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En Garde

Stocks, measured by the S&P 500, generated a total return of 3.8% for the first six months of 2016. By most accounts, this is a below average year for stocks, and the sub-par returns in hand have been hard fought.  From the get go stock prices fell, and (cumulatively) did not turn positive until March 17th.  The S&P 500 inched its way higher (toward its 2,130 all-time high set in May 2015) until the Brexit vote surprisingly knocked 5.4% off prices in two painful days.

Stock price declines (5% two-day declines) are not uncommon, except when the market is trading within 1% of an all-time high.  As noted by Bespoke Research, before the Brexit vote the S&P 500 was 1.6 standard deviations above its 50-day moving average and two days later it was 3.2 standard deviations below.  The two day swing was the steepest on record over a period spanning close to 90 years.  Much of this was “noise” thanks to computer driven trading in ETF’s and futures.

Investors were clearly caught off guard by the Brexit vote and then sucked into a vortex of misinformed commentary.  As much as Brexit captivated the world’s attention and whip-sawed stock prices, I think it will prove to be both a local issue and a political bone in the craw of an older generation.  I would expect longer term it will hamper an already sluggish UK economy and spur another Scottish secession vote.  Near term the implosion in the value of the pound will be a tailwind.

In my opinion, we are better served focusing on some of the more obvious risks to both the global and US economies.  One critical factor is China.  As we saw last August, concerns over slowing economic growth, and the steady devaluation of the Chinese currency (the RMB), are true global risks as China is the largest contributor to global GDP growth.  I suspect these concerns have not been put to rest.

The outlook for S&P 500 earnings for the second half of 2016 is favorable, largely due to low interest rates, a tempering US$, and higher oil prices.  The US 10-year is yielding around 1.4% and due to macro factors, rates may well surprise and trend lower as global capital seeks safe haven.  The US$ has stabilized (stopped rising) which will provide a huge tailwind to US companies repatriating foreign based earnings.  And, oil prices, the culprit for much of the turmoil markets have suffered over the last 18 months, have stabilized.  A good sign is inventories appear to be on the decline.  Supply and demand will come together.  With oil prices in the $50 bbl range, volumes of economic activity will come back on line, and with it, $’s of lost earnings.      

Overall, the undercurrents of the market have not changed since the start of the year.  For the time being, large cap value is outperforming growth, and small and mid cap stocks are generating stronger returns than large cap stocks.  Dividends (REITs, utilities and most consumer staple stocks) have been the big attraction for investors this year.  They have become expensive.  While I expect the interest in dividend yield to continue, I think the growth stocks will come back into fashion when the S&P 500 begins to show evidence it is breaking out of its long running earnings slump.

Though confusion reigns from time to time, I think we can take heart in a brighter long term outlook.  The millennials (born 1981-1997) are now the largest generation, at roughly 75 million, and are the largest share of the American workforce (Pew Research Center).  The millennials are just starting to get married, buy homes and have children.  The US is on the verge of a tremendous demographic dividend as the largest share of the population for the coming years will be young, highly educated, and ready to consume (Bespoke Research). 

Over the years, common sense and an attentive hand have allowed us to navigate some challenging markets.  Our approach is to anchor on facts, take a long term view of what we’re all about, and to acknowledge (and refine) an effective process.  We are here to serve you.  In these curious times, if you would like to share your thoughts or schedule a review, we would love to hear from you.

Bruce Hotaling, CFA

Managing Partner

The Road Not Taken

The first two months of 2016 have been a challenge. Stock prices started the year in free-fall and didn’t let up until February 11.  At that point prices were down an eye opening 10.3%, measured by the S&P 500.  Over that 28 trading-day span, prices fell on 16 days or nearly 60% of the time.  Worse, on a staggering 13 of the 16 down days, prices fell by more than 1%.  Market corrections of 10% or more are not uncommon, in fact they tend to occur every 18 months on average.  This correction was sharp and unexpected.

Interestingly, oil prices also fell on 19 of the first 28 trading days of the year, and they also bottomed on February 11th – down an astounding 29.2%.  The correlation between stock prices and oil was nearly perfect in January, higher than any time since 1990.  Then suddenly, blue sky reappeared on the 12th, and prices began to rebound recovering more than 50% of their respective losses by month end.

The hope is the 18 month collapse in global oil markets has stabilized. One of the most damaging aspects of the plunge in oil prices has been the impact on earnings – both for the energy sector and the S&P 500 as a whole.  According to FactSet Research, earnings estimates for the energy sector fell from $2.97 to $0.20 during the first two months of 2016.  Interestingly, at the start of 2015, the Q1 estimate for energy was $8.38.  The point here is earnings from energy companies have effectively gone away.  At this point, I think there is reason to expect a substantial rebound in earnings forecasts for the S&P 500 as we move into 2016.

Separate from the energy patch, the bottom up earnings estimates for the S&P 500 have been falling – for the last four quarters. We have been grinding through an earnings recession.  Based on FactSet Research data, this is the first time S&P 500 earnings have seen four quarters of year-over-year declines since the period Q4 2008 through Q3 2009.  This has caused a drag on the market dating back to mid-year 2015.  A popular topic in the news is a global recession, but the slow-drip erosion in earnings has been nagging stock prices, primarily energy, materials and industrials, for the last nine months.

Amidst this backdrop, the market’s fundamentals are sound (measures such as earnings yield, price to earnings ratio) making the 10% correction in prices look very disconnected. When the emotions clear and speculative traders have exhausted themselves, the baseline valuation of the underlying stocks once again becomes the imperative.  According to FactSet Research, the 12-month forward P/E ratio for the S&P 500 is 16.1x based on the recent 1993.4 price level and forward earnings estimates of $124.  This is underpinned by a generally constructive domestic economic outlook.

The recent bounce in prices has brought a welcome tail-wind to our favored asset classes: stocks, corporate and municipal bonds, REITs and oil and gas pipelines (MLPs). Out of respect for the market’s recent directionality, we will hold an overweight position in cash, though I expect the recent bump in prices to have a somewhat calming effect. Our baseline measures of growth, valuation and dividend distribution remain firm.  If the stability holds, we will look to put more excess cash to work. 

Just as in Robert Frost’s well know poem “The Road Not Taken”, we are faced with something of a divergence. Many investors have shifted their portfolios into lower growth value stocks, including consumer staples and utilities.  They are seeking temporary shelter.  The transition occurred at the end of last year, as though a switch were flipped.  The path we have chosen is, “the one less traveled,” anchored by higher growth names we expect to outperform the broader market, over time.  These are investments that require a little more research and conviction, but have the potential to deliver attractive rates of return.  I expect some patience will be required, as we allow our growth oriented and strong free-cash flow based stocks to regain their position of dominance. 

As the damage from the storm passes, I suspect we will be proven right. Of course, time will tell.  In the meantime, please feel free to call if we have not been in touch recently.  When the markets are volatile, it’s often useful for us to connect.  

Bruce Hotaling, CFA

Managing Partner

Oil

After a less-than-impressive return from stocks in 2015, things have taken a turn for the worse in the early part of 2016. For the month of January, stock prices measured by the S&P 500 fell 4.96%. Of the 20 days stocks traded, they fell in 9 instances, each day by an amount in excess of 1% (3 in excess of 2%). Not a pleasant way to start the year.

Large cap stocks tended to fare better than mid cap, and small caps simply fell apart. There was little differentiation between growth stocks and value stocks. Sector wise, financials and materials had it the worst. Consumer staples and utilities, both considered defensive sectors, actually had positive returns. There was nowhere to hide either. Stocks from every primary global market, including oil, gas and commodities all fell in value. The one bright spot, gold, silver and fixed income (particularly US Treasury bonds) did show positive returns.

So, where do stocks go from here? The answer, at the moment, hinges on oil. Stock prices have begun to trade in lockstep with the price of a barrel of oil. Oil prices did bounce off a 13 year low on January 20th and have rebounded nearly 14% since that date. In classic thinking, lower oil prices were considered a boon to the economy. Lower energy brings down the cost of production, transportation and ultimately puts more money in consumer’s pockets.

Historically there is not a strong correlation between stock prices and oil, until now. So what has changed? One variation from the old paradigm is we import far less oil today. On top of that, there is little clarity with respect to true global demand and talk of a recession. Some analysts feel the direction of the trade-weighted dollar starting in 2014, was the key driver of the price of oil. US monetary policy began to diverge from the rest of the world, oil depreciated as the action took liquidity out of the system.

There may be more fallout from the drop in the price of oil than anyone could have foreseen. Sovereign wealth funds which had been overflowing in accumulated oil profits may well be raising funds to support budget deficits. The world’s sovereign-wealth funds together have assets estimated in the $6-$7 trillion range, (US GDP in 2015 was approximately $18 trillion). More than three quarters of these assets are in funds from emerging market countries, many based in the Middle East and Asia, and naturally the assets easiest to sell are their global stocks and bonds.

The oil patch has developed a knack for talking its own book. For example, T Boone Pickens, in a June 13, 2014 CNBC interview said oil prices could hit $150-$200 a barrel. Today, only 18 months later, several noted global banks are saying prices could drop to as low as $10-$15 a barrel. The unfortunate truth is no one really has any idea where the balance between supply and demand will be struck. Once oil prices stop falling, many other financial assets will follow.

The general economic backdrop is mixed. Talk of a global recession looms, but in the US, the housing and auto sectors continue to perform well and the jobs numbers are strong. 4Q GDP came in at 0.7% with a notable bump from consumer goods and services. While the industrial manufacturing sector slumps consumer confidence remains above its long term averages.

According to FactSet Research, the 2016 bottom-up estimates for the S&P 500 are $123.3 (versus $117.7 in 2015). This is the true foundation for the market, and stocks are trading in a reasonable range of 15.4x forward earnings. Energy remains the primary issue as returns have nearly evaporated dropping from $8.38 in Q1 2015 to $1.36 in Q1 2016, a drop of over 83%. Earnings for materials and industrials have also dropped, in large part due to oil.

In my opinion it’s most prudent to remain prepared to back away from risky assets. We did this back in August 2015 and we may find it prudent to do the same in February 2016. Many of our favored stocks are selling at attractive prices. This does not mean they cannot become even more attractive, if conditions take a turn for the worse. So, for the moment, we are watching cautiously.

Please feel free to reach out if you would like to review with us. In more difficult times such as these, it is important for us to remain in close communication.      

Bruce Hotaling, CFA

Managing Partner