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Hotaling

Tariffs and Taxes

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 

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

Trick or Treat

October, the month of Halloween and two of the most memorable stock market crashes, can be a scary time.    Fear is often considered the most powerful and uncontrollable human emotion.  When it ignites, the primal human survival instinct takes over and reason and logic go out the window.  This year’s October was no exception, and investor fear levels are clearly on the rise once again.

Stock prices for the month of October fell 6.94%, bringing the year-to-date total return of the S&P 500 down to an unsatisfying 3.01%.  For some context, February (-3.89%) and March (-2.69%) were also difficult months in which to own stocks.  From January 26th to the April 2nd low, stock prices fell over 10%.  The recent drop, from September 20th to the October 29th low, was 9.8%.  Both were uncomfortable drops in price and can be labeled corrections.  Seasoned investors often consider corrections a necessary evil when one chooses to commit financial assets to the stock market for the long run. 

The market’s behavior in October was unusual.  For example, of the 23 trading days in October, 16 saw negative returns.  There were 5 days on which prices rose more than 1%, and 5 days when prices fell more than 1%.  According to Bespoke Research, October 30 marked the end of a 28-day run for the S&P 500 without back-to-back days of positive returns; the preceding occurrence of this phenomenon dates back to World War II.  Stocks have recently struggled mightily and lost ground.  My concern is stock prices themselves are often considered the most telling indicator of future stock prices.

Of course, the stock market is made up of a vast array of companies occupying different sectors of the economy.  Different stocks have characteristics that cause them to respond differently to the same events.  For example, stocks that fared best during October were ones that had the highest dividend yields, the highest level of international revenues, and the poorest Wall Street analysts’ ratings.  Consumer staples and utilities were the only two sectors with positive performance. 

In my opinion, the increased agitation in stock prices may be an early signal of an earnings deceleration. This will likely be coincident with slowing economic growth and possibly even a recession.  For example, expectations are for earnings growth of 10% in 2019.  This is a reduction by 50% of the 20% growth we’ve experienced in 2018.  By mid-2019, investors will fixate on earnings projections for 2020, and those figures will probably be impacted by several factors.   For example, the trade war is causing higher costs for some US companies as a result of higher tariffs, longer lead times, and broken supply chains.  In addition, hints of inflation and indications that wage pressure is building will likely lead the Federal Reserve to continue on its current course of restrictive monetary policy.

Consumer confidence (at the moment) remains extremely high, both historically and in absolute terms.  This is a good thing, at least for now.  The confidence levels reflect the fact that jobs are available and people with jobs are out spending money.   There is still some punch in the proverbial punch bowl, and that could extend what has already been a prolonged economic run.  Given that we live primarily in a service-oriented economy, the historical cycles of older industrial economic cycles do not necessarily work as a barometer.  There may well be more room to run, but according to Bespoke Research, when consumer confidence has peaked historically, we tended to be at the early stages of a recession.

In my opinion, stocks are still the asset class of choice.  The backdrop is the same as when the speed limit on the freeway drops from 75 to 55 and suddenly you feel like you’re crawling along; the freeway still beats the back roads for a long road trip.  We will need to quickly become accustomed to the new rate of economic growth and the new market place and likely pivot to a more value-oriented stock selection approach.  Expected returns from stocks may well be lower going forward than they have been since 2009.  Our work is to choose the best stocks to own as the future characteristics of the market become clearer.  I am happy to discuss this with you in greater detail if we have not spoken recently.  Please feel free to reach out.

 

Bruce Hotaling, CFA

Managing Partner

The Beat Goes On

Stock prices, as measured by the S&P 500, rose 3.6% in July and are now up 6.5% year to date.  In my opinion, these are reasonable (not too hot, not too cold) considering the backdrop.  Take a look under the hood, and things don’t look too bad.  Market breadth (measure of advancing stocks relative to declining) is fair, with 60% of the S&P 500 above its 50-day moving average.  Strength among the tech stocks has been extraordinary, and they have contributed the lion share of the market’s gains.

Impressive 2Q earnings reports serve as the foundation of these gains.   According to FactSet, 80% of S&P 500 companies have reported earnings surprises and 74% revenue surprises, the highest percentages since FactSet began monitoring them in 2008.  The valuations (P/E ratios) of stocks across the board have been falling as a result, making the fundamental backdrop of the stock market that much stronger.  Results are balanced, with all sectors showing positive earnings growth.

Some of the strength in recent numbers may be due to companies front-ending their sales in order to beat the coming tariffs.  This may lead to a reciprocal slow-down, but that will reveal itself in the coming quarters.  Stock buybacks, when companies retire (buy back) their shares and allocate profits across a smaller number of shares, typically boost share prices.  The recent spate of buy-back announcements led year-end expectations to top the $1T mark for 2018, a nearly 50% increase over 2017.

Apple, for instance, repurchased $43.5B in the first half of the year.  For comparison, Ford’s entire market cap is $40.1B.  This was partly due to the tax overhaul, enabling repatriation of overseas dollars at tax rates between 8% and 15.5%.  Further, chapeau to Apple, the world’s most valuable public company, and the first stock ever to reach $1T in market cap.  A few others nearing the $1T mark, with impressive year-to-date returns are Amazon (59%), Alpahbet (Google) (19%), and Microsoft (27%).

Record earnings, stock buybacks, and buoyant stock prices aside, many investors are walking on eggshells.  This is not surprising, as most would agree that the backdrop is difficult.  The divisive tone of much of the news flow forces investors to soldier on.   Our goal is to rely upon indicators with some degree of measurability to watch for tides that begin to turn.   When that time arrives, we will look to buffer the effects of falling stock prices with higher levels of fixed income and cash.

  We monitor multiple market factors, and any number of them could signal the onset of the next market cycle.  Among them are relative strength and valuation.  Additionally, we monitor interest rate levels, as the Federal Reserve is tightening monetary policy.  Higher rates will eventually stall economic growth.  Home sales have also slowed.   This could be due to rising mortgage rates, a shortage of inventory, or in the US, the recent restriction on deductibility of state and local taxes, and mortgage interest.   Globally, there is rising concern over a bust in the highly speculative Chinese housing market.

The elephant in the room remains the trade war.  The government intends to modify China’s behavior with respect to trade and intellectual property by hitting them with a stick.  Globalization and economic interdependence have positively impacted national economies around the world.  The European Union, initially the Common Market, was formed to establish political end economic stability in an unstable region.  I expect that the impact of the trade war will be greater on consumers’ wallets and US corporate earnings than on anything related to the trade deficit.

One final item, which we will have to confront one day, is the US Congressional Budget Office’s recent forecast for the US annual deficit to exceed $1 trillion in 2020.  In spite of the underlying economic growth, the national debt is soaring and is forecast to exceed $33 trillion by 2028.  Our nation’s leaders do not appear to have considered the negative consequences of too much leverage, and those consequences may unfairly become a political tool.

The market’s strength is enriching investors.  At the moment, Wall Street likes its man in Washington, and that’s that.  We are watching closely for shifts in the indicators and any other clear signs of change, but until then, we march on.  Please feel free to call if we have not been in touch recently.

Bruce Hotaling, CFA

Managing Partner