Blue Skies

Stock prices rebounded nicely in February with a 4.3% return, as measured by the S&P 500. This bump came on the heels of a worrisome -3.6% start to the year in January. For the trailing 12 month period, stocks have risen 9 of 12 months and are up a cumulative 25%. While the S&P 500 continues to make new highs, the number of stocks hitting 52 week highs is declining. A falling rate of participation (market breadth) is a warning sign the bull market may be weakening.

According to the Bespoke Investment Group, a bull market is any period where the S&P 500 gains 20% or more without a decline of 20% in between. Our current bull market began on March 9, 2009. During that period of 1,817 days, the market has risen 175%. We experienced one extended pull-back. It began in May of 2011 and the market dropped by just over 19% before finally hitting a trough in early October[i]. The scare ended, and the bull market rumbled on.

Large cap growth stocks are out-performing value stocks and this is helpful to our growth at a reasonable price approach. Of the sectors we own, healthcare and technology are doing well while telecom, staples and energy are lagging. In addition to style selection and sector weightings, good stock selection remains the most significant return driver for our portfolios.

I would expect sharper pull-backs in stock prices as the market cycle ages. The dip in stock prices in January looks to have been an excellent buying opportunity, in hind sight. Of course, at that time, many investors were anticipating a larger drop and had their eye on the emergency door. I think the market looks like it wants to go higher, and yet it also wants to make it more difficult for investors to remain invested. Some refer to this as climbing the wall of worry.

Economic data has generally been trending up. Home sales and prices are moving in the right direction. Real estate brokers will tell you there is not enough inventory, that construction shut down during the financial crisis and is only just coming back on line. This will take some time and prices are likely to continue upward.

The jobs data is improving. While encouraging, on one hand, there is critical work to be done here. Many of the positions being created are low paying. We ultimately need a strong job market with better access to education, skills training and technology to build a better foundation for economic growth well into the future.

Earnings have been encouraging. According to FactSet’s John Butters, 71% of companies reported Q4 2013 earnings above the mean estimate and 63% reported sales above the mean estimate. Technology companies have shown the highest incidence of reporting above estimates. The other side of the earnings coin is Wall Street analysts have been downgrading their earnings forecasts for the coming year at a pace. This may be largely due to recent weather, and if so, should reverse itself later in the year.

Valuation appears reasonable. Earnings growth, a critical metric, is Goldilocks, in the 8-9% range. The forward P/E ratio for the S&P 500 is 15.3. This is in relation to the 10-year average of 13.9[i]. The P/E to growth (PEG ratio) is not outside an historical range. In this context, there is ample opportunity to find well priced stocks

Stock price seasonality may be a near term factor in support of owning stocks. While the weather has wreaked some havoc, the good news is Spring is in sight. And, according to Bespoke, March and April are historically the two best months of the year, when combined. Then of course comes May, when investors are supposed to “go away”. We’ll cross that bridge when we get there.

Fixed income is performing markedly better than last year, with most sectors and maturities showing positive returns year to date. US 10-year Treasury is parked at a 2.6% yield. The long prognosticated run-up in interest rates is just not happening. GDP growth will of course prompt higher rates, but with no fiscal stimulus in sight, this will not be the case any time soon. Credit spreads are tightening, municipal balance sheets are improving, and bonds are playing a viable role in many portfolios.

As he does each year, Warren Buffett has written an interesting shareholder letter posted on the Berkshire Hathaway web site. In 2013, Buffett missed his benchmark by the widest margin since 1999. He is curious. For example, he refuses to own technology stocks, Coke may be going the way of the pay phone and last year he bought Philadelphia’s Fox & Roach. At the same time, I admire his focus and his perspective on value. Quoting from his 2013 letter, the Oracle says, “Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)”. Finally, it’s his blue sky optimism I admire more than any of his remarkable attributes, as he states, “Indeed, who has ever benefited during the past 237 years by betting against America?”

As usual, I am available to discuss the market backdrop in greater detail if you like. Please feel free to call

Bruce Hotaling, CFA

Managing Partner

[i] FactSet Earnings Insight, February 28, 2014 [i] The Bespoke Report, February 28, 2014

The views and opinions stated herein are those of Bruce Hotaling, are as of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation. This note contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.

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