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Bruce Hotaling

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The Deal

One of the more newsworthy things about November was the surge in Wall Street transactions.  Approximately $70bn in deals were announced, including Charles Schwab & Co.’s purchase of TD Ameritrade, LVMH’s agreement to buy Tiffany & Co. and Novartis’ acquisition of The Medicines Company.  In the spirit of the moment, Xerox made an attempt to buy the much larger HP Inc. (the old Hewlett-Packard), but was swatted away by the board.   

This flurry of deals came on the heels of what had already been a busy year, particularly among some of Wall Street’s financial titans.  For example, JP Morgan Chase bought InstaMed Inc., BB&T purchased SunTrust Banks and both Morgan Stanley and Goldman Sachs got in on a wave of corporate deal making.  It’s not perfectly clear what is driving the move toward more deals.  We can speculate it represents the last gasps of the bull-run in stocks, or possibly more worrisome, the current administration’s lax oversight and dismissive view toward financial regulation. 

You may remember that some misaligned interests, both in Congress and in the savings and loan sector, led to aggressive deregulation of the S&Ls in 1982.  Within a few years, this led to a collapse of over 1000 banks, and a tax payer bailout in excess of $130bn.  It was a disaster second only to the thousands of banks that closed in the Great Depression.  While a lot of people bristle at the Dodd-Frank Act implemented in the shadow of the 2008 housing crisis and the Great Recession, we may be entering the next chapter of low/no regulation.

The surge in deals may also be a product of the low interest rate backdrop.  It’s inexpensive to borrow money today.  The Federal Reserve’s decision to lower the Fed Funds rate three times (for a total of 0.75%) this year, after it raised rates four times in 2018, may have sparked a borrowing spree.  After rate cuts in July, September and October, animal spirits are running high.

Also key to the current merger boom are the record high stock prices.  Companies often use their stock as currency when they look to make acquisitions.  Companies with high P/E ratios seek out companies with lower P/E ratios, as this can be accretive to earnings, an instant way for management to shine.

Amidst the flurry of corporate activity on Wall Street this November, stock prices, as measured by the S&P 500, rose a smart 3.6%, and are now up 27.6% for the year.  The last year with returns this big was 2013.  The last three years have produced 14.8% annualized returns, and during that span, stock prices fell in only 6 of 36 months.  That’s an extremely high batting average (percentage of positive months).  One of my concerns is that the down months have been dramatic, dropping by an average of 5%.  That is a jarring number.  Sharp drops in stock prices tend to freeze investors – as they hope for prices to rebound or struggle to recalibrate their expectations.  There is a touch of complacency with the market’s recent strength, and I don’t want our accumulated gains to be snatched away due to the deer in the headlights effect.

Sensational headlines day after day desensitize us to the nuance of the information being reported.  In my opinion, a trade war with China cannot be won; the global market place is interdependent and isolationism does not work.  Though fear of recession has receded, forward earnings forecasts are only modest.  The view from the c-suite is cautious as measured by recent capital spending surveys.  Fundamentals are stagnant and the change in stock prices this year has been driven by higher valuations (P/E’s).  The deal is, we are on thin ice; the economy is not nearly as robust as stock prices would like us to believe. I expect we will see consistently higher volatility (making stocks more challenging to hold) which means next year may require more effort, for less return. 

Investors have banked some nice returns this year, and in my opinion it is a good time to take some profits. We find it’s always more attractive paying capital gains taxes with realized investment gains.  In relation to historical levels, current capital gains tax rates are a gift we want to take full advantage of.  Stocks remain the best game in town, but we have to anticipate lower expected rates of return going forward.  Please don’t hesitate to call if we have not spoken recently.

 

Bruce Hotaling, CFA

Managing Partner

What A Difference

A year ago, most investment markets were experiencing freefall.  The Federal Reserve, intent on normalizing interest rates, had raised the Fed Funds rate eight times since 2016.  By late 2018, markets in general were beginning to exhibit their collective displeasure.  The Fed then announced it would ease up on its tightening program, and stock prices have been rising ever since.  Stocks, measured by the S&P 500, rose 2.17% in October 2019 and are making new highs.  They are now up 23.16% year to date after a dismal -4.75% in 2018.

The stock market has been deftly climbing a wall of worry.  This somewhat dated reference alludes to the ability of stock prices to continue to rise in the face of factors or issues that one generally would consider a deterrent to that growth.  This backdrop makes it extremely difficult to put fresh money to work – there never seems to be a clear green light.  Many investors have experienced this hesitation since November 2016.  The worry is in fact the market’s risk premium: the risk of loss investors must embrace in order to receive equity-like returns.

One month ago, many investors and market pundits were expecting corporate earnings to continue on their recessionary track.  The trade war was wreaking havoc in multiple ways on US business overseas, supply chains and access to markets; and global economic growth was stalling in China, Europe and the US.  There was also the inverted yield curve, a tell-all indicator that the US economy was on the brink of a recession.  There was not much to look forward to.

Today, it seems all that has changed.  Whether true or not, the administration via popular media outlets is feeding the public optimistic soundbites regarding the eventual resolution of the trade war.  The “seasonal effect” which tends to see stock prices perform well during this period of the year may be influencing investor thinking.  The global economic backdrop suddenly appears brighter too, based on more recent economic data points. 

In my opinion, more central than the above is the fact that 3Q earnings were more or less on target.  This was immensely reassuring to investors.  Over 70% of companies reporting earnings have done better than expected, a stark reversal from 2Q where the earnings beat rate was the lowest in over a decade.  Investors were poised for disappointing earnings, and surprised with the outcome.

Two factors have produced a nice bump in stock prices:  the PE ratio has increased about 20%, largely due to falling interest rates and earnings for 2020 are anticipated to increase in the high single digits above their expected 2019 level.  The key now is whether forward earnings forecasts can hold up as we move into 2020. 

In my opinion, US stocks remain the best game in town.  We can more accurately assess the intrinsic value of US companies based on reliable and transparent data.  So even at somewhat elevated levels, the expected return from US stocks still remains more attractive than other asset classes, bonds in particular.  While we consider the valuation of the market as a whole, we do not buy the market – we focus on specific investment opportunities inherent in individual names, their unique merits in relation to their peer companies, growth rates, strength of their management, and other factors.

Lastly, I have some news to report on changes here at Hotaling.  First, we have added another advisor, Gretchen Regan.  I’ve known Gretchen for some time.  She is a talented analyst and immediately adds value to our work for you on a number of fronts.  You can read about her at www.hotalingllc.com.  Second, after years of working together, Valerie has decided to move on to the next big thing and retire.  She intends to spend important time with her family.  We will all miss her here, as I’m sure you will too.  In our attempt to fill that void, we have brought Jennie Wilber on board.  Jennie is young and energetic and will do everything Valerie had done for you, and then some.  I’m sure you will have the opportunity to meet her, at least over the phone, before year end.  We have been doing a lot of outreach to make sure you are informed, but please do not hesitate to call if we have not been in touch recently.  

 

Bruce Hotaling, CFA

Managing Partner

Gretchen Regan, CFA, joins Hotaling’s Investment Advisory Team

Gretchen Regan, CFA Investment Advisor

We are very excited to announce the addition of Gretchen Regan, CFA, to our Investment Advisory team at Hotaling Investment Management.

Gretchen’s financial industry foundation of more than 20 years will offer our clients an even greater Hotaling proprietary experience. Bruce Hotaling, Managing partner of Hotaling Investment Management shares, “We are very lucky to have Gretchen on board. Her strength in equity analysis coupled with her personal approach to managing clients’ investments will be a huge asset to our team.”
Before joining us, Gretchen worked as a Quantitative analyst at Chartwell Investment Partners covering Large Cap Value, Small & Mid Cap Growth, and Small & Mid Cap Value Investments. She spent 15 years in the Quantitative Research and Analytics group at Macquarie Investment Management, Americas (formerly known as Delaware Investments) specializing in quantitative methods, equity analysis, model building, data gathering, reporting and automating, attribution analysis, and risk exposure assessment.

Gretchen is a Chartered Financial Analyst (CFA) and holds a Bachelor of Science degree from the Pennsylvania State University in Management Science and Information Systems. She is a member of the CFA Society and CFA Society of Philadelphia.

Growing up on the Main Line, she now lives with her two children in Devon, Pennsylvania. Outside of the workplace, Gretchen enjoys golf, fitness, skiing, beaching and hiking. She is also committed to coaching youth athletics, fostering confidence and teamwork among young girls.

Haunted House

Amidst a torrent of unrest around the globe, the US stock market has essentially reacted with a shrug, racking up returns of 20.55% through the first three quarters of the year. September, often a challenging month for stocks, returned 1.72%. Historically, when stocks have done as well as they have at this point in the year, they tend to finish out the year with positive results. On the other hand, here we are in October, the month of Halloween and also the two worst months in recent stock market history: October 2008 and October 1987.

In my opinion, the backdrop is something akin to a haunted house. The fear people sense is related to the shenanigans in Washington DC. Controlling the narrative, manipulating the average person’s view, is the tool in traditional and social media. The goal is to sway the popular viewpoint. With November 2020 looming, one powerful tenet dating back to 1992 is “it’s the economy, stupid”, meaning one’s election fortunes are closely tied to the economy, and by extension, the stock market. The conviction that everything will be done to buoy the stock market may well be the foundation investors are building their hopes on for the coming 12 months.

While stock prices are up over 20% year to date, it’s more or less a return to baseline. Everyone is avoiding the fact that at the start of the year, stock prices had just fallen nearly 20% from their late summer 2018 highs. Today, if we consider the trailing 12-month returns of the S&P 500 (instead of the year to date) stocks are up 4.25%, less than ½ the long term historical average.

Fundamental concerns for investors at this juncture are related to upended global trade and business activity in disarray, the Federal Reserve’s next move, and the all-important earnings for 4Q2019 and forecasts for 2020.

The trade war the administration has undertaken with China, Mexico, Canada and the Euro-zone is not benefitting US business. To the contrary, it’s a significant factor in the deceleration of global growth. Without constructive policy and a predictable rules-based system, the current backdrop causes businesses to withhold investment. In the coming years, there is a good chance we will experience economic fallout in the form of low growth and negative interest rates due to lack of business investment today.

The Federal Reserve may not be able to jump-start an economy that is principally under pressure from erratic policy from Washington. Since 2008 and the financial crisis, many cite monetary policy has become a far less effective tool. I would argue that the economy in fact needs targeted spending (fiscal stimulus) and public/private partnerships to jump-start largely stalled economic growth. The deficits resulting from the 2017 tax-cut will of course make stimulus more challenging.

Earnings are clearly the elephant in the room. At the moment, according to FactSet Research, estimated earnings for 3Q 2019 are expected to decline 4.1%. This will mark the third successive quarter of year over year earnings declines. Heading into the end of the quarter, more and more companies have been issuing negative guidance. The 12 months forward earnings estimates (through 9/30/2020) for the S&P 500 are 181.66. The S&P is currently in the 2,900 range, implying a 15.9x forward P/E multiple. From here, for stock prices to rise, earnings growth must resume.

October is typically not the time of year to taunt the stock market with anything that might frighten investors. At the same time, U.S. corporations, up to this point, appear to be making their way through the corn maze. This is the foundation on which our guarded optimism rests. Stocks remain the most attractive investment option. We are still finding growth opportunities, though it is clearly a market for stock pickers. Quality U.S. corporate names with solid fundamentals and prospects for steady earnings make up the universe of names we keep on our short list.

As we approach year end, we will be reaching out to you to make sure we have addressed your concerns, capital gains constraints, or any other aspects of your financial life. Please feel free to reach out to us if you have any concerns in the meantime.

Bruce Hotaling, CFA
Managing Partner

Hurricane Dorian

For days now Floridians have been in a state of suspension – the massive hurricane Dorian sitting just off the coast. It ravaged the Bahamas and is now making its way slowly northward. Much as they try, meteorologists (and presidents) cannot truly predict the direction or the intensity of a hurricane. So, Floridians are more or less forced to brace themselves, and then wait it out.

In many ways, this tension is precisely what investors in the equity markets have been facing. For the trailing 12 month period, stocks have generated a total return of 2.92%. This was hard-earned, as during that period of time, stocks fell during 4 months, and in each case, by an average 6%. Year to date, stocks have rebounded off their 2018 year-end low for a total return of 18.34%, as measured by the S&P 500. In stormy August, stock prices fell 1.81% and were down on 10 of 22 trading days. The worst damage was from three days in particular, when prices fell nearly 3%, and those happen to be the three worst trading days of the year so far.

There are a lot of things investors in stocks and bonds are fixating on. High on the list is the trade war the administration boldly initiated, and the resultant economic fallout around the globe. Economic fundamentals are beginning to erode and it’s not clear how some aspects of the global economic mosaic will repair itself. For instance, distribution channels have been shut, supply chains cut and re-routed, hours worked in manufacturing are on the decline and corporate (S&P 500) revenue growth has fallen from 8% a year ago to 2%. Corporate leaders are less likely to make capital commitments related to trade as long as Washington is unreliable.

While Washington has taken to brow beating the Federal Reserve Bank in an attempt to influence policy, it is not clear monetary policy functions as it once did. We are late in the economic cycle and rates have been low for a long time. The 10-year US Treasury note, which anchors many aspects of the borrowing markets (student loans, mortgage loans) is now at roughly 1.45%. It is nearing the record 1.36%, the lowest level ever, set in July of 2016. The Federal Reserve Bank and the European Central Bank are both expected to lower their respective benchmark rates later this month by 0.25% and 0.10% respectively. Neither of these amounts are significant, economically, apart from the symbolic messaging. People, and companies, are unlikely to change their behavior due to a 0.10% drop in rates.

Fallout from the protracted low interest rates is evident in the banking system. This is most apparent in Europe, where many banks have arguably never recovered from the financial crisis in ’08, and the sovereign debt crisis that followed in ’10. In the US, commercial banks have recovered, but they still cannot overcome the business challenges of perpetual low interest rates which pinch profit margins, and sow doubt in borrowers minds that rates may go lower. There is the fear rates are under pressure only to stave off recession. For monetary policy to work, bank lending is key, and people have to have a degree of confidence to borrow.

Based on our work, I continue to focus on select stocks that screen well for their growth characteristics, constraints on capital spending and strong levels of free cash flow. We are watching, though have not begun to own more defensive or value oriented stocks. As we’ve discussed, (the market) the S&P 500, is selling for 17x forward earnings ($178 per share). In general terms, for stock prices to move higher, either the multiple, or earnings, must rise. At the moment, the factor allowing the multiple to rise has been falling interest rates. Corporate earnings estimates have been declining, since Q1 19, as analysts have been revising their forward estimates down. Select stock picking, and judicious timing is the way forward.

The big question today is, how does this curious backdrop begin to disentangle itself? With no clear path forward, we have to continuously monitor the underlying activity in the markets and stock specific fundamentals for signs of real change. When we have some greater degree of clarity we will act accordingly. In the meantime, please feel free to check in if we have not spoken. I hope you are enjoying both the start of the new school year and the onset of fall and the cooler weather it will bring.

Bruce Hotaling, CFA
Managing Partner

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