Weathering Stocks

Stocks prices have started 2014 with a wobbly move into negative territory.  Prices, fell for 12 of 21 days in January, and as measured by the S&P 500 fell 3.52% for the month.  Looking back, the last down month for stock prices was August 2013.  Otherwise, returns in 2013 were hypnotically positive (10 of 12 months) so the rocky start to the year has been all the more jarring.

The most likely source of the recent selling is profit taking without any capital gains constraints and an as-yet unclear economic outlook.  Last year, investing in stocks was akin to driving on the New Jersey Turnpike.  This year, even hardened travelers are pulling into the right hand lane to avoid the dreaded speeding ticket.

In my opinion, the outlook is “goldilocks” with nothing particularly scary or inspiring to direct investors.  Economic reports are mixed.  We should expect a continued positive slope to most data.  Contrary to many forecasters, interest rates have gently fallen, since the Federal Reserve announced the beginning of its taper on December 18th.  Earnings reports for S&P 500 companies are coming in nicely above estimates on both the revenue and the EPS lines.

Fundamentals support owning stocks.  Earnings forecasts for the S&P500 companies are currently forecast $120 for 2014 and $133 for 2015 (FactSet Data).  With the S&P currently trading at $1,782 stocks are trading at 14.7x 2014 earnings.  This is slightly above the 13.1x average multiple of the last five years, but certainly not inflated to a degree that should generate concern.  In fact, with inflation rates as low as they are, there is the distinct possibility the market multiple will trend higher in 2014.

One factor brewing uncertainty and certain to impact estimate revisions is the weather.  The polar vortex aside, this has been a very cold year across much of the country.  On the east coast, the cold and snow have likely kept shoppers at home instead of the malls, or buying snow boots instead of window treatments.  Energy prices for natural gas have shot up, and prices at the pump have tapered off.  We should expect some shift in spending patterns.

On a potentially larger scale, the drought emergency in California could have disastrous implications.  This is the driest year ever recorded.  There is virtually no snowpack in the Sierra Nevada.  The impact on industry at this point is immeasurable, though it’s likely to be substantial.  Farming and agriculture will change.  On top of this, the depletion of the Ogallala aquifer in the Midwest, critical to ranching and primary grains production, virtually guarantees change in the coming years.  This could well be a factor that comes to the forefront, and then spreads to unforeseen areas of the economy.

It is not clear, yet, whether the fall-out from the recent weather turmoil will spark a more prolonged market downturn.

And, there is the perpetual risk of a black swan-like event, unknown to us at this point.  In my opinion, things are not that dire, and this is in fact the third time in the last 13 months, where stock prices are approachable.  Pricing is critical, and producing good returns are a function of what you pay for those investments.   Large cap growth stocks behaved relatively well in January, extending the performance gap they exhibited for the second half of 2013.  My suspicion is that the trend continues, and that we are enduring a bout of profit taking.

Beware of the cause and effect discussion.  Every day, market analysts attempt to attribute a reason for the markets’ collective action that day.  I think this can be misleading.  The true direction of stock prices is more impacted by events 6-12 months into the future.  The day to day volatility tends to be a lot of noise.  While one cannot ignore it, most needs to be dismissed.  The talk is of the difficult year the BRIC’s and emerging markets are having, and commotion in the currency markets due to the Federal Reserve tapering.  In my opinion, the markets understood and priced in the effects of the Fed tapering some time ago.

Seasonal patterns often lead investors without any other source of direction to rely on anecdotal correlations.  This is a form of alchemy for the unknowing.  For example, the January Indicator is well known.  The crux is, when January has a negative return, the likelihood of stocks returning a positive return for the coming year drops.  Today is Groundhog Day.  Punxsutawney Phil did in fact see his shadow early this morning, so we may need to put up with another six weeks of winter weather.  But, don’t sell your stocks, or put your snow shovel away, just yet.  The fact is, Phil has seen his shadow the vast majority of the years since he first became relevant.  Most anecdotal correlations work for some periods, and fail for others.  They may even become self-fulfilling for brief periods of time.  Oh, and then there is the Superbowl indicator.  The NFC team won, in case you missed the game, and that means we’re in for a good year.

Best course of action?  In my opinion, is to continue to buy and own stocks of well managed companies (particularly companies whose founders are still in place) selling for reasonable prices.

Reassess your asset allocation – after a year like 2013, many own more stock than they had intended.  This is an opportunity to rebalance and for some, to lower any margin borrowing.  We can work with you to set up a system where (optimistically) you can take profits when monthly returns are strong.  Good asset allocation discipline can make navigating more volatile markets easier.  And bear in mind, we have not had a 10% correction in stock prices for a long time, so the selling bout we are up against may become more uncomfortable, before it straightens itself out.

Bruce Hotaling, CFA

Managing Partner

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