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

Musical Chairs

Stock prices, measured by the S&P 500, continued to move higher in March, gaining 3.6%. The market is now up 10.6% year to date and 13.96% for the prior twelve-month period. While many other popular measures of stock prices had already hit new high water marks, the S&P 500 chose to wait it out. The April fools aspect to the new high is that it’s not a new high at all, on an inflation-adjusted basis. I will leave that discussion to the market naysayers. We are in a bull market, and until something shifts, the prevailing trend is positive. Recent returns are above long-term averages, prices have moved higher in 9 of the last 12 months, and the last month of any true “stress” was May of 2012 when prices tumbled 6%.

One might think the relatively smooth pattern of stock returns during the last year would allow investors to begin to embrace the “bull” and allocate a higher percentage of funds to stocks. Yet, for individual investors, fund flows into fixed income mutual funds continue to outpace flows into equity funds. Investors seem to be busily listening to the chatter of Wall Street media pundits as though it were the background for a curious game of musical chairs. There is a sense of imminence, that everything is about to come to a stop, and no one wants to be the person without a chair.

In light of the markets recent high, we can look back to the last two times the market reached a high-water mark for some clarity. In early 2000 the S&P hit a new high. The market was coming off a period of growth like never before. Between 1995 and 1999 stock prices rose over 130%. Then, the technology bubble burst, and the market lost 50% of its value over the course of the next three years. In October 2007, the S&P again hit a new high. Investors had only just dusted themselves off from the Y2K debacle, when the subprime mortgage and subsequent banking crisis hit, again taking the market down by 50% over the course of the following 18 months.

So here we are today, the S&P touching a new high of 1,569 to close out the first quarter, and no surprise, investors are processing every bit of news as to whether or not this is the onset of the next crisis. I think this is somewhat misleading and unhealthy. The media attempts to attach meaning to every global event, and the resultant daily change in the prices of stocks, and this simply has no bearing on the long term merit of the assets you hold.

The characteristics of a bull market, one that is about to become a bear market, are quite a bit different than what we have today. Today, low but improving GDP numbers, high but improving unemployment numbers, low but improving sentiment numbers and moderate but improving P/E figures do not add up to the backdrop for a bubble or crisis. The fundamentals behind the market’s trend are positive and unlikely to turn on a dime.

When the market’s direction eventually changes, it will likely result from one of three sources. Interest rates are attractively low today, but when they begin to rise, and Federal Reserve policy changes course, this will have a negative impact on the markets. Inflation too is quite low, but when it begins to take hold (particularly wage inflation) this will also put some pressure on the markets. There is also the constant of the unknown event, the unanticipated thing that causes a true directional change in the markets.

April is one of the best months for investing in stocks. Just the same, prices are high. The market as a whole and most sectors of the market are overbought. This overbought state will temper itself with time. The transition from cash to financial assets at this moment requires some patience. Selectivity is critical. Moving from one market exposure to another (seeking better value or higher opportunity) at this point is highly recommended. Our indicators show certain stocks in the large cap growth space (domestic industrials, technology, health care) look attractive.

Long-term results require, in my opinion, a technique that allows investors to stay in the game. Deciding in absolute terms to invest, or not, is a game no different than guessing when the music will stop. To maintain, the focus must be on owning high quality investments (no products), transparency (the ability to identify and accurately price your assets) and liquidity (the ability to sell without holdbacks or other limitations). These are the same aspects I have long emphasized along with regular attention to asset allocation. Please feel free to contact me if you have any questions.

Bruce Hotaling, CFA

Managing Partner

Spring Fever

The bull market rumbled on in February. Measured by the S&P 500 stock prices ended the month 1.36% higher and are now up 6.6% as of February month end. Over the last twelve months, stocks have returned 13.5%, slightly higher than the long-term averages and stocks have been positive for 9 of those twelve months. From a practical point of view, the month was important in that it worked off much of what analysts refer to as “over-bought” levels, following January’s surge. Many stocks had become too expensive to buy.

Such a long stretch of positive stock returns can eventually have a constructive influence on investor market outlook and behavior. It can be stressful and unprofitable, to continually struggle with fear of an imminent meltdown. What better than to be riding a bull market and to be able to enjoy the ride? My concern is there may be a bout of spring fever working its way into Wall Street’s view of stocks.

According to Bespoke Investment Group, although the 4Q2012 earnings figures were generally above expectations, analysts have been revising their earnings expectations for 2013 downward. In my opinion, while important to monitor, this is evidence of spring fever. It’s not at all clear what it is going to take to make analysts more positive, but for now at least the market doesn’t seem to care. Maybe once analysts turn positive, it will be time to sell. (Bespoke Earnings Estimate Revisions, 3/1/13). Earnings revisions may be an accurate indicator and a sign to lower exposure to stocks. These analysts’ views may also be symptomatic, as I suspect, of spring fever, and likely to remedy itself in short order.

The economic data that Wall Street media pundits fuss over has been encouraging. The general assumption is that there is a natural positive correlation between stock prices and economic data. Assuming that is the case, we can take some comfort in recently reported auto sales, the strongest manufacturing data in 20 months, improving consumer sentiment, job growth and housing data. The sequestration is likely to have some negative impact on the economy, though no one knows precisely to what degree. The elephant still lingering in the room is the federal borrowing limit that has been pushed out until some point later in the year. Persistent economic strength will dampen the impact of the automatic spending cuts, making for a softer landing. We shall see.

If you would like some interesting free reading in support of the positive long-term market outlook, you can go to berkshirehathaway.com and read Warren Buffett’s 2012 shareholder letter. As usual he is full of practical and easy to understand advice. He did us all a favor purchasing Heinz and resetting the valuation bar on most food stocks. He also remains optimistic on rails, an area I have felt strongly about for some time. Lastly, I’m happy to review his assessment of dividends. His view is straight out of the CFA curriculum, where the favored approach is for the investor to choose to sell shares to realize a “cash” return, versus receiving a dividend.

I think dividends are important. The dividend discount model is the gold standard for stock valuation. Dividend yield is an important relative measure and income is real. This is largely different than investing for growth, over time. The appreciation potential from good investments held over extended periods of time is one of the hallmark principals of Berkshire’s market beating results over the years.

An interesting anomaly, revealed by analysis from Bespoke Investment Group, was the dramatic outperformance of “appreciation” over “income” in 2012. The S&P 500 stocks (by decile), with the highest PE ratios were up an average of 29.25%. The worst performing stocks were those with the highest dividend yields, which declined an average of 0.63%. While investors were clamoring for the safety net of dividends, as a defense against uncertainty, they were unknowingly tying one hand behind their back.

Spring fever or not (particularly among the analyst community) my sense is corporate earnings will maintain their positive slope, and PE ratios will continue to rise from their below average levels. I’m a buyer, on the dips.

Finally, we are holding several Pop-Up classes in our Wayne office, in conjunction with the Main Line School Night. Please join us for these educational opportunities and to see our new space. Call Valerie for more details and to reserve your place.

Bruce Hotaling, CFA

Managing Partner

The Bull

Stocks are in a bull market. Measured by the S&P 500 stock prices ended January up 5.04%. The index, at 1498.11, hit its sixth highest month-end close, ever. The five other instances the market closed higher all took place in 2000 and 2007. The highest month-end close for the S&P ever was October 2007 when it closed at 1549.37. So, from today’s level, we are a mere 3.4% from a new high water mark. This bull began running in March of 2009, the low point in the stock market’s response to the 2008 financial crisis. According to Bespoke Investment Group, comparing all the bull markets since 1928, this one has run for 1,425 days (ranking eighth) and the S&P has risen 123.6% (ranking seventh among all bull markets in percent return).

The fundamentals support the market. Recent earnings reports (and importantly, revenue) for 4Q2012 have been well above expectations and recent quarters. FactSet consensus earnings forecasts are $111.6 and $124.1 for 2013 and 2014. The 2014 numbers are quite a ways out and subject to revision, but they set the table for the current bull market to continue on into next year.

If recent money flows into stock mutual funds are to be trusted, popular sentiment toward stocks is in fact beginning to shift. Stock prices (similar to consumer confidence or non-farm payrolls) are a leading indicator. The stock market does an efficient job discounting multiple factors into stock prices. Rising stock prices indicate the investment backdrop is improving and we can look forward to a stronger economy, better corporate revenues and earnings, and ultimately higher stock prices.

While this ought to push prices higher over the long term, in the near term stocks are somewhat overbought. With stocks hitting new highs, it can be difficult to put new money into the market. Under these circumstances, both art and science come into play and patience is of the utmost importance. My conviction for stocks remains high, but I think a good bit of caution is due when approaching the market.

With high hopes that we have finally closed the book on the ill effects of the financial crisis, and with markets poised to hit all-time highs, there are a number of issues worth our attention. One is a persistent level of distrust in the banks (the banking system), particularly in the US and among developed countries. This was reported on recently at the World Economic Forum

in Davos, Switzerland, and in the lead article in The Atlantic (January 2013) “What’s Inside America’s Banks? How Wall Street Could Blow Up the Economy –Again”. This issue has the potential to flair, either from attempts to re-regulate (reinstate Glass Steagall) or worse, another round of negative disclosure and write-downs due to mismanagement of financial derivatives.

On a more business-as-usual level, there are several other things that could shock the stock market 1) the withdraw of accommodative policy from the Federal Reserve, 2) the inability of Congress to implement effective fiscal policy needed to replace the Fed’s stimulus, 3) a reversal in the current improving trend of economic data or 4) some unknown, unforeseen series of events (a black swan) that is impossible for us to attach any probability to, at all. This would include the recent rising trend in natural disasters.

The most critical role, from an investment management point of view is to pay close attention, and to question herd-think. My goal is to determine as quickly as possible whether or not new information merits some asset re-allocation. At a more granular level, we closely monitor the characteristics of our stock holdings and the behavior of their respective sectors. Currently, we are watching a changing of the guard – low dividend and small market cap stocks have outperformed recently, a reversal of what we observed in 2012. On the sector level, health care, energy and financial stocks have become the new market leaders.

After a snappy start to the new year, it’s a good time to take a breath and dial in our focus. I contend this will be a good year for stocks, with new high water marks, and a return of the sentiment lost in the financial crisis. I also think the tendency of the market to become overbought and oversold on a short term basis should be respected. Please feel free to call if we have not spoken or if you have any other questions. Finally, keep your hopes high, as Punxsutawney Phil did not see his shadow today, so we are expecting a shortened winter, at least here in Pennsylvania.

Bruce Hotaling, CFA

Managing Partner

The Picture or the Frame

Welcome to 2013. We here at Hotaling Investment Management, LLC wish you and your family a safe and prosperous new year! We will do our best to work with you to obtain these goals.

By most measures, 2012 was quite a good year for investors. Stocks, measured by the S&P 500 generated a total return of 16%. Bonds, measured by Barclay’s US Intermediate Government/Credit, returned 3.89%. This is a broad look at fixed income returns – and the simple takeaway is that most fixed income sectors did alright last year.

The numbers are now in the books. When the calendar ticked over into 2013, good as the returns were, they no longer matter. Now, by convention, we are collectively focused on what our returns will be for the calendar year 2013.

I am not a big believer in forecasts, so I will not produce a top ten list of prognostications for the coming year. You can find some of the more prominent views (Barron’s Roundtable, Byron Wien or Bill Gross) on-line. Most seers, over time, only generate 50/50 results. Their opinions, while interesting, have limited “investability.”

What I can do is point out certain observations, constraints or opportunities as I perceive them. In my opinion, it is often difficult for investors to hone in on the important stuff, and look through the noise. It is not new information or strategies that make the difference, rather it is seeing and acting on what is already apparent.

  1. Volatility is here to stay. Uncertainty is inherent in investment markets and always has been. Without it, there would be no return potential to investors. When the commentator on CNBC says “markets dislike uncertainty” feel free to turn off the television.
  2. Try not to “love” your investments. As Tom Hanks said in A League of Their Own, “there’s no crying in baseball.” Emotions will only cause problems.
  3. Herd thinking. 2012 produced strong equity returns while in fact most investors were moving money from stock funds into bond funds. The overwhelming tendency is to do what everyone else does. Think about becoming a contrarian.
  4. Taxes are going up. The payroll tax, a new Medicare tax and the new Net Investment Income Tax. They will impact nearly everyone, but will not have any noticeable impact on the investment markets. These are separate from the tax increases/deduction limits agreed to by Obama and Congress in avoiding the fiscal cliff.
  1. Earnings Estimates. Stock prices and earnings are reasonably well correlated over time. Current estimates for the S&P 500 are $113.15 (2013) and $125.11 (2014) per share. Any revision to these numbers is a critical factor to watch relating to the direction of stock prices.
  2. Valuation. The market is trading at 12.8x 2013 earnings estimates, below the 10 year average of 14.2x. A 14.2x on $113.15 implies a $1,600 price level for the S&P 500 or an approximate 10% return from today’s level.
  3. Economic Data. There remains a lot of economic wood to chop. Job growth is stubbornly slow, real income growth is low (declining), and income inequality is growing.
  4. Low Interest Rates. The Federal Reserve has stated its intention to keep rates lower, longer, until true economic growth takes hold.
  5. Marginal Inflation. Labor costs are low. Energy (oil and gas) prices are expected to continue to fall. That’s it.
  6. Cost is critical. Do not overpay. The key sentiment when purchasing an asset is caution, not urgency.

While I am optimistic about the coming year, I think a good measure of patience is in order. Sitting still is OK. Few made their investment riches in one or two trades. We will follow the same tried and true investment process and guidelines we have in the past.

One aspect of our investment process we are improving is our transparency. We are implementing a new portfolio accounting and reporting system called Tamarac that I am confident you will find to your liking. You will be able to view the same reports and analyses we view (if you wish). It will also be available through a client “portal”, allowing you to log in any time you like. This will be in place by March.

In the meantime, please feel free to check in if you have any questions. Valerie, Eileen, Justin and I are always available to take care of you.

Bruce Hotaling, CFA

Managing Partner

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