Bruce Hotaling
Oil and the Dollar
After starting out the year with two extremely challenging months, March gave investors a big lift and some emotional respite. Stock prices, measured by the S&P 500, rebounded 6.6% in March, the biggest jump in monthly prices since last October’s dramatic 8.3% run-up. Dividend paying stocks have begun to stand out, as have value stocks, particularly small caps and mid-caps. Utilities, consumer staples and telecom stocks have led the way while financials and health care stocks have been notable laggards.
The S&P 500 started the year at 2,043. From day one (January 4th was the first trading day of the year), prices fell. They hit their lowest point on February 11th (possibly the new March 9th 2009?) when they closed at 1,810. In only six weeks, prices had fallen 10.27%. A 10% drop in prices is the generally accepted definition of a market correction. I think this utterly shocked investors. Most were evaluating how they intended to reposition their portfolios, not how they were going to execute triage.
In today’s world, there is a spectrum of issues dominating the emotional backdrop: unconventional presidential candidates, global warming, refugee crises and ever more incidences of terrorism. The year started with a contentious Fed rate hike and a resurgence of fear the global economy was spiraling into a recession. In my opinion, amidst all this noise, the critical component remains the outlook for US corporate earnings. The earnings recession we are in (I’ve mentioned in past letters) remains a cloud over markets. My expectation is for it to resolve.
According to FactSet Research, with the anticipated earnings drop in Q1 2016, it will be the first time the S&P 500 has seen four quarters of successive earnings declines since Q4 2008. The energy sector remains the culprit. If we overlook the anticipated 101% drop in earnings from energy stocks, the earnings decline for the S&P 500 would be 3.7%. At the present time, earnings forecasts are for declines in Q1 and Q2 of 8.5% and 2.5%. Analysts are calling for a turn-around in the second half, with positive earnings growth of 3.7% and 11% in Q3 and Q4.
Since the financial crisis in 2008, labor costs have been low, employment has recovered smartly (in spite of an aging work force) and corporate profit margins have improved dramatically. Things have been going well, but now revenue and earnings are decelerating. Today, growth in Europe is intact, it’s slow here at home, and middling around the rest of the world (China, Japan). With this backdrop, earnings improvement is not a given.
Critical factors in the expected second half earnings recovery are a normalization of oil prices and a continued fall in the value of the US$. Oil prices look to have stabilized and possibly put in a bottom. Airlines are reported to be purchasing oil hedges out 2-3 years. As earnings from the energy sector have evaporated – even a 50% recovery would be a nice bump to the S&P 500’s earnings. On the currency front, a further weakening of the US$ could provide an even bigger bump to earnings. According to JP Morgan, a 10% drop in the trade-weighted US$ could lift earnings as much as 5%. Oil and the US$ could be the differentiators this year.
Stock valuations are not unreasonable. If the price/earnings (PE) ratio remains constant, and earnings pick up, stock prices are likely to rise. According to FactSet Research, stocks are currently priced at a PE of 16x the next 12 months expected earnings. I am hopeful continued mean reversion in both oil prices and the US$ are enough to catalyze earnings going forward and anchor higher stock prices into next year.
The style shift I discussed in last month’s letter has not changed. Stocks correlated to a recovery in oil, unloved sectors (industrials, transports, materials), have begun to lift. The crowded sectors such as consumer staples and utilities have been safe places to hide but are all very expensive to buy. I continue to believe a second half earnings recovery will return the spotlight to quality growth companies in the technology, consumer discretionary and health care sectors.
Please feel free to call if we have not spoken recently. Now that the typically busy tax season is behind us, we can put renewed focus on portfolio positioning and other issues more central to your long term needs.
Bruce Hotaling, CFA
Managing Partner
The Road Not Taken
The first two months of 2016 have been a challenge. Stock prices started the year in free-fall and didn’t let up until February 11. At that point prices were down an eye opening 10.3%, measured by the S&P 500. Over that 28 trading-day span, prices fell on 16 days or nearly 60% of the time. Worse, on a staggering 13 of the 16 down days, prices fell by more than 1%. Market corrections of 10% or more are not uncommon, in fact they tend to occur every 18 months on average. This correction was sharp and unexpected.
Interestingly, oil prices also fell on 19 of the first 28 trading days of the year, and they also bottomed on February 11th – down an astounding 29.2%. The correlation between stock prices and oil was nearly perfect in January, higher than any time since 1990. Then suddenly, blue sky reappeared on the 12th, and prices began to rebound recovering more than 50% of their respective losses by month end.
The hope is the 18 month collapse in global oil markets has stabilized. One of the most damaging aspects of the plunge in oil prices has been the impact on earnings – both for the energy sector and the S&P 500 as a whole. According to FactSet Research, earnings estimates for the energy sector fell from $2.97 to $0.20 during the first two months of 2016. Interestingly, at the start of 2015, the Q1 estimate for energy was $8.38. The point here is earnings from energy companies have effectively gone away. At this point, I think there is reason to expect a substantial rebound in earnings forecasts for the S&P 500 as we move into 2016.
Separate from the energy patch, the bottom up earnings estimates for the S&P 500 have been falling – for the last four quarters. We have been grinding through an earnings recession. Based on FactSet Research data, this is the first time S&P 500 earnings have seen four quarters of year-over-year declines since the period Q4 2008 through Q3 2009. This has caused a drag on the market dating back to mid-year 2015. A popular topic in the news is a global recession, but the slow-drip erosion in earnings has been nagging stock prices, primarily energy, materials and industrials, for the last nine months.
Amidst this backdrop, the market’s fundamentals are sound (measures such as earnings yield, price to earnings ratio) making the 10% correction in prices look very disconnected. When the emotions clear and speculative traders have exhausted themselves, the baseline valuation of the underlying stocks once again becomes the imperative. According to FactSet Research, the 12-month forward P/E ratio for the S&P 500 is 16.1x based on the recent 1993.4 price level and forward earnings estimates of $124. This is underpinned by a generally constructive domestic economic outlook.
The recent bounce in prices has brought a welcome tail-wind to our favored asset classes: stocks, corporate and municipal bonds, REITs and oil and gas pipelines (MLPs). Out of respect for the market’s recent directionality, we will hold an overweight position in cash, though I expect the recent bump in prices to have a somewhat calming effect. Our baseline measures of growth, valuation and dividend distribution remain firm. If the stability holds, we will look to put more excess cash to work.
Just as in Robert Frost’s well know poem “The Road Not Taken”, we are faced with something of a divergence. Many investors have shifted their portfolios into lower growth value stocks, including consumer staples and utilities. They are seeking temporary shelter. The transition occurred at the end of last year, as though a switch were flipped. The path we have chosen is, “the one less traveled,” anchored by higher growth names we expect to outperform the broader market, over time. These are investments that require a little more research and conviction, but have the potential to deliver attractive rates of return. I expect some patience will be required, as we allow our growth oriented and strong free-cash flow based stocks to regain their position of dominance.
As the damage from the storm passes, I suspect we will be proven right. Of course, time will tell. In the meantime, please feel free to call if we have not been in touch recently. When the markets are volatile, it’s often useful for us to connect.
Bruce Hotaling, CFA
Managing Partner
Mixed Signals
2015 was a frustrating year for investors. Believe it or not, large cap stocks were one of the best performing asset classes. As measured by the S&P 500, stocks generated a total return of 1.38% for the year. I suspect most people, if asked, would assume their stock returns were negative for the year – it was that type of year. The stocks that performed well tended to be high growth and high valuation stocks (FANG – Facebook, Amazon.com, Netflix and Google). The stocks that performed poorly were a) energy, b) materials, and c) anything at all related to those two sectors.
For some historical context, the S&P 500 generated an average return of 11.41% from 1928-2015. Over that 88 year span, there were 31 instances, or 35% of the time, when stocks returned more than 20%. The other side of that coin were 6 instances, 7 percent of the time, when the S&P 500 generated returns less than -20%. This is the lure of the stock market. It delivers tantalizing returns, and then suddenly, it doesn’t. The message here is that in order to benefit from the stock market’s attractive average returns, investors have to put up with a good bit of volatility and the emotional stress that accompanies it.
In 2015, although stocks underperformed, they were not the ultimate cause of distress for most investors. In fact, technology stocks (QQQ +8.34%) and growth stocks (IVW + 3.76%) did relatively well. The difficulty was that virtually every other asset class came under selling pressure. Widely accepted approaches to portfolio management that rely on diversification and multiple asset classes all failed miserably. Common asset class, including commodities, metals, emerging markets, currencies and foreign stocks were under water and there was simply nowhere for these investors to hide.
What led to the mediocre returns in 2015? Generally speaking, economic data underpinning markets and growth expectations was unimpressive. According to Bespoke Research, 2015 will go down as a year when their Economic Indicator Diffusion Index saw fewer positive readings than any other year since tracking began in 1999. Economic data, co-incident or trailing, is often a reassuring corroboration of the behavior in the market. In that case, the returns of stocks, and most other asset classes meshed well with soft economic output from around the globe.
The oil patch was the principle fly in the ointment. The drop in oil prices led energy companies to slash their earnings estimates, which in turn dragged down the estimates for the whole S&P 500. According to FactSet Research, energy stocks were the largest contributor to the earnings decline for the S&P 500. If the energy sector was excluded, estimated earnings growth for 4Q’15 would jump by 5.3%. This will begin to unwind in 2016.
The monetary policy tightening in the US and easing in the Eurozone and other parts of the world will not help matters as this strengthens the US $. China, attempting to transition its economy and navigate a “soft landing” has devalued its currency and rocked the many emerging market and commodity dependent countries that trade with it. These issues and the oil supply imbalance will not repair themselves anytime soon.
In my opinion, US stocks remain the most appealing option in terms of potential return. Currently the market is looking for directionality. Stocks recorded negative returns in 2Q and 3Q last year. That put the spotlight on 4Q, and prices jumped in 4Q and disarmed what could have been the beginnings of a bear market. I think REITs with attractive dividends will once again function as bond surrogates. And, while I do not think oil prices will change appreciably, I think the attractive distributions from midstream MLPs will catch the attention of yield hungry investors and prices will rebound in the coming year. Finally, I think investment grade corporate and municipal bonds will do the important though unglamorous heavy lifting they so often do.
I do not expect the coming year to be any more or less difficult than any other. We have our work cut out for us, looking to preserve your wealth in financial assets, while seeking every opportunity to make a profit. Please feel free to check in – we always look forward to hearing from you.
Bruce Hotaling, CFA, Managing Partner
US Banks – Why the Malaise?
US Banks – Why the malaise?
By Jean Rosenbaum, CFA and Portfolio Manager, Hotaling Investment Management, LLC
Banks are a key component in the economic jig saw puzzle. They make up between 6-8% of the S&P 500 and roughly half of the financial sector of the index. Banks as a whole have modestly underperformed the S&P 500 for the last two years. The industry continues to struggle with the “pricing” environment. The low interest rate environment, coupled with ample liquidity, has led to ever lower rates banks can charge for loans and earn on their securities. While loans continue to grow, the revenue line for banks has been almost stagnant as the price they can charge continues to decline.
Banks have been able to grow earnings in this weak top line environment through an improvement in credit quality. Following the financial crisis, banks significantly increased their loan loss reserves. In the subsequent years, as defaults (or net charge offs) came in lower than initially anticipated, banks have been able to reduce their reserves providing a tailwind for earnings. Loan loss reserves are now approaching previous lows, so this improvement appears to be ending, or at least slowing.
The next driver of earnings for the industry may be operating expense control. Many banks have been experiencing cost growth ahead of revenue growth due in part to additional regulatory expenses. The banks have also been reluctant to limit their branch networks. However, with earnings drivers limited, it appears that some management teams have begun to take action. Going forward, physical infrastructure (a bank on every street corner) is likely to be replaced by more digital infrastructure at an accelerating pace.
Many bank management teams have been hoping for a Fed rate increase and a steeper yield curve, but the ability to wait may be coming to an end. The recently announced hiring and wage growth data was nothing short of robust. This may give the Federal Reserve the impetus to raise rates later this year, and potentially offer some relief to the banking sector.