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Conundrum

 

Stocks, measured by the S&P 500, fell 1.51% for the month of July.  Normally a good month to own stocks, this was only the second month in 2014 stocks have fallen in value.  Year to date, stocks are up 5.6%, and by and large, it’s been an uneventful year and investor worry is outpacing stock returns by a good margin.

The volume of economic reports is difficult to process.  Amidst the hubbub, it’s obvious economic growth is going on.  Job growth continues, the housing data is holding steady, and inflation is not an economic issue.  Not too hot, not too cold.   The biggest concern investors have is that things are on the brink of being too good.  Hard to see how that makes sense, but the conversation is making the rounds.  If economic growth is too strong, the Federal Reserve will raise rates, and that spells trouble for stock prices.  So, the investor’s dilemma is that things are so good, they could become bad, at any moment.

The turmoil around the globe, at the moment, amounts to noise.  It could develop into a full-fledged mood swing, but I think that is unlikely.  Unlike the Euro crisis from a few years back, it’s not entirely clear how these hot-spots will ultimately impact our markets.  Yes, there are multiple scenarios one can draw, but betting on their probable outcome, or not, is a guessing game.

Second quarter corporate earnings have been respectable.  Investors pay close attention to the actual earnings reports, in relation to the estimates analysts’ have forecast.  The phrase “beat and raise” is music to the ears, as the company has outpaced expectations, and raised the outlook, often prompting a jump in price.  According to FactSet Research, approximately 74% of companies have reported EPS above their mean EPS estimates.  This is roughly 10% points above the average.

Looking through to the sector level, we see health care and information technology reporting well above their estimates.  On the flip side, telecom services and consumer staples have been a disappointment.  Generally speaking, revenues have been growing at about a 4.1% pace, boosted by health care and energy.  Earnings have been growing faster, at a 7.5% pace, benefitting from

strong profit margins and cost cutting.

In my opinion, the respectable earnings growth figures and current stock valuations are in synch.  On a P/E ratio basis, the S&P 500 is trading for roughly 17x trailing earnings.  This is just about where it began the year, and not signaling an overpriced market.  Based on the S&P 500’s recent price of 1930, and FactSet consensus forward 12-month EPS estimates of $127.97, the market is selling at a 15.1x forward P/E multiple.

While August is generally the best month to spend at the beach, it is regularly the worst month to own stocks.  Over the last 10 years, the only sector that has had positive returns more than 50% of the time is consumer staples.  According to Bespoke, over the last 20 years, August has been the worst month of the year with an average decline of 1.04%.  Energy stocks, according to Bespoke, have only been positive 2 of the last 10 years during the month of August.  Fortunately, energy is a sector we have been deemphasizing, due to the high risk of stranded assets as the domestic use of energy continues to rationalize.

The historical pattern of stock price behavior during mid-term election years is for stocks to lag until September 30th.  Then, prices tend to rally through election day, at which point they tend to finish out the year with a nice head of steam.  One thing unusual about this year is the low price volatility (the maximum intra-year decline), as prices have remained relatively tepid.

In case you missed it, an Italian named Vincenzo Nibali won the Tour de France with a certain panache only an Italian can muster.   I don’t expect our road ahead to be anything like the one Vincenzo tackled in the Tour, but there will no doubt be some tough moments.  That is the nature of financial markets – they can be quite friendly, and they can also make life difficult.  If you would like to call to review your portfolio, or discuss your asset allocation, I would be happy to speak with you.  If not, please enjoy the long sunny days of August.

Bruce Hotaling, CFA

Managing Partner

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