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Taxing

It’s been a taxing year in many respects, but clearly not for investors in US stocks.    Year to date, the total return to stocks (measured by the S&P 500) is a robust 20.5%.  With the exception of a modest miss in March, returns have been positive for 13 consecutive months.  This is the longest period of consecutive returns, and with the lowest month over month standard deviation, going all the way back to 1982.

The goodness extends beyond the US.  Year to date, stock markets in most major countries around the world have produced handsome returns.  These markets include traditional economic juggernauts (Germany +27%), old line economies experiencing difficulties with their neighbors (UK +16%) and even economies no one else seems to like all that much (Russia +1%).

In spite of the soap opera in Washington, there are a number of factors propelling our stock market: earnings growth is inflecting upward, oil prices are stable, economies around the world are echoing our economic expansion, central banks around the globe are withdrawing stimulus (inflation trade) and Wall Street’s animal spirits are running wild with anticipation of the benefits from tax-cuts for corporate America.

Seasonal return patterns tell a story.  Since 1982, December is clearly the best month for stocks, with a positive return (batting average) 77% of the time and a net average return of 1.75%.  The next best month is April, with a 72% average and a net average return of 1.64%.

Stock prices have risen, and are no longer cheap.  According to FactSet Research, the trailing P/E ratio for the S&P 500 is 21.  For context, at the apex of the dot com bubble, March 2000, the market’s P/E ratio was a healthy 30.  In contrast, at the low point of the financial crisis, March 2009, the market’s P/E ratio was 10.  So, best of times, worst of times – today we are smack in the middle.

 The overarching issue on everyone’s mind is taxes.  The drama is playing out inside the Beltway, but the repercussions are being felt on Wall Street.  The effort is to spin a new tax code, lowering taxes and simultaneously spurring future growth.  Investors are licking their chops. Income taxes were briefly imposed in 1861 to help pay for the civil war.  The 3% tax was repealed in 1872.  In 1913, the 16th amendment gave Congress the authority to levy a federal tax on income.  At that time, only a small number of people actually paid. 

 Our current progressive system has taxpayers with incomes over $200,000 paying nearly 60% of all federal income taxes.   Based on early analysis of the bill, the majority of tax cuts will benefit folks in this income group, and more so for higher income groups.

 The last time a tax cut was proposed, in 2001, the Congressional Budget Office projected a $5.6 trillion surplus over 10 years.  Today, the budget office forecasts deficits will total $10.1 trillion over the next decade.  The deficit is expected to top $1 trillion a year in 2022.  Federal debt held by the public is at the highest level since shortly after World War II, at 77 percent of GDP. (NYT 9/28/17)  The political imperative to cut taxes has now superseded any view toward fiscal prudence.

 We’ve done some analysis, and a reduction in corporate taxes will boost earnings for stocks.  The puzzle is which stocks, and to what degree.  Our working assumption is that some benefit is already priced into stocks, and there is the potential for more, though this will require clear and well communicated legislation.

 At some point, I expect the market to revert to the mean.  Consumer confidence is high, as is confidence in the stock market.  These can be yellow lights.  Since Thanksgiving, the market has begun to rotate, away from the year’s big gainers, and into “safer” low growth names.  We have been anticipating this shift in leadership from growth to value.  If the rotation persists, we will look to take more profits in our highest performing stocks before the end of December.  If we wait until the new tax year to rebalance, we may be faced with a multitude of investors with the same clever thought.  My preference is to stay in front of the pack, and if we owe capital gains, to pay them from this year’s generous profits.  Please feel free to check in if you have any concerns.

Bruce Hotaling, CFA

Managing Partner

Independence

It’s July 4th, 2017, 241 years from the day the Continental Congress adopted the Declaration of Independence, declaring the 13 American colonies to be independent from Great Britain.   For me, I cannot believe both the bravery and the foresight of the men who crafted the Declaration, the Constitution and the Bill of Rights.  So many things could have turned out differently, and yet, here we are, celebrating our independence.   

This year, stock investors can also celebrate what has been an exceptional first half of the year.  Returns to stocks, measured by the S&P 500, have produced a healthy total return of 9.34%.  One prominent aspect of the stock market this year has been the tail-wind for growth stocks, as opposed to value stocks.  This plays to our strength as we have been steadfast growth at a reasonable price investors for years.

Year to date, the technology sector has produced returns nearly double the next best sector, an impressive run.  Prices wavered some in late June, but I expect their leadership to continue.  The sharp end of the technology stick is referred to as FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) – and all have shown sensational returns this year.  Other pockets of strength include financials, where the banks are benefitting from favorable capital requirements, spurred by the heads of the European and US Central banks.  We have also seen attractive returns from healthcare stocks, likely indicating the market anticipates a more favorable business environment.  Bringing up the rear is energy.  In my lay opinion, there is simply too much oil out there, and demand looks suspect. 

On the economic front, growth is ok, but not by much.  Q1 2017 GDP came in at 1.2% annual growth, following a 2.1% reading for 4Q 2016.  My tarot cards do not include an inflation card.  It’s the equivalent of a child’s monster under the bed – scary but not there.  The Federal Reserve is staying with its script, raising rates and unwinding its balance sheet (tightening).  There are plusses and minuses that do not add up.  Energy prices are low, pleasing at the pump but bad for igniting capital spending.  The dollar is low.  This may boost exports, but conversely may raise prices on imported goods.  I am not convinced we will see strong enough economic data to support a steepening in the yield curve.

The market has shown a high degree of complacency since the election.  This will change, eventually.  There is the idea that great athletes have a high tolerance for physical discomfort.  I’m curious if that is a common characteristic for great investors too.  Can they remain even handed in a highly discomforting environment?  And for how long?  An observation of our current society is how uncomfortable with discomfort people are.  When something unpleasant arises, there is often a need to immediately re-direct, to take some medication, or do something to put the discomfort to rest.

Until the complacency lifts, we have a reasonable backdrop: the economy is standing on its own two feet and earnings growth is in the low double digits.  This “just so” scenario is allowing stock prices to rise.  The market seems to have given up any expectation of anything constructive from Washington DC.  In fact, the opposite may be true at this point.  If Washington DC does in fact do something, other than tweet, it may serve to disrupt what has become an acceptable status quo.  There is a watch what you wish for aspect to our current situation.

Looking ahead, my expectation is for the stock market to mark time, and then show some strength later in the year and into 2018.  I am optimistic on the earnings front and believe this will support stock valuations. I do not think we will see a substantive rise in interest rates, and therefore, I am neutral on tax free and corporate bond markets. I think they are relatively safe, and returns will be mediocre. Obviously, if any of these factors change, my opinion as to how best to invest will change and I will relay that to you. In the meantime, please have a peaceful Fourth of July and if you think of it, take a moment to pause and reflect on the amazing movement that began here in Philadelphia, all those years ago.

Bruce Hotaling, CFA

Managing Partner

Why is the high yield bond market struggling with liquidity concerns?

 

dollar

 

Why is the high yield bond market struggling with liquidity concerns?

Blog from Jean M. Rosenbaum, CFA, Portfolio Manager

Hotaling Investment Management, LLC

The high yield market has been in the news recently due in part to its lack of liquidity. The increasingly poor liquidity situation was brought to the forefront by Third Avenue’s decision to halt redemptions in its Focused Credit Fund mutual fund. (Open end mutual funds provide daily liquidity to investors so the inability to withdraw funds has caused concern among investors in the asset class.) The liquidity concerns come from 3 primary sources – the fund itself, the energy sector and the regulatory environment.

The first problem lies with the fund itself. The fund invested in assets which were illiquid. Providing daily liquidity from such an asset base is possible only if the fund is growing. Once the fund stopped growing, the inability to sell assets impaired its ability to provide liquidity.

The second problem is the financial stress in the energy sector. The energy sector has become a larger part of the high yield market in recent years. Investors were happy to fund these cash flow negative companies in a high and rising commodity price market. Once the oil and gas prices began to weaken, investors became increasingly concerned about the ability of these companies to service their debt. Default rates, which are at cyclical lows, are likely to rise.

The third problem is related to the post-Financial Crisis regulatory environment. New regulations are changing the way bonds are traded. The bond market is an “over-the-counter” market.   Unlike stocks, bonds are not on an exchange. Bond trading had been facilitated by an investment bank’s use of their own capital to create market liquidity by buying and selling securities, engaging in what is called proprietary trading. Following the financial crisis, new regulations limit the ability of investment banks to engage in proprietary trading, thus limiting their ability to create a liquid bond market. The limitation on proprietary trading, while put in place to safeguard the banking system by limiting the size of the balance sheets, has had the unintended consequence of severely limiting bond market liquidity.

Over time, market liquidity will return as the challenges of moving an over-the-counter market to an exchange are solved. The problem is most acute for active bond traders and for other investors that require liquidity and need to sell their bonds. Recent market events could be the catalyst to force market participants to solve the trading gridlock.

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