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Hotaling

Crow’s Nest

In the UK, when you cross the street, there are friendly reminders to “look right” printed on the edge of the road.  The message is to pay attention, but in a direction many of us are not accustomed to looking.  Here in the US, in the world of financial assets, the implicit message today is to “look up”.  While some may think of prayer, I’m not heading in that direction.  As much as any time in recent memory, the imperative today is to keep a sharp watch on the horizon.

Stock prices, measured by the S&P 500, advanced again, 1.9% for the month of September, and are now up a cumulative 14.2% year to date.  It’s been steady going for share prices of US stocks, with March the only down month this year, and then a mere -0.04%.  According to The Bespoke Report, there have been only 8 days this year when the S&P 500 has moved +/- 1%, with only 1963, 1964 and 1972 recording fewer days.  We are deep into a long-running bull market, and at the moment, there are few signs the trend is about to turn.

From a behavioral perspective, it is clear investors are beginning to be lulled in.  While there is no specific reason to believe the slope of the uptrend is about to change, some baseline prudence at this point is warranted.  Anecdotally, we’re coming up on the 30th anniversary of the October 1987 crash – a point in time I remember well.   My concern now is our collective complacency is creating the foundation for people to own a greater percentage of stocks than they would otherwise be comfortable owning.

To be clear, the fundamentals look reasonable.  2Q GDP figures were recently revised to 3.1%.  The US is in the 9th year of an economic expansion.  It is likely growth can continue in spite of the damage inflicted by hurricanes in Florida and Texas and forest fires in California.  It is also hard to foresee higher growth than what we now have without a change in access to labor.  Unemployment, in the 4.4% range, is the lowest since 1960s.  Importantly, inflation is not apparent, yet.  The issue here again, is labor.  The job market is becoming tight and it seems like wage inflation is inevitable.

US 3Q earnings are just beginning to be reported. Expectations are for results better than analysts’ have projected.  The earnings beats will likely be attributed to several things: an unusual period of synchronized global growth, stable oil prices and improved US output, a “constructive” upward shift in the yield curve, and the low value of the US dollar.

I expect a continued resurgence in corporate earnings to support stock prices through 4Q 17 and likely into 1Q 18.  There has been speculation that corporate earnings would benefit from a realignment of the tax code.  In light of the recent disarray in Washington, it seems highly unlikely any real progress will be made.  There is no doubt a repatriation tax holiday would be a tail-wind, but I do not think the market expects it, and will shrug off one more disappointment as more of the “new normal”.  In my opinion, we will see no fiscal stimulus, modest growth and increasing (but not debilitating) inflation.

There is a good argument the most significant risk the markets face is geo-political.  This is a category of market risk that is in many ways not there, until suddenly it is.  So much takes place out of the public eye, surprises (market shocks) can stem from this largely indirect factor.  The greatest effect is the undermining of investor confidence due to extreme price volatility.

In this vein, a clear concern, fanned by the Equifax hack, is both the security of our personal data in an information driven world, and the ongoing attempts to manipulate popular media.  There appears to have been a well-orchestrated, and highly effective campaign by state sponsored Russian hackers to influence popular opinion in the US.  My primary concern is whether the foundation of our democratic process has been compromised. 

Harking back to our communication last month, if you have not frozen your credit, please do so.  We can send you instructions to put a freeze in place.  This time of year, we are busy reviewing portfolios for the year end.  We want to be tax prepared.  If we have not spoken recently, or if you would like to arrange a review, please do not hesitate to reach out.

 

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

Populism and Uncertainty

Stocks began 2017 with an undercurrent of optimism as prices touched new intra-day and all-time highs. The total return for stocks, measured by the S&P 500, was 1.9% for the month of January. The month was notable, if for anything other than competing events in Washington DC, in that it was both positive and dull. There were no trading days when the market moved up or down by more than 1% since the 1.11% move on November 9th, the day after the election. Often, when markets hit new highs, it clears the path to further price strength.

The shadow to this optimism is uncertainty. This is often measured by the VIX, or the volatility index. The VIX is the Chicago Board of Options Exchange Volatility Index, showing the implied volatility of the market using S&P 500 index options.   The figure has been skulking in the 10% range since the start of the year. For some context, just prior to the election it was around 20% (its historical average), and during the financial crisis back in 2008, the VIX spiked into the 80% range. The implications of a high VIX are that options traders are actively attempting to position themselves for what they anticipate will be a turbulent market.

The VIX is frequently referred to as the fear index. It often happens that when investors are at their emotional limit, the VIX measure is high. Today’s measure is historically low. Yet, more and more well-known and vocal investors have begun to express discomfort with the US’s lack of direction, protectionist tendencies and militaristic posturing. The market appears to be discounting the rhetoric. There is a curious air of complacency among investors empowering them to make substantial bets on tough talk.

The tough talk, or bombast, has lulled market participants and created a high expectation. The rub is all the pro-business talk may or may not bring forth change. It will be quite a task to double GDP growth to the 4% level, as promised, on the back of an economic expansion now more than seven years old. The economy is at full-employment, and the outcome of certain proposals (tax reform, reduced environmental and financial regulations, fiscal spending on military and infrastructure projects) may ironically lead to inflation and other unintended consequences – but not growth. I suspect the complacency may have allowed investor and corporate confidence to run ahead of itself.

The most important measure of future stock prices, corporate earnings, are now being released for the period 4Q2016. According to FactSet Research, the growth rate for Q4 S&P 500 EPS currently stands at 4.2%, better than the 3.1% expected at the end of the quarter and of the 34% of S&P 500 companies that have now reported for Q4, 65% have beat consensus. If the 500 companies that make up the S&P 500 are going to generate the current consensus earnings of $130.76 for 2017 and $146.11 for 2018, they are going to have to get a move on. On the plus side, the resolution of the damaging oil price shock of 2014-15 will help, as will a more normal and steeper yield curve, and the addition of some fiscal stimulus the market has been begging for since 2008.

None of this will be clear, until it is. In a market such as this, we could cautiously step out of the car anticipating its imminent breakdown, only for it to rumble on down the road, without us. My impression of the way forward is to proceed, with a foot on both the gas and the break – a two footed driver. As expected, the big theme thus far has been the post-election landscape, though also as expected, companies are unable to quantify potential policy implications given lack of details. So, we wait.

My expectations remain somewhat guarded. I think average returns from stocks and bonds for the year ahead can be attained. My concern is that these average returns will be delivered on the back of greater than average volatility and unrest in the financial markets. We of course, cannot see this at the moment. With this in mind, I am happy to speak with you if we have not been in touch recently. My goal is to check-in, in order to reaffirm your asset allocation and near and long term investment goals.

 

Bruce Hotaling, CFA

Managing Partner

The Accelerating Change of the Retail Landscape, blog from Jean Rosenbaum, CFA, Portfolio Manager

The recent announcement by Macy’s that they will be closing 100 stores is a rational reaction to the changing retail dynamics. For professional store shoppers like my mother-in-law, the news was quite unwelcome! However, the reduction of a high cost infrastructure is likely to continue as consumer buying habits change.  This trend will ultimately be positive for sales and earnings growth longer term, but getting there could be quite painful for management teams and shareholders.

The price action of the various retail segments foreshadowed these changes. While we have all known Amazon (the ecommerce powerhouse) has significantly outperformed the S&P 500 since going public, the stocks of store based retailers have only recently begun to underperform the S&P 500.  Investors have been well rewarded for embracing fundamental change in retail.  The Bespoke “Death by Amazon” index, which includes a number of traditional retailers, is down close to 28% vs the S&P 500 over the last two years, while Amazon has outperformed the S&P by almost 200%.  The changing landscape is also impacting the mall operators.  An index of mall REITs is down 34% during the same timeframe as their customers, the retailers, have begun to struggle in terms of sales.

The stock performance of the “Death by Amazon” index foreshadowed the significant weakening of fundamentals for the group. While the stocks peaked in 2015, fundamentals did not peak until 2016.  In early 2016, same-store sales growth began to slow and EPS growth turned negative in mid-2016.  Sales and earnings growth could remain a challenge for some time as the move to e-commerce has not been fully embraced.

Online sales frequently have lower profitability, limiting the retailer’s ability to offer free shipping without putting significant pressure on margins. Store and online inventory systems may not be integrated, causing retailers to invest in duplicate inventory.  IT infrastructure to meet the demands of the increasingly mobile consumer base may need further updates.  Solving these problems requires higher capital spending. Profitability will remain under pressure as lower margin online sales become a higher percent of the business.  Supporting online sales while carrying an increasingly less productive store base creates a very challenging situation for management teams that are being asked to increase sales and earnings.  

The rationalization of the store base is a logical response. This trend will ultimately be a positive for store based retailers in the long term as they work to stabilize and ultimately grow earnings.  However, the transition period could be painful due to higher capital spending requirements and to pressure on profitability.  Some retailers may be unable to adapt and will go bankrupt.  Mall operators face “collateral damage” as retailers reduce their square footage and pay lower rent, leading to potential cash flow problems.  Fundamental change is difficult for managements and shareholders, but by focusing on the winners, shareholders can be rewarded with significant outperformance.

Oil and the Dollar

After starting out the year with two extremely challenging months, March gave investors a big lift and some emotional respite. Stock prices, measured by the S&P 500, rebounded 6.6% in March, the biggest jump in monthly prices since last October’s dramatic 8.3% run-up.  Dividend paying stocks have begun to stand out, as have value stocks, particularly small caps and mid-caps.  Utilities, consumer staples and telecom stocks have led the way while financials and health care stocks have been notable laggards.

The S&P 500 started the year at 2,043. From day one (January 4th was the first trading day of the year), prices fell.  They hit their lowest point on February 11th (possibly the new March 9th 2009?) when they closed at 1,810.  In only six weeks, prices had fallen 10.27%.  A 10% drop in prices is the generally accepted definition of a market correction.  I think this utterly shocked investors.  Most were evaluating how they intended to reposition their portfolios, not how they were going to execute triage. 

In today’s world, there is a spectrum of issues dominating the emotional backdrop: unconventional presidential candidates, global warming, refugee crises and ever more incidences of terrorism. The year started with a contentious Fed rate hike and a resurgence of fear the global economy was spiraling into a recession.  In my opinion, amidst all this noise, the critical component remains the outlook for US corporate earnings.  The earnings recession we are in (I’ve mentioned in past letters) remains a cloud over markets.  My expectation is for it to resolve.

According to FactSet Research, with the anticipated earnings drop in Q1 2016, it will be the first time the S&P 500 has seen four quarters of successive earnings declines since Q4 2008. The energy sector remains the culprit.  If we overlook the anticipated 101% drop in earnings from energy stocks, the earnings decline for the S&P 500 would be 3.7%.  At the present time, earnings forecasts are for declines in Q1 and Q2 of 8.5% and 2.5%.  Analysts are calling for a turn-around in the second half, with positive earnings growth of 3.7% and 11% in Q3 and Q4.  

Since the financial crisis in 2008, labor costs have been low, employment has recovered smartly (in spite of an aging work force) and corporate profit margins have improved dramatically.  Things have been going well, but now revenue and earnings are decelerating.  Today, growth in Europe is intact, it’s slow here at home, and middling around the rest of the world (China, Japan).  With this backdrop, earnings improvement is not a given.

Critical factors in the expected second half earnings recovery are a normalization of oil prices and a continued fall in the value of the US$. Oil prices look to have stabilized and possibly put in a bottom.  Airlines are reported to be purchasing oil hedges out 2-3 years.  As earnings from the energy sector have evaporated – even a 50% recovery would be a nice bump to the S&P 500’s earnings.  On the currency front, a further weakening of the US$ could provide an even bigger bump to earnings.  According to JP Morgan, a 10% drop in the trade-weighted US$ could lift earnings as much as 5%.  Oil and the US$ could be the differentiators this year.

Stock valuations are not unreasonable. If the price/earnings (PE) ratio remains constant, and earnings pick up, stock prices are likely to rise.  According to FactSet Research, stocks are currently priced at a PE of 16x the next 12 months expected earnings.  I am hopeful continued mean reversion in both oil prices and the US$ are enough to catalyze earnings going forward and anchor higher stock prices into next year.

The style shift I discussed in last month’s letter has not changed. Stocks correlated to a recovery in oil, unloved sectors (industrials, transports, materials), have begun to lift.  The crowded sectors such as consumer staples and utilities have been safe places to hide but are all very expensive to buy.  I continue to believe a second half earnings recovery will return the spotlight to quality growth companies in the technology, consumer discretionary and health care sectors. 

Please feel free to call if we have not spoken recently. Now that the typically busy tax season is behind us, we can put renewed focus on portfolio positioning and other issues more central to your long term needs.

 

Bruce Hotaling, CFA

Managing Partner