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Favorable time to own stocks

Happy New Year

                In 2019, U.S. based large cap stocks, as measured by the S&P 500, produced a generous total return of 31.49%.  Over the last 30 years, the S&P 500 has returned more than 30% only five times or 17% of the time.  The average annual return for stocks in the last decade, beginning January 1, 2010 was a heady 14.1%, the only down year being 2018.  The average for the prior decade, beginning January 1, 2000 was only 1.2%, with four down years and staggering price drops in 2002 and 2008. 

                Last year at this time, stocks had just taken a precipitous year-end nose-dive to end the year down 4.4%.  Stocks were oversold and the PE multiple was relatively low; the Federal Reserve had raised interest rates the fourth and final time December 20th.  A lot of investors were disheartened by the rate hikes and on their heels when the market sentiment turned in early 2019, causing them to miss some of the upturn. 

                Today, the market is regularly making new highs.  The Federal Reserve opted to reverse its 2018 rate hikes with three cuts in 2019.  This drove animal spirits that were wrestling with negative fallout from the trade war and slowing growth around the globe.  One argument is that the Federal Reserve, bullied or not, became the only adult in the room.

                Now, at 18.2x expected 2020 earnings, stocks are more expensive than a year ago.  According to JP Morgan, the 25-year average is 16.3x.  Just how pricy the market is, of course, is contingent on multiple factors – during those 25 years, stocks have sold for over 24x, and below 10x.  FactSet currently estimates $178 per share in earnings for 2020, a nice 9% bump from the $162 companies in the S&P 500 managed for 2019.

                My biggest concern for the coming year is a protracted deterioration in our economic relations with China.  The U.S.’s self-declared war on trade is now two years old and the loser in the trade war has been the American consumer, forking over billions of dollars in tariffs to no effect.    Trade wars are clearly not good or easy.  The economy and the stock market will both be better off once there is resolution.  In my opinion, the U.S. has been busy wasting time and money in the Middle East, while China has been investing, and building diplomatic and economic relationships around the world.  Bullying the Chinese will not help the American economy.

                Earnings will prove key to stock prices this year.  This may seem obvious, but last year earnings were flat, while stock prices skyrocketed.  This jump was due entirely to PE multiple expansion, which in turn was driven by the reduction in interest rates.  The Federal Reserve cut rates three times in 2019, and that is unlikely to happen again in 2020.   So, if stock prices are to rise this year, it will hinge on improved corporate profit margins and earnings per share.

                Our energy is directed at selecting quality U.S. stocks and bonds where we have reliable information.  We make active bets on companies we believe from a fundamental and a quantitative perspective are positioned for price appreciation.  Stocks and bonds, our asset classes of choice, are reliably non-correlating, counter-balancing each other’s volatility.  We manage our bets, and the overall exposure to risk, in each portfolio. This is in distinct contrasts to the use of multiple asset classes, deployed via mutual funds and ETFs, as is the common practice among many investors.

                For 2020, I expect the markets will likely behave a lot like they did in 2019, until November.  Then, we shall see.  In the meantime, we will continue with our emphasis on growth stocks.  This tilt has enabled strong performances from our primary equity models over the last several years.  If it begins to look as though the expected 9% bump in earnings is not going to come to fruition, we will re-assess and modify our approach.  Until then, stocks (even slightly more expensive stocks) remain the best bet.  We look forward to getting together with you in the New Year.

 

Bruce Hotaling, CFA

Managing Partner

What A Difference

A year ago, most investment markets were experiencing freefall.  The Federal Reserve, intent on normalizing interest rates, had raised the Fed Funds rate eight times since 2016.  By late 2018, markets in general were beginning to exhibit their collective displeasure.  The Fed then announced it would ease up on its tightening program, and stock prices have been rising ever since.  Stocks, measured by the S&P 500, rose 2.17% in October 2019 and are making new highs.  They are now up 23.16% year to date after a dismal -4.75% in 2018.

The stock market has been deftly climbing a wall of worry.  This somewhat dated reference alludes to the ability of stock prices to continue to rise in the face of factors or issues that one generally would consider a deterrent to that growth.  This backdrop makes it extremely difficult to put fresh money to work – there never seems to be a clear green light.  Many investors have experienced this hesitation since November 2016.  The worry is in fact the market’s risk premium: the risk of loss investors must embrace in order to receive equity-like returns.

One month ago, many investors and market pundits were expecting corporate earnings to continue on their recessionary track.  The trade war was wreaking havoc in multiple ways on US business overseas, supply chains and access to markets; and global economic growth was stalling in China, Europe and the US.  There was also the inverted yield curve, a tell-all indicator that the US economy was on the brink of a recession.  There was not much to look forward to.

Today, it seems all that has changed.  Whether true or not, the administration via popular media outlets is feeding the public optimistic soundbites regarding the eventual resolution of the trade war.  The “seasonal effect” which tends to see stock prices perform well during this period of the year may be influencing investor thinking.  The global economic backdrop suddenly appears brighter too, based on more recent economic data points. 

In my opinion, more central than the above is the fact that 3Q earnings were more or less on target.  This was immensely reassuring to investors.  Over 70% of companies reporting earnings have done better than expected, a stark reversal from 2Q where the earnings beat rate was the lowest in over a decade.  Investors were poised for disappointing earnings, and surprised with the outcome.

Two factors have produced a nice bump in stock prices:  the PE ratio has increased about 20%, largely due to falling interest rates and earnings for 2020 are anticipated to increase in the high single digits above their expected 2019 level.  The key now is whether forward earnings forecasts can hold up as we move into 2020. 

In my opinion, US stocks remain the best game in town.  We can more accurately assess the intrinsic value of US companies based on reliable and transparent data.  So even at somewhat elevated levels, the expected return from US stocks still remains more attractive than other asset classes, bonds in particular.  While we consider the valuation of the market as a whole, we do not buy the market – we focus on specific investment opportunities inherent in individual names, their unique merits in relation to their peer companies, growth rates, strength of their management, and other factors.

Lastly, I have some news to report on changes here at Hotaling.  First, we have added another advisor, Gretchen Regan.  I’ve known Gretchen for some time.  She is a talented analyst and immediately adds value to our work for you on a number of fronts.  You can read about her at www.hotalingllc.com.  Second, after years of working together, Valerie has decided to move on to the next big thing and retire.  She intends to spend important time with her family.  We will all miss her here, as I’m sure you will too.  In our attempt to fill that void, we have brought Jennie Wilber on board.  Jennie is young and energetic and will do everything Valerie had done for you, and then some.  I’m sure you will have the opportunity to meet her, at least over the phone, before year end.  We have been doing a lot of outreach to make sure you are informed, but please do not hesitate to call if we have not been in touch recently.  

 

Bruce Hotaling, CFA

Managing Partner

Higher Highs

Stock prices, measured by the S&P 500, continued their upward march, gaining 1.93% for the month of July.  Year to date, the S&P 500 has generated a total return of 11.6%.  These returns are respectable, by most historical measures of stock market behavior.  Certainly some investors may be tempted to “step off” the merry-go-round, end the year right here, and wait around until the game starts up again January 1st, 2018.  

An old Wall Street adage is “the trend is your friend,” and the recent period has been about as friendly as one could hope.  July marked the sixth of seven months this year when prices advanced, an unusually steady winning streak.  Over the trailing twelve month period, stocks rose eight of twelve months (stocks typically rise 66% of the time) for a total return of 16.04%.

During the period just prior to the election, earnings (and stock prices to some extent) tracked sideways.  There was a long stretch, from 2014 to 2016, when oil prices imploded and the S&P 500 aggregate earnings were stuck at $117 per share.  There is no doubt, the election injected a wave of optimism.  But unnoticed, and coincident with this wave of populist fantasticism was a true inflection in corporate earnings growth.  Beginning with Q1 17, corporate earnings leapt by over 14%.   According to FactSet Research, growth for 2Q 17 EPS is expected to be over 10%, and expectations are for $131 per share in 2017 and $145 per share in 2018.

So what’s the fuss?  These are terrific numbers. Stock prices measured by the Dow Jones, the S&P 500 and the tech heavy Nasdaq have been hitting record high after record high.  In my opinion, investors see the earnings, and they see the stock prices, but there is this nagging sensation something awful is just around the corner.  According to sentiment data from the American Association of Individual Investors, bullish sentiment is at 36%, having spent 28 of the last 29 weeks below 38.5%, the historical average.  Another old Wall Street adage is stock prices climb a “wall of worry,” and this is largely what we have going on today.

The spectrum of worry is vast.  Clearly, one dark cloud shading popular sentiment for owning risky stocks is the torrent of noise coming from Washington DC.  Even amidst a period of record earnings, investors cannot take their eyes off the clowns.  The void of leadership has left several investment grade “brides” standing at the altar. Up to this point, nothing has been accomplished with respect to regulatory reforms, infrastructure spending or lower tax rates.  The pro-growth agenda that was going to accelerate corporate America and pacify Joe-the-plumber is gasping.  With no fiscal policy and the Federal Reserve looking to normalize monetary policy, growth hangs in the balance.

Beyond the US, the worries expand.  Constant geopolitical tension has become the new normal, whether it’s related to security, trade or the environment.  It was clear at the recent G20 meetings in Hamburg Germany that the leaders of the developed world do not view the US in the same light they once did, expressing concern that the US is no longer the reliable partner it was in the past.  

Tangible evidence of diminished faith in the US is the constant downward pressure on the US dollar index.  While this is a tailwind for US corporate earnings, it also indicates fewer investors want to own US dollars.  This is happening in the face of Federal Reserve tightening, generally reflective of higher interest rates and growth, something that would normally attract foreign investors to buy US dollars and assets. 

As Mad’s mascot Alfred E. Neuman would ask, “What, Me Worry?”  Stock prices are higher.  It is widely viewed that stocks are the only game in town.  If sentiment ever does take hold, and more investors overweight their allocations to stocks, the table is set for troubled times.  I continue to have confidence in corporate America’s ability to leverage improving global growth and a low US dollar, and look forward to seeing the expected earnings realized.  I am also well aware we have to tread cautiously here, as a lot of folks have their eye on the exit door, and don’t want to be the last one out.  I look forward to catching up with you if we have not been in touch recently.  Please enjoy your August.

 

Bruce Hotaling, CFA

Managing Partner

Bulldog

Stocks rebounded in October, returning 8.3% for the month, and lifting the return on the S&P 500 to 2.9% for the year. October has something of a reputation for producing volatile investment returns. This year, August and September were both volatile and down months. It was important that stocks put up a strong showing to avoid sliding into a prolonged decline, or worse. The cautionary evidence in hand was strong, with two consecutive quarters and months with negative returns. Thankfully, October’s stock returns showed some muscle and broke the market’s downtrend.

Several catalysts drove the change in tone. For instance, corporate merger activity (Walgreens and Rite Aid, Ace and Chubb, Heinz and Kraft) leapt to new heights and gave investors an emotional lift. Another catalyst in October was the resurgence of corporate debt issuance. Corporate borrowings increased signaling improved confidence in the economic outlook and the fortunes of corporate America. Finally, and most importantly, earnings reports have been robust and reassured many sitting on the fence.

According to FactSet Research, the blended growth rate for Q3 S&P 500 EPS improved to (2.2%) at the end of last week from (5.2%) at end of last quarter. With the majority of companies reporting, 76% have beat consensus EPS expectations and in the aggregate, companies reporting earnings are 5.9% ahead of expectations. Nine of ten industry sectors have produced positive earnings growth surprises. Earnings have been impressive and the primary driver of the outstanding returns stocks posted in October.

To be clear, the backdrop for stocks is not overly compelling – so I am somewhat wary. At the same time, there is a constructive backdrop often referred to as “climbing the wall of worry.” The macro headwinds are widely discussed in the media. The ones concerning to me are : 1) slower growth across the globe, 2) the strong US $’s impact on US corporate earnings and 3) certain weak economic stats, such as the recent four-straight disappointing monthly non-farm payroll reports.

While stocks do not look cheap at this point, they do look as though they have a reasonable chance of generating their historical rate of return looking ahead 12 months. This cannot be said for some of the other asset classes investors have popularized. I profess “simple is good” and we avoid using asset classes we cannot cash flow forecast, or own directly (without having to use a third party manager or mutual fund). Our decision drivers are based on transparency, quality and liquidity. We utilize a number of different tools to accomplish this including fundamental, technical and quantitative research methods.

In many instances, we had raised cash (sold stocks) taking a more defensive posture as the market became more and more unsettled over the summer. The strength of the market’s rebound in October is reassurance that the market simply needed to blow off some steam, and is not in fact on the precipice of a prolonged downturn. It had not sold off in some time and there is a high likelihood that it needed to “reset” to a certain degree. Now, our focus is to remain well invested, building stock positons at attractive prices. Seasonally, the final two months of the year and first part of the new year tend to be favorable times to own stocks, and we want to take advantage of that tendency.

Difficult as it’s been, stocks remain the prime driver of returns for most investors this year. Growth stocks continue to generate higher returns than value stocks and dividends still do not matter as much as growth. So we will continue down this path. The fears rippling through the REIT market have tempered as have the fears related to the eventual Federal Reserve rate hike. The MLP market, now tied to the price of oil more than ever, will take longer to “normalize”, in my opinion, though the Q32015 reports are making it clear the businesses are maintaining themselves.

If we have not spoken or if you would like to review your portfolio I would be more than happy to get together with you. In the meantime, we are preparing for year end and want to minimize the effects of capital gains in your taxable accounts. Please feel free to call if you would like to discuss further.

Bruce Hotaling, CFA

Managing Partner