snow boots instead of window treatments.  Energy prices for natural gas have shot up, and prices at the pump have tapered off.  We should expect some shift in spending patterns.

On a potentially larger scale, the drought emergency in California could have disastrous implications.  This is the driest year ever recorded.  There is virtually no snowpack in the Sierra Nevada.  The impact on industry at this point is immeasurable, though it’s likely to be substantial.  Farming and agriculture will change.  On top of this, the depletion of the Ogallala aquifer in the Midwest, critical to ranching and primary grains production, virtually guarantees change in the coming years.  This could well be a factor that comes to the forefront, and then spreads to unforeseen areas of the economy.

It is not clear, yet, whether the fall-out from the recent weather turmoil will spark a more prolonged market downturn.

And, there is the perpetual risk of a black swan-like event, unknown to us at this point.  In my opinion, things are not that dire, and this is in fact the third time in the last 13 months, where stock prices are approachable.  Pricing is critical, and producing good returns are a function of what you pay for those investments.   Large cap growth stocks behaved relatively well in January, extending the performance gap they exhibited for the second half of 2013.  My suspicion is that the trend continues, and that we are enduring a bout of profit taking.

Beware of the cause and effect discussion.  Every day, market analysts attempt to attribute a reason for the markets’ collective action that day.  I think this can be misleading.  The true direction of stock prices is more impacted by events 6-12 months into the future.  The day to day volatility tends to be a lot of noise.  While one cannot ignore it, most needs to be dismissed.  The talk is of the difficult year the BRIC’s and emerging markets are having, and commotion in the currency markets due to the Federal Reserve tapering.  In my opinion, the markets understood and priced in the effects of the Fed tapering some time ago.

Seasonal patterns often lead investors without any other source of direction to rely on anecdotal correlations.  This is a form of alchemy for the unknowing.  For example, the January Indicator is well known.  The crux is, when January has a negative return, the likelihood of stocks returning a positive return for the coming year drops.  Today is Groundhog Day.  Punxsutawney Phil did in fact see his shadow early this morning, so we may need to put up with another six weeks of winter weather.  But, don’t sell your stocks, or put your snow shovel away, just yet.  The fact is, Phil has seen his shadow the vast majority of the years since he first became relevant.  Most anecdotal correlations work for some periods, and fail for others.  They may even become self-fulfilling for brief periods of time.  Oh, and then there is the Superbowl indicator.  The NFC team won, in case you missed the game, and that means we’re in for a good year.

Best course of action?  In my opinion, is to continue to buy and own stocks of well managed companies (particularly companies whose founders are still in place) selling for reasonable prices.

Reassess your asset allocation – after a year like 2013, many own more stock than they had intended.  This is an opportunity to rebalance and for some, to lower any margin borrowing.  We can work with you to set up a system where (optimistically) you can take profits when monthly returns are strong.  Good asset allocation discipline can make navigating more volatile markets easier.  And bear in mind, we have not had a 10% correction in stock prices for a long time, so the selling bout we are up against may become more uncomfortable, before it straightens itself out.

Bruce Hotaling, CFA

Managing Partner

Pigs Get Fat

Happy New Year!  2013 was some year for U.S. stocks.  As measured by the S&P 500, December’s 2.3% upward move pushed the return on the benchmark index up to 32.4% for the year.  In 2013, stocks were up for 10 of 12 months producing an impressive 85% batting average.  For some context, over the past 25 years, the S&P 500 has been positive 18 times, for a 72% batting average.  During that span, the only year with a better record was 2006, when stocks rose in 11 of 12 months.  While these numbers are impressive, many investors have become conditioned to expect fits of volatility (stocks dropped 38.5% in 2008, and by 46.6% from 2000-2002) and were caught off-guard by the market’s recent strength.

In E.B. White’s Charlotte’s Web, Charlotte writes the message “SOME PIG” in her web in an effort to convince Farmer Zuckerman that Wilbur is special.  I suspect this market is special and like Wilbur it will endure.  In my opinion, what we have before us is not so much a bull market, rather something more akin to a pig market, if there is such a thing.  In my view, the market is nearly fully valued.  It is alive and well, but wallowing somewhat.  In keeping with the pig theme, I sense we will need to carefully root around for stocks that represent both value and opportunity.

As an investor, it is often difficult to separate one’s decision making from the animal spirits (John Maynard Keynes’ term) of the market.  All too often we base our investing on unrealistic expectations, or worse, what everyone else is doing.  The psychology of investing, somewhere between art and science, is where even the foremost investors can become stuck in their own rethinking.  At the moment, I agree some profit taking makes sense (the common worry is that overdoing it will only lead to ruin) yet I also believe the fundamentals are in place for the market to continue upward.

The stock market is forecasting good economic numbers (via its discounting function) in 2014.  The jobs numbers will continue to improve, interest rates will remain in check (and more importantly, the yield curve will maintain its positive slope), there will be no surprise changes in monetary policy from the Federal Reserve, and the U.S. Congress will not do any greater harm to the economy through their fiscal ineptitude.  As reported by The Bespoke Report – 2014, there has never been a recession in the U.S. that was not preceded by

a negatively sloped yield curve (long term interest rates lower than short term) so one can take some comfort we are not on the brink of another recession.  In addition, with the new all-time high in industrial production, “the economic recovery has now shifted from merely a recovery to outright expansion.[i]

The thing we have to fear, in my opinion, is the inevitable “unknown” event.  Call it a black swan or a shock, something will come along and jar investor confidence.  The news media spends mountains of time assessing the known – it’s the unknown that will change the market’s course.  We have to expect this.  And after so many months of positive returns, the rumblings of change, and the jolts of fear will be uncomfortable.  The market has not seen a 10% correction in a long time.  Our decision at that point is whether the event will lead to a directional change in the markets, or whether it’s simply a buying opportunity.

Our goal at the moment is to revise our sector weightings in our stock portfolios to emphasize where we think the greatest opportunities lie.  In my opinion, technology, telecom, industrials and financials (non-bank) are attractive.  Both health care and consumer stocks are interesting, but I’d prefer to wait for them to re-price.

The outlook for our other primary asset classes is mixed.  I expect only average returns from short to medium term bonds (5-10 year maturities).  I favor municipal and higher yielding corporates.  Interest rates will likely edge higher with the strength in the economy, but nothing like the dramatic shift that hit in May of 2013.  I think REIT’s will recover from a difficult year, despite rising cap rates, and I expect another strong year from MLP’s.  There is good reason to maintain a well allocated portfolio.

I am available to discuss your asset allocation, opportunities to take profits or to put new funds to work, as your circumstances dictate.  Please do not hesitate to call.  I am most thankful for a prosperous 2013 and looking forward to the challenges and the opportunities 2014 will bring.

Bruce Hotaling, CFA

Managing Partner

[i] The Bespoke Report – 2014, p. 89

Mad Dash

Continuing its pursuit of a top-10 year, the stock market raced ahead in November to new high after new high.  As measured by the S&P 500, the stock market rose 2.8% for the month and is now up 29.12% for the year.   On a price return basis (not including dividends), the market is up 26.6% year to date.  If we look back to 1929, the S&P 500 has ended the year with a price gain of 26% or higher 15% of the time.  Expanding that thought, it has ended the year with a gain of 20% or higher nearly 30% of the time.  Investors tend to become uncomfortable with double-digit returns.  The media quickly begins to talk of the next bubble.  The fact is, 20% plus returns are fairly common in the stock market.

So, 2013 has been a super year for US stocks.  The question is, what should we expect next year?  Historically, the year following a 20% plus return year is overwhelmingly positive, by a factor of 2 to 1.  There have been 22 years where the market has returned in excess of 20%.  The year following, 15 were positive with an average return of over 16%.  There is no reason to assume next year will be down, only because this year has been so strong.

The context is important, possibly more important than historical data.  In the last 15 years, investors have experienced two market drops of greater than 50%: September 2000-October 2002 and again from October 2007-March 2009.  The first was the TTM (Tech, Telecom and Media) bubble and the second was the Financial Crisis, which led to the Great Recession.  The roller-coaster effect is there – no one wants to feel that pit in their stomach, of a market in freefall.

In my opinion, there are several factors key to what we should expect from the market.  The first is simple and well known.  Seasonality – December is typically the best month for stocks – widely acknowledged by investors.   Since 2000, the S&P has averaged a gain of 1.7% from Thanksgiving through Christmas with positive returns 77% of the time. (Bespoke Report 11/29/2013)

The second is the mixed nature of current economic data.  It is not giving investors direction.  The Federal Reserve, shortly with Janet Yellen at its helm, is likely to begin to reduce its bond buying program early in 2014.  This does not mean the economy is back on its feet, nor does it mean interest rates are at the beginning of a secular uptrend.  There are several things that will likely change the popular and over-simplified view of the near future.  Economic growth remains sluggish, Congress will in fact have to enact some policy to support it, and deflation may be the true monster-under-the-bed.

Finally, the demographic and economic landscape is changing, quickly.  The younger generation catalyzing this economy is different.  They are not like their parents, the typical economist’s generation, at all.  For example, fewer Americans have a driver’s license and even fewer drive cars.  Since 2007, the estimated vehicle miles driven figures have fallen.  Total new car sales in 2012 are the same (15M) as they were in 1978.  Total new home sales remain 50% below the level reported 20 years ago.  And, according to the Washington Post (April 17, 2013), student debt has gone off the hook.  In 2003, 25% of people under 25 had an average student debt load of $10K.  As of 2013, 43% of people under 25 have average debt in excess of $20K. There is no reversion to the mean here.  The baseline of the economy is changing.

At the moment, we’re in the home stretch – approaching the annual finish line where investors can measure their returns and claim victory, or defeat.  The S&P is up 8 weeks in a row and it’s reasonable to take some profits, and put a little change in your pocket (or buy some presents for your family).  If your capital gains are such that selling more stock now is not an option, you can sell and rebalance in January and apply any capital gains to next year.

If you are looking to increase your stock exposure, as many of you are, extreme selectivity and patience is key here.  There has been a lot more volatility around earnings release dates this fall, and I expect that to continue.  These temporary price swings are what we look for to initiate or increase positions.  The S&P 500 and five of its ten primary sectors are too “overbought” or too expensive to approach right now.  We are available to discuss your allocation and opportunities to take profits or to put funds to work, as your circumstances dictate.  Please do not hesitate to call as we look forward to a happy and prosperous December.

Bruce Hotaling, CFA

Managing Partner

Fear of Heights

It’s not uncommon for rock climbers to confront some fear of heights at different points in time.  This can be due to several factors.  On one hand, each of us has their own unique psychological makeup.  Some people cannot overcome their own nerves, in certain situations.  On the other side, there is the raw exposure, the vastness of the space below.  This, in combination with elements such as wind and snow can amplify hollow fear to an insurmountable degree.

Climbers talk of the fear, the tendency to freeze and become unable to decide where or how to move next.  These are all sensations stock investors encounter, although and importantly, without the physical risk.  The metaphor is effective.   Often times, the higher one finds oneself, the more difficult it is to think clearly, to make sound decisions and continue forward.  This is where we find ourselves today.

This year, U.S. stocks have scaled heights never seen before.  We are in the midst of a fantastic bull market.  Stock prices have risen 8 of 10 months this year, a solid 80% and well above the historical 66% average.  Bull markets are not precisely defined, but are generally characterized by rising prices, increasing investor confidence and expectations that strong results will continue.  Rising markets, such as the one we are in today can remain in place for long periods of time.

Year to date, the S&P 500 has generated a total return of 25.30% – good results for a full year, no less 10 months.   For the month of October, stocks rose 4.46%.  This is noteworthy as investors are often skeptical of October and this has nothing to do with Halloween.  Possibly the most infamous month in market history, October ‘29, ‘87 and ‘08, all saw stock market crashes, drops so precipitous it took years for prices to recover.

One change, something to monitor as stock prices seek new highs, is the rising valuation of the market.  According to FactSet Data, the trailing PE ratio (price/earnings ratio) is in the 16x range.  PE ratios were in this range when stocks crested back in October ’07.  For context, when the market peaked in December 1999 the multiple was over 30x, and when it bottomed in March ’09 it was below 9x.  At the current S&P 500 level of $1,766.5, stocks are selling for 16x 2013 expected earnings of $109.7 a share.  FactSet aggregate earnings forecast for 2014 are for $120.9 a share or a 10% growth rate.   If the PE ratio remains the same (ie. 16x) then the dollar value of the S&P 500 should also be expected to rise with earnings, to a level in the $1,935 range.

As the 3Q2013 earnings season wraps up, I would grade the results a B+.  Although the S&P 500 recorded all time high earnings, and the blended earnings growth rate was 2.3% (eight of the ten sectors reported higher earnings relative to a year ago), the results were not glowing.  In fact, Wall Street analysts lowered their forecasts for the fourth quarter – aggregate estimates went from $28.90 to $28.46.  As noted by FactSet, companies are beating earnings estimates, but fewer are beating revenue estimates.  This implies that business levels are not overly strong, even though companies continue to squeeze out higher profits.

For the market to move higher from here, we need growth.  Either the PE ratio or corporate earnings must move higher.  This is the point where some investors become stuck.  They are uncomfortable with the notion earnings can move materially higher.  The answer may lie with interest rates.  Everyone is afraid of rising interest rates.  While there are clear negatives to higher rates, on the positive side, higher rates typically signal stronger levels of economic growth.  This will boost corporate earnings and serve as a counter influence to a lower PE ratio.

In my opinion, though there may be some volatility in stock prices toward year end, December and January are seasonally strong months of the year to own stocks.  While some may seek to lock in profits, others will be equally keen to own enough stocks and will be bargain hunting.  I think the market is one of many leading indicators, signaling the future potential of the economy, GDP, and stock prices.

As we edge closer to the end of 2013, it’s an appropriate time to review your realized capital gains and finalize efforts to offset gains.  It has been a good year so you should expect some capital gains.  We also want to be sure your accountant knows what to expect.   If we have not talked about this, or if there is something else you would like to cover, please feel free to give a call.  Just as a reminder, you can review this, and other useful information, on your Tamarac portal.

Bruce Hotaling, CFA

Managing Partner

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