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Dollar

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

Change is Coming

The stock market is all about earnings.  Corporate earnings and their level in relation to stock prices is the fundamental basis, the keystone, of stock valuation.  US stocks have been enjoying an unprecedented period of earnings growth and price appreciation.  Much of this stems from the stock friendly behavior coming out of Washington DC.  In general, corporate America could not be more pleased with the US corporate tax cuts and the across the board emphasis on de-regulation.

For the month of May, this symbiotic relationship continued to self-reinforce, and stocks responded with a total return of 2.41%.  The solid returns for the month brought the S&P back into the black for the year.  May’s positive returns and moderate volatility (only three of 21 trading days had price moves +/- 1%) were a welcome relief for investors after two stressful months with sharply negative returns in February and March.

While stock returns are modestly positive this year, it’s a shadow of the 8.8% return through May of 2017.   I do not expect the S&P 500 to return 22% again this year.  Signs of trouble are brewing.  Few asset classes are faring well.  Most larger foreign markets are down (Brazil -11.9%, Germany -4.2%, China -4.6%).  Gold and silver, and almost every maturity level across the fixed income spectrum are also down year to date.

It’s a challenge to make forward looking determinations on how best to position the portfolios in the face of so much media noise and misplaced commentary.  In my opinion, there are two overhangs to the market that are threatening to spoil what has been an intoxicating run for stock investors.

One of the supportive backdrops for the upbeat market in 2017 into 2018 has been coordinated global growth.  The idea behind this concept is a stronger global economy supports improving demand for US goods and services, and spurs corporate profits.  The US$ had been low, amplifying the effect.  Suddenly, this growth driver is under assault, and isolationism and protectionism are on the rise.

Further, tension on the Korean peninsula, threats of a trade war with China, tariffs on steel and aluminum imports from Canada, Mexico and the Eurozone, and the US’s withdrawal from the Iran nuclear deal have led to a destabilization of the world political-economic order.  This is thin ice.

Much of the anticipated global growth was fueled by debt.  Now, global debt has reached levels never seen before, equivalent to 225% of global GDP (according to the Economist 4/24/2018). China is guilty of leveraging up to sustain its economic growth.  This is similar to the US tax cuts that will push the US deficit over the $1 trillion mark.  Emerging markets are suffering with many of their obligations issued in US$s (Argentina, Turkey).  Growth, measured by GDP has slowed.  The question here is whether we have come to that point, the tipping point, when things begin to change, while no one wants to believe that is truly the case.

The question isn’t so much if there will be trouble, but when.  I do not think any changes in asset allocation need to be made, yet.  I do expect returns to bonds to be minimal, and stocks to be in the average range.  I am pleased the market continues to reward growth over value.  This is a tailwind for our portfolios.  Our core approach to investing is referred to as GARP or growth at a reasonable price.  Growth stocks continue to outperform value stocks at the large, mid and small cap levels, by notable margins.  The two highest returning sectors are technology and consumer discretionary, both sectors where we hold overweight positions. 

One of the clearest reasons to take a more cautious posture toward stock investing is because many, possibly too many investors and market commentators are overwhelmingly positive.  They tend to tick down the list of supportive economic or consumer data points.  There is a lot of cool-aid being consumed out there.  I’m not a contrarian, but I’m also not one to get sucked into the vortex.  The best course of action today is to avoid getting drawn in to owning too much stock.  We need to stay well invested, while hovering one foot over the break. 

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