Oil and the Dollar

After starting out the year with two extremely challenging months, March gave investors a big lift and some emotional respite. Stock prices, measured by the S&P 500, rebounded 6.6% in March, the biggest jump in monthly prices since last October’s dramatic 8.3% run-up.  Dividend paying stocks have begun to stand out, as have value stocks, particularly small caps and mid-caps.  Utilities, consumer staples and telecom stocks have led the way while financials and health care stocks have been notable laggards.

The S&P 500 started the year at 2,043. From day one (January 4th was the first trading day of the year), prices fell.  They hit their lowest point on February 11th (possibly the new March 9th 2009?) when they closed at 1,810.  In only six weeks, prices had fallen 10.27%.  A 10% drop in prices is the generally accepted definition of a market correction.  I think this utterly shocked investors.  Most were evaluating how they intended to reposition their portfolios, not how they were going to execute triage. 

In today’s world, there is a spectrum of issues dominating the emotional backdrop: unconventional presidential candidates, global warming, refugee crises and ever more incidences of terrorism. The year started with a contentious Fed rate hike and a resurgence of fear the global economy was spiraling into a recession.  In my opinion, amidst all this noise, the critical component remains the outlook for US corporate earnings.  The earnings recession we are in (I’ve mentioned in past letters) remains a cloud over markets.  My expectation is for it to resolve.

According to FactSet Research, with the anticipated earnings drop in Q1 2016, it will be the first time the S&P 500 has seen four quarters of successive earnings declines since Q4 2008. The energy sector remains the culprit.  If we overlook the anticipated 101% drop in earnings from energy stocks, the earnings decline for the S&P 500 would be 3.7%.  At the present time, earnings forecasts are for declines in Q1 and Q2 of 8.5% and 2.5%.  Analysts are calling for a turn-around in the second half, with positive earnings growth of 3.7% and 11% in Q3 and Q4.  

Since the financial crisis in 2008, labor costs have been low, employment has recovered smartly (in spite of an aging work force) and corporate profit margins have improved dramatically.  Things have been going well, but now revenue and earnings are decelerating.  Today, growth in Europe is intact, it’s slow here at home, and middling around the rest of the world (China, Japan).  With this backdrop, earnings improvement is not a given.

Critical factors in the expected second half earnings recovery are a normalization of oil prices and a continued fall in the value of the US$. Oil prices look to have stabilized and possibly put in a bottom.  Airlines are reported to be purchasing oil hedges out 2-3 years.  As earnings from the energy sector have evaporated – even a 50% recovery would be a nice bump to the S&P 500’s earnings.  On the currency front, a further weakening of the US$ could provide an even bigger bump to earnings.  According to JP Morgan, a 10% drop in the trade-weighted US$ could lift earnings as much as 5%.  Oil and the US$ could be the differentiators this year.

Stock valuations are not unreasonable. If the price/earnings (PE) ratio remains constant, and earnings pick up, stock prices are likely to rise.  According to FactSet Research, stocks are currently priced at a PE of 16x the next 12 months expected earnings.  I am hopeful continued mean reversion in both oil prices and the US$ are enough to catalyze earnings going forward and anchor higher stock prices into next year.

The style shift I discussed in last month’s letter has not changed. Stocks correlated to a recovery in oil, unloved sectors (industrials, transports, materials), have begun to lift.  The crowded sectors such as consumer staples and utilities have been safe places to hide but are all very expensive to buy.  I continue to believe a second half earnings recovery will return the spotlight to quality growth companies in the technology, consumer discretionary and health care sectors. 

Please feel free to call if we have not spoken recently. Now that the typically busy tax season is behind us, we can put renewed focus on portfolio positioning and other issues more central to your long term needs.


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


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