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Unchartered Water

Returns to investors in both stocks and bonds have been surprisingly positive this year. We are only one third of the way into the year, yet stocks and bonds have already generated returns the equivalent of what many were hoping would be the final result for 2017.  What surprised many, a post-election growth buzz, seems to now have run its course.  It remains altogether unclear whether stock prices moved as they did due to unfounded optimism, or in anticipation of what may be a remarkable upturn in corporate earnings. 

After a slight falter in March, the S&P 500 returned to its winning ways in April, advancing 0.91% for the month.  Through the end of April, the benchmark has generated a total return of 7.16%.  In my opinion, the sturdy year to date returns have mostly to do with earnings (including a tempered US$, stronger exports, steeper yield curve and a normalized $/bbl oil).  There was evidence of an inflection in Q42016, and Q12017 results have been remarkable, to say the least.  The blended earnings growth rate is 13.5%, which if it holds will be the highest year over year earnings growth for stocks since Q3 2011.  According to FactSet Research, as of May 5, 2017, 75% of S&P 500 companies had beaten Wall Street analysts’ mean earnings estimates.

As is typically the case, not all stocks are in favor at the same time.  Since the beginning of the year, companies with growth characteristics have been outperforming companies with value characteristics, largely reversing the value tilt the market adopted early in 2016.  For investors like us, this is a tailwind, as we have traditionally focused on US companies that for various reasons are able to sustain an above trend growth rate.  Sectors reporting the best earnings include information technology, health care and the financials.

The primary drivers of the earnings renaissance, and thus the accelerated returns to stocks, are many.  First is the employment backdrop.  Jobless claims are the lowest they’ve been since the early 1970s.  This in turn may provide a platform for wage growth.  Wage growth is critical, especially in certain segments of the economy, such as improving the ability of millennials to form new households.  An uptick in spending ultimately could light the fuse for some future inflation.  Rising asset prices are “normal” and expected in a growing economy and incent consumers to act.  The Federal Reserve has signaled its intent to continue to hike short term rates, indicating it supports this thesis.  Finally, the tempered strength in the US$ has helped as there is evidence of improved exports to some of the strengthening economies around the globe. 

The other side of the coin is akin to North Atlantic shipping lanes clogged with icebergs.  On a fundamental level, stocks are nearly fully priced.  Earnings must continue to expand.  Expected returns to bond investors, in a rising rate environment, are likely already in hand.  Geo-political risks, though hard to quantify, must be nearing a high water mark.  The typical safety net of leadership and statesmanship is not apparent based on the news flow, an odd place for a country like ours to find itself.  The much manipulated growth narrative is suffering from policy paralysis – there is no game plan – nothing is getting done – and no one knows what to do about it.

I think it is a prudent time to take a more cautious stance, and as I have said before, drive with one foot on the brake.  While I do not think we should re-allocate (as stocks still have the highest expected returns) we ought to take profits in positions with outsized returns.  My preference is to pay some capital gains taxes on realized gains, rather than allow the market to take those gains back.  Our emphasis remains on a more discerning investment management approach, utilizing our fundamental and quantitative tools to help select individual opportunities to make money, versus owning the market, or segments of the market that may, or may not maintain favor. 

I ask that you please call us if we have not spoken recently.  It’s an appropriate time to review your asset allocation and we can take some time to have a more detailed discussion as to the best path for you going forward.

 

Bruce Hotaling, CFA

Managing Partner

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