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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

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