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Jean Rosenbaum

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

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

Hotaling Investment Management Proudly Sponsors the 12th Annual Plein Air Festival, Wayne Art Center

En plein air is a French expression meaning “in the open air”, and refers to the act of painting outdoors with the artist’s subject in full view. Plein air artists capture the spirit and essence of a landscape or subject by incorporating natural light, color and movement into their works.

The high point of plein air art came with the emergence of Impressionism in the mid-to-late nineteenth century. Artists of that period who painted outdoor landscapes included Monet, Renoir, Pissarro, Cezanne and Van Gogh. Interest in outdoor painting has remained constant since the twentieth century. Today’s artists carry on the traditions of these past masters by capturing light and movement in landscapes that can only come from seeing the subject outdoors in its natural form.

The last twenty years have seen a resurgence of interest in plein air painting in the United States. During this time, groups of plein air painters began gathering together to paint at single locations or within certain geographic boundaries. These “Paint Outs” are now very popular and give artists a chance to share their talents and creativity with the public and with one another.

Wayne Art Center

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

Low Interest Rates – Good today, but bad tomorrow?

Low Interest Rates – Good today, but bad tomorrow?


Blog by Jean M Rosenbaum, CFA, Hotaling Investment Management, LLC

 

Borrowers typically find low interest rates very attractive because it reduces the amount of money they have to repay to their lender. Think about the impact of lower interest rates on your mortgage or your auto loan!

Savers on the other hand, find them less attractive as lower interest rates means lower earnings on their savings such as bank deposits, CDs or bonds. Have you seen the rates on bank “interest” checking and savings accounts?!

While a brief period can be positive for consumption, an extended period of low interest rates can cause some long term problems. The longer rates remain low, the more difficult it will be to generate income and savings needed for future consumption.  The lower rates mean lower earnings for pension funds which rely on investment gains to meet their obligations.  Insurance companies may also find it increasingly difficult to meet their obligations as the return on their investment portfolios continues to fall below previous assumptions.  When the obligations for these firms were first established years ago, the assumption was the investment portfolio would grow and in some cases, the growth is critical to their ability to meet the future obligations.  This situation could result in individuals receiving less money (or even no money) from sources they had previously believed were secure. 

Taking this a step further, many European debt instruments are yielding negative rates. Negative interest rates means that investors pay to hold debt obligations as opposed to a positive rate environment where investors get paid to take risk and hold the debt of another entity.  In the case of an investment portfolio that holds negatively yielding instruments, the investment portfolio will shrink!  These companies cannot abandon the bond markets as they are regulated by their respective governments.  The basic operating assumption of these organizations is that they can take in money and then generate a positive investment return and meet or exceed their obligations.  This assumption has now been turned upside down as investment returns are meager at best.

The low interest rates helped consumption at a time when the sales of consumer durable items (houses, cars, etc.) were at very low levels. These sectors have recovered, but the ongoing environment of ever lower rates could cause more serious long term damage.  Workers that have entered retirement may need to find a new source of income which could be very difficult.  New workers will need to save even more money than expected to counteract the inability to generate a positive return or accept greater risk and/or volatility in their investment portfolios.  With one part of the population saving more and another receiving less income, the outlook for consumption growth looks difficult.  The economy could remain in a slow growth or even deflationary environment due to the “medicine” that has been used to try to counteract the problem of low economic growth.