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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

Rock Steady

April was a “backing and filling” month for investors.  This is a stock market term that applies to prices as they attempt to digest a large run up.   After a monstrous 5.6% jump in prices in January, the return to stocks in April, measured by the S&P 500, was a mere 0.27%.  Year to date, returns have fizzled and are now down 0.38%.    These results mask some eye catching day to day price moves.  For example, out of the 21 trading days in the month, 9 involved an up or down move in prices of greater than 1%.

This volatile yet sideways pattern is likely a byproduct of last years extended rally in stock prices that led so many investors to the trough of complacency.  Fifteen months of positive returns will attract a lot of attention – suddenly investors began chasing returns, and taking on more risk.  It had become too easy.  A reflection of this mindset was the craze over bitcoin.  That was an extension of the high risk-taking mentality that consumed investors worldwide.

On January 26th, stock prices hit their 14th record high of the year.  Over the next couple of weeks we experienced a full on reversal of the prior year’s blind optimism and things turned ugly.  By February 9th, stock prices had fallen over 10% on an intra-day basis.  The dust settled, and things seemed ok, until April 2nd when prices went right back down to those uncomfortable levels.       The origins of this sudden shift in market direction initiated a raft of media speculation as to what might have gone wrong.  Was it the US 10-year Treasury nearing 3%, the looming Federal Reserve interest rate hikes or possibly saber-rattling talk from Washington about trade wars?  When market trends change, it is often unclear what precipitated the change.  For us, the more important question is the emerging trend – what does the slope of the developing trend in prices look like?

As an investor, it’s important to focus on and identify investment goals, particularly long term.  The big considerations are, what are we working toward and what is the best path to get there?   Trouble often shows itself in the short term.  While things that come up admittedly do not normally have any bearing on long term goals, or the agreed upon path, they can be un-nerving to the point investors retreat.  There are times when owning stocks is flat out uncomfortable. 

After years advising people how best to position their financial assets, one thing clear to me is how easy it is for investors to become disillusioned.  Admittedly, there is some concern the world at large is sliding down a slippery slope.  This may be true, or it may not.  In my opinion, though we perceive a tenuous backdrop today, there has always been a long list of things that could go wrong.  Often, we did not know there was a monster under the bed.  I suspect our current cautious awareness puts us in a better position to look ahead and acknowledge risk.  Stocks are inherently high risk, high return, and when investors dismiss this we are collectively on thin ice.

Our goal is to guide our investors in a way that allows them to hold quality investments during challenging times.   As active investment managers, this requires our constant attention and a balance of art and science.  We use analytical tools and fundamental analysis, along with a considerable dose of experience.  We also use a risk-on, risk-off approach to profit during the good times and temper the effect of the difficult periods.  This is in stark contrast to passive index strategies or a blind reliance on asset allocation models. 

My expectations are for the recent surge in volatility to continue, though tempered somewhat.  I also expect stock prices to move higher by the end of the year.  Earnings have been strong through the first quarter and analysts’ forecasts through the year-end are high.  I do not expect stocks to deliver anything close to the 20%+ returns we saw in 2017.  Considering the backdrop, we ought to expect it to remain challenging.  We are constantly asking whether the choices we are making today are additive to your long term goals.  At the moment, I am optimistic we are well positioned for the year ahead, but I am also prepared to change course if need be.  I invite you to call if you have concerns.

 

Bruce Hotaling, CFA

Managing Partner

Mish Mash

Investor behavior has been by and large complacent.  The market commentary has been Pollyannaish.  The combined effect has been an extended period of positive returns and low volatility.  Stock prices, measured by the S&P 500, rose for 15 consecutive months, something they had not done in over 20 years.  Then, in February, stock prices fell by an uncomfortable 3.69%.  Sharp price drops, 4.1% on the 5th and 3.75% on the 8th, echoed swings felt prior to the onset of the financial crisis.

The market backdrop looks to have shifted.  A trend change cannot be extrapolated from one month’s returns.  Just the same, it may be that the majority of the market friendly changes (tax cuts, regulatory roll-back, loose spending) are baked in.  If this is the case, the return/risk profile stocks offer may have begun to seesaw.  Here are some observations worth your consideration.

The dominant factor influencing stock prices is earnings.  4Q 2017 was one of the strongest earnings seasons in the last 20 years, according to Bespoke Research. The “inflection” in earnings is remarkable, as they had been flat.  We tend to extrapolate data forward, and expectations going forward may be too high.

The surge in US corporate earnings has been bolstered by an up-swell in economic growth around the world.  Manufacturing PMI’s around the world are simultaneously rising, and although Europe’s emergence from the global debt crisis lagged, it’s now the catalyst for a full-fledged global economic revival.

Another boost to earnings has been a weakening US$.  This allows for a currency translation bump, when earnings from abroad are repatriated.  This tailwind has been in effect since November 2016, as the US$ has fallen roughly 15% against the Euro.

The current administration’s weak US$ policy is apparently intended to cure the trade deficit.  Curiously, the trade gap widened in January to the highest level since October 2008.  The recent imposition of tariffs on various imports may help offset the trade deficit but the true economic result will more likely be a decline in domestic growth – the opposite effect from the intended goal of making America great (protecting US industry).

The recent emphasis on fiscal policy and deficit spending is a significant concern at this point in the economic cycle.  It’s inflationary by definition, and the budget deficit may well exceed $1TN in 2018, something last accomplished in the dismal recovery from the financial crisis.  The looming cost of financing increased government debt levels is a large reason for the sharp increase in longer term interest rates.

Wages are also going up, which is good for workers earning the $7.25 federal minimum wage, but this too is a source of inflation.  Last month’s inflation data was the spark that ignited the February stock market sell-off.  The Fed has signaled it will raise rates three to four times in 2018.  Long term, there is a good likelihood the Fed (rising interest rates) will take the blame for triggering the next recession – not the ambitious policies that catalyzed the need for higher rates.

Finally, volatility is back.  This is a reflection of these disparate factors.  Stock prices move up and down and this normally tempers investor behavior.  When price volatility is low, investing in stocks becomes too easy.  The spike in volatility in February was only the second time the “fear” index hit those levels since the 2008 financial crisis.

Often times the stock market is not reacting to an event, as many TV commentators attempt to explain, rather it is signaling.  Stock prices are a leading indicator.  Along these lines, the sudden jump in price volatility (the VIX) may well be foreshadowing change.  The stock market may be telling us inflation is here and the Fed’s response will be to raise interest rates.  Four rate hikes may be the equivalent of taking away the punch bowl.  In my opinion, a raised level of caution is healthy here.  We have to be able to live with the ups and downs, and to do this may require owning less of the risky asset.  We have been repositioning portfolios to reduce oversized positions and address our view of the trend going forward.  If you would like to review this with us in more detail, please don’t hesitate to check in.

 

Bruce Hotaling, CFA

Managing Partner

Animal Spirits

Happy New Year!  I wish you a peaceful and prosperous 2018.  Looking back, 2017 was prosperous for US investors, as stocks generated a total return of 21.8%, measured by the S&P 500.  It was a good year, by historical standards.  Over the last 30 years, stocks have averaged a total return of 12% with an annual standard deviation of 17%.  Other years with big returns, such as 2009, 2003 and 2013 to some degree, were classic rebound years.  Then, there was the stratospheric run in the late 1990’s when stocks averaged 28% returns for five consecutive years.

What drove stock prices in 2017?  There were several things that cumulatively led to a “perfect storm” for stocks: the US $ weakened against most major currencies, oil prices moved back into a range supportive of normal capital spending, OECD countries collectively grew, US corporations experienced double-digit earnings growth after several flat years, the prospects of corporate tax cuts stirred animal spirits, interest rates remained low and the Federal Reserve was somewhat accommodative, all with a general backdrop of full employment and improving consumer sentiment.

What should we look for in 2018?   According to FactSet Research, Wall Street analysts are forecasting S&P 500 earnings growth to continue at an 11.8% clip, with energy, materials, financials and info tech leading the way.  Stocks with higher international exposure generated superior earnings growth in ’17 and this is expected to persist in 2018.  Analysts’ estimates are for continued double-digit growth and $146.60 per share in 2018 and $161.30 in 2019.  Stock investors are thrilled to move on from the meager 3.2% pace of growth from 2012 to 2016.

The tax cuts recently passed by Congress have long been anticipated by investors.  They will fuel investor optimism for a time – until the true benefits to corporate earnings and household wallets start to pencil out.  Sadly, elected officials in Washington have given up on any sense of fiscal discipline.  The federal deficit is north of $20 trillion.  Tax cuts will unnecessarily increase the deficits (both financial and environmental), lead to higher interest rates and inflated costs (housing) and cause more sensible governments in the future to have to raise taxes to account for this generation’s need to have it all, now.

On the immediate horizon, there are flashing yellow lights – things to watch for that may stall the stock market juggernaut.  Unemployment is low, and the number of job openings is near record levels.  Labor force growth, a critical element in the economic equation, continues to decline.  With no constructive immigration policy, higher wages will ultimately spark inflation and hamper profits. In response to an uptick in inflation, the Federal Reserve will likely raise rates, making credit more expensive.

We are also faced with a chaotic backdrop that many people cannot embrace.  There is a lingering feeling of apprehension continually poked by twitter trolls and divisive memes.  The trend is troubling and mirrored to some extent in the Bitcoin bubble – an emerging tendency for people to put more faith in computer code than human institutions.  Technology is driving change that we are only beginning to understand in retrospect – there is risk these uncharted waters continue to disrupt.

My view is we have to rely on what we can measure.  The market has been trending higher, so like a good angler, the trick is to play out slack.  I think we have to defend against complacent thinking and remain disciplined.  Early this year we will be busy resetting asset allocations that have become stock heavy over the past 18 months.  This will require trimming some of our big growers, and repositioning to allow for more growth/value balance in your portfolio.  Capital gains taxes have not changed, and this works to our advantage.

There is an old stock market truism, “pigs get fat and hogs get slaughtered”.  As is the case, with heightened returns come animal spirits.  Our job, at the moment, is to defend against greed trampling common sense.  I have confidence in our process, and would be happy to review your asset allocation with you, necessary cash levels and tolerance for capital gains, as we start the New Year. 

Bruce Hotaling, CFA

Managing Partner

Taxing

It’s been a taxing year in many respects, but clearly not for investors in US stocks.    Year to date, the total return to stocks (measured by the S&P 500) is a robust 20.5%.  With the exception of a modest miss in March, returns have been positive for 13 consecutive months.  This is the longest period of consecutive returns, and with the lowest month over month standard deviation, going all the way back to 1982.

The goodness extends beyond the US.  Year to date, stock markets in most major countries around the world have produced handsome returns.  These markets include traditional economic juggernauts (Germany +27%), old line economies experiencing difficulties with their neighbors (UK +16%) and even economies no one else seems to like all that much (Russia +1%).

In spite of the soap opera in Washington, there are a number of factors propelling our stock market: earnings growth is inflecting upward, oil prices are stable, economies around the world are echoing our economic expansion, central banks around the globe are withdrawing stimulus (inflation trade) and Wall Street’s animal spirits are running wild with anticipation of the benefits from tax-cuts for corporate America.

Seasonal return patterns tell a story.  Since 1982, December is clearly the best month for stocks, with a positive return (batting average) 77% of the time and a net average return of 1.75%.  The next best month is April, with a 72% average and a net average return of 1.64%.

Stock prices have risen, and are no longer cheap.  According to FactSet Research, the trailing P/E ratio for the S&P 500 is 21.  For context, at the apex of the dot com bubble, March 2000, the market’s P/E ratio was a healthy 30.  In contrast, at the low point of the financial crisis, March 2009, the market’s P/E ratio was 10.  So, best of times, worst of times – today we are smack in the middle.

 The overarching issue on everyone’s mind is taxes.  The drama is playing out inside the Beltway, but the repercussions are being felt on Wall Street.  The effort is to spin a new tax code, lowering taxes and simultaneously spurring future growth.  Investors are licking their chops. Income taxes were briefly imposed in 1861 to help pay for the civil war.  The 3% tax was repealed in 1872.  In 1913, the 16th amendment gave Congress the authority to levy a federal tax on income.  At that time, only a small number of people actually paid. 

 Our current progressive system has taxpayers with incomes over $200,000 paying nearly 60% of all federal income taxes.   Based on early analysis of the bill, the majority of tax cuts will benefit folks in this income group, and more so for higher income groups.

 The last time a tax cut was proposed, in 2001, the Congressional Budget Office projected a $5.6 trillion surplus over 10 years.  Today, the budget office forecasts deficits will total $10.1 trillion over the next decade.  The deficit is expected to top $1 trillion a year in 2022.  Federal debt held by the public is at the highest level since shortly after World War II, at 77 percent of GDP. (NYT 9/28/17)  The political imperative to cut taxes has now superseded any view toward fiscal prudence.

 We’ve done some analysis, and a reduction in corporate taxes will boost earnings for stocks.  The puzzle is which stocks, and to what degree.  Our working assumption is that some benefit is already priced into stocks, and there is the potential for more, though this will require clear and well communicated legislation.

 At some point, I expect the market to revert to the mean.  Consumer confidence is high, as is confidence in the stock market.  These can be yellow lights.  Since Thanksgiving, the market has begun to rotate, away from the year’s big gainers, and into “safer” low growth names.  We have been anticipating this shift in leadership from growth to value.  If the rotation persists, we will look to take more profits in our highest performing stocks before the end of December.  If we wait until the new tax year to rebalance, we may be faced with a multitude of investors with the same clever thought.  My preference is to stay in front of the pack, and if we owe capital gains, to pay them from this year’s generous profits.  Please feel free to check in if you have any concerns.

Bruce Hotaling, CFA

Managing Partner