fed rate increase
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
For days now Floridians have been in a state of suspension – the massive hurricane Dorian sitting just off the coast. It ravaged the Bahamas and is now making its way slowly northward. Much as they try, meteorologists (and presidents) cannot truly predict the direction or the intensity of a hurricane. So, Floridians are more or less forced to brace themselves, and then wait it out.
In many ways, this tension is precisely what investors in the equity markets have been facing. For the trailing 12 month period, stocks have generated a total return of 2.92%. This was hard-earned, as during that period of time, stocks fell during 4 months, and in each case, by an average 6%. Year to date, stocks have rebounded off their 2018 year-end low for a total return of 18.34%, as measured by the S&P 500. In stormy August, stock prices fell 1.81% and were down on 10 of 22 trading days. The worst damage was from three days in particular, when prices fell nearly 3%, and those happen to be the three worst trading days of the year so far.
There are a lot of things investors in stocks and bonds are fixating on. High on the list is the trade war the administration boldly initiated, and the resultant economic fallout around the globe. Economic fundamentals are beginning to erode and it’s not clear how some aspects of the global economic mosaic will repair itself. For instance, distribution channels have been shut, supply chains cut and re-routed, hours worked in manufacturing are on the decline and corporate (S&P 500) revenue growth has fallen from 8% a year ago to 2%. Corporate leaders are less likely to make capital commitments related to trade as long as Washington is unreliable.
While Washington has taken to brow beating the Federal Reserve Bank in an attempt to influence policy, it is not clear monetary policy functions as it once did. We are late in the economic cycle and rates have been low for a long time. The 10-year US Treasury note, which anchors many aspects of the borrowing markets (student loans, mortgage loans) is now at roughly 1.45%. It is nearing the record 1.36%, the lowest level ever, set in July of 2016. The Federal Reserve Bank and the European Central Bank are both expected to lower their respective benchmark rates later this month by 0.25% and 0.10% respectively. Neither of these amounts are significant, economically, apart from the symbolic messaging. People, and companies, are unlikely to change their behavior due to a 0.10% drop in rates.
Fallout from the protracted low interest rates is evident in the banking system. This is most apparent in Europe, where many banks have arguably never recovered from the financial crisis in ’08, and the sovereign debt crisis that followed in ’10. In the US, commercial banks have recovered, but they still cannot overcome the business challenges of perpetual low interest rates which pinch profit margins, and sow doubt in borrowers minds that rates may go lower. There is the fear rates are under pressure only to stave off recession. For monetary policy to work, bank lending is key, and people have to have a degree of confidence to borrow.
Based on our work, I continue to focus on select stocks that screen well for their growth characteristics, constraints on capital spending and strong levels of free cash flow. We are watching, though have not begun to own more defensive or value oriented stocks. As we’ve discussed, (the market) the S&P 500, is selling for 17x forward earnings ($178 per share). In general terms, for stock prices to move higher, either the multiple, or earnings, must rise. At the moment, the factor allowing the multiple to rise has been falling interest rates. Corporate earnings estimates have been declining, since Q1 19, as analysts have been revising their forward estimates down. Select stock picking, and judicious timing is the way forward.
The big question today is, how does this curious backdrop begin to disentangle itself? With no clear path forward, we have to continuously monitor the underlying activity in the markets and stock specific fundamentals for signs of real change. When we have some greater degree of clarity we will act accordingly. In the meantime, please feel free to check in if we have not spoken. I hope you are enjoying both the start of the new school year and the onset of fall and the cooler weather it will bring.
Bruce Hotaling, CFA
Stock struggled in May. As measured by the S&P 500, prices fell 6.58%, and the year-to-date return to the benchmark now totals 10.74%. This comes as something of a shock after four successive months of hefty returns. The market’s historical pattern of giving steadily, and taking-away quickly, is clearly evident. Since the November 2016 election, on three occasions, stocks have somewhat violently taken back virtually all the prior period’s gains. Stocks were routed in February 2018, in December 2018, and again in May of 2019. On one hand, this could be considered normal volatility in the market place. On the other hand, this “triple top” formation is considered a warning sign by technical analysts.
The 800 pound gorilla investors around the world are now contending with are tariffs. Since the 1930s era Reciprocal Tariff Act, successive administrations have used their authority to liberalize trade, promote economic growth and strategically de-risk regions and relations. This has all changed. The justification now being distributed is that increased tariffs will help the US win, they are a counter to national security threats, and they will force our foes to the bargaining table.
The consequences for the American consumer is they either forego buying certain products, or pay more for them. Tariffs are a burden on US businesses in multiple respects, through higher input costs, loss of market share, or the elimination of businesses as the tariffs make them unprofitable to continue. Farmers, particularly soy beans, pork and cotton, have seen their businesses stall. The sad truth is that the bounty from the Tax Cuts and Jobs Act of 2017 is now lost, as Americans are being taxed, indirectly, to support a global war on free trade.
It’s not at all clear the trade overhang will lift. This will require cooperation and agreement with trade partners, as opposed to standing on their dog leashes. We ought to expect this to be a lingering presence in the marketplace, until at least November 2020. The White House will game, talking up economic growth and stock prices while whirling the politically potent trade stick. Some of our research providers project the damage from the tariffs could be as much as 5% of earnings. This would ostensibly wipe out the forecasted earnings growth for the current year. A valid question, in the face of this degree of uncertainty, is how much can investors continue to digest?
Separately, market fundamentals are not alarming, but they are also a long way from anchoring confidence. Several April economic data points were down. Q22019 GDP is now expected in the 0.6% range, the weakest since Q42015, the last time we had an earnings recession. The slowdown in growth began in advance of the recent trade news with respect to China, Mexico and Canada. Interest rates and inflation look to me as though they will remain low and range bound well into the future.
Today, based on current earnings expectations for the S&P 500 of roughly $180 per share (12 months forward) stocks are selling for a little over 15x earnings. This is slightly below the 25 year average. Expected returns, from this valuation level, are roughly 10%, which is also in line with historical averages. The Goldilocks outlook is that barring any surprises, these earnings levels can be attained, and the multiple does not erode any further.
On our end we are pleased the market continues to favor growth stocks over values stocks. The S&P 500 Growth index (IVV) is up 13.32% ytd versus the S&P Value index (IVE) up 8.18% ytd. We are concerned with the recent anti-trust talk directed at stocks such as Google, Amazon, Apple and Facebook. Other factors investors use to assess stocks such as size, valuation, dividend yield, etc., are not additive at this time. We are taking a much more idiosyncratic approach and are targeting stocks with strong secular growth, innovative management teams and limited supply chain exposure to foreign trade.
I expect the tension we see in the markets to continue, and it will remain challenging to own stocks. I also think the best opportunities for investment gains remain in select stocks, versus owning the market or making sector bets. This makes good quality stocks the best game in town and one we pursue with vigor. Please feel free to check in in if we have not spoken recently.
Bruce Hotaling, CFA
Stock prices, measured by the S&P 500, rose an impressive 3.93% in April, boosting the total return to stocks to 18.25% year to date. These returns are among the best ever for the first four months of the year. The month was notable in that prices rose in all but five of the 21 trading days, a 76% batting average. Also notable is the low volatility, or daily price movement. With the exception of April 1st, when prices rose 1.16%, the average daily price change (up or down) was only .25%. This compares to December 2018, when the market was in free-fall. The average daily price change was 1.38%.
Stock prices are behaving as though they are intent on setting a new high water mark. The last time the S&P 500 hit an all-time high, September 20, 2018, it closed at 2,930.75. At that point, prices were comfortably up 13.07% for the year. Few investors would ever have guessed their returns would be negative by year-end. Between September 20 and December 24, stock prices fell 19.36%. One of the most universally unwelcomed Christmas presents ever – a bear market.
A strong start to the year for stock prices cannot necessarily be extrapolated forward. As we saw last year, the strong behavior of stocks can turn on a dime. In the past, there have been years such as 1995, when stocks did continue higher after a strong start to the year. Then, other years with strong starts, such as 1930, infamously saw the complete implosion of stock prices by year end. More often than not, after a big start, the market tends to saw-tooth for the remainder of the year, challenging investor’s resolve against giving back precious gains with each subsequent downswing.
In an effort to gauge where things stand, investors often try and establish a point of reference based on the duration of the economic cycle. The current expansion has been in place since early 2009. The average expansion over the last 70 years has been roughly 5 years. By these simple terms we ought to prepare for a contraction in the fundamentals and stock prices. Some have pointed to the more services oriented nature of the economy, and the general low intensity of the expansion. Questions revolve around the degree of pent up demand, the fact wages have been suppressed, and changes in the structure of the labor force. The recovery has been going on since 2009, but not all segments of the economy have responded equally.
Currently, the fundamentals are mixed. Economic growth is challenged. The tax cut was a one-time thing and will not spur any further corporate spending. 1Q earnings reports have been alright, but only in relation to reduced estimates. Revenues have underwhelmed. It’s harder to mask underlying issues with revenues, than with earnings. The US posture toward China, and other trading partners, will not likely be resolved anytime soon. The risk here is for unintended consequences. Finally, and likely a positive consideration, the Federal Reserve is seemingly on hold for a number of months.
We are seeing some positive signals. While we find stocks with secular growth trends attractive, we are also paying more attention to defensive businesses. Utilities and staples have been two of the best performing sectors over the last 6 months. We are also seeing the beginnings of recovery in housing related stocks likely due to the lower interest rates and in spite of the SALT limitations, and some interesting support from semiconductors.
In conclusion, we do not want to give away our shot. Stocks are fully priced and we are in the midst of a global stock price rally. We are jointly committed to our secular growth stocks, and looking at select opportunities to take profits and put some $ onto the sidelines. We are also beginning to see the first signs of value stocks attracting interest. In many ways this is a signal long investors are beginning to lose their conviction. If this continues, we will address some of our holdings appropriately.
In the immediate term, we look forward to speaking to you about keeping equity exposures in check. Complacency is high and with this backdrop, things will be ok until all of a sudden they are not. We don’t want to be looking at one another wondering “what did we miss.” Please feel free to call if we have not spoken recently.
Bruce Hotaling, CFA
Consider it an early Christmas present. In the month of November, the S&P 500 rose 1.79% bringing its gains to 5.11% for the year. The reversal from the prior month was pivotal. After October’s -6.94% beating, we needed this positive result to avoid having to take an even more cautious stance and raise cash levels. The stock market has been challenging.
I anticipate that it may take more time for the market to digest the selloff that began in early October. My hope is that we have seen the worst of it, but the 200-day moving average is in a downtrend, and that is not a healthy indicator. I also expect some earnings revisions to begin to temper investor enthusiasm, possibly spurred by the poorly performing energy stocks and fall-out from the trade war.
There are a handful of disparate circumstances unfolding that may become problematic. The oil patch is in disarray, and oil prices are in a freefall. Over the last month, prices have fallen by 25%. However, according to FactSet Research, the energy sector is expected to report the strongest earnings growth (+24%) for 2018 of the 11 S&P 500 sectors. That’s an interesting contrast. Historically, there has been an extremely high correlation between oil prices and earnings estimates from the energy sector. Therefore, oil prices are possibly foreshadowing a notable decline in the earnings forecast from the energy sector.
The housing industry may already be in a recession, with all manner of housing-related data (new home sales, housing starts, buyer traffic) showing signs of weakness. Housing stocks have done poorly. The mortgage lending business is now dominated by non-bank lenders, which are responsible for more than 52% of the $1.26 trillion in originations in the first nine months of 2018 (WSJ 11/22/18). The affordability of certain markets has made buying difficult. Further, the interest rate increases by the Federal Reserve are causing many potential buyers to take pause.
Corporate debt is another concern. The volume of corporate debt has more than doubled since the financial crisis of a decade ago. Credit rating agencies (Moody’s and S&P) have been actively downgrading debt issues to low or below investment grade. The primary concern is the waterfall effect from rising downgrades and defaults. The recent plight of GE is a poster child for this issue, and this is a problem that could spread like the plague.
While investors have celebrated recent US profits and economic strength, the above-trend growth rates are unsustainable. Growth rates in 2018 (20%+ EPS and 2.8% GDP) are skewed by tax changes, government stimulus, and other non-recurring impacts. Importantly, a growth reset (5-8% EPS and 2.4% GDP) should be more than sufficient for markets to continue to advance. In my opinion, 2019 will deliver growth for stock prices, though expectations will need to be tempered. Dividend yield may become a more important component of the total return than in 2018.
My thinking is to remain focused on US growth stocks but to pare back some of the higher-growth and higher-priced names. The style that may be most suitable for a flat or even declining earnings growth environment is referred to as growth at a reasonable price (GARP). We intend to focus on stocks that have stable growth rates, pay a reasonable dividend, and are not overpriced (on a P/E basis) in relation to both their peers and the market as a whole.
US financial assets have dramatically outperformed the rest of the world in 2018. Many investors are convinced that investing funds in regions, sectors or asset classes for the sake of diversification is a good thing. On the contrary, I believe it’s is more important to make investment decisions utilizing reliable information on the companies that we believe have merit and closely monitoring our exposure.
As we close out 2018, we are actively reviewing portfolios to take advantage of tax loss selling. It has been a challenging year, and we have purposefully taken gains in stocks that have outperformed over the last several years. We are all available to discuss this with you or to review your portfolio if we have not been in touch recently. We wish you and your family a wonderful holiday season and best wishes for a prosperous and peaceful new year.
Bruce Hotaling, CFA