Investor behavior has been by and large complacent. The market commentary has been Pollyannaish. The combined effect has been an extended period of positive returns and low volatility. Stock prices, measured by the S&P 500, rose for 15 consecutive months, something they had not done in over 20 years. Then, in February, stock prices fell by an uncomfortable 3.69%. Sharp price drops, 4.1% on the 5th and 3.75% on the 8th, echoed swings felt prior to the onset of the financial crisis.
The market backdrop looks to have shifted. A trend change cannot be extrapolated from one month’s returns. Just the same, it may be that the majority of the market friendly changes (tax cuts, regulatory roll-back, loose spending) are baked in. If this is the case, the return/risk profile stocks offer may have begun to seesaw. Here are some observations worth your consideration.
The dominant factor influencing stock prices is earnings. 4Q 2017 was one of the strongest earnings seasons in the last 20 years, according to Bespoke Research. The “inflection” in earnings is remarkable, as they had been flat. We tend to extrapolate data forward, and expectations going forward may be too high.
The surge in US corporate earnings has been bolstered by an up-swell in economic growth around the world. Manufacturing PMI’s around the world are simultaneously rising, and although Europe’s emergence from the global debt crisis lagged, it’s now the catalyst for a full-fledged global economic revival.
Another boost to earnings has been a weakening US$. This allows for a currency translation bump, when earnings from abroad are repatriated. This tailwind has been in effect since November 2016, as the US$ has fallen roughly 15% against the Euro.
The current administration’s weak US$ policy is apparently intended to cure the trade deficit. Curiously, the trade gap widened in January to the highest level since October 2008. The recent imposition of tariffs on various imports may help offset the trade deficit but the true economic result will more likely be a decline in domestic growth – the opposite effect from the intended goal of making America great (protecting US industry).
The recent emphasis on fiscal policy and deficit spending is a significant concern at this point in the economic cycle. It’s inflationary by definition, and the budget deficit may well exceed $1TN in 2018, something last accomplished in the dismal recovery from the financial crisis. The looming cost of financing increased government debt levels is a large reason for the sharp increase in longer term interest rates.
Wages are also going up, which is good for workers earning the $7.25 federal minimum wage, but this too is a source of inflation. Last month’s inflation data was the spark that ignited the February stock market sell-off. The Fed has signaled it will raise rates three to four times in 2018. Long term, there is a good likelihood the Fed (rising interest rates) will take the blame for triggering the next recession – not the ambitious policies that catalyzed the need for higher rates.
Finally, volatility is back. This is a reflection of these disparate factors. Stock prices move up and down and this normally tempers investor behavior. When price volatility is low, investing in stocks becomes too easy. The spike in volatility in February was only the second time the “fear” index hit those levels since the 2008 financial crisis.
Often times the stock market is not reacting to an event, as many TV commentators attempt to explain, rather it is signaling. Stock prices are a leading indicator. Along these lines, the sudden jump in price volatility (the VIX) may well be foreshadowing change. The stock market may be telling us inflation is here and the Fed’s response will be to raise interest rates. Four rate hikes may be the equivalent of taking away the punch bowl. In my opinion, a raised level of caution is healthy here. We have to be able to live with the ups and downs, and to do this may require owning less of the risky asset. We have been repositioning portfolios to reduce oversized positions and address our view of the trend going forward. If you would like to review this with us in more detail, please don’t hesitate to check in.
Bruce Hotaling, CFA
We are sitting in the front row seats, mouths and eyes wide open, hearts racing, gripping the arm rests. We’re watching the stock market equivalent of a Zombie – it’s barely moving, arms outstretched, lumbering forward, and it’s somewhat terrifying to watch. Something bad must be about to happen, but it’s not clear what. This is how many investors are experiencing their participation in the stock market today. Fear is on the rise but it’s not clear yet whether it’s an illusion (created by the media) or real and we should be looking for someplace to hide.
For the month of June, stock prices fell 2.1%. This was the third time in six months stocks have produced a negative return for a .500 batting average (below their .667 historical average). For the first half of the year, stocks measured by the S&P 500 returned a scant 1.2%. This is not much reward for taking on all the risk that typically comes with owning stocks. In fact, according to Bespoke Investment Group, the first half of 2015 will be the first time ever the S&P 500 has not been either up, or down, more than 3.5% at any point, during the first six months of the year. In years past when the market has been this passive, the average returns for the second half of the year have been around 6%.
The good news for you is our stock portfolios are well positioned to take advantage of the sub-tendencies in this market. Growth stocks outperformed value at every capitalization level. High P/E and low dividend yields outperformed. Sectors we are overweight remain health care, consumer discretionary and increasingly the financial sector. They are all generating excess return. We expect financials to work well if the yield curve begins to shift upward and retains a positive slope. The other sector we are attracted to is technology. There are many innovative companies we own with an emphasis on the internet of things, and emerging technologies. We are underweight energy, consumer staples and industrials. Materials are of no special significance and we simply do not own utilities.
For the most part, the recent news flow has been little more than media contrivance. Greece, whose economy is similar in size to the greater Miami (according to Paul Krugman) is not going to destabilize the US stock market. Reported declining growth in China, a controlled communist economy, is suspect. We do not invest in Chinese companies. The US companies we do own make their own decisions as to the degree to which they deal with China. Apple, for example, produces and sells vast quantities of product in China. I believe the events that ultimately validate investors’ fear, the black-swans, will surprise all of us. I also believe Russia remains the greatest possible source of near term market disruption – far more than Greece.
More importantly, we are just entering 2nd quarter earnings season. Strong 2nd quarter earnings will be supportive of even stronger 3rd and 4th quarter earnings, and thus positive for earnings revisions. As we have discussed in the past, the stock market is an effective discounting mechanism. Today’s stock price tendencies are reflective of what we should expect in the future. Stock prices are primarily driven by future earnings expectations. The stock market’s Zombie-like behavior to this point in time could be signaling some reticence with respect to earnings for the second half of the year.
According to FactSet Research, the P/E ratio of the S&P 500 for the forward 12 month period is 16.5x. For some context, this is above the 5-year average of 13.9x and the 10-year average of 14.1x. Current bottom-up earnings expectations for 2015 are $119.5 a share and $133.72 for 2016, a 12% rate of growth. This would be the index’s highest growth rate since 2011. I expect the market to recognize this forecasted rate in earnings growth, and for stocks to behave accordingly in the second half. To be clear, if it looks as though the growth is unobtainable, then it could be the Zombies are more real than illusionary. If that is the case, we will want to consider selling some stocks, and de-risking your portfolio.
Until that day, if the fear becomes overwhelming, please call so we can discuss the best next steps for you. Of course, it may be time to simply turn off your television and enjoy the beautiful summertime.
Bruce Hotaling, CFA
La Pina – July 2014
Pinarello is an Italian bicycle manufacturer founded by Giovanni Pinarello in Treviso Italy in the early 1950’s. The brand has enjoyed huge success in the professional peloton. Today, son Fausto (pictured above with Sir Bradley Wiggins, and Miguel Indurain) is the company’s ambassador to the cycling community.
Each year, Pinarello sponsors a Grand Fondo, (also known as a cyclosportive) which has been popular in Italy since the early 1900’s. La Pina is a challenging timed course across the Veneto and then up over the Treviso Alps with two category 1 climbs.
We rode through the narrow streets of Treviso for the 7:45 am start and the forecast was for rain throughout the day. With over 1,000 entrants, it took our group from InGamba (www.ingamba.pro) a few minutes to reach the start line. A few of us (Chris, Mark and Danny) were planning on riding the Lungo, while others were going to tackle the slightly less daunting Medio. We more or less stayed together, moving up through the swarms of riders. The road was a sea of 60-70 rider pelotons. For 30 km we leap frogged up the road from group to group at a ferocious pace.
By the time we turned off the main road toward the first hills, the roads narrowed and thankfully the crowds thinned. The short steep climbs on the narrow roads (paved cart paths) were challenging, and no one seemed to be settling into a pace, we were going full gas, up the hills and down.
After the medium and long routes split, the long route went up, in a big way. The Passo Praderadego is not to be taken lightly. The climb, roughly 14 km, is a maze of switchbacks. The roads were not regularly traveled and shrouded in trees, making them mossy and slippery. The constant climb reached grades of up to 18%, which made for 720 vertical meters of tough climbing. At the top, Chris was never to be seen again (until the finish). Danny, Mark and I bellied up to the table with Coca-Cola to re-fuel. Mark immediately bolted, my final clue this was no Sunday jaunt – it was everyone for themselves and the no-waiting rule was in effect.
The descent was steep and cold. Even though the rains never came, we had gained a lot of altitude. Danny and I rode with a small group of riders we had cobbled together, across the Valle di Schievenin, a valley floor. Before long, we began to wind our way back up into the foothills. We sliced through several small villages and suddenly were at the base of Monte Tomba. This climb rose 540 vertical meters, and while it wasn’t as high, it was every bit as steep. I found myself looking down at my gears wishing I had another sprocket or two on my rear cassette.
At the top, I was exhausted, soaking wet and sick of climbing, but I got with the program and did not sit around eating sandwiches. A quick Coca-Cola from Jose and the InGamba support van and boom, I was straight onto the super fast and technical descent. When I came out of the switchbacks, the speeds were unbelievable. Curiously, there were also not many riders around. By the time I hit the main road at the bottom a group of 20 or so appeared out of nowhere. We organized ourselves into a paceline, and began picking up stragglers as we raced on toward Treviso and an ice-cold beer.
Not having studied the route carefully (beyond the two monster climbs) I didn’t process the last little “bump” we had to cross, the Santa Maria delle Vittorie, before the final 20km run into Treviso. This was a test, as my legs and back were aching and begging to get off the bike. As we powered down off the back of the Santa Maria, some of the remnants of our prior group reformed. My legs were cramping and I couldn’t accelerate as fast as some in our group wanted, prompting a good old fashion Italian tongue lashing. I countered with the peace sign, knowing my legs were close, but not done yet.
We came onto the canal lined streets surrounding Treviso and flew under the city torre and the finishing banners. According to my Garmin, I had been riding for 5:58. I’d covered 171km and climbed 2,264 meters. It turns out my friend Chris had finished in 5:15, and my long-time cycling hero, Miguel Indurain had stopped the clock at 5:45. I was quite pleased to have handled La Pina at all and to have kept my time somewhere in the ballpark. Of course, my official timing chip does not agree with my Garmin, giving me a more modest time of 6:08 on the day.
We all enjoyed a cold beer and some “big fish” stories in the finish area and met up with some of the other InGamba riders. One of them, Rudi Napolitano, won the Medio in just under 3 hours and an average pace of 40.5km per hour, an absolutely blistering pace. Then it was off for a hot shower and probably the very best aspect of any InGamba ride, a post ride massage from soigneur Raul. That evening, my wife Bibbi and I settled into a canal side table at Ristorante Enoteca Odeon La Colonna for the perfect Italian meal. We opened a bottle of the local Valpolicella and celebrated the extraordinary culture of cycling in Italy, La Pina, and our first visit to the beautiful Veneto region.