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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

Window of Opportunity

In broad terms, there have only been two clear points in time this year to buy stocks; late June and late August.  If you did not own stocks at the start of the year, the opportunities to get into the stock market have been limited and purchases at other points in time likely yielded less than optimal results.  This is not an unusual problem for investors navigating a bull market.  The impulse to buy becomes greater and greater.

Year to date, the S&P 500 is up 19.97%, a very good year by historical measures.  For the month of September, stocks rose 2.97%, a strong performance on the heels of a worrisome August.  A poor performance in September would have been a troublesome signal to many Wall Street analysts.  Now we face the risk of a big “give back” in these returns due to macro issues we usually take for granted; the federal budget and the national debt limit.  If the foundation becomes unstable, investors will conclude these issues are not resolvable, and prices will fall.  This will provide another window of opportunity.

Shakespeare is probably rolling in his grave watching the bizarre comedy (farce) taking place in Washington DC.  Our   Congressional leaders have allowed the Federal Government to partially shut down.  Ultimately, this will not play well on Wall Street and will do little to comfort foreign investors in US Treasury Bonds.  Depending on how long the impasse lasts, halting the government saves some federal spending, yet it will also eliminate distribution of all market related data, and will also put a crimp on an otherwise inchworm-like rate of GDP growth.  To the consternation of some, it will also end any efforts to push the Federal Reserve toward tapering its bond purchasing program.

The debt ceiling fight is a high stakes game, if it can be called a game.  To allow US debt to default and likely incur a downgrade from rating agencies is flagrantly irresponsible.  Our politicians have disconnected.   Since 1960, the debt limit has been raised a total of 78 times, 49 under Republican Presidents and 29 under Democratic Presidents.

As we move on into the fourth quarter, I suspect most investors have their hand on the dial and are braced to sell stocks.  I would expect a sell off to induce a lot of fear.  This is a distinct possibility.  At the same time, signals from Wall Street are that a resolution is expected.  Unless Washington drives the economy into a ditch, I think stocks remain the asset class of choice, from both a fundamental and long-term perspective.  Further, the surge in interest rates (beginning in May) has begun to normalize, and even reverse, as I expected.  It looks to me like the fixed income markets are beginning to come back into line (revert to the mean) as they often tend to.  The spike in the yield curve has been a fly in the ointment of an otherwise strong year in the investment markets.

Apple, the sleeping giant, has awoken.  The new iPhone launch appears to have been successful both in the US and abroad: 9mm phones sold versus 6mm in expectations. Additionally, the iOS7 operating system has already seen over 250mm downloads, the fastest in history. The most important metric for Apple is international growth.  Those solely focused on its domestic sales will miss the boat.

The Federal Reserve gave the stock and bond markets a positive surprise by leaving the current quantitative easing program in place.  The tapering of this program has been anticipated by markets, especially the bond market, since early this year.  With no constructive policy relating to jobs, education or anything that might ultimately bolster our economy, the Fed may have felt its hands were tied.

In my opinion, there is no need to reduce our allocation to stocks at this point in time, though I admit the backdrop is unsettling.  I think there will be some volatility and another opportunity to buy, before year end.  The reality is that any turbulence is likely to be short lived and with that in mind I am hesitant to take money off the table.  At the same time, fixed income assets are “cheap” and on a recovery track.

If you would like, please feel free to call me if we have not spoken recently.  Your quarterly statements are available on your Tamarac portal.  We have received a lot of positive feedback.  If you would like some help with your log-in please feel free to reach out to Valerie or Eileen.

Finally, with our Wealth for Women initiative, we are holding an evening seminar at the Radnor Memorial Library Tuesday October 15th on investment and financial planning issues confronting women.  I’m sure this will be an informative evening and I hope you can join us.

Bruce Hotaling, CFA

Managing Partner

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

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