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Unchartered Water

Returns to investors in both stocks and bonds have been surprisingly positive this year. We are only one third of the way into the year, yet stocks and bonds have already generated returns the equivalent of what many were hoping would be the final result for 2017.  What surprised many, a post-election growth buzz, seems to now have run its course.  It remains altogether unclear whether stock prices moved as they did due to unfounded optimism, or in anticipation of what may be a remarkable upturn in corporate earnings. 

After a slight falter in March, the S&P 500 returned to its winning ways in April, advancing 0.91% for the month.  Through the end of April, the benchmark has generated a total return of 7.16%.  In my opinion, the sturdy year to date returns have mostly to do with earnings (including a tempered US$, stronger exports, steeper yield curve and a normalized $/bbl oil).  There was evidence of an inflection in Q42016, and Q12017 results have been remarkable, to say the least.  The blended earnings growth rate is 13.5%, which if it holds will be the highest year over year earnings growth for stocks since Q3 2011.  According to FactSet Research, as of May 5, 2017, 75% of S&P 500 companies had beaten Wall Street analysts’ mean earnings estimates.

As is typically the case, not all stocks are in favor at the same time.  Since the beginning of the year, companies with growth characteristics have been outperforming companies with value characteristics, largely reversing the value tilt the market adopted early in 2016.  For investors like us, this is a tailwind, as we have traditionally focused on US companies that for various reasons are able to sustain an above trend growth rate.  Sectors reporting the best earnings include information technology, health care and the financials.

The primary drivers of the earnings renaissance, and thus the accelerated returns to stocks, are many.  First is the employment backdrop.  Jobless claims are the lowest they’ve been since the early 1970s.  This in turn may provide a platform for wage growth.  Wage growth is critical, especially in certain segments of the economy, such as improving the ability of millennials to form new households.  An uptick in spending ultimately could light the fuse for some future inflation.  Rising asset prices are “normal” and expected in a growing economy and incent consumers to act.  The Federal Reserve has signaled its intent to continue to hike short term rates, indicating it supports this thesis.  Finally, the tempered strength in the US$ has helped as there is evidence of improved exports to some of the strengthening economies around the globe. 

The other side of the coin is akin to North Atlantic shipping lanes clogged with icebergs.  On a fundamental level, stocks are nearly fully priced.  Earnings must continue to expand.  Expected returns to bond investors, in a rising rate environment, are likely already in hand.  Geo-political risks, though hard to quantify, must be nearing a high water mark.  The typical safety net of leadership and statesmanship is not apparent based on the news flow, an odd place for a country like ours to find itself.  The much manipulated growth narrative is suffering from policy paralysis – there is no game plan – nothing is getting done – and no one knows what to do about it.

I think it is a prudent time to take a more cautious stance, and as I have said before, drive with one foot on the brake.  While I do not think we should re-allocate (as stocks still have the highest expected returns) we ought to take profits in positions with outsized returns.  My preference is to pay some capital gains taxes on realized gains, rather than allow the market to take those gains back.  Our emphasis remains on a more discerning investment management approach, utilizing our fundamental and quantitative tools to help select individual opportunities to make money, versus owning the market, or segments of the market that may, or may not maintain favor. 

I ask that you please call us if we have not spoken recently.  It’s an appropriate time to review your asset allocation and we can take some time to have a more detailed discussion as to the best path for you going forward.

 

Bruce Hotaling, CFA

Managing Partner

Spilled Milk

Stock prices have been on the move. Many investors firmly believed that if the election went the wrong way, stock prices were destined to tumble.  Since that infamous day back in November, to the utter exasperation of those same investors, stock prices (measured by the S&P 500) are up a total return of 11.22%.  Year to date, the total return to stocks is 5.94% with February contributing an impressive 3.97%.

The upward move has in fact coincided with a flourish of positive economic data.  According to Empirical Research, much of the recent strength in stock prices can be attributed to improving economic fundamentals, as evidenced by the recent spike in the PMI index.  The PMI is a widely accepted indicator of current business conditions in the manufacturing sector.  In support of the manufacturing data, the employment data is equally strong.  According to Bespoke Research, jobless claims have fallen to their lowest level since 1973.

Although the run in stock prices has coincided with strong economic data, there is more.  Stock prices have also benefitted from a newfound optimism over proposed tax cuts, deregulation and an infrastructure build-out.   Expectations have run amok.  To date, there is nothing that has happened on the fiscal policy front to support the heightened fervor pushing stock prices higher.  There is a notable void of detail and a surfeit of spin.  The timing and ultimate impact of any proposals is either unknown or carries the greater risk of disappointing the markets with a failure to deliver.  True policy is needed to implement any changes and with the degree to which the messages are mixed, one wonders whether there is an intractable void in competence.

Against this disconcerting backdrop, there is some basis for sitting tight.  According to FactSet, earnings estimates look to have stabilized at $130 per share for 2017.  Earnings are perpetually subject to revision by Wall Street analysts, and almost always downward, as initial optimism fades.  For 2018, consensus estimates for the S&P 500 are now a lofty $145 per share, an 11.5% increase over 2017.  This would be the biggest bump in earnings since the 15% leap from 2010 to 2011.  One comment that has attracted some attention is the speculation that these earnings can be obtained without the benefit of any of the planned stimulus. 

Stock prices may well manage to trend for some time, if only due to the fly-wheel effect.  By many measures, stocks are overbought and sadly the alternatives are either overpriced, or don’t offer any substantive return.  Investors are caught between a rock and a hard place.   According to Bespoke Research, the advance decline line has tipped downward, meaning fewer stocks are behaving well, even though the market continues to rise.  This is not a great sign for the bulls.

The present risks include the fact that the Federal Reserve has said it will be raising interest rates.  This has historically made it difficult for both stocks and bonds (don’t’ fight the Fed).  In addition, there is the pervasive tail-risk, the risk of an extra-ordinary event or tweet that leads to an avalanche of unintended consequences.  Finally, the failure to implement on the promised policy agenda, and ongoing political contagion, will begin to disappoint investors.

In my opinion, it’s no time to be a hanger-on.  I think we can take some profits in stocks that have gotten ahead of themselves.  Technology, healthcare and financial stocks all come to mind.  On the other hand, some stocks in the energy and real estate space have been bringing up the rear and look as though we can add to positions.  The level of complacency among market participants has been high, and as once reluctant investors are pulled in, the risk increases.  This sets the table for some challenging times when some selling inevitably begins.

Overall, my expectations run similar to last month: guarded and without window dressing.  For the remainder of the year, I expect average returns from stocks and below average returns from bonds.  My worry is a good portion of these average returns have already arrived, and the rest will be delivered on the back of greater than average volatility and unrest in the financial markets. 

 

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

Take a Deep Breath

Halloween came and went this year, and not a single clown came by the house. I have to say, I felt a degree of relief.  Something new this year, creepy clowns, have been in the news and haunting us in ways most of us have never imagined.  There is a cloak of fear now associated with clowns.  I think many of us have been holding our breath in response to the vastly irrational circus we’ve been watching.  I suspect and hope there is a collective sigh of relief November 9th when this very odd chapter in our history is in the rear view mirror.

Stock prices, measured by the S&P 500, fell 1.9% in October, the largest monthly drop we’ve seen since the 5.07% plunge in January.  October’s lull follows -.12% returns in both August and September.   Bespoke Investments pointed out that the three month drop, which tallied less than 2%, was quite unusual and in fact, such a modest three month fade has only happened three other times dating back to 1951.  Year to date, stock prices are in the black, having returned a surprising 5.87%, as investors have largely looked through the upcoming election.

On the economic front, GDP figures for 3Q 2016 came in at 2.9%, driven largely by consumer spending and exports.  We haven’t seen a GDP number that high since 3Q 2014.  Good news is that economic growth in this range is expected to continue through the fourth quarter and into next year.  The jobs creation figures have been encouraging for some time, and we’ve recently seen a meaningful pick-up in wage growth.  The oil patch continues to stabilize after a near 2-year swoon, and the rebound in prices, contrary to common thinking, is encouraging renewed investment (infrastructure, transportation) in energy related businesses.  These factors, in my opinion, will likely allow the Federal Reserve to raise the Fed Funds benchmark next month.  

Last year, on December 16, 2015, the Federal Reserve raised rates by 0.25%, for the first time in over 10 years.  Stock prices immediately proceeded to correct.  From that day until the market’s low on February 11, 2016 stock prices fell 11.5%, echoing the old mantra “don’t fight the Fed.”  Some believe when the Fed is raising rates, tightening monetary policy, it indicates a top to the cycle, and is a bad omen for stocks.  Whether this thinking played a part in the market drop, or not, we will never know.  While I do not agree, be aware there are a lot of people who think this way, and there is a good chance the Fed will raise rates again, for the second time in over 11 years, on December 14, 2016. 

According to FactSet Research, impressive earnings reports this quarter have at long last moved the dial.  As recently as September 30, Q3 earnings were expected to fall 2.2%.  Now, as of October 28, the earnings growth rate for the S&P 500 is a positive 1.6%.  That is an important swing and one I have been counting on.  After the relentless drag on corporate earnings due to the oil price implosion and the high US$, this quarter may well mark the first year over year earnings growth we’ve seen since the 1Q 2015.  The financial stocks have been the largest contributor to the bump in earnings.  Assuming the energy sector continues to normalize, we should expect a dramatic lift to the earnings for the S&P 500 in 2017.

I think it’s prudent to reduce asset allocations to fixed income at this point.  The credit concerns in the corporate and municipal space that shook the world in 2008 are healed.  Today, the primary issue is interest rate risk.  Rates appear to have inflected, and individual bonds and bond mutual funds are vulnerable to price degradation.  Interest rate surrogates such as REIT’s and MLP’s have also come under some selling pressure as investors consider a shift in the yield curve, but I have confidence that a favorable economic backdrop and their ability to increase their distribution levels will offset worries over higher rates.

Please feel free to check in if you have concerns related to the pending election.  Fears of a Brexit-like outcome have compelled some investors to raise cash, and this is likely the source of current pressure on the market.  My expectation is that the fundamentally sound backdrop in place today will allow quality growth stocks to continue to work for us.  Take a deep breath.

Bruce Hotaling, CFA, Managing Partner

Labor

Labor Day is here. For some, along with Memorial Day, it bookends the summer, and that’s that.  It represents the end of the heat, and the beginning of another school year.  In fact, the date became a national holiday in 1894 to recognize the incredible achievements of the American worker.  This was around the time the AC motor, the radio, the gasoline engine and a plethora of other economic dial-movers were discovered.  It was a period of dynamic technological change.  Today, robotics, drones, AI and the like are transforming the world and how we work.

Labor (productivity) is important today as one of the two primary components of economic growth along with population growth.  Population growth is on the decline, so the emphasis is on technological innovation to make the U.S. laborer more efficient.  Curiously, the U.S.’s total output, measured by GDP, has been growing at a lackluster rate ever since the Great Recession.  Payroll numbers have been growing steadily for years now and the unemployment rate is at a low 4.9%, but GDP growth has not been able to pick up.

Last year (2015) U.S. GDP measured 2.4% and stock returns, measured by the S&P 500, were 1.4%.  This year, despite equally low-growth, stock prices have been rising.  I suspect there are several things happening here.  One is the market may be anticipating stronger growth and increasing estimates for Q4 2016 and 2017.   With the election coming up, the market seems to be anticipating a change in the use of fiscal policy.  It would appear that ideology aside, policy makers (not the Federal Reserve) realize they are the ones that can make a difference.  Little if anything constructive has been done to spur economic growth since the American Recovery and Reinvestment Act of 2009 – far too long. 

Another change the market may be anticipating has to do with how corporate America allocates its prodigious cash flow.  Traditionally, spending by businesses large and small is oriented around research, innovation, capital investment and expansion.  These are factors that have traditionally propelled the future growth of American industry.  Recently, much of the surplus cash has been oriented toward pleasing investors on Wall Street in the form of higher dividends and stock buybacks.  This may be good for the board room and bonus calculations, but it is not the correct route to sustainable growth.

Last, but not least, the most evident driver of the strong stock market this year (stocks have generated a total return of 7.66% year to date as measured by the S&P 500) is the search for yield.  For multiple reasons, bond yields are as low as they have ever been.  On top of this, demand for yield is off the charts, as our sovereign counterparts, Germany and Japan, are paying negative yields on their debt.  This makes the current 2.1% yield on the S&P 500 look extremely attractive to income investors, and not just U.S. investors – there is evidence of huge demand for U.S. equities from Europe and Asia. 

Stock sectors known for their dividends, such as utilities and telecom, are up 20% year to date.  It’s no surprise that high dividend payers and value oriented stocks such as these continue to outpace growth stocks.  The shift from growth to value, as I have discussed before, began in December 2015 and accelerated into 2016.  I am making a somewhat contrarian bet that a positive inflection in earnings growth in the coming months will allow growth stocks to return to the head of the pack.

 It’s hard to grasp the degree to which the world has changed since 1894.  The role of labor and the importance of technology are as critical as ever, though they bear little resemblance to what they were.  I have to say, the recent dust up between Apple, Ireland and the EU reflects just how critical innovation in the labor force has become.  A recent Fortune list of the largest technology companies around the globe showed that of the top 25, 14 are from the U.S., 8 are from Asia-Pacific (China, Taiwan and South Korea) and only 3 are from the Euro-zone (Germany, Sweden and Finland).  That says a lot.

Please feel free to check in if we have not spoken recently.  The last few months have been smooth sailing, and often times that means there’s a storm somewhere on the horizon, even if we cannot see it yet.

Bruce Hotaling, CFA

Managing Partner