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Rock Steady

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

Managing Partner

Nor’easter

Let’s hope March of 2018 was an anomaly.  Just as signs of spring were beginning to appear, folks living in the northeast and mid-Atlantic encountered what was likely their first ever cyclone bomb.  Exhausted from shoveling snow, they were then clobbered by three more nor’easters in a three week span.  It could be we need to place more trust in Punxsutawney Phil’s early February predictions. 

The unpredictable nature of these storms reflects closely the unsettled activity in Washington, which is becoming so chaotic it looks to be finally having the effect on financial markets many had feared back in November 2016.  Stock prices, measured by the S&P 500, have begun to mimic both the unforgiving nature of recent weather – and the chaos inside the beltway.  Stocks fell in March by 2.7%.  This is on the heels of a 3.9% decline in February.  Year to date, stock prices are down 0.76%.

For some context, over the last 30 years, the S&P 500 has produced an average return of 12.2%, with an annual standard deviation of 17.3%.  There have been 5 years (17% of the time) when the return to stocks was negative, and in those years, stock prices fell on average 16.6%.  After a larger than average 21.8% return in 2017, stock prices may be reverting to the mean.

On a more granular level, the stock market looks to be attempting to assess the potential damage from a trade war.  Old school protectionism is the latest contrivance out of Washington in hopes of making America great again.   Restrictive trade, whether it leads to a trade war, will put the brakes on the positive effect foreign competition has on holding down price inflation.

The recent stock price volatility highlights the concern that fractured global supply chains may negatively impact US corporate margins.  Free trade is proven to stimulate economic growth.  Higher tariffs will eliminate the process of comparative advantage that allows all parties to benefit from globalization.  If the root of the problem is infringement of intellectual property rights, then that needs to be addressed directly, without the random and damaging effects of trade warfare.               

Recent economic data has not been compelling and the nine year expansion is long in the tooth.   Employment levels are high, so high investors have been on alert for signs of inflation.  The brutal stock sell-off in early February was ignited due to clear signs of inflation based on reports of increasing wages.  Stock investors are well aware, if a cycle of higher inflation has begun, the Fed will continue to raise interest rates.

The yield curve has shifted upward, and flattened.  This is a mixed signal.  It may well be telling us growth expectations have deteriorated.  The Federal Reserve has raised rates now for the sixth time since the first 0.25% hike in mid-2015.  Expectations are for 3 hikes this year and 3 more in 2019.  Ambitious fiscal spending, at this late point in the economic cycle, will support the Fed’s hawkish position.  The ballooning deficit, continued deficit spending and higher interest rates will raise the probability of a slowdown (recession) sometime in the near future. 

The other curiosity I’ve discussed before is the perpetual weakness in the US$.  It has been in a steady decline since the November 2016 election.  The higher interest rates available in the US would support buying dollars.  On the contrary, global investors have been selling US$s, and buying yen and euros.   It’s not clear what is causing this, though it’s likely related to increased tariffs, restrictive immigration and rising deficits.  The persistent US current account deficits are spurring talk the US$ may not be the safe-haven it once was.

The current backdrop is mixed.  Earnings estimates remain high and stocks are not excessively expensive with the forward P/E multiple in the 16x range.  Volatility has risen, making stocks harder to own.  From a contrarian perspective, this is constructive.  Yet, if the earnings forecasts falter, for whatever reason, this will spell trouble for stock prices.  With the high level of volatility, and two successive down months in stock prices, we are taking a more constructive stance, and will become more cautious if conditions persist.  Please feel free to call us if you would like to discuss further or if your investment parameters have changed since we last spoke.

 

Bruce Hotaling, CFA

Managing Partner

Ignorance is Bliss

Much of the activity in the stock market since November 8th, both in the US and around the world, has been a speculative response to the election results. The surprise optimism was evident in November, as stock prices measured by the S&P 500 rose 3.7% (0.7% prior to the election and 3.0% after).  Year to date, stock prices have risen 9.8% and by most standards, 2016 has been a reasonably good year for stock investors.  Historical returns for the S&P 500 average 10% per year, and recently stocks returned 1.3% in 2015 and 13.3% in 2014.

Amidst the frenzy of tweets and conjecture, many investors are having trouble developing an actionable thesis.  So, the immediate question is, what facts do we have to work with?  First, interest rates have risen on the long end of the curve in anticipation of higher growth and inflation.  Unemployment is hovering in the 4.6% range, low enough to spark wage inflation among the prime-age workforce.  Consensus is the Federal Reserve will raise rates at its December 14 meeting.  The US$ is higher today versus the Euro than any time since ’03.  Historically, energy prices and the US $ are inversely correlated.  And, since November 8th, technology (de-globalization) and health care (elimination of affordable care) have underperformed, while financials (higher interest rates and de-regulation) consumer discretionary (tax cuts) and industrials (fiscal spending and infrastructure) have been bid up smartly by investors.

The cup half-full view of what’s to come is compelling.  Some fiscal spending may give the economy the boost it has long yearned for.  Lower tax rates are a pure windfall, and the combination of the two may well lift GDP above its recent 2-2.5% ceiling.  The last time GDP was north of 3% was ’04-’05 and north of 4% was ‘’97-’00.  Many aspects of US infrastructure are in urgent need of attention, from roads to levees, electric transmission to water.  Some investment here would spur growth, improve our quality of life and longer term well-being.  Increased inflation, historically integral to growing economies, will help avert the dreaded deflationary spiral, and also help Congress navigate out from under the ever growing $20 trillion gross national debt.

On the other side of the coin, there are a number of things to watch for, akin to unintended consequences.  As I noted, the value of the US$ has skyrocketed.  A high US$ will be a drag on US multinationals’ earnings.  It will also exacerbate the trade deficit and pressure GDP downward.  The rising yield curve and higher interest rates will make credit more expensive, raising mortgage rates and slowing growth.  Higher inflation may well push down the already elevated P/E ratio on the stock market.  Unless earnings can reverse their malaise of the last few years, prices are ripe to revalue downward at the first hint of trouble.  The flow of funds into stocks (out of bonds) has been pronounced.  This means more investors are taking on more risk, at the very point in time when the risk of an unanticipated event is high, extremely high. 

With so little facts to work with, markets have been jumping at shadows.  My thought at this point is to underweight fixed income.  I think rising rates will allow us to buy better yielding bonds.  At the same time, bond mutual funds are slightly less attractive, as they behave poorly with the threat of higher rates.  Stocks remain the highest potential-return asset class, though we should be wary of getting caught up in a momentum trade.  Valuations are high, and the “tail-risk” present in the markets today is unquantifiable.  Investors have shifted their focus to value stocks this year.  Growth stocks, historically our preferred type of stock, have had a more difficult time this year. For example, technology and health care and many consumer stocks have been under pressure since the election. We are working hard to rebalance our holdings to best reflect our view of the present landscape. 

 Finally, we are preparing for year-end, and doing our best to limit realized capital gains.  I think we have to be both patient, and attentive.  We are long term investors, and before making strategic changes to our portfolios, I prefer to see some evidence of actual policy, footprints in the snow so to speak.  If you like, please feel free to check in, and I can explain in greater detail.

Bruce Hotaling, CFA

Managing Partner

Touch Bottom

The long bull run in US stock prices has been thrown off track, at least temporarily. Stock prices, measured by the S&P 500 fell 2.6% for the month of September following a 6.2% drop in August. Prices are down 5.29% through the end of 3Q15. Two consecutive months of negative returns and I opt to toe-tap the brakes. In fact, I have been raising cash since the stock market began acting up mid-summer.

Often times, stocks record back to back down months, and that’s that. Then, there are times like the Summer of 2011, when prices fell for five consecutive months. When the dust settled, prices were down 18%. So, if the slope of the market remains negative, I will continue to lean away from the falling prices, and raise cash. The other edge of the sword is that prices often recover sharply – October 2011 saw prices jump 10%. Caution is key at this point, but as conditions improve, we will want to move quickly back into stocks.

The initial drop in US stocks began when China devalued the yuan. As market forces took the yuan down on subsequent days, stock prices cascaded lower. The concerns hinged mainly on decelerating growth out of China, the world’s second largest economy, and the economic ramifications of currency wars among export and commodity dependent emerging economies.

Contrary to what many have been citing in the news media, the health of the global economy is a large factor in the well being of our domestic economy. While the Federal Reserve’s mandate is full employment and price stability, global influences can dramatically alter the strength of our economy. In my opinion, while the data is difficult to rely on, China is not crash landing, rather transitioning from a manufacturing based economy to a consumption based model.

The list of ills is long. Though China may be the poster child, low energy prices have led to a domino effect of issues hampering stocks.   Profits for most energy companies have been cut dramatically and for some their dividends, capital expenditures, and even their ongoing viability is in question. FactSet Data Systems (Earnings Insight 9/25/15) noted that “If the Energy sector is excluded (from the S&P 500 3Q2015 estimates) the estimated earnings growth rate for the S&P 500 would jump to 2.9% from -4.5%.”

In addition to the immediate impact on overall earnings, there are secondary effects. For example, industrial companies that manufacture equipment, metals and mining equipment, and banks that lend to the oil patch are all being pinched. There has been an echo effect on many other sectors of the market. For example, the MLP’s, which transport and store oil and gas, have also come under immense price pressure. In my opinion, this is an over extrapolation on the part of naïve investors and will correct itself in due course. Nonetheless, the oil glut has been a boone for $2 a gallon at the pump, and a confusing snarl for companies unprepared for the first and second derivative fallout.

In my opinion, US stocks remain the best asset class in that they offer a reasonable expected return for the risk of owning them. Good growth stocks have outperformed the market as a whole, and are well ahead of value stocks. Investors tend toward the value category when they become less sure of themselves. There has been no place to hide this year – no asset classes have offered up easy or obvious returns. It’s been tough sledding almost everywhere you look.

Between now and the end of the year, some things ought to become more clear. Concerns related to China’s growth rate and how it opts to handle its currency will temper. The Federal Reserve will likely raise interest rates, even though the economic data does not support a rate hike. Finally, 3Q earnings ought to paint a clearer picture as to the valuation of stock prices and the marginal outlook for growth heading into the coming year. As the negative impact from the drop in energy prices fades, the earnings outlook will correspondingly improve.

There is a lot of noise out there. Today, the concern is Volkswagen fudged emissions measurements on 11M of its diesel motors. If you remember, only last fall a wave of fear struck the country over the Ebola virus and the likelihood of airborne transmission. These things tend to pass. Luckily for us, the Pope visited Philadelphia recently and lifted everyone’s spirits, if only for a moment. This is proving to be a more challenging year than the last two. Some patience and fortitude are required. If you are not comfortable moving forward then I suggest we meet and review you portfolio.  Please feel free to call.

Bruce Hotaling, CFA, Managing Partner