Let’s hope March of 2018 was an anomaly. Just as signs of spring were beginning to appear, folks living in the northeast and mid-Atlantic encountered what was likely their first ever cyclone bomb. Exhausted from shoveling snow, they were then clobbered by three more nor’easters in a three week span. It could be we need to place more trust in Punxsutawney Phil’s early February predictions.
The unpredictable nature of these storms reflects closely the unsettled activity in Washington, which is becoming so chaotic it looks to be finally having the effect on financial markets many had feared back in November 2016. Stock prices, measured by the S&P 500, have begun to mimic both the unforgiving nature of recent weather – and the chaos inside the beltway. Stocks fell in March by 2.7%. This is on the heels of a 3.9% decline in February. Year to date, stock prices are down 0.76%.
For some context, over the last 30 years, the S&P 500 has produced an average return of 12.2%, with an annual standard deviation of 17.3%. There have been 5 years (17% of the time) when the return to stocks was negative, and in those years, stock prices fell on average 16.6%. After a larger than average 21.8% return in 2017, stock prices may be reverting to the mean.
On a more granular level, the stock market looks to be attempting to assess the potential damage from a trade war. Old school protectionism is the latest contrivance out of Washington in hopes of making America great again. Restrictive trade, whether it leads to a trade war, will put the brakes on the positive effect foreign competition has on holding down price inflation.
The recent stock price volatility highlights the concern that fractured global supply chains may negatively impact US corporate margins. Free trade is proven to stimulate economic growth. Higher tariffs will eliminate the process of comparative advantage that allows all parties to benefit from globalization. If the root of the problem is infringement of intellectual property rights, then that needs to be addressed directly, without the random and damaging effects of trade warfare.
Recent economic data has not been compelling and the nine year expansion is long in the tooth. Employment levels are high, so high investors have been on alert for signs of inflation. The brutal stock sell-off in early February was ignited due to clear signs of inflation based on reports of increasing wages. Stock investors are well aware, if a cycle of higher inflation has begun, the Fed will continue to raise interest rates.
The yield curve has shifted upward, and flattened. This is a mixed signal. It may well be telling us growth expectations have deteriorated. The Federal Reserve has raised rates now for the sixth time since the first 0.25% hike in mid-2015. Expectations are for 3 hikes this year and 3 more in 2019. Ambitious fiscal spending, at this late point in the economic cycle, will support the Fed’s hawkish position. The ballooning deficit, continued deficit spending and higher interest rates will raise the probability of a slowdown (recession) sometime in the near future.
The other curiosity I’ve discussed before is the perpetual weakness in the US$. It has been in a steady decline since the November 2016 election. The higher interest rates available in the US would support buying dollars. On the contrary, global investors have been selling US$s, and buying yen and euros. It’s not clear what is causing this, though it’s likely related to increased tariffs, restrictive immigration and rising deficits. The persistent US current account deficits are spurring talk the US$ may not be the safe-haven it once was.
The current backdrop is mixed. Earnings estimates remain high and stocks are not excessively expensive with the forward P/E multiple in the 16x range. Volatility has risen, making stocks harder to own. From a contrarian perspective, this is constructive. Yet, if the earnings forecasts falter, for whatever reason, this will spell trouble for stock prices. With the high level of volatility, and two successive down months in stock prices, we are taking a more constructive stance, and will become more cautious if conditions persist. Please feel free to call us if you would like to discuss further or if your investment parameters have changed since we last spoke.
Bruce Hotaling, CFA
We are sitting in the front row seats, mouths and eyes wide open, hearts racing, gripping the arm rests. We’re watching the stock market equivalent of a Zombie – it’s barely moving, arms outstretched, lumbering forward, and it’s somewhat terrifying to watch. Something bad must be about to happen, but it’s not clear what. This is how many investors are experiencing their participation in the stock market today. Fear is on the rise but it’s not clear yet whether it’s an illusion (created by the media) or real and we should be looking for someplace to hide.
For the month of June, stock prices fell 2.1%. This was the third time in six months stocks have produced a negative return for a .500 batting average (below their .667 historical average). For the first half of the year, stocks measured by the S&P 500 returned a scant 1.2%. This is not much reward for taking on all the risk that typically comes with owning stocks. In fact, according to Bespoke Investment Group, the first half of 2015 will be the first time ever the S&P 500 has not been either up, or down, more than 3.5% at any point, during the first six months of the year. In years past when the market has been this passive, the average returns for the second half of the year have been around 6%.
The good news for you is our stock portfolios are well positioned to take advantage of the sub-tendencies in this market. Growth stocks outperformed value at every capitalization level. High P/E and low dividend yields outperformed. Sectors we are overweight remain health care, consumer discretionary and increasingly the financial sector. They are all generating excess return. We expect financials to work well if the yield curve begins to shift upward and retains a positive slope. The other sector we are attracted to is technology. There are many innovative companies we own with an emphasis on the internet of things, and emerging technologies. We are underweight energy, consumer staples and industrials. Materials are of no special significance and we simply do not own utilities.
For the most part, the recent news flow has been little more than media contrivance. Greece, whose economy is similar in size to the greater Miami (according to Paul Krugman) is not going to destabilize the US stock market. Reported declining growth in China, a controlled communist economy, is suspect. We do not invest in Chinese companies. The US companies we do own make their own decisions as to the degree to which they deal with China. Apple, for example, produces and sells vast quantities of product in China. I believe the events that ultimately validate investors’ fear, the black-swans, will surprise all of us. I also believe Russia remains the greatest possible source of near term market disruption – far more than Greece.
More importantly, we are just entering 2nd quarter earnings season. Strong 2nd quarter earnings will be supportive of even stronger 3rd and 4th quarter earnings, and thus positive for earnings revisions. As we have discussed in the past, the stock market is an effective discounting mechanism. Today’s stock price tendencies are reflective of what we should expect in the future. Stock prices are primarily driven by future earnings expectations. The stock market’s Zombie-like behavior to this point in time could be signaling some reticence with respect to earnings for the second half of the year.
According to FactSet Research, the P/E ratio of the S&P 500 for the forward 12 month period is 16.5x. For some context, this is above the 5-year average of 13.9x and the 10-year average of 14.1x. Current bottom-up earnings expectations for 2015 are $119.5 a share and $133.72 for 2016, a 12% rate of growth. This would be the index’s highest growth rate since 2011. I expect the market to recognize this forecasted rate in earnings growth, and for stocks to behave accordingly in the second half. To be clear, if it looks as though the growth is unobtainable, then it could be the Zombies are more real than illusionary. If that is the case, we will want to consider selling some stocks, and de-risking your portfolio.
Until that day, if the fear becomes overwhelming, please call so we can discuss the best next steps for you. Of course, it may be time to simply turn off your television and enjoy the beautiful summertime.
Bruce Hotaling, CFA
La Pina – July 2014
Pinarello is an Italian bicycle manufacturer founded by Giovanni Pinarello in Treviso Italy in the early 1950’s. The brand has enjoyed huge success in the professional peloton. Today, son Fausto (pictured above with Sir Bradley Wiggins, and Miguel Indurain) is the company’s ambassador to the cycling community.
Each year, Pinarello sponsors a Grand Fondo, (also known as a cyclosportive) which has been popular in Italy since the early 1900’s. La Pina is a challenging timed course across the Veneto and then up over the Treviso Alps with two category 1 climbs.
We rode through the narrow streets of Treviso for the 7:45 am start and the forecast was for rain throughout the day. With over 1,000 entrants, it took our group from InGamba (www.ingamba.pro) a few minutes to reach the start line. A few of us (Chris, Mark and Danny) were planning on riding the Lungo, while others were going to tackle the slightly less daunting Medio. We more or less stayed together, moving up through the swarms of riders. The road was a sea of 60-70 rider pelotons. For 30 km we leap frogged up the road from group to group at a ferocious pace.
By the time we turned off the main road toward the first hills, the roads narrowed and thankfully the crowds thinned. The short steep climbs on the narrow roads (paved cart paths) were challenging, and no one seemed to be settling into a pace, we were going full gas, up the hills and down.
After the medium and long routes split, the long route went up, in a big way. The Passo Praderadego is not to be taken lightly. The climb, roughly 14 km, is a maze of switchbacks. The roads were not regularly traveled and shrouded in trees, making them mossy and slippery. The constant climb reached grades of up to 18%, which made for 720 vertical meters of tough climbing. At the top, Chris was never to be seen again (until the finish). Danny, Mark and I bellied up to the table with Coca-Cola to re-fuel. Mark immediately bolted, my final clue this was no Sunday jaunt – it was everyone for themselves and the no-waiting rule was in effect.
The descent was steep and cold. Even though the rains never came, we had gained a lot of altitude. Danny and I rode with a small group of riders we had cobbled together, across the Valle di Schievenin, a valley floor. Before long, we began to wind our way back up into the foothills. We sliced through several small villages and suddenly were at the base of Monte Tomba. This climb rose 540 vertical meters, and while it wasn’t as high, it was every bit as steep. I found myself looking down at my gears wishing I had another sprocket or two on my rear cassette.
At the top, I was exhausted, soaking wet and sick of climbing, but I got with the program and did not sit around eating sandwiches. A quick Coca-Cola from Jose and the InGamba support van and boom, I was straight onto the super fast and technical descent. When I came out of the switchbacks, the speeds were unbelievable. Curiously, there were also not many riders around. By the time I hit the main road at the bottom a group of 20 or so appeared out of nowhere. We organized ourselves into a paceline, and began picking up stragglers as we raced on toward Treviso and an ice-cold beer.
Not having studied the route carefully (beyond the two monster climbs) I didn’t process the last little “bump” we had to cross, the Santa Maria delle Vittorie, before the final 20km run into Treviso. This was a test, as my legs and back were aching and begging to get off the bike. As we powered down off the back of the Santa Maria, some of the remnants of our prior group reformed. My legs were cramping and I couldn’t accelerate as fast as some in our group wanted, prompting a good old fashion Italian tongue lashing. I countered with the peace sign, knowing my legs were close, but not done yet.
We came onto the canal lined streets surrounding Treviso and flew under the city torre and the finishing banners. According to my Garmin, I had been riding for 5:58. I’d covered 171km and climbed 2,264 meters. It turns out my friend Chris had finished in 5:15, and my long-time cycling hero, Miguel Indurain had stopped the clock at 5:45. I was quite pleased to have handled La Pina at all and to have kept my time somewhere in the ballpark. Of course, my official timing chip does not agree with my Garmin, giving me a more modest time of 6:08 on the day.
We all enjoyed a cold beer and some “big fish” stories in the finish area and met up with some of the other InGamba riders. One of them, Rudi Napolitano, won the Medio in just under 3 hours and an average pace of 40.5km per hour, an absolutely blistering pace. Then it was off for a hot shower and probably the very best aspect of any InGamba ride, a post ride massage from soigneur Raul. That evening, my wife Bibbi and I settled into a canal side table at Ristorante Enoteca Odeon La Colonna for the perfect Italian meal. We opened a bottle of the local Valpolicella and celebrated the extraordinary culture of cycling in Italy, La Pina, and our first visit to the beautiful Veneto region.