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What A Difference

A year ago, most investment markets were experiencing freefall.  The Federal Reserve, intent on normalizing interest rates, had raised the Fed Funds rate eight times since 2016.  By late 2018, markets in general were beginning to exhibit their collective displeasure.  The Fed then announced it would ease up on its tightening program, and stock prices have been rising ever since.  Stocks, measured by the S&P 500, rose 2.17% in October 2019 and are making new highs.  They are now up 23.16% year to date after a dismal -4.75% in 2018.

The stock market has been deftly climbing a wall of worry.  This somewhat dated reference alludes to the ability of stock prices to continue to rise in the face of factors or issues that one generally would consider a deterrent to that growth.  This backdrop makes it extremely difficult to put fresh money to work – there never seems to be a clear green light.  Many investors have experienced this hesitation since November 2016.  The worry is in fact the market’s risk premium: the risk of loss investors must embrace in order to receive equity-like returns.

One month ago, many investors and market pundits were expecting corporate earnings to continue on their recessionary track.  The trade war was wreaking havoc in multiple ways on US business overseas, supply chains and access to markets; and global economic growth was stalling in China, Europe and the US.  There was also the inverted yield curve, a tell-all indicator that the US economy was on the brink of a recession.  There was not much to look forward to.

Today, it seems all that has changed.  Whether true or not, the administration via popular media outlets is feeding the public optimistic soundbites regarding the eventual resolution of the trade war.  The “seasonal effect” which tends to see stock prices perform well during this period of the year may be influencing investor thinking.  The global economic backdrop suddenly appears brighter too, based on more recent economic data points. 

In my opinion, more central than the above is the fact that 3Q earnings were more or less on target.  This was immensely reassuring to investors.  Over 70% of companies reporting earnings have done better than expected, a stark reversal from 2Q where the earnings beat rate was the lowest in over a decade.  Investors were poised for disappointing earnings, and surprised with the outcome.

Two factors have produced a nice bump in stock prices:  the PE ratio has increased about 20%, largely due to falling interest rates and earnings for 2020 are anticipated to increase in the high single digits above their expected 2019 level.  The key now is whether forward earnings forecasts can hold up as we move into 2020. 

In my opinion, US stocks remain the best game in town.  We can more accurately assess the intrinsic value of US companies based on reliable and transparent data.  So even at somewhat elevated levels, the expected return from US stocks still remains more attractive than other asset classes, bonds in particular.  While we consider the valuation of the market as a whole, we do not buy the market – we focus on specific investment opportunities inherent in individual names, their unique merits in relation to their peer companies, growth rates, strength of their management, and other factors.

Lastly, I have some news to report on changes here at Hotaling.  First, we have added another advisor, Gretchen Regan.  I’ve known Gretchen for some time.  She is a talented analyst and immediately adds value to our work for you on a number of fronts.  You can read about her at www.hotalingllc.com.  Second, after years of working together, Valerie has decided to move on to the next big thing and retire.  She intends to spend important time with her family.  We will all miss her here, as I’m sure you will too.  In our attempt to fill that void, we have brought Jennie Wilber on board.  Jennie is young and energetic and will do everything Valerie had done for you, and then some.  I’m sure you will have the opportunity to meet her, at least over the phone, before year end.  We have been doing a lot of outreach to make sure you are informed, but please do not hesitate to call if we have not been in touch recently.  

 

Bruce Hotaling, CFA

Managing Partner

Hurricane Dorian

For days now Floridians have been in a state of suspension – the massive hurricane Dorian sitting just off the coast. It ravaged the Bahamas and is now making its way slowly northward. Much as they try, meteorologists (and presidents) cannot truly predict the direction or the intensity of a hurricane. So, Floridians are more or less forced to brace themselves, and then wait it out.

In many ways, this tension is precisely what investors in the equity markets have been facing. For the trailing 12 month period, stocks have generated a total return of 2.92%. This was hard-earned, as during that period of time, stocks fell during 4 months, and in each case, by an average 6%. Year to date, stocks have rebounded off their 2018 year-end low for a total return of 18.34%, as measured by the S&P 500. In stormy August, stock prices fell 1.81% and were down on 10 of 22 trading days. The worst damage was from three days in particular, when prices fell nearly 3%, and those happen to be the three worst trading days of the year so far.

There are a lot of things investors in stocks and bonds are fixating on. High on the list is the trade war the administration boldly initiated, and the resultant economic fallout around the globe. Economic fundamentals are beginning to erode and it’s not clear how some aspects of the global economic mosaic will repair itself. For instance, distribution channels have been shut, supply chains cut and re-routed, hours worked in manufacturing are on the decline and corporate (S&P 500) revenue growth has fallen from 8% a year ago to 2%. Corporate leaders are less likely to make capital commitments related to trade as long as Washington is unreliable.

While Washington has taken to brow beating the Federal Reserve Bank in an attempt to influence policy, it is not clear monetary policy functions as it once did. We are late in the economic cycle and rates have been low for a long time. The 10-year US Treasury note, which anchors many aspects of the borrowing markets (student loans, mortgage loans) is now at roughly 1.45%. It is nearing the record 1.36%, the lowest level ever, set in July of 2016. The Federal Reserve Bank and the European Central Bank are both expected to lower their respective benchmark rates later this month by 0.25% and 0.10% respectively. Neither of these amounts are significant, economically, apart from the symbolic messaging. People, and companies, are unlikely to change their behavior due to a 0.10% drop in rates.

Fallout from the protracted low interest rates is evident in the banking system. This is most apparent in Europe, where many banks have arguably never recovered from the financial crisis in ’08, and the sovereign debt crisis that followed in ’10. In the US, commercial banks have recovered, but they still cannot overcome the business challenges of perpetual low interest rates which pinch profit margins, and sow doubt in borrowers minds that rates may go lower. There is the fear rates are under pressure only to stave off recession. For monetary policy to work, bank lending is key, and people have to have a degree of confidence to borrow.

Based on our work, I continue to focus on select stocks that screen well for their growth characteristics, constraints on capital spending and strong levels of free cash flow. We are watching, though have not begun to own more defensive or value oriented stocks. As we’ve discussed, (the market) the S&P 500, is selling for 17x forward earnings ($178 per share). In general terms, for stock prices to move higher, either the multiple, or earnings, must rise. At the moment, the factor allowing the multiple to rise has been falling interest rates. Corporate earnings estimates have been declining, since Q1 19, as analysts have been revising their forward estimates down. Select stock picking, and judicious timing is the way forward.

The big question today is, how does this curious backdrop begin to disentangle itself? With no clear path forward, we have to continuously monitor the underlying activity in the markets and stock specific fundamentals for signs of real change. When we have some greater degree of clarity we will act accordingly. In the meantime, please feel free to check in if we have not spoken. I hope you are enjoying both the start of the new school year and the onset of fall and the cooler weather it will bring.

Bruce Hotaling, CFA
Managing Partner

August

According to meteorologists, July was the hottest month, ever. It was a relatively “hot” month on Wall Street too, as stock prices rose once again, gaining 1.3% for the month (as measured by the S&P 500). Year to date, the total return from stocks now totals a remarkable 20.2%. Thus far in 2019, stocks have only had one down month. That was May, when prices fell 6.6%. Otherwise, it’s been a rewarding time to own stocks and most investors, while somewhat guarded, are pleased with this.

The return to stocks looks less remarkable when viewed over a rolling 12 month period. Stocks delivered a 7.9% return for the trailing 12 month period. This is not a bad return, but nothing remarkable, and less than the historical return for large cap stocks. Last fall, stock prices fell 6.9% in October and an alarming 9.2% in December. The market was a whisker away from a full 20% decline, typically the benchmark for a bear market. In January of this year, when the Federal Reserve indicated it would stop raising interest rates, stocks immediately rose and erased all of the losses from the second half of last year.. 

We are now just coming to the end of 2Q 2019 earnings season. According to FactSet Research, as of July 31, 76% of companies reporting had beaten earnings and 73% had beaten revenue. The reports were a good bit better than expected. In general, margin contraction was offset by higher revenue growth. In the end, the change agent was fewer shares outstanding due to stock buybacks. Analyst forecasts of earnings estimates for 4Q19 and for 2020 have been drifting lower. This is due to deteriorating economic conditions in the US and around the globe, and is being exacerbated by tariffs.

Since the start of the year, stock prices have been on the rise. This is not due to improved fundamentals or an increase in earnings estimates. It is simply due to an increase in the P/E ratio (the multiple the market applies to earnings) which has risen from 16x to over 19X today. The increase in the multiple is the result of the steadily falling interest rate expectations. The multiple is not likely to continue to expand. In my opinion, stocks are fully valued, based on what we can discern at the moment.

Unfortunately, at this juncture, bonds are expensive too. As measured by the iShares Core US Aggregate (AGG), bonds have returned over 6% year to date, more than double the 2.5% per year the 2.5% the AGG has averaged over the last five calendar years. Bonds are important. They provide reliable, albeit modest income. They can also provide some protection from volatility in a portfolio holding stocks. We refer to this as ballast. In a perfect scenario, stocks and bonds in a portfolio together behave in a non-correlating manner. This is more often the case when utilizing municipal or corporate bonds, as opposed to bond mutual funds.

The recent collapse in yields is a significant tell that the economy is stalling. Anxiety over the trade debacle, and hopes of monetary policy penicillin (ever lower interest rates) has become a volatility cloud over investors’ sentiment toward stocks. If the economy goes into a stall, or if we even suffer several quarters of flat or declining earnings, it will be a challenge for stock prices. The ability of central banks around the world to repair the damage from a metastasizing trade war is limited, at best.

Just the same, stocks remain the best game in town, especially when we consider a holding period greater than 12-18 months. I prefer US stocks due to 1) a high degree of transparency and communication with respect to assessing how businesses are faring, 2) our access to research and quality information from an accounting and reporting perspective and 3) a data base that enables us to sort and screen stocks quickly and effectively. One of the components of success in the complex world of investment management is keeping watch for changes on the margin.

It seems obvious that figuratively and literally, temperatures are rising. I hope August is cooler than July, but my confidence is guarded. We remain on alert to raise cash and take a more cautious position, as soon as we see the beginning of a trend. Heightened volatility can mask or mark the onset of a trend. Please feel free to check in if we have not spoken recently.

Bruce Hotaling, CFA
Managing Partner

Wait For It

Stock prices, measured by the S&P 500, rose an impressive 3.93% in April, boosting the total return to stocks to 18.25% year to date.  These returns are among the best ever for the first four months of the year.  The month was notable in that prices rose in all but five of the 21 trading days, a 76% batting average.  Also notable is the low volatility, or daily price movement.  With the exception of April 1st, when prices rose 1.16%, the average daily price change (up or down) was only .25%.  This compares to December 2018, when the market was in free-fall.  The average daily price change was 1.38%.

Stock prices are behaving as though they are intent on setting a new high water mark.  The last time the S&P 500 hit an all-time high, September 20, 2018, it closed at 2,930.75.  At that point, prices were comfortably up 13.07% for the year.   Few investors would ever have guessed their returns would be negative by year-end.  Between September 20 and December 24, stock prices fell 19.36%.  One of the most universally unwelcomed Christmas presents ever – a bear market. 

A strong start to the year for stock prices cannot necessarily be extrapolated forward.   As we saw last year, the strong behavior of stocks can turn on a dime.  In the past, there have been years such as 1995, when stocks did continue higher after a strong start to the year.  Then, other years with strong starts, such as 1930, infamously saw the complete implosion of stock prices by year end.   More often than not, after a big start, the market tends to saw-tooth for the remainder of the year, challenging investor’s resolve against giving back precious gains with each subsequent downswing.

In an effort to gauge where things stand, investors often try and establish a point of reference based on the duration of the economic cycle.  The current expansion has been in place since early 2009.  The average expansion over the last 70 years has been roughly 5 years.  By these simple terms we ought to prepare for a contraction in the fundamentals and stock prices.  Some have pointed to the more services oriented nature of the economy, and the general low intensity of the expansion.  Questions revolve around the degree of pent up demand, the fact wages have been suppressed, and changes in the structure of the labor force.  The recovery has been going on since 2009, but not all segments of the economy have responded equally.

Currently, the fundamentals are mixed.  Economic growth is challenged.  The tax cut was a one-time thing and will not spur any further corporate spending.  1Q earnings reports have been alright, but only in relation to reduced estimates.  Revenues have underwhelmed.  It’s harder to mask underlying issues with revenues, than with earnings.  The US posture toward China, and other trading partners, will not likely be resolved anytime soon.  The risk here is for unintended consequences.  Finally, and likely a positive consideration, the Federal Reserve is seemingly on hold for a number of months.

We are seeing some positive signals.  While we find stocks with secular growth trends attractive, we are also paying more attention to defensive businesses.  Utilities and staples have been two of the best performing sectors over the last 6 months.  We are also seeing the beginnings of recovery in housing related stocks likely due to the lower interest rates and in spite of the SALT limitations, and some interesting support from semiconductors.

In conclusion, we do not want to give away our shot.  Stocks are fully priced and we are in the midst of a global stock price rally.  We are jointly committed to our secular growth stocks, and looking at select opportunities to take profits and put some $ onto the sidelines.  We are also beginning to see the first signs of value stocks attracting interest.  In many ways this is a signal long investors are beginning to lose their conviction.  If this continues, we will address some of our holdings appropriately.

In the immediate term, we look forward to speaking to you about keeping equity exposures in check.  Complacency is high and with this backdrop, things will be ok until all of a sudden they are not.  We don’t want to be looking at one another wondering “what did we miss.”  Please feel free to call if we have not spoken recently.

 

Bruce Hotaling, CFA

Managing Partner

 

Charlotte’s Web

Terrific is the only way one can describe the performance of the stock market through the first quarter of 2019. Prices rose for the third consecutive month, adding on 1.79% in March. Year-to-date, the total return to stocks, measured by the S&P 500, is 13.65%. The remarkable surge in prices nearly perfectly matches (reverses) the utter devastation stock prices faced in 4Q18 when prices fell a cumulative 13.52%. In 4Q18, stock prices fell more than 1% on 16 occasions, while in 1Q19 prices fell more than 1% only three times. This was some change.

From my perspective, I am somewhat surprised by the sudden rebound, and also suspicious that eventually some less-good news is going to let the air out of the market. As much fear as there was in investor’s eyes last December, there is a renewed sense of urgency to own stocks again. Wall Street clearly favors Washington’s policy agenda. Possibly the single largest change agent was the more dovish stance by the Federal Reserve.
The headwinds I’ve discussed in prior letters remain firmly in place. In addition, the yield curve has inverted, with short term interest rates now higher than long. This has historically been a caution sign and is highly correlated with recessions and often challenging stock markets. We’re faced with a chicken and the egg scenario. Does an inverted yield curve signal a recession? Or, does the early phase of an economic slowdown cause the yield curve to invert? This is the first time the yield curve has inverted since 2007.

The short-term economic boost from the 2017 Tax Cuts and Jobs Act has petered out. What we are left with is a $1.5B increase to the federal deficit. Contrary to the plan, there is no economic growth to spur deficit reducing tax revenue. Normally, the intention during good times is to use the excess wealth to deleverage or repay borrowings taken on during the tough times. The increases to the federal deficit are not sustainable and will ultimately have to be corrected. The self-imposed trade war is hurting domestic profits, according to recent earnings calls.

1Q19 earnings season is just about to be begin. According to FactSet Research, earnings estimates for the S&P 500 are expected to decline 3.9% for the first quarter 2019, which would be the first year over year decline in earnings since 2Q 2016. Stocks, at the moment, seem to be looking through these numbers. In fact, it’s not uncommon for the value of the index to increase while the S&P 500 earnings estimates are decreasing.
If companies miss earnings or are forced to reduce guidance, their response will be a key indicator for us. Companies that miss earnings estimates could respond by cutting spending on capital improvements and labor, further strangling economic growth and possibly igniting a stock-market selloff. Earnings misses tend to force companies to rethink their priorities.

Amidst this challenging backdrop, investors are radiant. Prices are rising like its 1999, again. That was a long time ago, but one of the most remarkable periods in stock market history. While 1999 receives all the popular acclaim, (stocks were up 19.5% in 1999), in the four preceding years, prices rose 26.6%, 31%, 20.2% and 34%. While we are clearly in the business of pursuing investment gains, I think a more humble posture is appropriate. Let’s hope we do not repeat the fear of missing out syndrome that owned Wall Street in the late ‘90s.

My take on the way forward is to buy (and sell) stocks selectively. Stocks overall are not that cheap, but individually, some are attractively priced, and others have high growth rates that are unrecognized. Patience in putting funds into the market is key. As the market saw-tooths, we want to buy the dips. We are also watching closely the emergence of new companies, new business models, that may prove to be the next transformative move in the market’s life-cycle. I’m confident that our keen eye and years of active investment experience will allow us to work through this odd hodgepodge of factors.

Please do not hesitate to give us a call if we have not spoken recently. We are happy to work closely with you to asset allocate your portfolio and answer any questions you may have as to the best way forward. All the best, and enjoy the emerging spring time.

Bruce Hotaling, CFA
Managing Partner

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