Mixed Signals

2015 was a frustrating year for investors. Believe it or not, large cap stocks were one of the best performing asset classes. As measured by the S&P 500, stocks generated a total return of 1.38% for the year. I suspect most people, if asked, would assume their stock returns were negative for the year – it was that type of year. The stocks that performed well tended to be high growth and high valuation stocks (FANG – Facebook, Amazon.com, Netflix and Google). The stocks that performed poorly were a) energy, b) materials, and c) anything at all related to those two sectors.

For some historical context, the S&P 500 generated an average return of 11.41% from 1928-2015.   Over that 88 year span, there were 31 instances, or 35% of the time, when stocks returned more than 20%.   The other side of that coin were 6 instances, 7 percent of the time, when the S&P 500 generated returns less than -20%. This is the lure of the stock market. It delivers tantalizing returns, and then suddenly, it doesn’t. The message here is that in order to benefit from the stock market’s attractive average returns, investors have to put up with a good bit of volatility and the emotional stress that accompanies it.

In 2015, although stocks underperformed, they were not the ultimate cause of distress for most investors. In fact, technology stocks (QQQ +8.34%) and growth stocks (IVW + 3.76%) did relatively well. The difficulty was that virtually every other asset class came under selling pressure. Widely accepted approaches to portfolio management that rely on diversification and multiple asset classes all failed miserably.   Common asset class, including commodities, metals, emerging markets, currencies and foreign stocks were under water and there was simply nowhere for these investors to hide.

What led to the mediocre returns in 2015? Generally speaking, economic data underpinning markets and growth expectations was unimpressive. According to Bespoke Research, 2015 will go down as a year when their Economic Indicator Diffusion Index saw fewer positive readings than any other year since tracking began in 1999. Economic data, co-incident or trailing, is often a reassuring corroboration of the behavior in the market. In that case, the returns of stocks, and most other asset classes meshed well with soft economic output from around the globe.

The oil patch was the principle fly in the ointment. The drop in oil prices led energy companies to slash their earnings estimates, which in turn dragged down the estimates for the whole S&P 500. According to FactSet Research, energy stocks were the largest contributor to the earnings decline for the S&P 500. If the energy sector was excluded, estimated earnings growth for 4Q’15 would jump by 5.3%. This will begin to unwind in 2016.

The monetary policy tightening in the US and easing in the Eurozone and other parts of the world will not help matters as this strengthens the US $. China, attempting to transition its economy and navigate a “soft landing” has devalued its currency and rocked the many emerging market and commodity dependent countries that trade with it. These issues and the oil supply imbalance will not repair themselves anytime soon.

In my opinion, US stocks remain the most appealing option in terms of potential return. Currently the market is looking for directionality. Stocks recorded negative returns in 2Q and 3Q last year. That put the spotlight on 4Q, and prices jumped in 4Q and disarmed what could have been the beginnings of a bear market. I think REITs with attractive dividends will once again function as bond surrogates. And, while I do not think oil prices will change appreciably, I think the attractive distributions from midstream MLPs will catch the attention of yield hungry investors and prices will rebound in the coming year. Finally, I think investment grade corporate and municipal bonds will do the important though unglamorous heavy lifting they so often do.

I do not expect the coming year to be any more or less difficult than any other. We have our work cut out for us, looking to preserve your wealth in financial assets, while seeking every opportunity to make a profit. Please feel free to check in – we always look forward to hearing from you.

Bruce Hotaling, CFA, Managing Partner

US Banks – Why the Malaise?

US Banks – Why the malaise?

Bank BuildingBy Jean Rosenbaum, CFA and Portfolio Manager, Hotaling Investment Management, LLC 

Banks are a key component in the economic jig saw puzzle. They make up between 6-8% of the S&P 500 and roughly half of the financial sector of the index. Banks as a whole have modestly underperformed the S&P 500 for the last two years. The industry continues to struggle with the “pricing” environment. The low interest rate environment, coupled with ample liquidity, has led to ever lower rates banks can charge for loans and earn on their securities. While loans continue to grow, the revenue line for banks has been almost stagnant as the price they can charge continues to decline.

Banks have been able to grow earnings in this weak top line environment through an improvement in credit quality. Following the financial crisis, banks significantly increased their loan loss reserves. In the subsequent years, as defaults (or net charge offs) came in lower than initially anticipated, banks have been able to reduce their reserves providing a tailwind for earnings. Loan loss reserves are now approaching previous lows, so this improvement appears to be ending, or at least slowing.

The next driver of earnings for the industry may be operating expense control. Many banks have been experiencing cost growth ahead of revenue growth due in part to additional regulatory expenses. The banks have also been reluctant to limit their branch networks. However, with earnings drivers limited, it appears that some management teams have begun to take action. Going forward, physical infrastructure (a bank on every street corner) is likely to be replaced by more digital infrastructure at an accelerating pace.

Many bank management teams have been hoping for a Fed rate increase and a steeper yield curve, but the ability to wait may be coming to an end. The recently announced hiring and wage growth data was nothing short of robust. This may give the Federal Reserve the impetus to raise rates later this year, and potentially offer some relief to the banking sector.