Take a Deep Breath

Halloween came and went this year, and not a single clown came by the house. I have to say, I felt a degree of relief.  Something new this year, creepy clowns, have been in the news and haunting us in ways most of us have never imagined.  There is a cloak of fear now associated with clowns.  I think many of us have been holding our breath in response to the vastly irrational circus we’ve been watching.  I suspect and hope there is a collective sigh of relief November 9th when this very odd chapter in our history is in the rear view mirror.

Stock prices, measured by the S&P 500, fell 1.9% in October, the largest monthly drop we’ve seen since the 5.07% plunge in January.  October’s lull follows -.12% returns in both August and September.   Bespoke Investments pointed out that the three month drop, which tallied less than 2%, was quite unusual and in fact, such a modest three month fade has only happened three other times dating back to 1951.  Year to date, stock prices are in the black, having returned a surprising 5.87%, as investors have largely looked through the upcoming election.

On the economic front, GDP figures for 3Q 2016 came in at 2.9%, driven largely by consumer spending and exports.  We haven’t seen a GDP number that high since 3Q 2014.  Good news is that economic growth in this range is expected to continue through the fourth quarter and into next year.  The jobs creation figures have been encouraging for some time, and we’ve recently seen a meaningful pick-up in wage growth.  The oil patch continues to stabilize after a near 2-year swoon, and the rebound in prices, contrary to common thinking, is encouraging renewed investment (infrastructure, transportation) in energy related businesses.  These factors, in my opinion, will likely allow the Federal Reserve to raise the Fed Funds benchmark next month.  

Last year, on December 16, 2015, the Federal Reserve raised rates by 0.25%, for the first time in over 10 years.  Stock prices immediately proceeded to correct.  From that day until the market’s low on February 11, 2016 stock prices fell 11.5%, echoing the old mantra “don’t fight the Fed.”  Some believe when the Fed is raising rates, tightening monetary policy, it indicates a top to the cycle, and is a bad omen for stocks.  Whether this thinking played a part in the market drop, or not, we will never know.  While I do not agree, be aware there are a lot of people who think this way, and there is a good chance the Fed will raise rates again, for the second time in over 11 years, on December 14, 2016. 

According to FactSet Research, impressive earnings reports this quarter have at long last moved the dial.  As recently as September 30, Q3 earnings were expected to fall 2.2%.  Now, as of October 28, the earnings growth rate for the S&P 500 is a positive 1.6%.  That is an important swing and one I have been counting on.  After the relentless drag on corporate earnings due to the oil price implosion and the high US$, this quarter may well mark the first year over year earnings growth we’ve seen since the 1Q 2015.  The financial stocks have been the largest contributor to the bump in earnings.  Assuming the energy sector continues to normalize, we should expect a dramatic lift to the earnings for the S&P 500 in 2017.

I think it’s prudent to reduce asset allocations to fixed income at this point.  The credit concerns in the corporate and municipal space that shook the world in 2008 are healed.  Today, the primary issue is interest rate risk.  Rates appear to have inflected, and individual bonds and bond mutual funds are vulnerable to price degradation.  Interest rate surrogates such as REIT’s and MLP’s have also come under some selling pressure as investors consider a shift in the yield curve, but I have confidence that a favorable economic backdrop and their ability to increase their distribution levels will offset worries over higher rates.

Please feel free to check in if you have concerns related to the pending election.  Fears of a Brexit-like outcome have compelled some investors to raise cash, and this is likely the source of current pressure on the market.  My expectation is that the fundamentally sound backdrop in place today will allow quality growth stocks to continue to work for us.  Take a deep breath.

Bruce Hotaling, CFA, Managing Partner


The stock market, in the face of some high levels of skepticism, continues to befuddle investors who thought they understood what was going on. Stocks, measured by the S&P 500, finished the month of May at the 2,096 level, up 1.5% for the month.  Stocks are now up 3.6% year to date.  After a rocky start to the year, when prices fell relentlessly for two months, stocks have recovered 8.4% since the end of February.

The market made an abrupt shift to value stocks with the start of 2016 and looked to be committed to that path.  Oil prices were in total free fall the first 6 weeks of the year, leading to uncommon correlations between asset classes and immense levels of fear.  Investors drank the Kool-Aid and began to unload all the favored growth stocks of the last few years, hoping to ride out the storm with dividends and low valuations.

Then, growth stocks woke up in May. Not all, to be sure, but enough to raise the level of doubt that the newly proclaimed value regime had legs.  Stocks with ties back to the energy complex have strengthened with the recovery in oil prices.  Industrials, some transportation stocks and a range of materials stocks have shown solid earnings strength and price improvement.  The financial stocks, banks in particular, after a difficult start to the year, have also been coming around.  This reflects the market’s anticipation of a more friendly yield curve, and some relief that loan losses from the oil patch are manageable.

At a time of year when things tend to simmer down, there are some sideshows looming.  Brexit may bring some added volatility when the UK’s “should I stay” referendum takes place on June 23rd.  It’s interesting that roughly half of Britain’s exports go to the EU, while only about 6% of the EU’s exports end up in the UK.  The unknowns surrounding this question are weighing on the UK financial markets and currency.  The UK, on its own, is in the top 10 US trading partners.

Brazil is host to the 2016 Summer Olympics (Rio 2016) this August.  This year’s competition will include rugby sevens and golf for the first time, at the expense of baseball and squash.  The issue is the mosquito-borne Zika virus.  It is largely symptomless and no current vaccine exists.  This has led athletes from several countries to withdraw from competition.  It’s not at all clear how this will develop, but the situation harks back to the Ebola scare during the fall of 2014.  When fear raises its ugly head, all rational thinking goes out the window.

As I have discussed in the past, we have been slogging our way through an earnings recession.  The earnings decline for 2Q 2016 will mark the fifth consecutive quarter of quarter over quarter earnings decline since Q3 2008.  The anticipation of weak earnings was likely the prime factor in the milquetoast returns to stocks in 2015 (the year of the FANG stocks).  The market was discounting a prolonged earnings recession due to the expanded fallout from the implosion in oil prices.

In my opinion the market’s current lift is both a reflection of a slowing rate of decline and an expected recovery in the second half of 2016 and into 2017.  The most significant change is the recovery in the energy space. According to FactSet Research, the energy sector actually recorded an increase in the bottom-up earnings estimate of 1.8% (to $1.10) over the first two months of the quarter.  During this time the price of crude (WTI) has increased 28% to $49.10.

According to FactSet Research, the CY2017 bottom-up earnings forecast is for $135.42.  With the S&P 500 currently in the 2,090 range, stocks are trading 15.4x next year’s earnings.  Stocks are not cheap.  At the same time, they are discounting an earnings recovery or a return to earnings growth which we have not seen for some time.

As is the case, things will develop that destabilize the markets, temporarily.  The stock market corrects on average once a year.  It corrected in September ’15 and February ’16.  I think the evidence supports small steps toward an improving market and looking for higher returns for stocks in the second half of the year.  Please touch base if you would like to review. 

Bruce Hotaling, CFA, Managing Partner

Take a Step Back

For the month of April, stock prices measured by the S&P 500 nudged incrementally higher, up 0.27%, and are now in 1.74% above where they finished 2015. These modest numbers mask a lot of price movement, speculative news flow and investor angst during the first third of the year.

Recently, the market has been shape shifting. For example, after a long period when growth stocks outperformed value stocks, the tide has turned.  The S&P 500 growth ETF (IVW) is -0.74% for the year, while the S&P 500 value ETF (IVE) is 4.23%.  The spread in favor of value is even greater for the mid cap and the small cap segments.  And dividends are the thing, today, as the DJ Dividend ETF (DVY) is up an eye opening 10% year to date.  This is a sudden and complete reversal of the trend in 2015 when the growth IVW returned 5.37% while the value IVE returned a -3.29%.

There are multiple reasons for the u-turn in the return characteristics of the market. Core CPI is in the 2% range, and holding.  With the US 10-year Treasury currently in the 1.8% range, the real yield is negative, pushing investors to own higher yielding assets, including dividend paying stocks.  Dividends are generally taxed at a much lower rate than traditional fixed income, increasing the appeal.

Another reason is investors are generally bearish, marginally outnumbering bullish investors, as measured by the American Association of Individual Investors. This bearishness in conjunction with a declining Consumer Sentiment Index does not historically represent a lot of upside for stock prices.  The numbers are leading investors’ intent on staying in the market to lower their perceived risk, by owning dividends and stocks with lower valuation metrics.

Seasonality often comes up this time of year – the May through September window is historically not the most profitable.  In my opinion, the old wives tale to sell in May is not actionable.  While returns are generally lower, they are also generally positive.  In addition, it’s difficult to justify realizing capital gains (paying taxes on profits) to buffer some near term volatility, when in fact these are stocks with attractive long term growth potential. 

Q1 earnings reports are coming in and by and large the results have been slightly better than expected. One exception has been large cap technology stocks (Apple, Microsoft, Alphabet) have surprised with reports below expectations.  In my view, Q1 is the turning point, and I expect the trend in earnings to recover, aided by the stabilization in the US$, which had been a headwind, and from a recovery in oil prices by the end of 2016.

Some patience is key to successful investing. There have been roughly six pull-backs in stock prices since 2010.  These have trampled the unhealed nerves of investors still recovering from the financial crisis.  The Flash Crash in July ’10, Europe in October 2011, the Taper Tantrum in June 2013, Ebola in October 2014, China in August 2015 and Oil in February 2016.  Unnerving points in time such as these reveal the importance of a solid strategy and continued monitoring of factors effecting the markets. 

In that light, we have been shifting our portfolios into stocks with more value characteristics.  According to Empirical Research, growth and value stocks are traditionally non-correlating.  In today’s market, the focus is more on stability, and thus, the dividend as a key factor.  The value tilt we are enacting is in an attempt to capture the heart of the market.  According to Empirical Research, the value shift is one half complete based on historical trends.  We are not jumping in with both feet, as I believe the tilt will revert later in the year.

In response to the demand for yield, we have launched two new models (Dividend 5 and 10). The intent is for them to complement a traditional growth portfolio, and act as somewhat of a replacement to traditional fixed income.  We will be happy to discuss how these “sleeves” might complement your investment portfolio going forward.

Finally, with tax season behind us, we can all take a step back and assess. The shifting characteristics of the investment landscape will remain a challenge.  Further, with the market regime shifting, we have taken more capital gains than is typically the case.  I am happy to review these and other topics with you if we have not already done so.


Bruce Hotaling, CFA

Managing Partner


After a less-than-impressive return from stocks in 2015, things have taken a turn for the worse in the early part of 2016. For the month of January, stock prices measured by the S&P 500 fell 4.96%. Of the 20 days stocks traded, they fell in 9 instances, each day by an amount in excess of 1% (3 in excess of 2%). Not a pleasant way to start the year.

Large cap stocks tended to fare better than mid cap, and small caps simply fell apart. There was little differentiation between growth stocks and value stocks. Sector wise, financials and materials had it the worst. Consumer staples and utilities, both considered defensive sectors, actually had positive returns. There was nowhere to hide either. Stocks from every primary global market, including oil, gas and commodities all fell in value. The one bright spot, gold, silver and fixed income (particularly US Treasury bonds) did show positive returns.

So, where do stocks go from here? The answer, at the moment, hinges on oil. Stock prices have begun to trade in lockstep with the price of a barrel of oil. Oil prices did bounce off a 13 year low on January 20th and have rebounded nearly 14% since that date. In classic thinking, lower oil prices were considered a boon to the economy. Lower energy brings down the cost of production, transportation and ultimately puts more money in consumer’s pockets.

Historically there is not a strong correlation between stock prices and oil, until now. So what has changed? One variation from the old paradigm is we import far less oil today. On top of that, there is little clarity with respect to true global demand and talk of a recession. Some analysts feel the direction of the trade-weighted dollar starting in 2014, was the key driver of the price of oil. US monetary policy began to diverge from the rest of the world, oil depreciated as the action took liquidity out of the system.

There may be more fallout from the drop in the price of oil than anyone could have foreseen. Sovereign wealth funds which had been overflowing in accumulated oil profits may well be raising funds to support budget deficits. The world’s sovereign-wealth funds together have assets estimated in the $6-$7 trillion range, (US GDP in 2015 was approximately $18 trillion). More than three quarters of these assets are in funds from emerging market countries, many based in the Middle East and Asia, and naturally the assets easiest to sell are their global stocks and bonds.

The oil patch has developed a knack for talking its own book. For example, T Boone Pickens, in a June 13, 2014 CNBC interview said oil prices could hit $150-$200 a barrel. Today, only 18 months later, several noted global banks are saying prices could drop to as low as $10-$15 a barrel. The unfortunate truth is no one really has any idea where the balance between supply and demand will be struck. Once oil prices stop falling, many other financial assets will follow.

The general economic backdrop is mixed. Talk of a global recession looms, but in the US, the housing and auto sectors continue to perform well and the jobs numbers are strong. 4Q GDP came in at 0.7% with a notable bump from consumer goods and services. While the industrial manufacturing sector slumps consumer confidence remains above its long term averages.

According to FactSet Research, the 2016 bottom-up estimates for the S&P 500 are $123.3 (versus $117.7 in 2015). This is the true foundation for the market, and stocks are trading in a reasonable range of 15.4x forward earnings. Energy remains the primary issue as returns have nearly evaporated dropping from $8.38 in Q1 2015 to $1.36 in Q1 2016, a drop of over 83%. Earnings for materials and industrials have also dropped, in large part due to oil.

In my opinion it’s most prudent to remain prepared to back away from risky assets. We did this back in August 2015 and we may find it prudent to do the same in February 2016. Many of our favored stocks are selling at attractive prices. This does not mean they cannot become even more attractive, if conditions take a turn for the worse. So, for the moment, we are watching cautiously.

Please feel free to reach out if you would like to review with us. In more difficult times such as these, it is important for us to remain in close communication.      

Bruce Hotaling, CFA

Managing Partner

Touch Bottom

The long bull run in US stock prices has been thrown off track, at least temporarily. Stock prices, measured by the S&P 500 fell 2.6% for the month of September following a 6.2% drop in August. Prices are down 5.29% through the end of 3Q15. Two consecutive months of negative returns and I opt to toe-tap the brakes. In fact, I have been raising cash since the stock market began acting up mid-summer.

Often times, stocks record back to back down months, and that’s that. Then, there are times like the Summer of 2011, when prices fell for five consecutive months. When the dust settled, prices were down 18%. So, if the slope of the market remains negative, I will continue to lean away from the falling prices, and raise cash. The other edge of the sword is that prices often recover sharply – October 2011 saw prices jump 10%. Caution is key at this point, but as conditions improve, we will want to move quickly back into stocks.

The initial drop in US stocks began when China devalued the yuan. As market forces took the yuan down on subsequent days, stock prices cascaded lower. The concerns hinged mainly on decelerating growth out of China, the world’s second largest economy, and the economic ramifications of currency wars among export and commodity dependent emerging economies.

Contrary to what many have been citing in the news media, the health of the global economy is a large factor in the well being of our domestic economy. While the Federal Reserve’s mandate is full employment and price stability, global influences can dramatically alter the strength of our economy. In my opinion, while the data is difficult to rely on, China is not crash landing, rather transitioning from a manufacturing based economy to a consumption based model.

The list of ills is long. Though China may be the poster child, low energy prices have led to a domino effect of issues hampering stocks.   Profits for most energy companies have been cut dramatically and for some their dividends, capital expenditures, and even their ongoing viability is in question. FactSet Data Systems (Earnings Insight 9/25/15) noted that “If the Energy sector is excluded (from the S&P 500 3Q2015 estimates) the estimated earnings growth rate for the S&P 500 would jump to 2.9% from -4.5%.”

In addition to the immediate impact on overall earnings, there are secondary effects. For example, industrial companies that manufacture equipment, metals and mining equipment, and banks that lend to the oil patch are all being pinched. There has been an echo effect on many other sectors of the market. For example, the MLP’s, which transport and store oil and gas, have also come under immense price pressure. In my opinion, this is an over extrapolation on the part of naïve investors and will correct itself in due course. Nonetheless, the oil glut has been a boone for $2 a gallon at the pump, and a confusing snarl for companies unprepared for the first and second derivative fallout.

In my opinion, US stocks remain the best asset class in that they offer a reasonable expected return for the risk of owning them. Good growth stocks have outperformed the market as a whole, and are well ahead of value stocks. Investors tend toward the value category when they become less sure of themselves. There has been no place to hide this year – no asset classes have offered up easy or obvious returns. It’s been tough sledding almost everywhere you look.

Between now and the end of the year, some things ought to become more clear. Concerns related to China’s growth rate and how it opts to handle its currency will temper. The Federal Reserve will likely raise interest rates, even though the economic data does not support a rate hike. Finally, 3Q earnings ought to paint a clearer picture as to the valuation of stock prices and the marginal outlook for growth heading into the coming year. As the negative impact from the drop in energy prices fades, the earnings outlook will correspondingly improve.

There is a lot of noise out there. Today, the concern is Volkswagen fudged emissions measurements on 11M of its diesel motors. If you remember, only last fall a wave of fear struck the country over the Ebola virus and the likelihood of airborne transmission. These things tend to pass. Luckily for us, the Pope visited Philadelphia recently and lifted everyone’s spirits, if only for a moment. This is proving to be a more challenging year than the last two. Some patience and fortitude are required. If you are not comfortable moving forward then I suggest we meet and review you portfolio.  Please feel free to call.

Bruce Hotaling, CFA, Managing Partner