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Tariffs and Taxes

Stock struggled in May.  As measured by the S&P 500, prices fell 6.58%, and the year-to-date return to the benchmark now totals 10.74%.  This comes as something of a shock after four successive months of hefty   returns.  The market’s historical pattern of giving steadily, and taking-away quickly, is clearly evident.  Since the November 2016 election, on three occasions, stocks have somewhat violently taken back virtually all the prior period’s gains.  Stocks were routed in February 2018, in December 2018, and again in May of 2019.  On one hand, this could be considered normal volatility in the market place.  On the other hand, this “triple top” formation is considered a warning sign by technical analysts. 

The 800 pound gorilla investors around the world are now contending with are tariffs.  Since the 1930s era Reciprocal Tariff Act, successive administrations have used their authority to liberalize trade, promote economic growth and strategically de-risk regions and relations.  This has all changed.  The justification now being distributed is that increased tariffs will help the US win, they are a counter to national security threats, and they will force our foes to the bargaining table. 

The consequences for the American consumer is they either forego buying certain products, or pay more for them.  Tariffs are a burden on US businesses in multiple respects, through higher input costs, loss of market share, or the elimination of businesses as the tariffs make them unprofitable to continue.  Farmers, particularly soy beans, pork and cotton, have seen their businesses stall.  The sad truth is that the bounty from the Tax Cuts and Jobs Act of 2017 is now lost, as Americans are being taxed, indirectly, to support a global war on free trade.

It’s not at all clear the trade overhang will lift.  This will require cooperation and agreement with trade partners, as opposed to standing on their dog leashes.  We ought to expect this to be a lingering presence in the marketplace, until at least November 2020.  The White House will game, talking up economic growth and stock prices while whirling the politically potent trade stick.  Some of our research providers project the damage from the tariffs could be as much as 5% of earnings.  This would ostensibly wipe out the forecasted earnings growth for the current year.  A valid question, in the face of this degree of uncertainty, is how much can investors continue to digest?

Separately, market fundamentals are not alarming, but they are also a long way from anchoring confidence.  Several April economic data points were down.  Q22019 GDP is now expected in the 0.6% range, the weakest since Q42015, the last time we had an earnings recession.  The slowdown in growth began in advance of the recent trade news with respect to China, Mexico and Canada.  Interest rates and inflation look to me as though they will remain low and range bound well into the future.

Today, based on current earnings expectations for the S&P 500 of roughly $180 per share (12 months forward) stocks are selling for a little over 15x earnings.  This is slightly below the 25 year average.  Expected returns, from this valuation level, are roughly 10%, which is also in line with historical averages.  The Goldilocks outlook is that barring any surprises, these earnings levels can be attained, and the multiple does not erode any further.

On our end we are pleased the market continues to favor growth stocks over values stocks.  The S&P 500 Growth index (IVV) is up 13.32% ytd versus the S&P Value index (IVE) up 8.18% ytd.  We are concerned with the recent anti-trust talk directed at stocks such as Google, Amazon, Apple and Facebook.  Other factors investors use to assess stocks such as size, valuation, dividend yield, etc., are not additive at this time.  We are taking a much more idiosyncratic approach and are targeting stocks with strong secular growth, innovative management teams and limited supply chain exposure to foreign trade. 

I expect the tension we see in the markets to continue, and it will remain challenging to own stocks.  I also think the best opportunities for investment gains remain in select stocks, versus owning the market or making sector bets.  This makes good quality stocks the best game in town and one we pursue with vigor.  Please feel free to check in in if we have not spoken recently.

Bruce Hotaling, CFA 

Managing Partner

Like a Hawk

2018 has been a profitable year to invest in US stocks.  Apart from a sudden drawdown early in the year (stocks fell 3.89% in February and 2.69% in March), stock prices have moved upward at a fairly reliable rate.  August saw prices rise 3.03%, and the S&P 500 has generated a 9.94% total return year to date.  In the 21-month span since the November 2016 election, stock prices have risen in 19 of those months for a cumulative return of 36.59%.   In spite of a record long bull market for stocks, there is a level of discomfort, like we are playing a high-stakes game of musical chairs. 

The discomfort stems from the charged backdrop.  Daily news paints a picture more reminiscent of a reality TV show than what we became accustomed to growing up with Walter Cronkite and David Brinkley.  The tension may only continue to increase.  September is historically the worst performing month of the year and often the most crisis-riddled as well.  Ten years ago, on September 15th, Lehman Brothers declared bankruptcy, setting off a months-long decline in the markets.  Seventeen years ago, on September 11th, four coordinated terrorist attacks on the United States caused the stock market to close until September 17th and when it reopened, the S&P 500 lost 11.6% over the ensuing five trading days.

The strength in US stock prices since the November 2016 election can be attributed to many things, including somewhat remarkable corporate tax cuts, a hands-off regulatory approach, low interest rates, low wage growth and a period of global economic stability.  These factors have all led to a remarkable inflection in corporate earnings.  During the period 2013 through 2016, earnings grew, but at a modest 2.4% rate.  According to FactSet Research, earnings are expected to grow 20% in 2018 and 10% in 2019.  Wall Street analysts who forecast earnings are maintaining their optimistic outlook for the future.

From a fundamental perspective, as impressive as this growth cycle has been, the forward P/E multiple on the market is 16.8x, only slightly higher than the 5-year average of 16.3x.  We have a situation where stock prices are hitting record highs, but stocks are not overly expensive from a fundamental viewpoint.  This, like so many aspects of investing in the stock market, is nuanced.  The relative attractiveness of a stock, or the stock market as a whole, is tied to investors’ subjective interpretation of the marketplace. 

In the shadow of the market’s recent strength, there are some indications change we are watching closely.  The Federal Reserve continues to normalize (raise) interest rates and de-lever its balance sheet.  Often times, a rising rate environment can be challenging for stock prices.  2019 GDP forecasts have fallen.  Much of what caused the recent surge in economic activity has now run its course.  Markets around the world are beginning to show signs of slowing.  The emerging markets have been in a bear market territory for months and a high US dollar will challenge their ability to repay dollar denominated debt.

Some investors have pre-emptively begun to transition to more risk-averse positions in defensive stocks with low valuations and high dividends.  While not unreasonable, the growth stocks that anchor our investment style have led the market in 2018 and I expect this to continue, for the near term.  We will watch closely on September 26th when the industry classifications for many influential stocks will be changed, thus effecting the industry makeup of the S&P 500.  Stocks such as Alphabet and Facebook are leaving the technology sector, and Netflix will leave the consumer sector to become part of the new communications services sector.  Prices may experience some turbulence while the ETFs and mutual funds are rebalanced.

                At this juncture, I think the best course of action is to watch closely and review our target asset allocation.  The atmosphere on Wall Street is a juxtaposition of fear and unconstrained optimism.  This is often referred to as climbing the wall of worry. I suggest we stay close to our target allocations to stocks.  For many this may involve some profit taking, as many of our growth stocks have seen outsized returns over the last few years.  In the meantime, please feel free to call if we have not been in touch recently.

 

Bruce Hotaling, CFA

Managing Partner

Rock Steady

April was a “backing and filling” month for investors.  This is a stock market term that applies to prices as they attempt to digest a large run up.   After a monstrous 5.6% jump in prices in January, the return to stocks in April, measured by the S&P 500, was a mere 0.27%.  Year to date, returns have fizzled and are now down 0.38%.    These results mask some eye catching day to day price moves.  For example, out of the 21 trading days in the month, 9 involved an up or down move in prices of greater than 1%.

This volatile yet sideways pattern is likely a byproduct of last years extended rally in stock prices that led so many investors to the trough of complacency.  Fifteen months of positive returns will attract a lot of attention – suddenly investors began chasing returns, and taking on more risk.  It had become too easy.  A reflection of this mindset was the craze over bitcoin.  That was an extension of the high risk-taking mentality that consumed investors worldwide.

On January 26th, stock prices hit their 14th record high of the year.  Over the next couple of weeks we experienced a full on reversal of the prior year’s blind optimism and things turned ugly.  By February 9th, stock prices had fallen over 10% on an intra-day basis.  The dust settled, and things seemed ok, until April 2nd when prices went right back down to those uncomfortable levels.       The origins of this sudden shift in market direction initiated a raft of media speculation as to what might have gone wrong.  Was it the US 10-year Treasury nearing 3%, the looming Federal Reserve interest rate hikes or possibly saber-rattling talk from Washington about trade wars?  When market trends change, it is often unclear what precipitated the change.  For us, the more important question is the emerging trend – what does the slope of the developing trend in prices look like?

As an investor, it’s important to focus on and identify investment goals, particularly long term.  The big considerations are, what are we working toward and what is the best path to get there?   Trouble often shows itself in the short term.  While things that come up admittedly do not normally have any bearing on long term goals, or the agreed upon path, they can be un-nerving to the point investors retreat.  There are times when owning stocks is flat out uncomfortable. 

After years advising people how best to position their financial assets, one thing clear to me is how easy it is for investors to become disillusioned.  Admittedly, there is some concern the world at large is sliding down a slippery slope.  This may be true, or it may not.  In my opinion, though we perceive a tenuous backdrop today, there has always been a long list of things that could go wrong.  Often, we did not know there was a monster under the bed.  I suspect our current cautious awareness puts us in a better position to look ahead and acknowledge risk.  Stocks are inherently high risk, high return, and when investors dismiss this we are collectively on thin ice.

Our goal is to guide our investors in a way that allows them to hold quality investments during challenging times.   As active investment managers, this requires our constant attention and a balance of art and science.  We use analytical tools and fundamental analysis, along with a considerable dose of experience.  We also use a risk-on, risk-off approach to profit during the good times and temper the effect of the difficult periods.  This is in stark contrast to passive index strategies or a blind reliance on asset allocation models. 

My expectations are for the recent surge in volatility to continue, though tempered somewhat.  I also expect stock prices to move higher by the end of the year.  Earnings have been strong through the first quarter and analysts’ forecasts through the year-end are high.  I do not expect stocks to deliver anything close to the 20%+ returns we saw in 2017.  Considering the backdrop, we ought to expect it to remain challenging.  We are constantly asking whether the choices we are making today are additive to your long term goals.  At the moment, I am optimistic we are well positioned for the year ahead, but I am also prepared to change course if need be.  I invite you to call if you have concerns.

 

Bruce Hotaling, CFA

Managing Partner

Crow’s Nest

In the UK, when you cross the street, there are friendly reminders to “look right” printed on the edge of the road.  The message is to pay attention, but in a direction many of us are not accustomed to looking.  Here in the US, in the world of financial assets, the implicit message today is to “look up”.  While some may think of prayer, I’m not heading in that direction.  As much as any time in recent memory, the imperative today is to keep a sharp watch on the horizon.

Stock prices, measured by the S&P 500, advanced again, 1.9% for the month of September, and are now up a cumulative 14.2% year to date.  It’s been steady going for share prices of US stocks, with March the only down month this year, and then a mere -0.04%.  According to The Bespoke Report, there have been only 8 days this year when the S&P 500 has moved +/- 1%, with only 1963, 1964 and 1972 recording fewer days.  We are deep into a long-running bull market, and at the moment, there are few signs the trend is about to turn.

From a behavioral perspective, it is clear investors are beginning to be lulled in.  While there is no specific reason to believe the slope of the uptrend is about to change, some baseline prudence at this point is warranted.  Anecdotally, we’re coming up on the 30th anniversary of the October 1987 crash – a point in time I remember well.   My concern now is our collective complacency is creating the foundation for people to own a greater percentage of stocks than they would otherwise be comfortable owning.

To be clear, the fundamentals look reasonable.  2Q GDP figures were recently revised to 3.1%.  The US is in the 9th year of an economic expansion.  It is likely growth can continue in spite of the damage inflicted by hurricanes in Florida and Texas and forest fires in California.  It is also hard to foresee higher growth than what we now have without a change in access to labor.  Unemployment, in the 4.4% range, is the lowest since 1960s.  Importantly, inflation is not apparent, yet.  The issue here again, is labor.  The job market is becoming tight and it seems like wage inflation is inevitable.

US 3Q earnings are just beginning to be reported. Expectations are for results better than analysts’ have projected.  The earnings beats will likely be attributed to several things: an unusual period of synchronized global growth, stable oil prices and improved US output, a “constructive” upward shift in the yield curve, and the low value of the US dollar.

I expect a continued resurgence in corporate earnings to support stock prices through 4Q 17 and likely into 1Q 18.  There has been speculation that corporate earnings would benefit from a realignment of the tax code.  In light of the recent disarray in Washington, it seems highly unlikely any real progress will be made.  There is no doubt a repatriation tax holiday would be a tail-wind, but I do not think the market expects it, and will shrug off one more disappointment as more of the “new normal”.  In my opinion, we will see no fiscal stimulus, modest growth and increasing (but not debilitating) inflation.

There is a good argument the most significant risk the markets face is geo-political.  This is a category of market risk that is in many ways not there, until suddenly it is.  So much takes place out of the public eye, surprises (market shocks) can stem from this largely indirect factor.  The greatest effect is the undermining of investor confidence due to extreme price volatility.

In this vein, a clear concern, fanned by the Equifax hack, is both the security of our personal data in an information driven world, and the ongoing attempts to manipulate popular media.  There appears to have been a well-orchestrated, and highly effective campaign by state sponsored Russian hackers to influence popular opinion in the US.  My primary concern is whether the foundation of our democratic process has been compromised. 

Harking back to our communication last month, if you have not frozen your credit, please do so.  We can send you instructions to put a freeze in place.  This time of year, we are busy reviewing portfolios for the year end.  We want to be tax prepared.  If we have not spoken recently, or if you would like to arrange a review, please do not hesitate to reach out.

 

Bruce Hotaling, CFA

Managing Partner

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