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Blue

October was a frightening month in the stock market, and not just due to Halloween.  Stocks, measured by the S&P 500 fell 2.66% for the month, and are now up a slim 2.77% as of month end.  Stocks were uncharacteristically buoyant to close out the summer, leaving investors scratching their heads.  Then successive down months in September and October seemingly foreboded calamitous times ahead.

The election is now behind us.  The world seems to have breathed a collective sigh of relief with the announcement that Pennsylvania turned out in favor of Biden.  The recent surge in the stock market since election day reflects the market’s acknowledgement the US in fact needs clear and consistent policies with respect to trade, foreign relations and domestic priorities.  The potential for a divided government appeases many Wall Street pundits based on the presumption a republican senate will prevent higher corporate taxes and prevent expansion of health benefits and other regulations. 

Critically, the pandemic is worsening and is clearly the largest issue facing governments across the globe.  The US now has recorded over 120,000 infections per day.   In the wake of Sturgis, the virus is raging, particularly in the Midwest.  Hospitalizations and death rates are increasing.  Winter is nearing and indoor gathering will become a challenge.  Until the pandemic is contained, the service side of the economy in particular will remain hostage to the effects of the virus.

The labor force has been severely impacted by the virus.  While hiring has picked up, the unemployment rate remains 6.9% according to the US Bureau of Labor Statistics.  Labor force participation among women is in decline and minority unemployment has soared.  Services are a large and visually apparent component of the economy, and they remain well off pre-pandemic levels. Longer term the risk is unemployment becomes entrenched and economic growth stagnates.  Vast government stimulus, and public/private partnerships will be necessary to boost labor force participation rates and allow for a re-absorption into the workforce.

The Federal Reserve will continue to play a critical role in the economy’s ability to get back on its feet.  Interest rates are now likely to remain suppressed for an extended period.   It is not yet evident what post-election fiscal stimulus might look like.  Clearly state and local governments desperately need help as their tax receipts have been ravaged. 

Overall, stock price multiples are historically high, selling at approximately 21.5x expected 2021 operating earnings of $161 a share.  For the market to move meaningfully higher from here, gains will have to be driven by stronger earnings.  In spite of the country’s economic plight, 2021 may produce near all-time high corporate profits.  It is feasible for the S&P 500 to generate $176 a share in earnings by mid-2021.  That was the same earnings level we saw in 2019 just before the virus descended on us.  This would support what many feel is an emerging bull market in stocks.

At the moment, I see a host of opportunities in the stock market.  As I have discussed before, a market of stocks is quite distinct from the stock market.    Our key focus is on quality stocks showing continued improvement in earnings.  Of equal importance at this moment are dividend stocks.  Interest rates are historically low, and further multiple expansion is unlikely.  I think this backdrop will lead income investors away from bonds and toward more attractive dividend streams.

My preference is to continue to orient around strong growth stocks, while onboarding select value and cyclical plays.  I feel the digitized economy will continue to grow, and dominate the market’s attention.  Further, our research is focused on alternative energy, utility, and consumer stocks.  We feel that these sectors will extend the strength they’ve exhibited during the latter part of the year.

Please feel free to call us to review your portfolio.  I know we have been in touch with many of you with concerns leading up to the election.  We cannot discount the potential for disruption in the near term, but the longer term outlook looks better now than any time in the last several years.

Please, be safe out there.

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

Haunted House

Amidst a torrent of unrest around the globe, the US stock market has essentially reacted with a shrug, racking up returns of 20.55% through the first three quarters of the year. September, often a challenging month for stocks, returned 1.72%. Historically, when stocks have done as well as they have at this point in the year, they tend to finish out the year with positive results. On the other hand, here we are in October, the month of Halloween and also the two worst months in recent stock market history: October 2008 and October 1987.

In my opinion, the backdrop is something akin to a haunted house. The fear people sense is related to the shenanigans in Washington DC. Controlling the narrative, manipulating the average person’s view, is the tool in traditional and social media. The goal is to sway the popular viewpoint. With November 2020 looming, one powerful tenet dating back to 1992 is “it’s the economy, stupid”, meaning one’s election fortunes are closely tied to the economy, and by extension, the stock market. The conviction that everything will be done to buoy the stock market may well be the foundation investors are building their hopes on for the coming 12 months.

While stock prices are up over 20% year to date, it’s more or less a return to baseline. Everyone is avoiding the fact that at the start of the year, stock prices had just fallen nearly 20% from their late summer 2018 highs. Today, if we consider the trailing 12-month returns of the S&P 500 (instead of the year to date) stocks are up 4.25%, less than ½ the long term historical average.

Fundamental concerns for investors at this juncture are related to upended global trade and business activity in disarray, the Federal Reserve’s next move, and the all-important earnings for 4Q2019 and forecasts for 2020.

The trade war the administration has undertaken with China, Mexico, Canada and the Euro-zone is not benefitting US business. To the contrary, it’s a significant factor in the deceleration of global growth. Without constructive policy and a predictable rules-based system, the current backdrop causes businesses to withhold investment. In the coming years, there is a good chance we will experience economic fallout in the form of low growth and negative interest rates due to lack of business investment today.

The Federal Reserve may not be able to jump-start an economy that is principally under pressure from erratic policy from Washington. Since 2008 and the financial crisis, many cite monetary policy has become a far less effective tool. I would argue that the economy in fact needs targeted spending (fiscal stimulus) and public/private partnerships to jump-start largely stalled economic growth. The deficits resulting from the 2017 tax-cut will of course make stimulus more challenging.

Earnings are clearly the elephant in the room. At the moment, according to FactSet Research, estimated earnings for 3Q 2019 are expected to decline 4.1%. This will mark the third successive quarter of year over year earnings declines. Heading into the end of the quarter, more and more companies have been issuing negative guidance. The 12 months forward earnings estimates (through 9/30/2020) for the S&P 500 are 181.66. The S&P is currently in the 2,900 range, implying a 15.9x forward P/E multiple. From here, for stock prices to rise, earnings growth must resume.

October is typically not the time of year to taunt the stock market with anything that might frighten investors. At the same time, U.S. corporations, up to this point, appear to be making their way through the corn maze. This is the foundation on which our guarded optimism rests. Stocks remain the most attractive investment option. We are still finding growth opportunities, though it is clearly a market for stock pickers. Quality U.S. corporate names with solid fundamentals and prospects for steady earnings make up the universe of names we keep on our short list.

As we approach year end, we will be reaching out to you to make sure we have addressed your concerns, capital gains constraints, or any other aspects of your financial life. Please feel free to reach out to us if you have any concerns in the meantime.

Bruce Hotaling, CFA
Managing Partner

Hurricane Dorian

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
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

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