At long last we turn the page on one of the most tumultuous years in my lifetime. The House of Representatives voted to impeach the president for abuse of power in January. By March, cases of the coronavirus had been found in all 50 states. The stock market responded with one of the most dramatic drops in the last 40 years (-34% in 1987, -34% in 2002, -49% in 2008, and -34% in 2020). In June, millions protested in support of Black Lives Matter. The election in November felt as though it spanned three strained months. Now, an unprecedented movement is underway to overturn the popular and electoral college votes. Finally, beyond all common sense, the year closed with stock prices, measured by the S&P 500, up 3.8% for the month of December and up an eye opening 18.4% for the year. Amidst utter chaos, the stock market is evidently focused elsewhere.
We will probably never know the true disconnect between what was happening on Wall Street and what was happening on Main Street. This will likely become the work of analysts and scholars for some time. As the dust settles, and we turn toward what may unfold in 2021, there are a multitude of causes and outcomes for us to consider. Some we can clearly see, and others will surprise us.
On the positive side, there is a lot to support owning stocks. Vaccines by Pfizer-BioNTech, Moderna and AstraZeneca/Oxford are being administered and still others are in the pipeline. The stimulus already approved by Congress, with likely more to follow, will prove a stabilizer for the economy, likely all the way into 2022. Analyst earnings estimates project record earnings for the S&P 500, in the range of $170 per share. The Fed Funds rate is currently 0.25% and I would not expect interest rates to rise in a threatening way. The Fed’s Chair Jerome Powell, alongside Janet Yellen as Secretary of the Treasury, ought to give the markets comfort. Demand for stocks will be supported by the low rates which limit quality investment alternatives.
On the other hand, there is a lot that could be disruptive in owning stocks. As was the case in the response to the Financial Crisis, politicians now may use debt limits as a mechanism to foil attempts to rebuild the economy. The Federal budget deficit is expected to top 15% of GDP in 2020, and the total deficit now exceeds 100% of GDP, the highest level since WWII. Labor force growth is turning negative, and output per worker is declining, both ominous signs for future GDP growth. At some point, tax revenues will need to be found in order to begin to rein in the deficits, especially in light of low economic growth. If in fact interest rates do rise, they will suppress the market’s PE ratio, make the cost of doing business (owning homes, consumer credit) more expensive, and make financing the federal deficit more costly.
My expectations are that the markets will enjoy a more transparent and clearly policy based attitude from Washington with respect to foreign trade, environmental policy, public health and general support for the whole of the economy. I think some of the disparities in the economy that have been exacerbated by the pandemic will begin to be addressed. While I do think returns have been pulled forward to a certain extent, there are a range of opportunities in play such as electric vehicle technology, alternative and clean energy, ESG themed investment approaches, and continued work-from-home technologies. We are busy looking to incorporate these emerging themes into our portfolios.
Our basic work will not change in 2021. We will continue to put our energy into both leading-edge and time-tested investment management technique with the intent of making money owning quality equities. We will also focus on linking our investment management capabilities with your financial planning needs, to make sure your exposure to risk, asset allocation and future planning is appropriate.
While in many ways nothing has changed from a week ago when it was still 2020, in other ways everything has changed. No doubt 2021 will bring its share of unexpected events. It is our work to navigate and profit from them that will make the difference this time next year.
Happy New Year!
Bruce Hotaling, CFA
Stock prices, measured by the S&P 500 jumped a remarkable 10.7% in November, and are now up 14% year to date. November’s returns are the third best for any month over the last 20 years, led by 12.7% in April ’20 and 10.8% in November ’11. To contextualize these remarkable figures, it is worth pointing out the worst monthly returns during the same 240-month span. October ’08 saw stock prices fall 16.9% with the onset of the great financial crisis. In March ’20, COVID 19 hit, driving prices down 12.5%. Finally, in September ’02 prices fell 11% resulting from the dot com bust, 9/11 and a horrific recession (from its peak in March of ’00, the market had fallen 50% by October ’02). The market will move to the extreme, both up and down, and we often don’t know why until after the fact.
November’s jump in stock prices is likely due to multiple factors. The first, and most important, was the election of Joe Biden and Kamala Harris on November 3rd. The market responded favorably with the expectation that we will see 1) sensible, forward-looking policies to stimulate and rebalance the economy; 2) renewed emphasis on alternative energy and environmental sustainability; and 3) definitive steps taken to begin addressing some of the economic and social barriers perpetuating embarrassing levels of inequality. Importantly, the nonsensical trade war will end, and this alone will provide a boost to GDP.
Positive data was released by Pfizer/BioNTech on 11/9, Moderna on 11/16 and Astra Zeneca/Oxford on 11/23, providing a monthlong hope trade premised on economic re-opening. However, the virus is raging with new daily cases in excess of 220,000 and deaths in excess of 2,000 per day. When the vaccines are approved, the difficult task of prioritizing who receives the vaccine first will come into play. The roll out means help is on the way, but it’s not at all clear when enough of the population will be adequately protected. Nonetheless, November saw investors buying stocks with the expectation the virus will be contained.
Another fundamental driver of the recent stock price surge is corporate earnings. Q3 results were better than feared, we are seeing more companies reinstate guidance and forward expectations are high. In 2Q, earnings fell by over 20% due to the implosion of business activity in the travel/leisure sectors on fears of the virus, in the energy sector with oil prices less than $1 per barrel and in the financial sector with banks making huge provisions for the anticipated loan losses. Now, as businesses attempt to emerge from the pandemic-driven recession, stock prices are discounting a substantial recovery in earnings by late ’21.
November market activity generated a dramatic rotation from growth stocks to value stocks, along with the re-emergence of smaller cap stocks. This pro-cyclical trade is premised on a full economic recovery, rising interest rates and inflation. In my opinion, the cyclical trade has largely run its course and the economy is going to take a long time to fully recover. Stimulus aside, interest rates will remain low for a long time and there are structural shifts in effect which make a return to traditional levels of growth and inflation unlikely.
In my opinion, a drawn-out recovery does not mean that stocks cannot continue to perform. First of all, the economy is not the stock market. Second, we own select stocks in which we are confident they can generate above market returns. Growth, free cash flow and dividends remain critical fundamental qualities we screen for in our selection process. We have shifted our focus to accommodate the cyclical trade, and own numerous stocks today we would have never considered owning prior to the pandemic. We will watch and make further adjustments as circumstances dictate.
As we approach year end, we are available to review your accounts with you, with a special view towards capital gains. The good news is that returns have been solid this year and we can reserve funds for future tax payments. Tax planning, or at least tax awareness, is prudent at this time of year. Please feel free to check in with us; we are continuing to primarily work from home with limited work from the office. Take good care and please be safe out there.
Bruce Hotaling, CFA
October was a frightening month in the stock market, and not just due to Halloween. Stocks, measured by the S&P 500 fell 2.66% for the month, and are now up a slim 2.77% as of month end. Stocks were uncharacteristically buoyant to close out the summer, leaving investors scratching their heads. Then successive down months in September and October seemingly foreboded calamitous times ahead.
The election is now behind us. The world seems to have breathed a collective sigh of relief with the announcement that Pennsylvania turned out in favor of Biden. The recent surge in the stock market since election day reflects the market’s acknowledgement the US in fact needs clear and consistent policies with respect to trade, foreign relations and domestic priorities. The potential for a divided government appeases many Wall Street pundits based on the presumption a republican senate will prevent higher corporate taxes and prevent expansion of health benefits and other regulations.
Critically, the pandemic is worsening and is clearly the largest issue facing governments across the globe. The US now has recorded over 120,000 infections per day. In the wake of Sturgis, the virus is raging, particularly in the Midwest. Hospitalizations and death rates are increasing. Winter is nearing and indoor gathering will become a challenge. Until the pandemic is contained, the service side of the economy in particular will remain hostage to the effects of the virus.
The labor force has been severely impacted by the virus. While hiring has picked up, the unemployment rate remains 6.9% according to the US Bureau of Labor Statistics. Labor force participation among women is in decline and minority unemployment has soared. Services are a large and visually apparent component of the economy, and they remain well off pre-pandemic levels. Longer term the risk is unemployment becomes entrenched and economic growth stagnates. Vast government stimulus, and public/private partnerships will be necessary to boost labor force participation rates and allow for a re-absorption into the workforce.
The Federal Reserve will continue to play a critical role in the economy’s ability to get back on its feet. Interest rates are now likely to remain suppressed for an extended period. It is not yet evident what post-election fiscal stimulus might look like. Clearly state and local governments desperately need help as their tax receipts have been ravaged.
Overall, stock price multiples are historically high, selling at approximately 21.5x expected 2021 operating earnings of $161 a share. For the market to move meaningfully higher from here, gains will have to be driven by stronger earnings. In spite of the country’s economic plight, 2021 may produce near all-time high corporate profits. It is feasible for the S&P 500 to generate $176 a share in earnings by mid-2021. That was the same earnings level we saw in 2019 just before the virus descended on us. This would support what many feel is an emerging bull market in stocks.
At the moment, I see a host of opportunities in the stock market. As I have discussed before, a market of stocks is quite distinct from the stock market. Our key focus is on quality stocks showing continued improvement in earnings. Of equal importance at this moment are dividend stocks. Interest rates are historically low, and further multiple expansion is unlikely. I think this backdrop will lead income investors away from bonds and toward more attractive dividend streams.
My preference is to continue to orient around strong growth stocks, while onboarding select value and cyclical plays. I feel the digitized economy will continue to grow, and dominate the market’s attention. Further, our research is focused on alternative energy, utility, and consumer stocks. We feel that these sectors will extend the strength they’ve exhibited during the latter part of the year.
Please feel free to call us to review your portfolio. I know we have been in touch with many of you with concerns leading up to the election. We cannot discount the potential for disruption in the near term, but the longer term outlook looks better now than any time in the last several years.
Please, be safe out there.
Bruce Hotaling, CFA
Stocks began 2017 with an undercurrent of optimism as prices touched new intra-day and all-time highs. The total return for stocks, measured by the S&P 500, was 1.9% for the month of January. The month was notable, if for anything other than competing events in Washington DC, in that it was both positive and dull. There were no trading days when the market moved up or down by more than 1% since the 1.11% move on November 9th, the day after the election. Often, when markets hit new highs, it clears the path to further price strength.
The shadow to this optimism is uncertainty. This is often measured by the VIX, or the volatility index. The VIX is the Chicago Board of Options Exchange Volatility Index, showing the implied volatility of the market using S&P 500 index options. The figure has been skulking in the 10% range since the start of the year. For some context, just prior to the election it was around 20% (its historical average), and during the financial crisis back in 2008, the VIX spiked into the 80% range. The implications of a high VIX are that options traders are actively attempting to position themselves for what they anticipate will be a turbulent market.
The VIX is frequently referred to as the fear index. It often happens that when investors are at their emotional limit, the VIX measure is high. Today’s measure is historically low. Yet, more and more well-known and vocal investors have begun to express discomfort with the US’s lack of direction, protectionist tendencies and militaristic posturing. The market appears to be discounting the rhetoric. There is a curious air of complacency among investors empowering them to make substantial bets on tough talk.
The tough talk, or bombast, has lulled market participants and created a high expectation. The rub is all the pro-business talk may or may not bring forth change. It will be quite a task to double GDP growth to the 4% level, as promised, on the back of an economic expansion now more than seven years old. The economy is at full-employment, and the outcome of certain proposals (tax reform, reduced environmental and financial regulations, fiscal spending on military and infrastructure projects) may ironically lead to inflation and other unintended consequences – but not growth. I suspect the complacency may have allowed investor and corporate confidence to run ahead of itself.
The most important measure of future stock prices, corporate earnings, are now being released for the period 4Q2016. According to FactSet Research, the growth rate for Q4 S&P 500 EPS currently stands at 4.2%, better than the 3.1% expected at the end of the quarter and of the 34% of S&P 500 companies that have now reported for Q4, 65% have beat consensus. If the 500 companies that make up the S&P 500 are going to generate the current consensus earnings of $130.76 for 2017 and $146.11 for 2018, they are going to have to get a move on. On the plus side, the resolution of the damaging oil price shock of 2014-15 will help, as will a more normal and steeper yield curve, and the addition of some fiscal stimulus the market has been begging for since 2008.
None of this will be clear, until it is. In a market such as this, we could cautiously step out of the car anticipating its imminent breakdown, only for it to rumble on down the road, without us. My impression of the way forward is to proceed, with a foot on both the gas and the break – a two footed driver. As expected, the big theme thus far has been the post-election landscape, though also as expected, companies are unable to quantify potential policy implications given lack of details. So, we wait.
My expectations remain somewhat guarded. I think average returns from stocks and bonds for the year ahead can be attained. My concern is that these average returns will be delivered on the back of greater than average volatility and unrest in the financial markets. We of course, cannot see this at the moment. With this in mind, I am happy to speak with you if we have not been in touch recently. My goal is to check-in, in order to reaffirm your asset allocation and near and long term investment goals.
Bruce Hotaling, CFA