S&P return year to date
Independence
It’s July 4th, 2017, 241 years from the day the Continental Congress adopted the Declaration of Independence, declaring the 13 American colonies to be independent from Great Britain. For me, I cannot believe both the bravery and the foresight of the men who crafted the Declaration, the Constitution and the Bill of Rights. So many things could have turned out differently, and yet, here we are, celebrating our independence.
This year, stock investors can also celebrate what has been an exceptional first half of the year. Returns to stocks, measured by the S&P 500, have produced a healthy total return of 9.34%. One prominent aspect of the stock market this year has been the tail-wind for growth stocks, as opposed to value stocks. This plays to our strength as we have been steadfast growth at a reasonable price investors for years.
Year to date, the technology sector has produced returns nearly double the next best sector, an impressive run. Prices wavered some in late June, but I expect their leadership to continue. The sharp end of the technology stick is referred to as FAANG (Facebook, Apple, Amazon, Netflix and Google/Alphabet) – and all have shown sensational returns this year. Other pockets of strength include financials, where the banks are benefitting from favorable capital requirements, spurred by the heads of the European and US Central banks. We have also seen attractive returns from healthcare stocks, likely indicating the market anticipates a more favorable business environment. Bringing up the rear is energy. In my lay opinion, there is simply too much oil out there, and demand looks suspect.
On the economic front, growth is ok, but not by much. Q1 2017 GDP came in at 1.2% annual growth, following a 2.1% reading for 4Q 2016. My tarot cards do not include an inflation card. It’s the equivalent of a child’s monster under the bed – scary but not there. The Federal Reserve is staying with its script, raising rates and unwinding its balance sheet (tightening). There are plusses and minuses that do not add up. Energy prices are low, pleasing at the pump but bad for igniting capital spending. The dollar is low. This may boost exports, but conversely may raise prices on imported goods. I am not convinced we will see strong enough economic data to support a steepening in the yield curve.
The market has shown a high degree of complacency since the election. This will change, eventually. There is the idea that great athletes have a high tolerance for physical discomfort. I’m curious if that is a common characteristic for great investors too. Can they remain even handed in a highly discomforting environment? And for how long? An observation of our current society is how uncomfortable with discomfort people are. When something unpleasant arises, there is often a need to immediately re-direct, to take some medication, or do something to put the discomfort to rest.
Until the complacency lifts, we have a reasonable backdrop: the economy is standing on its own two feet and earnings growth is in the low double digits. This “just so” scenario is allowing stock prices to rise. The market seems to have given up any expectation of anything constructive from Washington DC. In fact, the opposite may be true at this point. If Washington DC does in fact do something, other than tweet, it may serve to disrupt what has become an acceptable status quo. There is a watch what you wish for aspect to our current situation.
Looking ahead, my expectation is for the stock market to mark time, and then show some strength later in the year and into 2018. I am optimistic on the earnings front and believe this will support stock valuations. I do not think we will see a substantive rise in interest rates, and therefore, I am neutral on tax free and corporate bond markets. I think they are relatively safe, and returns will be mediocre. Obviously, if any of these factors change, my opinion as to how best to invest will change and I will relay that to you. In the meantime, please have a peaceful Fourth of July and if you think of it, take a moment to pause and reflect on the amazing movement that began here in Philadelphia, all those years ago.
Bruce Hotaling, CFA
Managing Partner
Bear Trap
Stock prices, measured by the S&P 500, generated a meager 0.1% total return for the month of March. After January and February, when prices were clearly punching above their weight, things began to taper off. The change seems largely due to the relentless circus underway in Washington DC. At its height, optimistic and often fallacious tweets stoked investors. Recently, reports of corruption and self-dealing have thrown a wet blanket on the party. Normally, with the total return to stocks up 6.07% for the first quarter of the year, folks would be heading for the car dealership. Instead, bullish investor sentiment has dipped to the lowest level since the election.
Year to date, results have been driven by strong results from the technology sector (+12.4%). Consumer discretionary (+8.2%) also outperformed, but only when the extraordinary performance of Amazon is factored in. According to Bespoke Investment Group, Amazon was responsible for one-third of the sector’s gain in Q1. This is astonishing considering 6 of the 10 worst performing stocks in the S&P are from this sector, most of which are retail stores you know. On the losing side of the equation, energy was -7.2%. This was a surprise, as crude and especially natural gas prices struggled throughout the quarter. In 2016, the energy sector returned 42.6%. If there is a silver lining here, it’s the sky-high incidence of M&A in the energy sector. According to Deallogic.com, corporate transactions in the oil and gas space totaled $96.7bn through March, the highest level ever.
From a fundamental perspective, not a lot has changed since last month’s letter. Expected aggregate 2017 earnings for the S&P 500 now stand at $131, and the index is in the 2,350 range. More importantly, estimates for 2018 are in the mid $140’s, according to data compiled by FactSet Research. These numbers do not include any upside that might result from either fiscal stimulus or tax cuts. Until the 2018 estimates become more viable, and unless stimulus comes to pass, the market as a whole is fairly priced. The complacency that initially lulled investors as stocks began their end of year lift off remains firmly in place. I recommend buying and owning only a select portfolio of stocks, as opposed to buying the market.
The macro backdrop is murky, only because more can go wrong than right. Stocks are clearly the best house on the block and near term, I expect earnings to hold up. Inflation is modest, and that’s important for stocks since high inflation typically suppresses the market’s P/E ratio. Keep in mind, the Federal Reserve did raise the Fed Funds Rate for the second time in four months. Bonds and bond proxies have been under the thumb of a threatened steepening yield curve. A drag is the continuing high value of the US$. And, labor markets are at full-employment. It’s difficult for any government to effectively stimulate a full-employment economy, with a limited (or likely shrinking) labor supply and the intention to replace technology (productivity) with good old fashion labor.
The threats to a favorable outcome are many, and highlighted by the illogical talk of reviving the coal industry. The whole idea that this industry is relevant or will produce meaningful jobs is misguided. Coal is a dirty resource in an irreversible state of structural decline. According to Morgan Stanley Research, coal production from 2014 – 2018 is expected to be down 67% in Central Appalachia and 19% in Northern Appalachia. Natural gas is the leading source of power generation in the US, and it is transported via pipeline, just imagine that.
I think we need to proceed with caution here. In Wall Street parlance, a bear trap is a head-fake, an indicator that the bull market has or is about to reverse course. It induces investors to sell, while the market continues its upward trend. This has sadly been the case for many investors unable to stomach the swamp 2.0. We’ve become conditioned, with the trauma of 9/11 and the financial crisis clear in our memories. Fear can often be an unmanageable emotion, and lead to regrettable decisions. My suggestion, for now, is to wait until the market begins to show us it wants to change course, rather than making premature guesses. Please feel free to call me if you would like to review your asset allocation and the best path for you going forward.
Bruce Hotaling, CFA
Managing Partner
Spilled Milk
Stock prices have been on the move. Many investors firmly believed that if the election went the wrong way, stock prices were destined to tumble. Since that infamous day back in November, to the utter exasperation of those same investors, stock prices (measured by the S&P 500) are up a total return of 11.22%. Year to date, the total return to stocks is 5.94% with February contributing an impressive 3.97%.
The upward move has in fact coincided with a flourish of positive economic data. According to Empirical Research, much of the recent strength in stock prices can be attributed to improving economic fundamentals, as evidenced by the recent spike in the PMI index. The PMI is a widely accepted indicator of current business conditions in the manufacturing sector. In support of the manufacturing data, the employment data is equally strong. According to Bespoke Research, jobless claims have fallen to their lowest level since 1973.
Although the run in stock prices has coincided with strong economic data, there is more. Stock prices have also benefitted from a newfound optimism over proposed tax cuts, deregulation and an infrastructure build-out. Expectations have run amok. To date, there is nothing that has happened on the fiscal policy front to support the heightened fervor pushing stock prices higher. There is a notable void of detail and a surfeit of spin. The timing and ultimate impact of any proposals is either unknown or carries the greater risk of disappointing the markets with a failure to deliver. True policy is needed to implement any changes and with the degree to which the messages are mixed, one wonders whether there is an intractable void in competence.
Against this disconcerting backdrop, there is some basis for sitting tight. According to FactSet, earnings estimates look to have stabilized at $130 per share for 2017. Earnings are perpetually subject to revision by Wall Street analysts, and almost always downward, as initial optimism fades. For 2018, consensus estimates for the S&P 500 are now a lofty $145 per share, an 11.5% increase over 2017. This would be the biggest bump in earnings since the 15% leap from 2010 to 2011. One comment that has attracted some attention is the speculation that these earnings can be obtained without the benefit of any of the planned stimulus.
Stock prices may well manage to trend for some time, if only due to the fly-wheel effect. By many measures, stocks are overbought and sadly the alternatives are either overpriced, or don’t offer any substantive return. Investors are caught between a rock and a hard place. According to Bespoke Research, the advance decline line has tipped downward, meaning fewer stocks are behaving well, even though the market continues to rise. This is not a great sign for the bulls.
The present risks include the fact that the Federal Reserve has said it will be raising interest rates. This has historically made it difficult for both stocks and bonds (don’t’ fight the Fed). In addition, there is the pervasive tail-risk, the risk of an extra-ordinary event or tweet that leads to an avalanche of unintended consequences. Finally, the failure to implement on the promised policy agenda, and ongoing political contagion, will begin to disappoint investors.
In my opinion, it’s no time to be a hanger-on. I think we can take some profits in stocks that have gotten ahead of themselves. Technology, healthcare and financial stocks all come to mind. On the other hand, some stocks in the energy and real estate space have been bringing up the rear and look as though we can add to positions. The level of complacency among market participants has been high, and as once reluctant investors are pulled in, the risk increases. This sets the table for some challenging times when some selling inevitably begins.
Overall, my expectations run similar to last month: guarded and without window dressing. For the remainder of the year, I expect average returns from stocks and below average returns from bonds. My worry is a good portion of these average returns have already arrived, and the rest will be delivered on the back of greater than average volatility and unrest in the financial markets.
Bruce Hotaling, CFA
Managing Partner
Suspension of Disbelief
Looking back at 2016, US stock investors earned an 11.9% return, as measured by the S&P 500. That figure puts last year’s returns somewhere close to the historic average. Yet last year was no average year. Through the end of October 2016, stock prices had managed a return of only 5.8%. At that point, expectations were low – prices had been flat to down since the end of July, the only month to deliver any true incremental returns. Skepticism was running high and investors were holding higher than normal levels of cash, just in case. On election day, the unthinkable happened. Markets collapsed in panic, then normalized, and then managed to rally (returns jumped nearly 2x) into the year end. I don’t think anyone could have made this up.
The first question that comes to mind is, how did we get here? There is a clear movement around the globe from old school civic patriotism toward a more base nationalism. This was clearly evident in the June 23 Brexit vote. Similar rumblings have been taking place in Italy, Austria, France and Turkey to name a few. The primary drivers are economic disenfranchisement among white men, a growing sense of nationalism / xenophobia, and long simmering suspicion of political elitism at the top. Now the US has picked up the baton and is off and running.
The second question is, where do we go from here? Sadly, this is something akin to a leap of faith. My concern is that we experience spaghetti-throw leadership. My hope is the way forward involves thoughtful policy, with balanced leadership, clarity and purpose. At the moment, I’m shocked by the shaming of corporate leaders on Twitter. In my opinion, this form of demagoguery is antithetical to the spirit of US capitalist democracy.
The headwinds are there, but difficult to evaluate. An overly strong dollar and trade disputes will temper US corporate earnings and generally weigh down global growth. A border tax – would raise prices on most goods – and likely be damaging to a lot of the US technology industry. On the cup half full side, the ability of US firms to repatriate large sums of cash held outside the US is favorable. Lower corporate tax rates would in theory be additive to EPS, unless lowering the deductibility of interest on corporate debt acts as an offset. And, deregulating industry, the financial and energy complex, will likely be a tailwind, though important questions as to how, and when, may not be known for some time.
Talk is of expected higher economic growth. This is likely braggadocio. The fact is, productivity may well be crimped if the technology industry in the US comes under fire. Technology is one of our most important, and global industries. Labor, another primary factor of economic growth, may also stall, considering the full-employment economy, and a professed resistance to immigration. Some analysts have raised the possibility of a recession in 2018. In my opinion, it’s overly optimistic to assume a dramatic breakout in growth in the US.
I think the return/risk assessment favors stocks, but only with the premise they be held for a longer period of time. The near term risk of owning stocks is higher than has been the case in a long time. Overall, stock prices are full. Consensus EPS estimates for 2017 are in the $133 per share range. At a 17 multiple, that prices the S&P 500 at roughly 2,260, or approximately its current level. The market is ahead of itself, having pulled forward returns from 2017 into the tail end of 2016.
Sectors holding some interest are energy, financials and industrials. I assume oil prices remain in a range, and the energy sector continues its recovery. Financial stocks will see margin improvement with a normalized yield curve. Industrial stocks will generally benefit from stable energy prices, a focus on infrastructure and technological innovation. I am more inclined to own domestic stocks with a leaning toward value and smaller market capitalization. Our focus will remain on quality investments with strong fundamentals.
As 2017 unfolds, certain aspects of policy may develop clarity and hopefully become investible. Until that time, I believe a cautious stance is the most prudent. Please feel free to call so we can exchange thoughts and review the best course going forward.
Bruce Hotaling, CFA
Managing Partner
Take a Deep Breath
Halloween came and went this year, and not a single clown came by the house. I have to say, I felt a degree of relief. Something new this year, creepy clowns, have been in the news and haunting us in ways most of us have never imagined. There is a cloak of fear now associated with clowns. I think many of us have been holding our breath in response to the vastly irrational circus we’ve been watching. I suspect and hope there is a collective sigh of relief November 9th when this very odd chapter in our history is in the rear view mirror.
Stock prices, measured by the S&P 500, fell 1.9% in October, the largest monthly drop we’ve seen since the 5.07% plunge in January. October’s lull follows -.12% returns in both August and September. Bespoke Investments pointed out that the three month drop, which tallied less than 2%, was quite unusual and in fact, such a modest three month fade has only happened three other times dating back to 1951. Year to date, stock prices are in the black, having returned a surprising 5.87%, as investors have largely looked through the upcoming election.
On the economic front, GDP figures for 3Q 2016 came in at 2.9%, driven largely by consumer spending and exports. We haven’t seen a GDP number that high since 3Q 2014. Good news is that economic growth in this range is expected to continue through the fourth quarter and into next year. The jobs creation figures have been encouraging for some time, and we’ve recently seen a meaningful pick-up in wage growth. The oil patch continues to stabilize after a near 2-year swoon, and the rebound in prices, contrary to common thinking, is encouraging renewed investment (infrastructure, transportation) in energy related businesses. These factors, in my opinion, will likely allow the Federal Reserve to raise the Fed Funds benchmark next month.
Last year, on December 16, 2015, the Federal Reserve raised rates by 0.25%, for the first time in over 10 years. Stock prices immediately proceeded to correct. From that day until the market’s low on February 11, 2016 stock prices fell 11.5%, echoing the old mantra “don’t fight the Fed.” Some believe when the Fed is raising rates, tightening monetary policy, it indicates a top to the cycle, and is a bad omen for stocks. Whether this thinking played a part in the market drop, or not, we will never know. While I do not agree, be aware there are a lot of people who think this way, and there is a good chance the Fed will raise rates again, for the second time in over 11 years, on December 14, 2016.
According to FactSet Research, impressive earnings reports this quarter have at long last moved the dial. As recently as September 30, Q3 earnings were expected to fall 2.2%. Now, as of October 28, the earnings growth rate for the S&P 500 is a positive 1.6%. That is an important swing and one I have been counting on. After the relentless drag on corporate earnings due to the oil price implosion and the high US$, this quarter may well mark the first year over year earnings growth we’ve seen since the 1Q 2015. The financial stocks have been the largest contributor to the bump in earnings. Assuming the energy sector continues to normalize, we should expect a dramatic lift to the earnings for the S&P 500 in 2017.
I think it’s prudent to reduce asset allocations to fixed income at this point. The credit concerns in the corporate and municipal space that shook the world in 2008 are healed. Today, the primary issue is interest rate risk. Rates appear to have inflected, and individual bonds and bond mutual funds are vulnerable to price degradation. Interest rate surrogates such as REIT’s and MLP’s have also come under some selling pressure as investors consider a shift in the yield curve, but I have confidence that a favorable economic backdrop and their ability to increase their distribution levels will offset worries over higher rates.
Please feel free to check in if you have concerns related to the pending election. Fears of a Brexit-like outcome have compelled some investors to raise cash, and this is likely the source of current pressure on the market. My expectation is that the fundamentally sound backdrop in place today will allow quality growth stocks to continue to work for us. Take a deep breath.
Bruce Hotaling, CFA, Managing Partner