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
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
Stocks rebounded in October, returning 8.3% for the month, and lifting the return on the S&P 500 to 2.9% for the year. October has something of a reputation for producing volatile investment returns. This year, August and September were both volatile and down months. It was important that stocks put up a strong showing to avoid sliding into a prolonged decline, or worse. The cautionary evidence in hand was strong, with two consecutive quarters and months with negative returns. Thankfully, October’s stock returns showed some muscle and broke the market’s downtrend.
Several catalysts drove the change in tone. For instance, corporate merger activity (Walgreens and Rite Aid, Ace and Chubb, Heinz and Kraft) leapt to new heights and gave investors an emotional lift. Another catalyst in October was the resurgence of corporate debt issuance. Corporate borrowings increased signaling improved confidence in the economic outlook and the fortunes of corporate America. Finally, and most importantly, earnings reports have been robust and reassured many sitting on the fence.
According to FactSet Research, the blended growth rate for Q3 S&P 500 EPS improved to (2.2%) at the end of last week from (5.2%) at end of last quarter. With the majority of companies reporting, 76% have beat consensus EPS expectations and in the aggregate, companies reporting earnings are 5.9% ahead of expectations. Nine of ten industry sectors have produced positive earnings growth surprises. Earnings have been impressive and the primary driver of the outstanding returns stocks posted in October.
To be clear, the backdrop for stocks is not overly compelling – so I am somewhat wary. At the same time, there is a constructive backdrop often referred to as “climbing the wall of worry.” The macro headwinds are widely discussed in the media. The ones concerning to me are : 1) slower growth across the globe, 2) the strong US $’s impact on US corporate earnings and 3) certain weak economic stats, such as the recent four-straight disappointing monthly non-farm payroll reports.
While stocks do not look cheap at this point, they do look as though they have a reasonable chance of generating their historical rate of return looking ahead 12 months. This cannot be said for some of the other asset classes investors have popularized. I profess “simple is good” and we avoid using asset classes we cannot cash flow forecast, or own directly (without having to use a third party manager or mutual fund). Our decision drivers are based on transparency, quality and liquidity. We utilize a number of different tools to accomplish this including fundamental, technical and quantitative research methods.
In many instances, we had raised cash (sold stocks) taking a more defensive posture as the market became more and more unsettled over the summer. The strength of the market’s rebound in October is reassurance that the market simply needed to blow off some steam, and is not in fact on the precipice of a prolonged downturn. It had not sold off in some time and there is a high likelihood that it needed to “reset” to a certain degree. Now, our focus is to remain well invested, building stock positons at attractive prices. Seasonally, the final two months of the year and first part of the new year tend to be favorable times to own stocks, and we want to take advantage of that tendency.
Difficult as it’s been, stocks remain the prime driver of returns for most investors this year. Growth stocks continue to generate higher returns than value stocks and dividends still do not matter as much as growth. So we will continue down this path. The fears rippling through the REIT market have tempered as have the fears related to the eventual Federal Reserve rate hike. The MLP market, now tied to the price of oil more than ever, will take longer to “normalize”, in my opinion, though the Q32015 reports are making it clear the businesses are maintaining themselves.
If we have not spoken or if you would like to review your portfolio I would be more than happy to get together with you. In the meantime, we are preparing for year end and want to minimize the effects of capital gains in your taxable accounts. Please feel free to call if you would like to discuss further.
Bruce Hotaling, CFA