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Narrative

October ends with Halloween.  Apart from All Hallows Eve, and the Day of the Dead, there is a distinctly scary tone to the way Americans choose to celebrate the holiday.  It has somehow evolved into something folks just do each year, and it carries a frightening narrative.

Outside of the world of fabricated ghosts and goblins, there is a broader narrative at play, driving strength in the financial markets.  The underpinning of the narrative is the high level of anticipation in improved GDP figures (job growth and higher wages) with stimulus from tax cuts (both personal and corporate) and incentives to capital spending anchored in a renewed emphasis on active fiscal policy.

So far, we have not seen evidence this is anything other than a story.  But the stock market has another view and continues to march on.  Stocks, measured by the S&P 500, returned 2.2% for the month of October, and are now up a cumulative 16.9% year to date.  If we look back to the beginning of 2016 (a 22 month window) stocks have been up 16 of those months (a .727 batting average) and have generated a total return of 30.9%. 

It’s hard to determine how much of this story is already priced into the markets.  Certainly, influential people in the system are perpetuating it, as the Treasury Secretary recently threatened a dramatic drop in stock prices if tax cuts and reforms were not enacted as prescribed.  From my perspective, the strong returns to stocks is principally the result of a remarkable recovery in US corporate earnings.

We are in 3Q17 earnings season, and according to FactSet Research, as of 10/27/17, 76% of S&P 500 companies have reported positive EPS surprises and 67% positive sales surprises.  The blended earnings growth rate for the S&P 500 is 4.7% for the quarter, well up from the previous estimates in the 3% range, and without the hurricane related hit to the insurance industry, the blended earnings growth rate is 7.4%.

As the market is a discounting mechanism, meaning it extrapolates future outcomes, the current behavior of stocks implies a rosy future.  This is supported by the collective outlook of stock analysts’ predictions for future earnings.   Most people do not realize that between CY14 and CY16 S&P 500 earnings ground to a halt.  Mired at 119, earnings were dead flat for a three year span.  Today, according to FactSet Research, analysts are projecting near double-digit bottoms up earnings growth for the S&P 500: 130.8 for CY17, 145.8 for CY18 and 160.3 for CY19.

The underpinnings of this growth inflection are tied to several existent factors.  Synchronized global growth is spurring demand at multi-national companies.  The low value of the dollar is making US exports more affordable.  The continued stabilization in oil prices is allowing the energy industry as a whole to recover.  There is some confidence that the new leadership at the Federal Reserve will continue to prudently manage monetary policy.  All of this is taking place in spite of considerable concern that the tax reform and cuts that will ultimately spur the economy (and thus further corporate earnings growth) may never be implemented. 

Then, there is the scary Halloween narrative.  We collectively keep telling ourselves nothing is the matter – there is not a monster under the bed.  We try and put on a brave face, but the fear is there.  Washington is in disarray, and we often hear the monster either via Twitter, or bombastic claims in news reports.  The level of doubt rises.  This flies in the face of optimistic analyst earnings forecasts and stock returns we do not want to give up.

As we approach year end, we can take satisfaction in an extended period of stock price appreciation.  There will inevitably be an unsettling event that sparks selling.  Over the next few months our effort will be to take some profits in stocks that have outsized positions in portfolios, to lock in returns and raise some cash to allow a degree of comfort going forward.  Please feel free to check in if you would like to discuss further.  We are also taking a close look at realized capital gains, though I have to say there are not many off-setting losses after the period in the markets we have had.

 

Bruce Hotaling, CFA

Managing Partner

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

Uneventful August

True or not, August feels like the month most investors are away on holiday.  Oddly, even when summer trading volumes taper, and the weekend begins early on Friday, trouble still seems to crop up.  Over the last few weeks, we’ve navigated an eclipse, a flood, the threat of a government shutdown, and several missile tests.  There are times when there is simply no rest.

For me, the degree to which August’s markets were more or less event agnostic is a complete curiosity.  Stock prices, measured by the S&P 500, rose a mere 0.05%.  Including dividends, stocks generated a total return of 0.31% for the month.  Year to date, the total return for the S&P 500 is 11.93%, a respectable number.  With the exception of a 0.04% dip in March, prices have risen every month since they took a 1.94% hit way back in October 2016.        

One of the more important characteristics of the stock market this year, one highly supportive of our investment style, is the dramatic outperformance of large cap growth stocks.  The S&P 500 Growth benchmark, measured by the IVW, is up 17.85% year-to-date, while the S&P 500 Value benchmark, measured by the IVE, is only up 4.95%.  Other characteristics, such as size, have seen large cap stocks outperform small cap stocks.  And, stocks with greater exposure to foreign revenue sources have performed better than those with predominantly domestic revenue sources.

We are in a stock picker’s market.  Active investment managers are generating above benchmark returns for their clients.  Three key aspects of our more traditional approach to portfolio management are transparency, quality investments (companies from the upper tiers of brand and balance sheet), and ready liquidity.  These characteristics are often forfeit by managers implementing popular passive investment approaches.  These strategies rely on nicely colored pie charts, built around fabricated ETF’s with often opaque holdings, where liquidity has not been tested.

I am confident in our approach to your investment portfolios.  We utilize a combination of a macro assessment, quantitative factor screening, and some roll-your-sleeves-up fundamental analysis.  Certain sectors are suspect, including the consumer discretionary and staples areas.   Others, such as health care, industrials, and technology look attractive at this point.  Strong corporate earnings have propelled prices higher while broad valuation levels remain acceptable. 

In my opinion, near term economic growth, and robust US corporate earnings will continue to benefit from a favorable backdrop.  Two factors are dominant.  The job market has been strong.  The unemployment rate now stands at 4.4%, an impressively low number, with no sign of wage inflation yet.  Equally relevant is the weak US dollar juicing up earnings.  The dollar weakness likely stems from the traditional interest rate parity equation, a flattening yield curve, and a growing global distrust in US policy makers. 

There has been some talk in the press questioning whether we are in the late stages of the business cycle and the bull market.  In my opinion, this is media hype.  A true directional change will require a recession, a major policy failure from inside the Beltway, or some sort of exogenous shock the markets are unable to digest.  Other than raising cash, it is difficult and can be expensive to invest in defense of any of these risks.

With September here, we are now on to the final stretch of 2017, and in my opinion, weathered from what’s been a noisy year.  We have been in a state of perpetual alert, hoping odd tweets and other events manage to remain “uneventful”.  The stock market appears to be pricing in little probability of any meaningful legislation around taxes or infrastructure spending.   The market calm will ultimately change.  The common fear is when, and to what degree.

If we have not been in touch recently and you have some concerns, please feel free to reach out.  Valerie is busy scheduling reviews.   Also, many of you have not had the opportunity to meet the most recent additions to our team, Matthew Mulholland and Ray Masucci.  Please take a look at their bios on our web-site, at www.hotalingllc.com.  I look forward to introducing you at the next opportunity.  Be well.

 

Bruce Hotaling, CFA

Managing Partner

Independence

It’s July 4th, 2017, 241 years from the day the Continental Congress adopted the Declaration of Independence, declaring the 13 American colonies to be independent from Great Britain.   For me, I cannot believe both the bravery and the foresight of the men who crafted the Declaration, the Constitution and the Bill of Rights.  So many things could have turned out differently, and yet, here we are, celebrating our independence.   

This year, stock investors can also celebrate what has been an exceptional first half of the year.  Returns to stocks, measured by the S&P 500, have produced a healthy total return of 9.34%.  One prominent aspect of the stock market this year has been the tail-wind for growth stocks, as opposed to value stocks.  This plays to our strength as we have been steadfast growth at a reasonable price investors for years.

Year to date, the technology sector has produced returns nearly double the next best sector, an impressive run.  Prices wavered some in late June, but I expect their leadership to continue.  The sharp end of the technology stick is referred to as FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) – and all have shown sensational returns this year.  Other pockets of strength include financials, where the banks are benefitting from favorable capital requirements, spurred by the heads of the European and US Central banks.  We have also seen attractive returns from healthcare stocks, likely indicating the market anticipates a more favorable business environment.  Bringing up the rear is energy.  In my lay opinion, there is simply too much oil out there, and demand looks suspect. 

On the economic front, growth is ok, but not by much.  Q1 2017 GDP came in at 1.2% annual growth, following a 2.1% reading for 4Q 2016.  My tarot cards do not include an inflation card.  It’s the equivalent of a child’s monster under the bed – scary but not there.  The Federal Reserve is staying with its script, raising rates and unwinding its balance sheet (tightening).  There are plusses and minuses that do not add up.  Energy prices are low, pleasing at the pump but bad for igniting capital spending.  The dollar is low.  This may boost exports, but conversely may raise prices on imported goods.  I am not convinced we will see strong enough economic data to support a steepening in the yield curve.

The market has shown a high degree of complacency since the election.  This will change, eventually.  There is the idea that great athletes have a high tolerance for physical discomfort.  I’m curious if that is a common characteristic for great investors too.  Can they remain even handed in a highly discomforting environment?  And for how long?  An observation of our current society is how uncomfortable with discomfort people are.  When something unpleasant arises, there is often a need to immediately re-direct, to take some medication, or do something to put the discomfort to rest.

Until the complacency lifts, we have a reasonable backdrop: the economy is standing on its own two feet and earnings growth is in the low double digits.  This “just so” scenario is allowing stock prices to rise.  The market seems to have given up any expectation of anything constructive from Washington DC.  In fact, the opposite may be true at this point.  If Washington DC does in fact do something, other than tweet, it may serve to disrupt what has become an acceptable status quo.  There is a watch what you wish for aspect to our current situation.

Looking ahead, my expectation is for the stock market to mark time, and then show some strength later in the year and into 2018.  I am optimistic on the earnings front and believe this will support stock valuations. I do not think we will see a substantive rise in interest rates, and therefore, I am neutral on tax free and corporate bond markets. I think they are relatively safe, and returns will be mediocre. Obviously, if any of these factors change, my opinion as to how best to invest will change and I will relay that to you. In the meantime, please have a peaceful Fourth of July and if you think of it, take a moment to pause and reflect on the amazing movement that began here in Philadelphia, all those years ago.

Bruce Hotaling, CFA

Managing Partner

Connect the Dots

The S&P 500, the popular measure of U.S. stock behavior, remains firmly in bull territory. The month of May saw a total return of 1.4%, and the market is now up 8.6% year to date. Stoic stock investors have been rewarded. It is remarkable we have seen only two days this year when the prices swung down more than 1%.   This highly complacent market has a lot of investors shaking their heads in some bewilderment, unable to make sense of the behavior of stock prices in relation to the often hard to fathom events taking place around the world.

On the positive side of the ledger, the fundamental backdrop is reasonably strong. The powerful earnings recovery we observed in 1Q 2017 will likely continue. Corporate America is on fire and this has been driving stock prices. Earnings have been bolstered by robust manufacturing data at home and surprisingly strong business conditions from around the world, Europe in particular. The US$ has been falling relative to other currencies, and is now back below its pre-election levels. This improves demand for U.S. goods and services. The Federal Reserve is on track to raise the Fed Funds rate, its messaging has been clear, and at the moment the stock market is ok with that.

The stocks behaving the best in this market are in our wheelhouse. Generally referred to as growth stocks, these are stocks showing consistent improvements in revenues, margins and profits. Large cap growth stocks (measured by the ETF IVW) are up 14.9% year to date, head and shoulders above large cap value stocks (measured by the ETF IVE), which are up 3.7% year to date. To a certain extent, large cap technology stocks have been driving the parade. Stocks like Apple, Amazon and Facebook are all up over 30%. Market cap and a high percentage of international revenue have been positive factors. Also, typical of a momentum market, stocks that have been doing well are continuing to do well. Valuation, measured by P/E ratio, has fallen due to robust earnings, leaving the door open to further appreciation.

On the flip side, interest rates and energy prices may be flashing warning signs. Short term rates will rise with the anticipated increase in the Federal Funds Rate. On the long end, the benchmark US 10-year Treasury note is currently yielding 2.1%, its lowest level since the post-election bump. The drop in rates may be signaling a declining growth outlook for corporate America. It is not clear, yet. Worse, a flattening yield curve can precurse an inverted yield curve, which investors typically link with a recession and often a bear market. The energy patch is also worrisome. The horrendous drop in energy prices starting in 2014 led to utter havoc in multiple areas of the market. After largely stabilizing in the $50 bbl range, prices are falling again. Rising rig counts, discord in traditional oil producing countries, and the economic disruption caused by the US fracking industry are all at work here.

Possibly most difficult to read, and interpret in any meaningful way is the narrative. The news flow out of Washington is unsettling. This creates a musical chairs sense of mistrust. Importantly, it also causes greater mistrust among our traditional partners around the world, with respect to economics (trade), defense sharing arrangements, and most importantly, the environment. Wall Street continues to look through the noise. My concern is that when the troubled times inevitably arrive, as they always do, we do not have the strength in leadership required to reassure nervous markets and allow them to re-set.

Though the path forward is never clear, I have the feeling we are tap tapping along like a blind man with a long cane, principally concerned with identifying where not to step. This makes for cautious progress, at best. Defending against the arrival of a black swan is expensive, in money terms, and is purely a guessing game. I suggest the logical way to proceed is to watch for the beginnings of a change in trend, and to pro-actively take profits (sell) if the market begins to trend down. While we take this on, I would like to catch up with you if we have not spoken recently.

Bruce Hotaling, CFA

Managing Partner