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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

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

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

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