S&P return year to date
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
Mish Mash
Investor behavior has been by and large complacent. The market commentary has been Pollyannaish. The combined effect has been an extended period of positive returns and low volatility. Stock prices, measured by the S&P 500, rose for 15 consecutive months, something they had not done in over 20 years. Then, in February, stock prices fell by an uncomfortable 3.69%. Sharp price drops, 4.1% on the 5th and 3.75% on the 8th, echoed swings felt prior to the onset of the financial crisis.
The market backdrop looks to have shifted. A trend change cannot be extrapolated from one month’s returns. Just the same, it may be that the majority of the market friendly changes (tax cuts, regulatory roll-back, loose spending) are baked in. If this is the case, the return/risk profile stocks offer may have begun to seesaw. Here are some observations worth your consideration.
The dominant factor influencing stock prices is earnings. 4Q 2017 was one of the strongest earnings seasons in the last 20 years, according to Bespoke Research. The “inflection” in earnings is remarkable, as they had been flat. We tend to extrapolate data forward, and expectations going forward may be too high.
The surge in US corporate earnings has been bolstered by an up-swell in economic growth around the world. Manufacturing PMI’s around the world are simultaneously rising, and although Europe’s emergence from the global debt crisis lagged, it’s now the catalyst for a full-fledged global economic revival.
Another boost to earnings has been a weakening US$. This allows for a currency translation bump, when earnings from abroad are repatriated. This tailwind has been in effect since November 2016, as the US$ has fallen roughly 15% against the Euro.
The current administration’s weak US$ policy is apparently intended to cure the trade deficit. Curiously, the trade gap widened in January to the highest level since October 2008. The recent imposition of tariffs on various imports may help offset the trade deficit but the true economic result will more likely be a decline in domestic growth – the opposite effect from the intended goal of making America great (protecting US industry).
The recent emphasis on fiscal policy and deficit spending is a significant concern at this point in the economic cycle. It’s inflationary by definition, and the budget deficit may well exceed $1TN in 2018, something last accomplished in the dismal recovery from the financial crisis. The looming cost of financing increased government debt levels is a large reason for the sharp increase in longer term interest rates.
Wages are also going up, which is good for workers earning the $7.25 federal minimum wage, but this too is a source of inflation. Last month’s inflation data was the spark that ignited the February stock market sell-off. The Fed has signaled it will raise rates three to four times in 2018. Long term, there is a good likelihood the Fed (rising interest rates) will take the blame for triggering the next recession – not the ambitious policies that catalyzed the need for higher rates.
Finally, volatility is back. This is a reflection of these disparate factors. Stock prices move up and down and this normally tempers investor behavior. When price volatility is low, investing in stocks becomes too easy. The spike in volatility in February was only the second time the “fear” index hit those levels since the 2008 financial crisis.
Often times the stock market is not reacting to an event, as many TV commentators attempt to explain, rather it is signaling. Stock prices are a leading indicator. Along these lines, the sudden jump in price volatility (the VIX) may well be foreshadowing change. The stock market may be telling us inflation is here and the Fed’s response will be to raise interest rates. Four rate hikes may be the equivalent of taking away the punch bowl. In my opinion, a raised level of caution is healthy here. We have to be able to live with the ups and downs, and to do this may require owning less of the risky asset. We have been repositioning portfolios to reduce oversized positions and address our view of the trend going forward. If you would like to review this with us in more detail, please don’t hesitate to check in.
Bruce Hotaling, CFA
Managing Partner
Crow’s Nest
In the UK, when you cross the street, there are friendly reminders to “look right” printed on the edge of the road. The message is to pay attention, but in a direction many of us are not accustomed to looking. Here in the US, in the world of financial assets, the implicit message today is to “look up”. While some may think of prayer, I’m not heading in that direction. As much as any time in recent memory, the imperative today is to keep a sharp watch on the horizon.
Stock prices, measured by the S&P 500, advanced again, 1.9% for the month of September, and are now up a cumulative 14.2% year to date. It’s been steady going for share prices of US stocks, with March the only down month this year, and then a mere -0.04%. According to The Bespoke Report, there have been only 8 days this year when the S&P 500 has moved +/- 1%, with only 1963, 1964 and 1972 recording fewer days. We are deep into a long-running bull market, and at the moment, there are few signs the trend is about to turn.
From a behavioral perspective, it is clear investors are beginning to be lulled in. While there is no specific reason to believe the slope of the uptrend is about to change, some baseline prudence at this point is warranted. Anecdotally, we’re coming up on the 30th anniversary of the October 1987 crash – a point in time I remember well. My concern now is our collective complacency is creating the foundation for people to own a greater percentage of stocks than they would otherwise be comfortable owning.
To be clear, the fundamentals look reasonable. 2Q GDP figures were recently revised to 3.1%. The US is in the 9th year of an economic expansion. It is likely growth can continue in spite of the damage inflicted by hurricanes in Florida and Texas and forest fires in California. It is also hard to foresee higher growth than what we now have without a change in access to labor. Unemployment, in the 4.4% range, is the lowest since 1960s. Importantly, inflation is not apparent, yet. The issue here again, is labor. The job market is becoming tight and it seems like wage inflation is inevitable.
US 3Q earnings are just beginning to be reported. Expectations are for results better than analysts’ have projected. The earnings beats will likely be attributed to several things: an unusual period of synchronized global growth, stable oil prices and improved US output, a “constructive” upward shift in the yield curve, and the low value of the US dollar.
I expect a continued resurgence in corporate earnings to support stock prices through 4Q 17 and likely into 1Q 18. There has been speculation that corporate earnings would benefit from a realignment of the tax code. In light of the recent disarray in Washington, it seems highly unlikely any real progress will be made. There is no doubt a repatriation tax holiday would be a tail-wind, but I do not think the market expects it, and will shrug off one more disappointment as more of the “new normal”. In my opinion, we will see no fiscal stimulus, modest growth and increasing (but not debilitating) inflation.
There is a good argument the most significant risk the markets face is geo-political. This is a category of market risk that is in many ways not there, until suddenly it is. So much takes place out of the public eye, surprises (market shocks) can stem from this largely indirect factor. The greatest effect is the undermining of investor confidence due to extreme price volatility.
In this vein, a clear concern, fanned by the Equifax hack, is both the security of our personal data in an information driven world, and the ongoing attempts to manipulate popular media. There appears to have been a well-orchestrated, and highly effective campaign by state sponsored Russian hackers to influence popular opinion in the US. My primary concern is whether the foundation of our democratic process has been compromised.
Harking back to our communication last month, if you have not frozen your credit, please do so. We can send you instructions to put a freeze in place. This time of year, we are busy reviewing portfolios for the year end. We want to be tax prepared. If we have not spoken recently, or if you would like to arrange a review, please do not hesitate to reach out.
Bruce Hotaling, CFA
Managing Partner
Higher Highs
Stock prices, measured by the S&P 500, continued their upward march, gaining 1.93% for the month of July. Year to date, the S&P 500 has generated a total return of 11.6%. These returns are respectable, by most historical measures of stock market behavior. Certainly some investors may be tempted to “step off” the merry-go-round, end the year right here, and wait around until the game starts up again January 1st, 2018.
An old Wall Street adage is “the trend is your friend,” and the recent period has been about as friendly as one could hope. July marked the sixth of seven months this year when prices advanced, an unusually steady winning streak. Over the trailing twelve month period, stocks rose eight of twelve months (stocks typically rise 66% of the time) for a total return of 16.04%.
During the period just prior to the election, earnings (and stock prices to some extent) tracked sideways. There was a long stretch, from 2014 to 2016, when oil prices imploded and the S&P 500 aggregate earnings were stuck at $117 per share. There is no doubt, the election injected a wave of optimism. But unnoticed, and coincident with this wave of populist fantasticism was a true inflection in corporate earnings growth. Beginning with Q1 17, corporate earnings leapt by over 14%. According to FactSet Research, growth for 2Q 17 EPS is expected to be over 10%, and expectations are for $131 per share in 2017 and $145 per share in 2018.
So what’s the fuss? These are terrific numbers. Stock prices measured by the Dow Jones, the S&P 500 and the tech heavy Nasdaq have been hitting record high after record high. In my opinion, investors see the earnings, and they see the stock prices, but there is this nagging sensation something awful is just around the corner. According to sentiment data from the American Association of Individual Investors, bullish sentiment is at 36%, having spent 28 of the last 29 weeks below 38.5%, the historical average. Another old Wall Street adage is stock prices climb a “wall of worry,” and this is largely what we have going on today.
The spectrum of worry is vast. Clearly, one dark cloud shading popular sentiment for owning risky stocks is the torrent of noise coming from Washington DC. Even amidst a period of record earnings, investors cannot take their eyes off the clowns. The void of leadership has left several investment grade “brides” standing at the altar. Up to this point, nothing has been accomplished with respect to regulatory reforms, infrastructure spending or lower tax rates. The pro-growth agenda that was going to accelerate corporate America and pacify Joe-the-plumber is gasping. With no fiscal policy and the Federal Reserve looking to normalize monetary policy, growth hangs in the balance.
Beyond the US, the worries expand. Constant geopolitical tension has become the new normal, whether it’s related to security, trade or the environment. It was clear at the recent G20 meetings in Hamburg Germany that the leaders of the developed world do not view the US in the same light they once did, expressing concern that the US is no longer the reliable partner it was in the past.
Tangible evidence of diminished faith in the US is the constant downward pressure on the US dollar index. While this is a tailwind for US corporate earnings, it also indicates fewer investors want to own US dollars. This is happening in the face of Federal Reserve tightening, generally reflective of higher interest rates and growth, something that would normally attract foreign investors to buy US dollars and assets.
As Mad’s mascot Alfred E. Neuman would ask, “What, Me Worry?” Stock prices are higher. It is widely viewed that stocks are the only game in town. If sentiment ever does take hold, and more investors overweight their allocations to stocks, the table is set for troubled times. I continue to have confidence in corporate America’s ability to leverage improving global growth and a low US dollar, and look forward to seeing the expected earnings realized. I am also well aware we have to tread cautiously here, as a lot of folks have their eye on the exit door, and don’t want to be the last one out. I look forward to catching up with you if we have not been in touch recently. Please enjoy your August.
Bruce Hotaling, CFA
Managing Partner