federal reserve
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
August
According to meteorologists, July was the hottest month, ever. It was a relatively “hot” month on Wall Street too, as stock prices rose once again, gaining 1.3% for the month (as measured by the S&P 500). Year to date, the total return from stocks now totals a remarkable 20.2%. Thus far in 2019, stocks have only had one down month. That was May, when prices fell 6.6%. Otherwise, it’s been a rewarding time to own stocks and most investors, while somewhat guarded, are pleased with this.
The return to stocks looks less remarkable when viewed over a rolling 12 month period. Stocks delivered a 7.9% return for the trailing 12 month period. This is not a bad return, but nothing remarkable, and less than the historical return for large cap stocks. Last fall, stock prices fell 6.9% in October and an alarming 9.2% in December. The market was a whisker away from a full 20% decline, typically the benchmark for a bear market. In January of this year, when the Federal Reserve indicated it would stop raising interest rates, stocks immediately rose and erased all of the losses from the second half of last year..
We are now just coming to the end of 2Q 2019 earnings season. According to FactSet Research, as of July 31, 76% of companies reporting had beaten earnings and 73% had beaten revenue. The reports were a good bit better than expected. In general, margin contraction was offset by higher revenue growth. In the end, the change agent was fewer shares outstanding due to stock buybacks. Analyst forecasts of earnings estimates for 4Q19 and for 2020 have been drifting lower. This is due to deteriorating economic conditions in the US and around the globe, and is being exacerbated by tariffs.
Since the start of the year, stock prices have been on the rise. This is not due to improved fundamentals or an increase in earnings estimates. It is simply due to an increase in the P/E ratio (the multiple the market applies to earnings) which has risen from 16x to over 19X today. The increase in the multiple is the result of the steadily falling interest rate expectations. The multiple is not likely to continue to expand. In my opinion, stocks are fully valued, based on what we can discern at the moment.
Unfortunately, at this juncture, bonds are expensive too. As measured by the iShares Core US Aggregate (AGG), bonds have returned over 6% year to date, more than double the 2.5% per year the 2.5% the AGG has averaged over the last five calendar years. Bonds are important. They provide reliable, albeit modest income. They can also provide some protection from volatility in a portfolio holding stocks. We refer to this as ballast. In a perfect scenario, stocks and bonds in a portfolio together behave in a non-correlating manner. This is more often the case when utilizing municipal or corporate bonds, as opposed to bond mutual funds.
The recent collapse in yields is a significant tell that the economy is stalling. Anxiety over the trade debacle, and hopes of monetary policy penicillin (ever lower interest rates) has become a volatility cloud over investors’ sentiment toward stocks. If the economy goes into a stall, or if we even suffer several quarters of flat or declining earnings, it will be a challenge for stock prices. The ability of central banks around the world to repair the damage from a metastasizing trade war is limited, at best.
Just the same, stocks remain the best game in town, especially when we consider a holding period greater than 12-18 months. I prefer US stocks due to 1) a high degree of transparency and communication with respect to assessing how businesses are faring, 2) our access to research and quality information from an accounting and reporting perspective and 3) a data base that enables us to sort and screen stocks quickly and effectively. One of the components of success in the complex world of investment management is keeping watch for changes on the margin.
It seems obvious that figuratively and literally, temperatures are rising. I hope August is cooler than July, but my confidence is guarded. We remain on alert to raise cash and take a more cautious position, as soon as we see the beginning of a trend. Heightened volatility can mask or mark the onset of a trend. Please feel free to check in if we have not spoken recently.
Bruce Hotaling, CFA
Managing Partner
Wait For It
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
Managing Partner
Charlotte’s Web
Terrific is the only way one can describe the performance of the stock market through the first quarter of 2019. Prices rose for the third consecutive month, adding on 1.79% in March. Year-to-date, the total return to stocks, measured by the S&P 500, is 13.65%. The remarkable surge in prices nearly perfectly matches (reverses) the utter devastation stock prices faced in 4Q18 when prices fell a cumulative 13.52%. In 4Q18, stock prices fell more than 1% on 16 occasions, while in 1Q19 prices fell more than 1% only three times. This was some change.
From my perspective, I am somewhat surprised by the sudden rebound, and also suspicious that eventually some less-good news is going to let the air out of the market. As much fear as there was in investor’s eyes last December, there is a renewed sense of urgency to own stocks again. Wall Street clearly favors Washington’s policy agenda. Possibly the single largest change agent was the more dovish stance by the Federal Reserve.
The headwinds I’ve discussed in prior letters remain firmly in place. In addition, the yield curve has inverted, with short term interest rates now higher than long. This has historically been a caution sign and is highly correlated with recessions and often challenging stock markets. We’re faced with a chicken and the egg scenario. Does an inverted yield curve signal a recession? Or, does the early phase of an economic slowdown cause the yield curve to invert? This is the first time the yield curve has inverted since 2007.
The short-term economic boost from the 2017 Tax Cuts and Jobs Act has petered out. What we are left with is a $1.5B increase to the federal deficit. Contrary to the plan, there is no economic growth to spur deficit reducing tax revenue. Normally, the intention during good times is to use the excess wealth to deleverage or repay borrowings taken on during the tough times. The increases to the federal deficit are not sustainable and will ultimately have to be corrected. The self-imposed trade war is hurting domestic profits, according to recent earnings calls.
1Q19 earnings season is just about to be begin. According to FactSet Research, earnings estimates for the S&P 500 are expected to decline 3.9% for the first quarter 2019, which would be the first year over year decline in earnings since 2Q 2016. Stocks, at the moment, seem to be looking through these numbers. In fact, it’s not uncommon for the value of the index to increase while the S&P 500 earnings estimates are decreasing.
If companies miss earnings or are forced to reduce guidance, their response will be a key indicator for us. Companies that miss earnings estimates could respond by cutting spending on capital improvements and labor, further strangling economic growth and possibly igniting a stock-market selloff. Earnings misses tend to force companies to rethink their priorities.
Amidst this challenging backdrop, investors are radiant. Prices are rising like its 1999, again. That was a long time ago, but one of the most remarkable periods in stock market history. While 1999 receives all the popular acclaim, (stocks were up 19.5% in 1999), in the four preceding years, prices rose 26.6%, 31%, 20.2% and 34%. While we are clearly in the business of pursuing investment gains, I think a more humble posture is appropriate. Let’s hope we do not repeat the fear of missing out syndrome that owned Wall Street in the late ‘90s.
My take on the way forward is to buy (and sell) stocks selectively. Stocks overall are not that cheap, but individually, some are attractively priced, and others have high growth rates that are unrecognized. Patience in putting funds into the market is key. As the market saw-tooths, we want to buy the dips. We are also watching closely the emergence of new companies, new business models, that may prove to be the next transformative move in the market’s life-cycle. I’m confident that our keen eye and years of active investment experience will allow us to work through this odd hodgepodge of factors.
Please do not hesitate to give us a call if we have not spoken recently. We are happy to work closely with you to asset allocate your portfolio and answer any questions you may have as to the best way forward. All the best, and enjoy the emerging spring time.
Bruce Hotaling, CFA
Managing Partner
Santa is Checking His List
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
Managing Partner