Bear Trap

Stock prices, measured by the S&P 500, generated a meager 0.1% total return for the month of March. After January and February, when prices were clearly punching above their weight, things began to taper off.  The change seems largely due to the relentless circus underway in Washington DC.  At its height, optimistic and often fallacious tweets stoked investors.  Recently, reports of corruption and self-dealing have thrown a wet blanket on the party.  Normally, with the total return to stocks up 6.07% for the first quarter of the year, folks would be heading for the car dealership.  Instead, bullish investor sentiment has dipped to the lowest level since the election. 

Year to date, results have been driven by strong results from the technology sector (+12.4%). Consumer discretionary (+8.2%) also outperformed, but only when the extraordinary performance of Amazon is factored in.  According to Bespoke Investment Group, Amazon was responsible for one-third of the sector’s gain in Q1.  This is astonishing considering 6 of the 10 worst performing stocks in the S&P are from this sector, most of which are retail stores you know.  On the losing side of the equation, energy was -7.2%.  This was a surprise, as crude and especially natural gas prices struggled throughout the quarter.  In 2016, the energy sector returned 42.6%.  If there is a silver lining here, it’s the sky-high incidence of M&A in the energy sector.  According to Deallogic.com, corporate transactions in the oil and gas space totaled $96.7bn through March, the highest level ever.

From a fundamental perspective, not a lot has changed since last month’s letter.  Expected aggregate 2017 earnings for the S&P 500 now stand at $131, and the index is in the 2,350 range.  More importantly, estimates for 2018 are in the mid $140’s, according to data compiled by FactSet Research.  These numbers do not include any upside that might result from either fiscal stimulus or tax cuts.  Until the 2018 estimates become more viable, and unless stimulus comes to pass, the market as a whole is fairly priced.  The complacency that initially lulled investors as stocks began their end of year lift off remains firmly in place.  I recommend buying and owning only a select portfolio of stocks, as opposed to buying the market.  

The macro backdrop is murky, only because more can go wrong than right.  Stocks are clearly the best house on the block and near term, I expect earnings to hold up.  Inflation is modest, and that’s important for stocks since high inflation typically suppresses the market’s P/E ratio.  Keep in mind, the Federal Reserve did raise the Fed Funds Rate for the second time in four months.  Bonds and bond proxies have been under the thumb of a threatened steepening yield curve.  A drag is the continuing high value of the US$.  And, labor markets are at full-employment. It’s difficult for any government to effectively stimulate a full-employment economy, with a limited (or likely shrinking) labor supply and the intention to replace technology (productivity) with good old fashion labor.

The threats to a favorable outcome are many, and highlighted by the illogical talk of reviving the coal industry. The whole idea that this industry is relevant or will produce meaningful jobs is misguided. Coal is a dirty resource in an irreversible state of structural decline.  According to Morgan Stanley Research, coal production from 2014 – 2018 is expected to be down 67% in Central Appalachia and 19% in Northern Appalachia.  Natural gas is the leading source of power generation in the US, and it is transported via pipeline, just imagine that.

I think we need to proceed with caution here.  In Wall Street parlance, a bear trap is a head-fake, an indicator that the bull market has or is about to reverse course. It induces investors to sell, while the market continues its upward trend.  This has sadly been the case for many investors unable to stomach the swamp 2.0.  We’ve become conditioned, with the trauma of 9/11 and the financial crisis clear in our memories.  Fear can often be an unmanageable emotion, and lead to regrettable decisions.  My suggestion, for now, is to wait until the market begins to show us it wants to change course, rather than making premature guesses.  Please feel free to call me if you would like to review your asset allocation and the best path for you going forward.

Bruce Hotaling, CFA

Managing Partner

Spilled Milk

Stock prices have been on the move. Many investors firmly believed that if the election went the wrong way, stock prices were destined to tumble.  Since that infamous day back in November, to the utter exasperation of those same investors, stock prices (measured by the S&P 500) are up a total return of 11.22%.  Year to date, the total return to stocks is 5.94% with February contributing an impressive 3.97%.

The upward move has in fact coincided with a flourish of positive economic data.  According to Empirical Research, much of the recent strength in stock prices can be attributed to improving economic fundamentals, as evidenced by the recent spike in the PMI index.  The PMI is a widely accepted indicator of current business conditions in the manufacturing sector.  In support of the manufacturing data, the employment data is equally strong.  According to Bespoke Research, jobless claims have fallen to their lowest level since 1973.

Although the run in stock prices has coincided with strong economic data, there is more.  Stock prices have also benefitted from a newfound optimism over proposed tax cuts, deregulation and an infrastructure build-out.   Expectations have run amok.  To date, there is nothing that has happened on the fiscal policy front to support the heightened fervor pushing stock prices higher.  There is a notable void of detail and a surfeit of spin.  The timing and ultimate impact of any proposals is either unknown or carries the greater risk of disappointing the markets with a failure to deliver.  True policy is needed to implement any changes and with the degree to which the messages are mixed, one wonders whether there is an intractable void in competence.

Against this disconcerting backdrop, there is some basis for sitting tight.  According to FactSet, earnings estimates look to have stabilized at $130 per share for 2017.  Earnings are perpetually subject to revision by Wall Street analysts, and almost always downward, as initial optimism fades.  For 2018, consensus estimates for the S&P 500 are now a lofty $145 per share, an 11.5% increase over 2017.  This would be the biggest bump in earnings since the 15% leap from 2010 to 2011.  One comment that has attracted some attention is the speculation that these earnings can be obtained without the benefit of any of the planned stimulus. 

Stock prices may well manage to trend for some time, if only due to the fly-wheel effect.  By many measures, stocks are overbought and sadly the alternatives are either overpriced, or don’t offer any substantive return.  Investors are caught between a rock and a hard place.   According to Bespoke Research, the advance decline line has tipped downward, meaning fewer stocks are behaving well, even though the market continues to rise.  This is not a great sign for the bulls.

The present risks include the fact that the Federal Reserve has said it will be raising interest rates.  This has historically made it difficult for both stocks and bonds (don’t’ fight the Fed).  In addition, there is the pervasive tail-risk, the risk of an extra-ordinary event or tweet that leads to an avalanche of unintended consequences.  Finally, the failure to implement on the promised policy agenda, and ongoing political contagion, will begin to disappoint investors.

In my opinion, it’s no time to be a hanger-on.  I think we can take some profits in stocks that have gotten ahead of themselves.  Technology, healthcare and financial stocks all come to mind.  On the other hand, some stocks in the energy and real estate space have been bringing up the rear and look as though we can add to positions.  The level of complacency among market participants has been high, and as once reluctant investors are pulled in, the risk increases.  This sets the table for some challenging times when some selling inevitably begins.

Overall, my expectations run similar to last month: guarded and without window dressing.  For the remainder of the year, I expect average returns from stocks and below average returns from bonds.  My worry is a good portion of these average returns have already arrived, and the rest will be delivered on the back of greater than average volatility and unrest in the financial markets. 


Bruce Hotaling, CFA

Managing Partner

Populism and Uncertainty

Stocks began 2017 with an undercurrent of optimism as prices touched new intra-day and all-time highs. The total return for stocks, measured by the S&P 500, was 1.9% for the month of January. The month was notable, if for anything other than competing events in Washington DC, in that it was both positive and dull. There were no trading days when the market moved up or down by more than 1% since the 1.11% move on November 9th, the day after the election. Often, when markets hit new highs, it clears the path to further price strength.

The shadow to this optimism is uncertainty. This is often measured by the VIX, or the volatility index. The VIX is the Chicago Board of Options Exchange Volatility Index, showing the implied volatility of the market using S&P 500 index options.   The figure has been skulking in the 10% range since the start of the year. For some context, just prior to the election it was around 20% (its historical average), and during the financial crisis back in 2008, the VIX spiked into the 80% range. The implications of a high VIX are that options traders are actively attempting to position themselves for what they anticipate will be a turbulent market.

The VIX is frequently referred to as the fear index. It often happens that when investors are at their emotional limit, the VIX measure is high. Today’s measure is historically low. Yet, more and more well-known and vocal investors have begun to express discomfort with the US’s lack of direction, protectionist tendencies and militaristic posturing. The market appears to be discounting the rhetoric. There is a curious air of complacency among investors empowering them to make substantial bets on tough talk.

The tough talk, or bombast, has lulled market participants and created a high expectation. The rub is all the pro-business talk may or may not bring forth change. It will be quite a task to double GDP growth to the 4% level, as promised, on the back of an economic expansion now more than seven years old. The economy is at full-employment, and the outcome of certain proposals (tax reform, reduced environmental and financial regulations, fiscal spending on military and infrastructure projects) may ironically lead to inflation and other unintended consequences – but not growth. I suspect the complacency may have allowed investor and corporate confidence to run ahead of itself.

The most important measure of future stock prices, corporate earnings, are now being released for the period 4Q2016. According to FactSet Research, the growth rate for Q4 S&P 500 EPS currently stands at 4.2%, better than the 3.1% expected at the end of the quarter and of the 34% of S&P 500 companies that have now reported for Q4, 65% have beat consensus. If the 500 companies that make up the S&P 500 are going to generate the current consensus earnings of $130.76 for 2017 and $146.11 for 2018, they are going to have to get a move on. On the plus side, the resolution of the damaging oil price shock of 2014-15 will help, as will a more normal and steeper yield curve, and the addition of some fiscal stimulus the market has been begging for since 2008.

None of this will be clear, until it is. In a market such as this, we could cautiously step out of the car anticipating its imminent breakdown, only for it to rumble on down the road, without us. My impression of the way forward is to proceed, with a foot on both the gas and the break – a two footed driver. As expected, the big theme thus far has been the post-election landscape, though also as expected, companies are unable to quantify potential policy implications given lack of details. So, we wait.

My expectations remain somewhat guarded. I think average returns from stocks and bonds for the year ahead can be attained. My concern is that these average returns will be delivered on the back of greater than average volatility and unrest in the financial markets. We of course, cannot see this at the moment. With this in mind, I am happy to speak with you if we have not been in touch recently. My goal is to check-in, in order to reaffirm your asset allocation and near and long term investment goals.


Bruce Hotaling, CFA

Managing Partner

Suspension of Disbelief

Looking back at 2016, US stock investors earned an 11.9% return, as measured by the S&P 500.  That figure puts last year’s returns somewhere close to the historic average.  Yet last year was no average year.  Through the end of October 2016, stock prices had managed a return of only 5.8%.  At that point, expectations were low – prices had been flat to down since the end of July, the only month to deliver any true incremental returns.  Skepticism was running high and investors were holding higher than normal levels of cash, just in case.  On election day, the unthinkable happened.  Markets collapsed in panic, then normalized, and then managed to rally (returns jumped nearly 2x) into the year end.  I don’t think anyone could have made this up.

 The first question that comes to mind is, how did we get here?  There is a clear movement around the globe from old school civic patriotism toward a more base nationalism.  This was clearly evident in the June 23 Brexit vote.  Similar rumblings have been taking place in Italy, Austria, France and Turkey to name a few.  The primary drivers are economic disenfranchisement among white men, a growing sense of nationalism / xenophobia, and long simmering suspicion of political elitism at the top.  Now the US has picked up the baton and is off and running.

The second question is, where do we go from here?  Sadly, this is something akin to a leap of faith.  My concern is that we experience spaghetti-throw leadership.  My hope is the way forward involves thoughtful policy, with balanced leadership, clarity and purpose.  At the moment, I’m shocked by the shaming of corporate leaders on Twitter.  In my opinion, this form of demagoguery is antithetical to the spirit of US capitalist democracy.

The headwinds are there, but difficult to evaluate.  An overly strong dollar and trade disputes will temper US corporate earnings and generally weigh down global growth. A border tax – would raise prices on most goods – and likely be damaging to a lot of the US technology industry.   On the cup half full side, the ability of US firms to repatriate large sums of cash held outside the US is favorable.  Lower corporate tax rates would in theory be additive to EPS, unless lowering the deductibility of interest on corporate debt acts as an offset.  And, deregulating industry, the financial and energy complex, will likely be a tailwind, though important questions as to how, and when, may not be known for some time.

Talk is of expected higher economic growth.  This is likely braggadocio.  The fact is, productivity may well be crimped if the technology industry in the US comes under fire.  Technology is one of our most important, and global industries. Labor, another primary factor of economic growth, may also stall, considering the full-employment economy, and a professed resistance to immigration.  Some analysts have raised the possibility of a recession in 2018.  In my opinion, it’s overly optimistic to assume a dramatic breakout in growth in the US.

I think the return/risk assessment favors stocks, but only with the premise they be held for a longer period of time.  The near term risk of owning stocks is higher than has been the case in a long time.  Overall, stock prices are full.  Consensus EPS estimates for 2017 are in the $133 per share range.  At a 17 multiple, that prices the S&P 500 at roughly 2,260, or approximately its current level.  The market is ahead of itself, having pulled forward returns from 2017 into the tail end of 2016.

Sectors holding some interest are energy, financials and industrials.  I assume oil prices remain in a range, and the energy sector continues its recovery.  Financial stocks will see margin improvement with a normalized yield curve.  Industrial stocks will generally benefit from stable energy prices, a focus on infrastructure and technological innovation.  I am more inclined to own domestic stocks with a leaning toward value and smaller market capitalization.  Our focus will remain on quality investments with strong fundamentals. 

As 2017 unfolds, certain aspects of policy may develop clarity and hopefully become investible.  Until that time, I believe a cautious stance is the most prudent.  Please feel free to call so we can exchange thoughts and review the best course going forward.  


Bruce Hotaling, CFA

Managing Partner

Ignorance is Bliss

Much of the activity in the stock market since November 8th, both in the US and around the world, has been a speculative response to the election results. The surprise optimism was evident in November, as stock prices measured by the S&P 500 rose 3.7% (0.7% prior to the election and 3.0% after).  Year to date, stock prices have risen 9.8% and by most standards, 2016 has been a reasonably good year for stock investors.  Historical returns for the S&P 500 average 10% per year, and recently stocks returned 1.3% in 2015 and 13.3% in 2014.

Amidst the frenzy of tweets and conjecture, many investors are having trouble developing an actionable thesis.  So, the immediate question is, what facts do we have to work with?  First, interest rates have risen on the long end of the curve in anticipation of higher growth and inflation.  Unemployment is hovering in the 4.6% range, low enough to spark wage inflation among the prime-age workforce.  Consensus is the Federal Reserve will raise rates at its December 14 meeting.  The US$ is higher today versus the Euro than any time since ’03.  Historically, energy prices and the US $ are inversely correlated.  And, since November 8th, technology (de-globalization) and health care (elimination of affordable care) have underperformed, while financials (higher interest rates and de-regulation) consumer discretionary (tax cuts) and industrials (fiscal spending and infrastructure) have been bid up smartly by investors.

The cup half-full view of what’s to come is compelling.  Some fiscal spending may give the economy the boost it has long yearned for.  Lower tax rates are a pure windfall, and the combination of the two may well lift GDP above its recent 2-2.5% ceiling.  The last time GDP was north of 3% was ’04-’05 and north of 4% was ‘’97-’00.  Many aspects of US infrastructure are in urgent need of attention, from roads to levees, electric transmission to water.  Some investment here would spur growth, improve our quality of life and longer term well-being.  Increased inflation, historically integral to growing economies, will help avert the dreaded deflationary spiral, and also help Congress navigate out from under the ever growing $20 trillion gross national debt.

On the other side of the coin, there are a number of things to watch for, akin to unintended consequences.  As I noted, the value of the US$ has skyrocketed.  A high US$ will be a drag on US multinationals’ earnings.  It will also exacerbate the trade deficit and pressure GDP downward.  The rising yield curve and higher interest rates will make credit more expensive, raising mortgage rates and slowing growth.  Higher inflation may well push down the already elevated P/E ratio on the stock market.  Unless earnings can reverse their malaise of the last few years, prices are ripe to revalue downward at the first hint of trouble.  The flow of funds into stocks (out of bonds) has been pronounced.  This means more investors are taking on more risk, at the very point in time when the risk of an unanticipated event is high, extremely high. 

With so little facts to work with, markets have been jumping at shadows.  My thought at this point is to underweight fixed income.  I think rising rates will allow us to buy better yielding bonds.  At the same time, bond mutual funds are slightly less attractive, as they behave poorly with the threat of higher rates.  Stocks remain the highest potential-return asset class, though we should be wary of getting caught up in a momentum trade.  Valuations are high, and the “tail-risk” present in the markets today is unquantifiable.  Investors have shifted their focus to value stocks this year.  Growth stocks, historically our preferred type of stock, have had a more difficult time this year. For example, technology and health care and many consumer stocks have been under pressure since the election. We are working hard to rebalance our holdings to best reflect our view of the present landscape. 

 Finally, we are preparing for year-end, and doing our best to limit realized capital gains.  I think we have to be both patient, and attentive.  We are long term investors, and before making strategic changes to our portfolios, I prefer to see some evidence of actual policy, footprints in the snow so to speak.  If you like, please feel free to check in, and I can explain in greater detail.

Bruce Hotaling, CFA

Managing Partner

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