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Melt Up

Stock prices began 2018 right where they left off in 2017 – measured by the S&P 500, stocks recorded a total return of 5.7% in January.  The market’s buoyancy is uncharacteristic.  The last true down month in the stock market was October 2016, 15 months ago.  The steady month over month returns have in effect hypnotized investors into thinking this ongoing melt up is normal.  The monthly variability of returns to stocks in 2017 was 1.1%, the lowest measure our research produced in any year dating back to 1982 (the average monthly standard deviation was 4.2% during that time).

While I am uncomfortable with the pattern of returns, I think there is a fundamental basis for the strength in stock prices; the primary factor being earnings.  US corporations are delivering parabolic improvements in earnings, not seen in years.  According to FactSet Research, 4Q 2017 corporate earnings reports are outstanding, coming in with a blended growth rate of 13.4%.  In the last month alone, CY 2018 estimates for the S&P 500 earnings jumped 5.3% (from $147 to $155), representing the largest increase in estimates over the first month of the year since 1996.

Other factors supportive of the earnings inflection are the surprisingly weak US$ and turbo-charged global economic growth rates.  The weak US$ is difficult to understand.  Given the backdrop (Fed raising rates, wage inflation), one would expect the currency to strengthen.  Equally supportive is a healthy global economic revival boosting economic output and trade.  The IMF recently revised its global growth forecast to 3.9% – more customers buying more US made goods.

A fly in the ointment will inevitably appear, and the most likely catalyst of more normal behavior (regression to the mean) from stock prices will be higher interest rates.    When rates rise, equity risk/returns often do not look as favorable.  The yield on the US 10-year Treasury note rose to its highest level in nearly four years recently.  Inflation and unemployment data imply the Federal Reserve will remain on track to raise interest rates throughout the year.  The old adage, “don’t fight the Fed” may well lead stock investors to take pause.

The next spoiler to emerge will be skyrocketing US deficits.   Estimates are the Treasury will have to borrow up to $955 billion to make it to the September 30th fiscal year end, more than twice the year prior.  Lower tax receipts means we borrow more.  To induce lenders, interest rates will continue to rise.  Higher borrowing costs, on more debt with reduced tax receipts is a prescription for trouble.  Akin to a gambler or addict, leadership in Washington has opted for economic (and political) bliss today, at the expense of our children and grandchildren.  Eventually, someone will have to make hard choices.

Future investment returns are being pulled forward.  On the back of the one-time tax cut benefit, consumers and corporate America have their wallets out.  This will spur a flash of growth, but not long-term fundamental growth.  Further, expectations are lofty, regulations (financial and environmental) are withdrawn, and animal spirits are now alive unlike any time since the late 1920s or 1990s.  It’s no longer a fear of the stock market “crashing” or heading into a downward spiral, it’s now the fear of missing out, the age old driver of unbridled human behavior, greed.

Finally, the market place is changing in ways we cannot foresee.  For example, the emergence of ETF’s as primary investment vehicles, the emergence of crypto currencies as the next big thing, and the devolution of asset class correlations have made for a “wild west” backdrop.  A melt down, or at least some mean reversion is inevitable.  Our hope is that any downturn is measured and stair-stepped.  With this in mind, our effort is to guard against foolish impulses and focus our work on the investment policy we’ve discussed and put in place for you.  We are rebalancing over exposure to stocks and trimming specific over-weight holdings.  Changes to the tax code did not affect the favorable 15% long term capital gains rate.  Please feel free to give us a call if you would like to discuss our views in more detail or any changes to your profile.

Bruce Hotaling, CFA

Managing Partner

Animal Spirits

Happy New Year!  I wish you a peaceful and prosperous 2018.  Looking back, 2017 was prosperous for US investors, as stocks generated a total return of 21.8%, measured by the S&P 500.  It was a good year, by historical standards.  Over the last 30 years, stocks have averaged a total return of 12% with an annual standard deviation of 17%.  Other years with big returns, such as 2009, 2003 and 2013 to some degree, were classic rebound years.  Then, there was the stratospheric run in the late 1990’s when stocks averaged 28% returns for five consecutive years.

What drove stock prices in 2017?  There were several things that cumulatively led to a “perfect storm” for stocks: the US $ weakened against most major currencies, oil prices moved back into a range supportive of normal capital spending, OECD countries collectively grew, US corporations experienced double-digit earnings growth after several flat years, the prospects of corporate tax cuts stirred animal spirits, interest rates remained low and the Federal Reserve was somewhat accommodative, all with a general backdrop of full employment and improving consumer sentiment.

What should we look for in 2018?   According to FactSet Research, Wall Street analysts are forecasting S&P 500 earnings growth to continue at an 11.8% clip, with energy, materials, financials and info tech leading the way.  Stocks with higher international exposure generated superior earnings growth in ’17 and this is expected to persist in 2018.  Analysts’ estimates are for continued double-digit growth and $146.60 per share in 2018 and $161.30 in 2019.  Stock investors are thrilled to move on from the meager 3.2% pace of growth from 2012 to 2016.

The tax cuts recently passed by Congress have long been anticipated by investors.  They will fuel investor optimism for a time – until the true benefits to corporate earnings and household wallets start to pencil out.  Sadly, elected officials in Washington have given up on any sense of fiscal discipline.  The federal deficit is north of $20 trillion.  Tax cuts will unnecessarily increase the deficits (both financial and environmental), lead to higher interest rates and inflated costs (housing) and cause more sensible governments in the future to have to raise taxes to account for this generation’s need to have it all, now.

On the immediate horizon, there are flashing yellow lights – things to watch for that may stall the stock market juggernaut.  Unemployment is low, and the number of job openings is near record levels.  Labor force growth, a critical element in the economic equation, continues to decline.  With no constructive immigration policy, higher wages will ultimately spark inflation and hamper profits. In response to an uptick in inflation, the Federal Reserve will likely raise rates, making credit more expensive.

We are also faced with a chaotic backdrop that many people cannot embrace.  There is a lingering feeling of apprehension continually poked by twitter trolls and divisive memes.  The trend is troubling and mirrored to some extent in the Bitcoin bubble – an emerging tendency for people to put more faith in computer code than human institutions.  Technology is driving change that we are only beginning to understand in retrospect – there is risk these uncharted waters continue to disrupt.

My view is we have to rely on what we can measure.  The market has been trending higher, so like a good angler, the trick is to play out slack.  I think we have to defend against complacent thinking and remain disciplined.  Early this year we will be busy resetting asset allocations that have become stock heavy over the past 18 months.  This will require trimming some of our big growers, and repositioning to allow for more growth/value balance in your portfolio.  Capital gains taxes have not changed, and this works to our advantage.

There is an old stock market truism, “pigs get fat and hogs get slaughtered”.  As is the case, with heightened returns come animal spirits.  Our job, at the moment, is to defend against greed trampling common sense.  I have confidence in our process, and would be happy to review your asset allocation with you, necessary cash levels and tolerance for capital gains, as we start the New Year. 

Bruce Hotaling, CFA

Managing Partner

Taxing

It’s been a taxing year in many respects, but clearly not for investors in US stocks.    Year to date, the total return to stocks (measured by the S&P 500) is a robust 20.5%.  With the exception of a modest miss in March, returns have been positive for 13 consecutive months.  This is the longest period of consecutive returns, and with the lowest month over month standard deviation, going all the way back to 1982.

The goodness extends beyond the US.  Year to date, stock markets in most major countries around the world have produced handsome returns.  These markets include traditional economic juggernauts (Germany +27%), old line economies experiencing difficulties with their neighbors (UK +16%) and even economies no one else seems to like all that much (Russia +1%).

In spite of the soap opera in Washington, there are a number of factors propelling our stock market: earnings growth is inflecting upward, oil prices are stable, economies around the world are echoing our economic expansion, central banks around the globe are withdrawing stimulus (inflation trade) and Wall Street’s animal spirits are running wild with anticipation of the benefits from tax-cuts for corporate America.

Seasonal return patterns tell a story.  Since 1982, December is clearly the best month for stocks, with a positive return (batting average) 77% of the time and a net average return of 1.75%.  The next best month is April, with a 72% average and a net average return of 1.64%.

Stock prices have risen, and are no longer cheap.  According to FactSet Research, the trailing P/E ratio for the S&P 500 is 21.  For context, at the apex of the dot com bubble, March 2000, the market’s P/E ratio was a healthy 30.  In contrast, at the low point of the financial crisis, March 2009, the market’s P/E ratio was 10.  So, best of times, worst of times – today we are smack in the middle.

 The overarching issue on everyone’s mind is taxes.  The drama is playing out inside the Beltway, but the repercussions are being felt on Wall Street.  The effort is to spin a new tax code, lowering taxes and simultaneously spurring future growth.  Investors are licking their chops. Income taxes were briefly imposed in 1861 to help pay for the civil war.  The 3% tax was repealed in 1872.  In 1913, the 16th amendment gave Congress the authority to levy a federal tax on income.  At that time, only a small number of people actually paid. 

 Our current progressive system has taxpayers with incomes over $200,000 paying nearly 60% of all federal income taxes.   Based on early analysis of the bill, the majority of tax cuts will benefit folks in this income group, and more so for higher income groups.

 The last time a tax cut was proposed, in 2001, the Congressional Budget Office projected a $5.6 trillion surplus over 10 years.  Today, the budget office forecasts deficits will total $10.1 trillion over the next decade.  The deficit is expected to top $1 trillion a year in 2022.  Federal debt held by the public is at the highest level since shortly after World War II, at 77 percent of GDP. (NYT 9/28/17)  The political imperative to cut taxes has now superseded any view toward fiscal prudence.

 We’ve done some analysis, and a reduction in corporate taxes will boost earnings for stocks.  The puzzle is which stocks, and to what degree.  Our working assumption is that some benefit is already priced into stocks, and there is the potential for more, though this will require clear and well communicated legislation.

 At some point, I expect the market to revert to the mean.  Consumer confidence is high, as is confidence in the stock market.  These can be yellow lights.  Since Thanksgiving, the market has begun to rotate, away from the year’s big gainers, and into “safer” low growth names.  We have been anticipating this shift in leadership from growth to value.  If the rotation persists, we will look to take more profits in our highest performing stocks before the end of December.  If we wait until the new tax year to rebalance, we may be faced with a multitude of investors with the same clever thought.  My preference is to stay in front of the pack, and if we owe capital gains, to pay them from this year’s generous profits.  Please feel free to check in if you have any concerns.

Bruce Hotaling, CFA

Managing Partner

Narrative

October ends with Halloween.  Apart from All Hallows Eve, and the Day of the Dead, there is a distinctly scary tone to the way Americans choose to celebrate the holiday.  It has somehow evolved into something folks just do each year, and it carries a frightening narrative.

Outside of the world of fabricated ghosts and goblins, there is a broader narrative at play, driving strength in the financial markets.  The underpinning of the narrative is the high level of anticipation in improved GDP figures (job growth and higher wages) with stimulus from tax cuts (both personal and corporate) and incentives to capital spending anchored in a renewed emphasis on active fiscal policy.

So far, we have not seen evidence this is anything other than a story.  But the stock market has another view and continues to march on.  Stocks, measured by the S&P 500, returned 2.2% for the month of October, and are now up a cumulative 16.9% year to date.  If we look back to the beginning of 2016 (a 22 month window) stocks have been up 16 of those months (a .727 batting average) and have generated a total return of 30.9%. 

It’s hard to determine how much of this story is already priced into the markets.  Certainly, influential people in the system are perpetuating it, as the Treasury Secretary recently threatened a dramatic drop in stock prices if tax cuts and reforms were not enacted as prescribed.  From my perspective, the strong returns to stocks is principally the result of a remarkable recovery in US corporate earnings.

We are in 3Q17 earnings season, and according to FactSet Research, as of 10/27/17, 76% of S&P 500 companies have reported positive EPS surprises and 67% positive sales surprises.  The blended earnings growth rate for the S&P 500 is 4.7% for the quarter, well up from the previous estimates in the 3% range, and without the hurricane related hit to the insurance industry, the blended earnings growth rate is 7.4%.

As the market is a discounting mechanism, meaning it extrapolates future outcomes, the current behavior of stocks implies a rosy future.  This is supported by the collective outlook of stock analysts’ predictions for future earnings.   Most people do not realize that between CY14 and CY16 S&P 500 earnings ground to a halt.  Mired at 119, earnings were dead flat for a three year span.  Today, according to FactSet Research, analysts are projecting near double-digit bottoms up earnings growth for the S&P 500: 130.8 for CY17, 145.8 for CY18 and 160.3 for CY19.

The underpinnings of this growth inflection are tied to several existent factors.  Synchronized global growth is spurring demand at multi-national companies.  The low value of the dollar is making US exports more affordable.  The continued stabilization in oil prices is allowing the energy industry as a whole to recover.  There is some confidence that the new leadership at the Federal Reserve will continue to prudently manage monetary policy.  All of this is taking place in spite of considerable concern that the tax reform and cuts that will ultimately spur the economy (and thus further corporate earnings growth) may never be implemented. 

Then, there is the scary Halloween narrative.  We collectively keep telling ourselves nothing is the matter – there is not a monster under the bed.  We try and put on a brave face, but the fear is there.  Washington is in disarray, and we often hear the monster either via Twitter, or bombastic claims in news reports.  The level of doubt rises.  This flies in the face of optimistic analyst earnings forecasts and stock returns we do not want to give up.

As we approach year end, we can take satisfaction in an extended period of stock price appreciation.  There will inevitably be an unsettling event that sparks selling.  Over the next few months our effort will be to take some profits in stocks that have outsized positions in portfolios, to lock in returns and raise some cash to allow a degree of comfort going forward.  Please feel free to check in if you would like to discuss further.  We are also taking a close look at realized capital gains, though I have to say there are not many off-setting losses after the period in the markets we have had.

 

Bruce Hotaling, CFA

Managing Partner

Crow’s Nest

In the UK, when you cross the street, there are friendly reminders to “look right” printed on the edge of the road.  The message is to pay attention, but in a direction many of us are not accustomed to looking.  Here in the US, in the world of financial assets, the implicit message today is to “look up”.  While some may think of prayer, I’m not heading in that direction.  As much as any time in recent memory, the imperative today is to keep a sharp watch on the horizon.

Stock prices, measured by the S&P 500, advanced again, 1.9% for the month of September, and are now up a cumulative 14.2% year to date.  It’s been steady going for share prices of US stocks, with March the only down month this year, and then a mere -0.04%.  According to The Bespoke Report, there have been only 8 days this year when the S&P 500 has moved +/- 1%, with only 1963, 1964 and 1972 recording fewer days.  We are deep into a long-running bull market, and at the moment, there are few signs the trend is about to turn.

From a behavioral perspective, it is clear investors are beginning to be lulled in.  While there is no specific reason to believe the slope of the uptrend is about to change, some baseline prudence at this point is warranted.  Anecdotally, we’re coming up on the 30th anniversary of the October 1987 crash – a point in time I remember well.   My concern now is our collective complacency is creating the foundation for people to own a greater percentage of stocks than they would otherwise be comfortable owning.

To be clear, the fundamentals look reasonable.  2Q GDP figures were recently revised to 3.1%.  The US is in the 9th year of an economic expansion.  It is likely growth can continue in spite of the damage inflicted by hurricanes in Florida and Texas and forest fires in California.  It is also hard to foresee higher growth than what we now have without a change in access to labor.  Unemployment, in the 4.4% range, is the lowest since 1960s.  Importantly, inflation is not apparent, yet.  The issue here again, is labor.  The job market is becoming tight and it seems like wage inflation is inevitable.

US 3Q earnings are just beginning to be reported. Expectations are for results better than analysts’ have projected.  The earnings beats will likely be attributed to several things: an unusual period of synchronized global growth, stable oil prices and improved US output, a “constructive” upward shift in the yield curve, and the low value of the US dollar.

I expect a continued resurgence in corporate earnings to support stock prices through 4Q 17 and likely into 1Q 18.  There has been speculation that corporate earnings would benefit from a realignment of the tax code.  In light of the recent disarray in Washington, it seems highly unlikely any real progress will be made.  There is no doubt a repatriation tax holiday would be a tail-wind, but I do not think the market expects it, and will shrug off one more disappointment as more of the “new normal”.  In my opinion, we will see no fiscal stimulus, modest growth and increasing (but not debilitating) inflation.

There is a good argument the most significant risk the markets face is geo-political.  This is a category of market risk that is in many ways not there, until suddenly it is.  So much takes place out of the public eye, surprises (market shocks) can stem from this largely indirect factor.  The greatest effect is the undermining of investor confidence due to extreme price volatility.

In this vein, a clear concern, fanned by the Equifax hack, is both the security of our personal data in an information driven world, and the ongoing attempts to manipulate popular media.  There appears to have been a well-orchestrated, and highly effective campaign by state sponsored Russian hackers to influence popular opinion in the US.  My primary concern is whether the foundation of our democratic process has been compromised. 

Harking back to our communication last month, if you have not frozen your credit, please do so.  We can send you instructions to put a freeze in place.  This time of year, we are busy reviewing portfolios for the year end.  We want to be tax prepared.  If we have not spoken recently, or if you would like to arrange a review, please do not hesitate to reach out.

 

Bruce Hotaling, CFA

Managing Partner

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