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S&P return year to date

Tariffs and Taxes

Stock struggled in May.  As measured by the S&P 500, prices fell 6.58%, and the year-to-date return to the benchmark now totals 10.74%.  This comes as something of a shock after four successive months of hefty   returns.  The market’s historical pattern of giving steadily, and taking-away quickly, is clearly evident.  Since the November 2016 election, on three occasions, stocks have somewhat violently taken back virtually all the prior period’s gains.  Stocks were routed in February 2018, in December 2018, and again in May of 2019.  On one hand, this could be considered normal volatility in the market place.  On the other hand, this “triple top” formation is considered a warning sign by technical analysts. 

The 800 pound gorilla investors around the world are now contending with are tariffs.  Since the 1930s era Reciprocal Tariff Act, successive administrations have used their authority to liberalize trade, promote economic growth and strategically de-risk regions and relations.  This has all changed.  The justification now being distributed is that increased tariffs will help the US win, they are a counter to national security threats, and they will force our foes to the bargaining table. 

The consequences for the American consumer is they either forego buying certain products, or pay more for them.  Tariffs are a burden on US businesses in multiple respects, through higher input costs, loss of market share, or the elimination of businesses as the tariffs make them unprofitable to continue.  Farmers, particularly soy beans, pork and cotton, have seen their businesses stall.  The sad truth is that the bounty from the Tax Cuts and Jobs Act of 2017 is now lost, as Americans are being taxed, indirectly, to support a global war on free trade.

It’s not at all clear the trade overhang will lift.  This will require cooperation and agreement with trade partners, as opposed to standing on their dog leashes.  We ought to expect this to be a lingering presence in the marketplace, until at least November 2020.  The White House will game, talking up economic growth and stock prices while whirling the politically potent trade stick.  Some of our research providers project the damage from the tariffs could be as much as 5% of earnings.  This would ostensibly wipe out the forecasted earnings growth for the current year.  A valid question, in the face of this degree of uncertainty, is how much can investors continue to digest?

Separately, market fundamentals are not alarming, but they are also a long way from anchoring confidence.  Several April economic data points were down.  Q22019 GDP is now expected in the 0.6% range, the weakest since Q42015, the last time we had an earnings recession.  The slowdown in growth began in advance of the recent trade news with respect to China, Mexico and Canada.  Interest rates and inflation look to me as though they will remain low and range bound well into the future.

Today, based on current earnings expectations for the S&P 500 of roughly $180 per share (12 months forward) stocks are selling for a little over 15x earnings.  This is slightly below the 25 year average.  Expected returns, from this valuation level, are roughly 10%, which is also in line with historical averages.  The Goldilocks outlook is that barring any surprises, these earnings levels can be attained, and the multiple does not erode any further.

On our end we are pleased the market continues to favor growth stocks over values stocks.  The S&P 500 Growth index (IVV) is up 13.32% ytd versus the S&P Value index (IVE) up 8.18% ytd.  We are concerned with the recent anti-trust talk directed at stocks such as Google, Amazon, Apple and Facebook.  Other factors investors use to assess stocks such as size, valuation, dividend yield, etc., are not additive at this time.  We are taking a much more idiosyncratic approach and are targeting stocks with strong secular growth, innovative management teams and limited supply chain exposure to foreign trade. 

I expect the tension we see in the markets to continue, and it will remain challenging to own stocks.  I also think the best opportunities for investment gains remain in select stocks, versus owning the market or making sector bets.  This makes good quality stocks the best game in town and one we pursue with vigor.  Please feel free to check in in if we have not spoken recently.

Bruce Hotaling, CFA 

Managing Partner

Trick or Treat

October, the month of Halloween and two of the most memorable stock market crashes, can be a scary time.    Fear is often considered the most powerful and uncontrollable human emotion.  When it ignites, the primal human survival instinct takes over and reason and logic go out the window.  This year’s October was no exception, and investor fear levels are clearly on the rise once again.

Stock prices for the month of October fell 6.94%, bringing the year-to-date total return of the S&P 500 down to an unsatisfying 3.01%.  For some context, February (-3.89%) and March (-2.69%) were also difficult months in which to own stocks.  From January 26th to the April 2nd low, stock prices fell over 10%.  The recent drop, from September 20th to the October 29th low, was 9.8%.  Both were uncomfortable drops in price and can be labeled corrections.  Seasoned investors often consider corrections a necessary evil when one chooses to commit financial assets to the stock market for the long run. 

The market’s behavior in October was unusual.  For example, of the 23 trading days in October, 16 saw negative returns.  There were 5 days on which prices rose more than 1%, and 5 days when prices fell more than 1%.  According to Bespoke Research, October 30 marked the end of a 28-day run for the S&P 500 without back-to-back days of positive returns; the preceding occurrence of this phenomenon dates back to World War II.  Stocks have recently struggled mightily and lost ground.  My concern is stock prices themselves are often considered the most telling indicator of future stock prices.

Of course, the stock market is made up of a vast array of companies occupying different sectors of the economy.  Different stocks have characteristics that cause them to respond differently to the same events.  For example, stocks that fared best during October were ones that had the highest dividend yields, the highest level of international revenues, and the poorest Wall Street analysts’ ratings.  Consumer staples and utilities were the only two sectors with positive performance. 

In my opinion, the increased agitation in stock prices may be an early signal of an earnings deceleration. This will likely be coincident with slowing economic growth and possibly even a recession.  For example, expectations are for earnings growth of 10% in 2019.  This is a reduction by 50% of the 20% growth we’ve experienced in 2018.  By mid-2019, investors will fixate on earnings projections for 2020, and those figures will probably be impacted by several factors.   For example, the trade war is causing higher costs for some US companies as a result of higher tariffs, longer lead times, and broken supply chains.  In addition, hints of inflation and indications that wage pressure is building will likely lead the Federal Reserve to continue on its current course of restrictive monetary policy.

Consumer confidence (at the moment) remains extremely high, both historically and in absolute terms.  This is a good thing, at least for now.  The confidence levels reflect the fact that jobs are available and people with jobs are out spending money.   There is still some punch in the proverbial punch bowl, and that could extend what has already been a prolonged economic run.  Given that we live primarily in a service-oriented economy, the historical cycles of older industrial economic cycles do not necessarily work as a barometer.  There may well be more room to run, but according to Bespoke Research, when consumer confidence has peaked historically, we tended to be at the early stages of a recession.

In my opinion, stocks are still the asset class of choice.  The backdrop is the same as when the speed limit on the freeway drops from 75 to 55 and suddenly you feel like you’re crawling along; the freeway still beats the back roads for a long road trip.  We will need to quickly become accustomed to the new rate of economic growth and the new market place and likely pivot to a more value-oriented stock selection approach.  Expected returns from stocks may well be lower going forward than they have been since 2009.  Our work is to choose the best stocks to own as the future characteristics of the market become clearer.  I am happy to discuss this with you in greater detail if we have not spoken recently.  Please feel free to reach out.

 

Bruce Hotaling, CFA

Managing Partner

Casting About

Stock prices, as measured by the S&P 500, rose 7.7% during the third quarter and are now up 10.5% year-to-date.  These returns are generally in line with historical returns.  Stock prices did jump 21.8% in 2017, but over the last 30 years, stocks have averaged 12.1% annually (1988 – 2017) with a standard deviation of 17.2%.  Based on these figures, the stock market is in “business as usual” mode.  It generally produces returns for which investors, at the end of the day, are rewarded for the risk they undertake. 

That said, investing in the stock market (or staying invested) has always been challenging.  For example, in recent memory, stocks fell 37% in 2008, 22% in 2002, 12% in 2001 and 9% in 2000.  The message is that the average returns of the stock market are available, but to capture them requires a willingness to endure some discomfort and avoiding the impulse to completely disinvest.

Many people are anticipating some type of disruption, as the record bull market grows long in the tooth amidst heightened levels of political turmoil.  Some are casting about for the next sign of trouble.  This could be a peripheral economic indicator or an exogenous shock – something unpredicted that ends up influencing the economy and, ultimately, the financial markets.

Unknown risk factors are difficult to identify and can take control of the markets in a blink.   For example, on October 19, 1987, the Dow Jones Industrial Average fell 22 percent in one day!  It may have been the experimental use of portfolio insurance (program trading), inefficient stock market technology, the huge budget deficit, or who knows what else.  These and other factors led to panic on Wall Street.  That was thirty-one years ago, and while the stock market has evolved enormously since then, we are curiously no better equipped to predict a crash today than we were on Black Monday.  

On a macro level, there are valid concerns such as the national debt and student loans.  The national debt is approximately $21 trillion.  Interest on the debt is rising quickly.  A recent report by the Congressional Budget Office shows that the fastest-growing federal government expense is the interest on our debt.  The expected bill for 2019 is $390 billion, which is 50% more than in 2017.  The report projects the US budget deficit to expand from 3.5% of GDP last year to 9.5% by 2048.   Student loans now rank as the second-largest category of consumer debt (behind mortgages) with a total debt of $1.5 trillion, and 10.7% of the 44 million borrowers are 90 days or more delinquent. (Forbes 6/13/18)

On a more fundamental level, the housing and banking sectors typically do well when the markets are healthy and anticipating growth.  Though the stock market continues to trend higher (20 of the last 22 months), these very two sectors are demonstrating notable weakness.   Weakness in the housing market is evidenced by the CaseShiller Index, which has fallen to its lowest level since March 2010. The malaise in the banking stocks may be due to troubles banks are having securing and paying for deposits – which ultimately impacts their future profitability.

On the contrary, the 2017 Tax Cuts and Jobs Act has clearly spurred a robust inflection in corporate earnings, and this is moving stock prices.  Currently, the aggregate CY 2019 earnings estimates for the S&P 500 are $178.  Using an 18x (trailing PE ratio) multiple on $178 in earnings, would put the S&P 500 at $3,200 at the end of 2019.  Investors using these figures (based on the current quarter-end price of $2,914) expect a 10% return from stocks in the coming year, which is on par with historical averages.

In my opinion, the stock market (from a fundamental perspective) is not cheap, but it is certainly not overpriced, either.  According to FactSet Research, the current forward P/E ratio is 16.8x (based on the above earnings forecasts) versus a 5-year average of 16.3x.  The risk is a deceleration in earnings and/or a compressed multiple.  These are not new worries – they simply feel magnified by the remarkably emotional and politicized haze through which we now view and filter news.  Unable to attach market significance to odd behavior and mistruth, we will rely upon fundamental and technical factors and hold a steady course for now.  I am happy to discuss this with you in greater detail if we have not spoken recently.  Please feel free to reach out.

 

Bruce Hotaling, CFA

Managing Partner

Like a Hawk

2018 has been a profitable year to invest in US stocks.  Apart from a sudden drawdown early in the year (stocks fell 3.89% in February and 2.69% in March), stock prices have moved upward at a fairly reliable rate.  August saw prices rise 3.03%, and the S&P 500 has generated a 9.94% total return year to date.  In the 21-month span since the November 2016 election, stock prices have risen in 19 of those months for a cumulative return of 36.59%.   In spite of a record long bull market for stocks, there is a level of discomfort, like we are playing a high-stakes game of musical chairs. 

The discomfort stems from the charged backdrop.  Daily news paints a picture more reminiscent of a reality TV show than what we became accustomed to growing up with Walter Cronkite and David Brinkley.  The tension may only continue to increase.  September is historically the worst performing month of the year and often the most crisis-riddled as well.  Ten years ago, on September 15th, Lehman Brothers declared bankruptcy, setting off a months-long decline in the markets.  Seventeen years ago, on September 11th, four coordinated terrorist attacks on the United States caused the stock market to close until September 17th and when it reopened, the S&P 500 lost 11.6% over the ensuing five trading days.

The strength in US stock prices since the November 2016 election can be attributed to many things, including somewhat remarkable corporate tax cuts, a hands-off regulatory approach, low interest rates, low wage growth and a period of global economic stability.  These factors have all led to a remarkable inflection in corporate earnings.  During the period 2013 through 2016, earnings grew, but at a modest 2.4% rate.  According to FactSet Research, earnings are expected to grow 20% in 2018 and 10% in 2019.  Wall Street analysts who forecast earnings are maintaining their optimistic outlook for the future.

From a fundamental perspective, as impressive as this growth cycle has been, the forward P/E multiple on the market is 16.8x, only slightly higher than the 5-year average of 16.3x.  We have a situation where stock prices are hitting record highs, but stocks are not overly expensive from a fundamental viewpoint.  This, like so many aspects of investing in the stock market, is nuanced.  The relative attractiveness of a stock, or the stock market as a whole, is tied to investors’ subjective interpretation of the marketplace. 

In the shadow of the market’s recent strength, there are some indications change we are watching closely.  The Federal Reserve continues to normalize (raise) interest rates and de-lever its balance sheet.  Often times, a rising rate environment can be challenging for stock prices.  2019 GDP forecasts have fallen.  Much of what caused the recent surge in economic activity has now run its course.  Markets around the world are beginning to show signs of slowing.  The emerging markets have been in a bear market territory for months and a high US dollar will challenge their ability to repay dollar denominated debt.

Some investors have pre-emptively begun to transition to more risk-averse positions in defensive stocks with low valuations and high dividends.  While not unreasonable, the growth stocks that anchor our investment style have led the market in 2018 and I expect this to continue, for the near term.  We will watch closely on September 26th when the industry classifications for many influential stocks will be changed, thus effecting the industry makeup of the S&P 500.  Stocks such as Alphabet and Facebook are leaving the technology sector, and Netflix will leave the consumer sector to become part of the new communications services sector.  Prices may experience some turbulence while the ETFs and mutual funds are rebalanced.

                At this juncture, I think the best course of action is to watch closely and review our target asset allocation.  The atmosphere on Wall Street is a juxtaposition of fear and unconstrained optimism.  This is often referred to as climbing the wall of worry. I suggest we stay close to our target allocations to stocks.  For many this may involve some profit taking, as many of our growth stocks have seen outsized returns over the last few years.  In the meantime, please feel free to call if we have not been in touch recently.

 

Bruce Hotaling, CFA

Managing Partner

Change is Coming

The stock market is all about earnings.  Corporate earnings and their level in relation to stock prices is the fundamental basis, the keystone, of stock valuation.  US stocks have been enjoying an unprecedented period of earnings growth and price appreciation.  Much of this stems from the stock friendly behavior coming out of Washington DC.  In general, corporate America could not be more pleased with the US corporate tax cuts and the across the board emphasis on de-regulation.

For the month of May, this symbiotic relationship continued to self-reinforce, and stocks responded with a total return of 2.41%.  The solid returns for the month brought the S&P back into the black for the year.  May’s positive returns and moderate volatility (only three of 21 trading days had price moves +/- 1%) were a welcome relief for investors after two stressful months with sharply negative returns in February and March.

While stock returns are modestly positive this year, it’s a shadow of the 8.8% return through May of 2017.   I do not expect the S&P 500 to return 22% again this year.  Signs of trouble are brewing.  Few asset classes are faring well.  Most larger foreign markets are down (Brazil -11.9%, Germany -4.2%, China -4.6%).  Gold and silver, and almost every maturity level across the fixed income spectrum are also down year to date.

It’s a challenge to make forward looking determinations on how best to position the portfolios in the face of so much media noise and misplaced commentary.  In my opinion, there are two overhangs to the market that are threatening to spoil what has been an intoxicating run for stock investors.

One of the supportive backdrops for the upbeat market in 2017 into 2018 has been coordinated global growth.  The idea behind this concept is a stronger global economy supports improving demand for US goods and services, and spurs corporate profits.  The US$ had been low, amplifying the effect.  Suddenly, this growth driver is under assault, and isolationism and protectionism are on the rise.

Further, tension on the Korean peninsula, threats of a trade war with China, tariffs on steel and aluminum imports from Canada, Mexico and the Eurozone, and the US’s withdrawal from the Iran nuclear deal have led to a destabilization of the world political-economic order.  This is thin ice.

Much of the anticipated global growth was fueled by debt.  Now, global debt has reached levels never seen before, equivalent to 225% of global GDP (according to the Economist 4/24/2018). China is guilty of leveraging up to sustain its economic growth.  This is similar to the US tax cuts that will push the US deficit over the $1 trillion mark.  Emerging markets are suffering with many of their obligations issued in US$s (Argentina, Turkey).  Growth, measured by GDP has slowed.  The question here is whether we have come to that point, the tipping point, when things begin to change, while no one wants to believe that is truly the case.

The question isn’t so much if there will be trouble, but when.  I do not think any changes in asset allocation need to be made, yet.  I do expect returns to bonds to be minimal, and stocks to be in the average range.  I am pleased the market continues to reward growth over value.  This is a tailwind for our portfolios.  Our core approach to investing is referred to as GARP or growth at a reasonable price.  Growth stocks continue to outperform value stocks at the large, mid and small cap levels, by notable margins.  The two highest returning sectors are technology and consumer discretionary, both sectors where we hold overweight positions. 

One of the clearest reasons to take a more cautious posture toward stock investing is because many, possibly too many investors and market commentators are overwhelmingly positive.  They tend to tick down the list of supportive economic or consumer data points.  There is a lot of cool-aid being consumed out there.  I’m not a contrarian, but I’m also not one to get sucked into the vortex.  The best course of action today is to avoid getting drawn in to owning too much stock.  We need to stay well invested, while hovering one foot over the break. 

Bruce Hotaling, CFA

Managing Partner