Seventh-inning Stretch

Baseball fans in Philadelphia are hoping this is their year. The off-season signing of multiple superstar players has raised expectations. As a group, fans remain stubbornly buoyant from back to back World Series appearances in 2008 and 2009. Baseball and investing have some common traits. The baseball season is long, carrying on for 162 games, and of course, investing is a long term undertaking. It’s equally challenging to pick winners and often unclear whether skill or luck made the difference. Finally, both tend to be emotional to the extent rational decision making often goes out the window.

Turning more directly to recent activity in the stock market, February saw stock prices rise 2.9%, as measured by the S&P 500. Prices are now up a healthy 10.8% year to date. This rebound in prices is remarkable in light of the 14.3% drop in stock prices in 2018’s fourth quarter. The S&P 500 is now in the 2800 range, just below the 2900 level of late September 2018.

At the moment, there are a handful of dominant influences on the market. First, the Federal Reserve has taken a more dovish stance toward future interest rate increases. Second, investors are largely betting the US trade war with China (and other parts of the world) will ultimately cause less damage than had been feared. These are largely factored into prices today. The third influence is that the earnings forecasts are coming down, especially for companies with a greater portion of their revenue originating from outside the U.S. This is not priced into stocks today.

Declining earnings are difficult for stock prices to overcome. There is the possibility we are on the cusp of an earnings recession. The last one we lived through, from 2014-2016, saw stock prices struggle though most investors did not pay it much mind. Today, I think investors will care. The factors threatening earnings today include the tariffs, rising costs (wages and commodities), stagnant oil prices, the end of the corporate tax cut tailwind, and an economic malaise across parts of the globe, including the Eurozone. Slowing growth and rising costs spells trouble.

Another flashing yellow is the record high level of corporate stock repurchases that have been fueling the stock prices. Reported EPS (earnings per share) are the critical measure of corporate health. If for whatever reason, a company cannot increase its earnings, it can reduce its share count. This mathematically creates the same result. Sadly, one recent trend has been for companies to borrow money in order to raise necessary cash to buy back stock. According to research by Goldman Sachs, S&P 500 company buybacks will rise 22% to $940 billion in 2019, while capital expenditures (business investment) is expected to grow a more subdued 9% to $780 billion.

The greater issue here is near term gain as opposed to long term gain. In the near term, stock repurchases boost share prices and executives and shareholders are happy. In the long term, investments in technology, innovation and human capital all play an immense role in the companies’ ability to evolve and thrive. Thoughtful investments will lead to new innovation and greater competitiveness by U.S. companies in an increasingly competitive world. In my opinion, now is the time to take a more progressive view to lay the foundation for the success of future generations.

In my opinion, there remains good value in and a strong case for holding quality stocks. The timing of success can be fickle, so a long-term outlook is important. Our work is to continuously screen for investment opportunities the market will reward in the future. At the same time, I think a more tactical approach with an eye toward judiciously harvesting gains is important. Complacency often prevails. Then, when change does come, it’s a shock, and it turns out the catalyst was unforeseen. With the market, just like our beloved baseball team, expectations can be high (priced in). Predicting a drop in expectations, whether due to earnings guidance or another event is not easy. This is where our challenge lies.

Please feel free to reach out to us if we have not spoken recently. We are happy to review your asset allocation in light of the current backdrop. All the best, and enjoy the coming spring.

Bruce Hotaling, CFA
Managing Partner

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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