For the year 2018, stock prices as measured by the S&P 500 fell 4.4%.  The late-year selling frenzy came as quite a disappointment to many.  Through the end of September 2018, stock prices were up 10.6%.  Then, October brought a wave of selling, and prices fell 6.9%.  After an attempt to stabilize in November, the bottom dropped out in December, and prices fell another 9.2%. 

Since the November 2016 election, stock investors had been quite content.  The market went on a run of 15 straight months with positive returns.  Then trouble began to stir in early 2018 when prices fell in February and March.  Though prices recovered through mid-2018, the year-end disruption led to panicky selling and wiped out cumulative gains for the S&P 500 dating back to October 2017.  Investors are now anxiously wondering what’s to come.

We experienced unnerving volatility in 2008 when stocks fell relentlessly in reaction to the financial crisis and the ensuing recession.  However, the year was bookended by a 5.5% return in 2007 and a whopping 26.5% return in 2009.  Prices recovered quickly benefiting those that remained invested.  The height of the dot-com bubble in 2000 sent prices down 9.1% that year and then a further 11.9% and a painful 22.1% in the two ensuing years.  At present time, there is no evidence of another financial crisis (a one-year market debacle) or a dot-com bust (a multi-year market debacle) but rather a slowing of growth (which is normal for markets in later stages of the business cycle) and continuing political turmoil.

In my view, there are three things to monitor.    First, the backdrop: the trade war with China, the government shutdown, the ongoing Brexit talks, and the realization that political gridlock seems likely to prevail.  Second, the Federal Reserve has been raising interest rates, and the old axiom “don’t fight the Fed” clearly remains alive and well.  Finally, earnings growth crested dramatically last year and is now beginning to decelerate.

Investing can lead to heightened emotions, and I think it’s becoming more difficult for people to confront the random and reckless commentary from Washington.  My sense is that investors are at their limit, feeling that more damage is being done than their prior optimism can counter. 

My take on the Federal Reserve is that it views the US economy as generally healthy, though growth is slowing.  The Fed appears to be shifting away from its more hawkish position and is messaging more flexibility.  Importantly, it has raised rates nine times since near-zero rates three years ago, and that was the responsible thing to do.  It does not appear that current policy, with the Fed Funds rate in the 2.25% range, is overly restrictive.

The earnings outlook for 2019 is tempering.    Earlier in 2018, consensus was for $178 per share or 10% growth for 2019.   According to FactSet Research, analysts now have lowered their earnings estimates for the S&P 500 for the fourth quarter by 3.8%, which has led investors to lower their return assumptions.

Some patience with and confidence in the long-term tendency of the stock market to soldier on is important at this juncture.  I believe that the Federal Reserve will take the correct actions and does not need to be brow beaten.  While the market has re-rated and P/E ratios have fallen 25% from their highs, stocks are much more attractively priced than they were three months ago. 

Stocks are the primary sources of return for most investors.  The numbers bear out, as stocks have generated positive returns 75% of the time over the last 40 years.  When the markets are in flux, we advocate prudent re-balancing between stocks, bonds, and cash.  Since the second bout of volatility kicked up in late September, we have held above-normal levels of cash.  Now, our effort is to put cash to work in quality, stable growth companies selling at reasonable prices.  Our goal is to remain fluid as the market looks to orient itself between high growth and dividend-paying value companies. 

As always, we are available for a call or meeting if you would like to discuss whether some changes to your asset allocation are in order.


Bruce Hotaling, CFA

Managing Partner

The Beat Goes On

Stock prices, as measured by the S&P 500, rose 3.6% in July and are now up 6.5% year to date.  In my opinion, these are reasonable (not too hot, not too cold) considering the backdrop.  Take a look under the hood, and things don’t look too bad.  Market breadth (measure of advancing stocks relative to declining) is fair, with 60% of the S&P 500 above its 50-day moving average.  Strength among the tech stocks has been extraordinary, and they have contributed the lion share of the market’s gains.

Impressive 2Q earnings reports serve as the foundation of these gains.   According to FactSet, 80% of S&P 500 companies have reported earnings surprises and 74% revenue surprises, the highest percentages since FactSet began monitoring them in 2008.  The valuations (P/E ratios) of stocks across the board have been falling as a result, making the fundamental backdrop of the stock market that much stronger.  Results are balanced, with all sectors showing positive earnings growth.

Some of the strength in recent numbers may be due to companies front-ending their sales in order to beat the coming tariffs.  This may lead to a reciprocal slow-down, but that will reveal itself in the coming quarters.  Stock buybacks, when companies retire (buy back) their shares and allocate profits across a smaller number of shares, typically boost share prices.  The recent spate of buy-back announcements led year-end expectations to top the $1T mark for 2018, a nearly 50% increase over 2017.

Apple, for instance, repurchased $43.5B in the first half of the year.  For comparison, Ford’s entire market cap is $40.1B.  This was partly due to the tax overhaul, enabling repatriation of overseas dollars at tax rates between 8% and 15.5%.  Further, chapeau to Apple, the world’s most valuable public company, and the first stock ever to reach $1T in market cap.  A few others nearing the $1T mark, with impressive year-to-date returns are Amazon (59%), Alpahbet (Google) (19%), and Microsoft (27%).

Record earnings, stock buybacks, and buoyant stock prices aside, many investors are walking on eggshells.  This is not surprising, as most would agree that the backdrop is difficult.  The divisive tone of much of the news flow forces investors to soldier on.   Our goal is to rely upon indicators with some degree of measurability to watch for tides that begin to turn.   When that time arrives, we will look to buffer the effects of falling stock prices with higher levels of fixed income and cash.

  We monitor multiple market factors, and any number of them could signal the onset of the next market cycle.  Among them are relative strength and valuation.  Additionally, we monitor interest rate levels, as the Federal Reserve is tightening monetary policy.  Higher rates will eventually stall economic growth.  Home sales have also slowed.   This could be due to rising mortgage rates, a shortage of inventory, or in the US, the recent restriction on deductibility of state and local taxes, and mortgage interest.   Globally, there is rising concern over a bust in the highly speculative Chinese housing market.

The elephant in the room remains the trade war.  The government intends to modify China’s behavior with respect to trade and intellectual property by hitting them with a stick.  Globalization and economic interdependence have positively impacted national economies around the world.  The European Union, initially the Common Market, was formed to establish political end economic stability in an unstable region.  I expect that the impact of the trade war will be greater on consumers’ wallets and US corporate earnings than on anything related to the trade deficit.

One final item, which we will have to confront one day, is the US Congressional Budget Office’s recent forecast for the US annual deficit to exceed $1 trillion in 2020.  In spite of the underlying economic growth, the national debt is soaring and is forecast to exceed $33 trillion by 2028.  Our nation’s leaders do not appear to have considered the negative consequences of too much leverage, and those consequences may unfairly become a political tool.

The market’s strength is enriching investors.  At the moment, Wall Street likes its man in Washington, and that’s that.  We are watching closely for shifts in the indicators and any other clear signs of change, but until then, we march on.  Please feel free to call if we have not been in touch recently.

Bruce Hotaling, CFA

Managing Partner

En Garde

Stocks, measured by the S&P 500, generated a total return of 3.8% for the first six months of 2016. By most accounts, this is a below average year for stocks, and the sub-par returns in hand have been hard fought.  From the get go stock prices fell, and (cumulatively) did not turn positive until March 17th.  The S&P 500 inched its way higher (toward its 2,130 all-time high set in May 2015) until the Brexit vote surprisingly knocked 5.4% off prices in two painful days.

Stock price declines (5% two-day declines) are not uncommon, except when the market is trading within 1% of an all-time high.  As noted by Bespoke Research, before the Brexit vote the S&P 500 was 1.6 standard deviations above its 50-day moving average and two days later it was 3.2 standard deviations below.  The two day swing was the steepest on record over a period spanning close to 90 years.  Much of this was “noise” thanks to computer driven trading in ETF’s and futures.

Investors were clearly caught off guard by the Brexit vote and then sucked into a vortex of misinformed commentary.  As much as Brexit captivated the world’s attention and whip-sawed stock prices, I think it will prove to be both a local issue and a political bone in the craw of an older generation.  I would expect longer term it will hamper an already sluggish UK economy and spur another Scottish secession vote.  Near term the implosion in the value of the pound will be a tailwind.

In my opinion, we are better served focusing on some of the more obvious risks to both the global and US economies.  One critical factor is China.  As we saw last August, concerns over slowing economic growth, and the steady devaluation of the Chinese currency (the RMB), are true global risks as China is the largest contributor to global GDP growth.  I suspect these concerns have not been put to rest.

The outlook for S&P 500 earnings for the second half of 2016 is favorable, largely due to low interest rates, a tempering US$, and higher oil prices.  The US 10-year is yielding around 1.4% and due to macro factors, rates may well surprise and trend lower as global capital seeks safe haven.  The US$ has stabilized (stopped rising) which will provide a huge tailwind to US companies repatriating foreign based earnings.  And, oil prices, the culprit for much of the turmoil markets have suffered over the last 18 months, have stabilized.  A good sign is inventories appear to be on the decline.  Supply and demand will come together.  With oil prices in the $50 bbl range, volumes of economic activity will come back on line, and with it, $’s of lost earnings.      

Overall, the undercurrents of the market have not changed since the start of the year.  For the time being, large cap value is outperforming growth, and small and mid cap stocks are generating stronger returns than large cap stocks.  Dividends (REITs, utilities and most consumer staple stocks) have been the big attraction for investors this year.  They have become expensive.  While I expect the interest in dividend yield to continue, I think the growth stocks will come back into fashion when the S&P 500 begins to show evidence it is breaking out of its long running earnings slump.

Though confusion reigns from time to time, I think we can take heart in a brighter long term outlook.  The millennials (born 1981-1997) are now the largest generation, at roughly 75 million, and are the largest share of the American workforce (Pew Research Center).  The millennials are just starting to get married, buy homes and have children.  The US is on the verge of a tremendous demographic dividend as the largest share of the population for the coming years will be young, highly educated, and ready to consume (Bespoke Research). 

Over the years, common sense and an attentive hand have allowed us to navigate some challenging markets.  Our approach is to anchor on facts, take a long term view of what we’re all about, and to acknowledge (and refine) an effective process.  We are here to serve you.  In these curious times, if you would like to share your thoughts or schedule a review, we would love to hear from you.

Bruce Hotaling, CFA

Managing Partner