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Independence

It’s July 4th, 2017, 241 years from the day the Continental Congress adopted the Declaration of Independence, declaring the 13 American colonies to be independent from Great Britain.   For me, I cannot believe both the bravery and the foresight of the men who crafted the Declaration, the Constitution and the Bill of Rights.  So many things could have turned out differently, and yet, here we are, celebrating our independence.   

This year, stock investors can also celebrate what has been an exceptional first half of the year.  Returns to stocks, measured by the S&P 500, have produced a healthy total return of 9.34%.  One prominent aspect of the stock market this year has been the tail-wind for growth stocks, as opposed to value stocks.  This plays to our strength as we have been steadfast growth at a reasonable price investors for years.

Year to date, the technology sector has produced returns nearly double the next best sector, an impressive run.  Prices wavered some in late June, but I expect their leadership to continue.  The sharp end of the technology stick is referred to as FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) – and all have shown sensational returns this year.  Other pockets of strength include financials, where the banks are benefitting from favorable capital requirements, spurred by the heads of the European and US Central banks.  We have also seen attractive returns from healthcare stocks, likely indicating the market anticipates a more favorable business environment.  Bringing up the rear is energy.  In my lay opinion, there is simply too much oil out there, and demand looks suspect. 

On the economic front, growth is ok, but not by much.  Q1 2017 GDP came in at 1.2% annual growth, following a 2.1% reading for 4Q 2016.  My tarot cards do not include an inflation card.  It’s the equivalent of a child’s monster under the bed – scary but not there.  The Federal Reserve is staying with its script, raising rates and unwinding its balance sheet (tightening).  There are plusses and minuses that do not add up.  Energy prices are low, pleasing at the pump but bad for igniting capital spending.  The dollar is low.  This may boost exports, but conversely may raise prices on imported goods.  I am not convinced we will see strong enough economic data to support a steepening in the yield curve.

The market has shown a high degree of complacency since the election.  This will change, eventually.  There is the idea that great athletes have a high tolerance for physical discomfort.  I’m curious if that is a common characteristic for great investors too.  Can they remain even handed in a highly discomforting environment?  And for how long?  An observation of our current society is how uncomfortable with discomfort people are.  When something unpleasant arises, there is often a need to immediately re-direct, to take some medication, or do something to put the discomfort to rest.

Until the complacency lifts, we have a reasonable backdrop: the economy is standing on its own two feet and earnings growth is in the low double digits.  This “just so” scenario is allowing stock prices to rise.  The market seems to have given up any expectation of anything constructive from Washington DC.  In fact, the opposite may be true at this point.  If Washington DC does in fact do something, other than tweet, it may serve to disrupt what has become an acceptable status quo.  There is a watch what you wish for aspect to our current situation.

Looking ahead, my expectation is for the stock market to mark time, and then show some strength later in the year and into 2018.  I am optimistic on the earnings front and believe this will support stock valuations. I do not think we will see a substantive rise in interest rates, and therefore, I am neutral on tax free and corporate bond markets. I think they are relatively safe, and returns will be mediocre. Obviously, if any of these factors change, my opinion as to how best to invest will change and I will relay that to you. In the meantime, please have a peaceful Fourth of July and if you think of it, take a moment to pause and reflect on the amazing movement that began here in Philadelphia, all those years ago.

Bruce Hotaling, CFA

Managing Partner

En Garde

Stocks, measured by the S&P 500, generated a total return of 3.8% for the first six months of 2016. By most accounts, this is a below average year for stocks, and the sub-par returns in hand have been hard fought.  From the get go stock prices fell, and (cumulatively) did not turn positive until March 17th.  The S&P 500 inched its way higher (toward its 2,130 all-time high set in May 2015) until the Brexit vote surprisingly knocked 5.4% off prices in two painful days.

Stock price declines (5% two-day declines) are not uncommon, except when the market is trading within 1% of an all-time high.  As noted by Bespoke Research, before the Brexit vote the S&P 500 was 1.6 standard deviations above its 50-day moving average and two days later it was 3.2 standard deviations below.  The two day swing was the steepest on record over a period spanning close to 90 years.  Much of this was “noise” thanks to computer driven trading in ETF’s and futures.

Investors were clearly caught off guard by the Brexit vote and then sucked into a vortex of misinformed commentary.  As much as Brexit captivated the world’s attention and whip-sawed stock prices, I think it will prove to be both a local issue and a political bone in the craw of an older generation.  I would expect longer term it will hamper an already sluggish UK economy and spur another Scottish secession vote.  Near term the implosion in the value of the pound will be a tailwind.

In my opinion, we are better served focusing on some of the more obvious risks to both the global and US economies.  One critical factor is China.  As we saw last August, concerns over slowing economic growth, and the steady devaluation of the Chinese currency (the RMB), are true global risks as China is the largest contributor to global GDP growth.  I suspect these concerns have not been put to rest.

The outlook for S&P 500 earnings for the second half of 2016 is favorable, largely due to low interest rates, a tempering US$, and higher oil prices.  The US 10-year is yielding around 1.4% and due to macro factors, rates may well surprise and trend lower as global capital seeks safe haven.  The US$ has stabilized (stopped rising) which will provide a huge tailwind to US companies repatriating foreign based earnings.  And, oil prices, the culprit for much of the turmoil markets have suffered over the last 18 months, have stabilized.  A good sign is inventories appear to be on the decline.  Supply and demand will come together.  With oil prices in the $50 bbl range, volumes of economic activity will come back on line, and with it, $’s of lost earnings.      

Overall, the undercurrents of the market have not changed since the start of the year.  For the time being, large cap value is outperforming growth, and small and mid cap stocks are generating stronger returns than large cap stocks.  Dividends (REITs, utilities and most consumer staple stocks) have been the big attraction for investors this year.  They have become expensive.  While I expect the interest in dividend yield to continue, I think the growth stocks will come back into fashion when the S&P 500 begins to show evidence it is breaking out of its long running earnings slump.

Though confusion reigns from time to time, I think we can take heart in a brighter long term outlook.  The millennials (born 1981-1997) are now the largest generation, at roughly 75 million, and are the largest share of the American workforce (Pew Research Center).  The millennials are just starting to get married, buy homes and have children.  The US is on the verge of a tremendous demographic dividend as the largest share of the population for the coming years will be young, highly educated, and ready to consume (Bespoke Research). 

Over the years, common sense and an attentive hand have allowed us to navigate some challenging markets.  Our approach is to anchor on facts, take a long term view of what we’re all about, and to acknowledge (and refine) an effective process.  We are here to serve you.  In these curious times, if you would like to share your thoughts or schedule a review, we would love to hear from you.

Bruce Hotaling, CFA

Managing Partner

Oil

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

Why is the high yield bond market struggling with liquidity concerns?

 

dollar

 

Why is the high yield bond market struggling with liquidity concerns?

Blog from Jean M. Rosenbaum, CFA, Portfolio Manager

Hotaling Investment Management, LLC

The high yield market has been in the news recently due in part to its lack of liquidity. The increasingly poor liquidity situation was brought to the forefront by Third Avenue’s decision to halt redemptions in its Focused Credit Fund mutual fund. (Open end mutual funds provide daily liquidity to investors so the inability to withdraw funds has caused concern among investors in the asset class.) The liquidity concerns come from 3 primary sources – the fund itself, the energy sector and the regulatory environment.

The first problem lies with the fund itself. The fund invested in assets which were illiquid. Providing daily liquidity from such an asset base is possible only if the fund is growing. Once the fund stopped growing, the inability to sell assets impaired its ability to provide liquidity.

The second problem is the financial stress in the energy sector. The energy sector has become a larger part of the high yield market in recent years. Investors were happy to fund these cash flow negative companies in a high and rising commodity price market. Once the oil and gas prices began to weaken, investors became increasingly concerned about the ability of these companies to service their debt. Default rates, which are at cyclical lows, are likely to rise.

The third problem is related to the post-Financial Crisis regulatory environment. New regulations are changing the way bonds are traded. The bond market is an “over-the-counter” market.   Unlike stocks, bonds are not on an exchange. Bond trading had been facilitated by an investment bank’s use of their own capital to create market liquidity by buying and selling securities, engaging in what is called proprietary trading. Following the financial crisis, new regulations limit the ability of investment banks to engage in proprietary trading, thus limiting their ability to create a liquid bond market. The limitation on proprietary trading, while put in place to safeguard the banking system by limiting the size of the balance sheets, has had the unintended consequence of severely limiting bond market liquidity.

Over time, market liquidity will return as the challenges of moving an over-the-counter market to an exchange are solved. The problem is most acute for active bond traders and for other investors that require liquidity and need to sell their bonds. Recent market events could be the catalyst to force market participants to solve the trading gridlock.

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