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Happy New Year

                In 2019, U.S. based large cap stocks, as measured by the S&P 500, produced a generous total return of 31.49%.  Over the last 30 years, the S&P 500 has returned more than 30% only five times or 17% of the time.  The average annual return for stocks in the last decade, beginning January 1, 2010 was a heady 14.1%, the only down year being 2018.  The average for the prior decade, beginning January 1, 2000 was only 1.2%, with four down years and staggering price drops in 2002 and 2008. 

                Last year at this time, stocks had just taken a precipitous year-end nose-dive to end the year down 4.4%.  Stocks were oversold and the PE multiple was relatively low; the Federal Reserve had raised interest rates the fourth and final time December 20th.  A lot of investors were disheartened by the rate hikes and on their heels when the market sentiment turned in early 2019, causing them to miss some of the upturn. 

                Today, the market is regularly making new highs.  The Federal Reserve opted to reverse its 2018 rate hikes with three cuts in 2019.  This drove animal spirits that were wrestling with negative fallout from the trade war and slowing growth around the globe.  One argument is that the Federal Reserve, bullied or not, became the only adult in the room.

                Now, at 18.2x expected 2020 earnings, stocks are more expensive than a year ago.  According to JP Morgan, the 25-year average is 16.3x.  Just how pricy the market is, of course, is contingent on multiple factors – during those 25 years, stocks have sold for over 24x, and below 10x.  FactSet currently estimates $178 per share in earnings for 2020, a nice 9% bump from the $162 companies in the S&P 500 managed for 2019.

                My biggest concern for the coming year is a protracted deterioration in our economic relations with China.  The U.S.’s self-declared war on trade is now two years old and the loser in the trade war has been the American consumer, forking over billions of dollars in tariffs to no effect.    Trade wars are clearly not good or easy.  The economy and the stock market will both be better off once there is resolution.  In my opinion, the U.S. has been busy wasting time and money in the Middle East, while China has been investing, and building diplomatic and economic relationships around the world.  Bullying the Chinese will not help the American economy.

                Earnings will prove key to stock prices this year.  This may seem obvious, but last year earnings were flat, while stock prices skyrocketed.  This jump was due entirely to PE multiple expansion, which in turn was driven by the reduction in interest rates.  The Federal Reserve cut rates three times in 2019, and that is unlikely to happen again in 2020.   So, if stock prices are to rise this year, it will hinge on improved corporate profit margins and earnings per share.

                Our energy is directed at selecting quality U.S. stocks and bonds where we have reliable information.  We make active bets on companies we believe from a fundamental and a quantitative perspective are positioned for price appreciation.  Stocks and bonds, our asset classes of choice, are reliably non-correlating, counter-balancing each other’s volatility.  We manage our bets, and the overall exposure to risk, in each portfolio. This is in distinct contrasts to the use of multiple asset classes, deployed via mutual funds and ETFs, as is the common practice among many investors.

                For 2020, I expect the markets will likely behave a lot like they did in 2019, until November.  Then, we shall see.  In the meantime, we will continue with our emphasis on growth stocks.  This tilt has enabled strong performances from our primary equity models over the last several years.  If it begins to look as though the expected 9% bump in earnings is not going to come to fruition, we will re-assess and modify our approach.  Until then, stocks (even slightly more expensive stocks) remain the best bet.  We look forward to getting together with you in the New Year.

 

Bruce Hotaling, CFA

Managing Partner

The Deal

One of the more newsworthy things about November was the surge in Wall Street transactions.  Approximately $70bn in deals were announced, including Charles Schwab & Co.’s purchase of TD Ameritrade, LVMH’s agreement to buy Tiffany & Co. and Novartis’ acquisition of The Medicines Company.  In the spirit of the moment, Xerox made an attempt to buy the much larger HP Inc. (the old Hewlett-Packard), but was swatted away by the board.   

This flurry of deals came on the heels of what had already been a busy year, particularly among some of Wall Street’s financial titans.  For example, JP Morgan Chase bought InstaMed Inc., BB&T purchased SunTrust Banks and both Morgan Stanley and Goldman Sachs got in on a wave of corporate deal making.  It’s not perfectly clear what is driving the move toward more deals.  We can speculate it represents the last gasps of the bull-run in stocks, or possibly more worrisome, the current administration’s lax oversight and dismissive view toward financial regulation. 

You may remember that some misaligned interests, both in Congress and in the savings and loan sector, led to aggressive deregulation of the S&Ls in 1982.  Within a few years, this led to a collapse of over 1000 banks, and a tax payer bailout in excess of $130bn.  It was a disaster second only to the thousands of banks that closed in the Great Depression.  While a lot of people bristle at the Dodd-Frank Act implemented in the shadow of the 2008 housing crisis and the Great Recession, we may be entering the next chapter of low/no regulation.

The surge in deals may also be a product of the low interest rate backdrop.  It’s inexpensive to borrow money today.  The Federal Reserve’s decision to lower the Fed Funds rate three times (for a total of 0.75%) this year, after it raised rates four times in 2018, may have sparked a borrowing spree.  After rate cuts in July, September and October, animal spirits are running high.

Also key to the current merger boom are the record high stock prices.  Companies often use their stock as currency when they look to make acquisitions.  Companies with high P/E ratios seek out companies with lower P/E ratios, as this can be accretive to earnings, an instant way for management to shine.

Amidst the flurry of corporate activity on Wall Street this November, stock prices, as measured by the S&P 500, rose a smart 3.6%, and are now up 27.6% for the year.  The last year with returns this big was 2013.  The last three years have produced 14.8% annualized returns, and during that span, stock prices fell in only 6 of 36 months.  That’s an extremely high batting average (percentage of positive months).  One of my concerns is that the down months have been dramatic, dropping by an average of 5%.  That is a jarring number.  Sharp drops in stock prices tend to freeze investors – as they hope for prices to rebound or struggle to recalibrate their expectations.  There is a touch of complacency with the market’s recent strength, and I don’t want our accumulated gains to be snatched away due to the deer in the headlights effect.

Sensational headlines day after day desensitize us to the nuance of the information being reported.  In my opinion, a trade war with China cannot be won; the global market place is interdependent and isolationism does not work.  Though fear of recession has receded, forward earnings forecasts are only modest.  The view from the c-suite is cautious as measured by recent capital spending surveys.  Fundamentals are stagnant and the change in stock prices this year has been driven by higher valuations (P/E’s).  The deal is, we are on thin ice; the economy is not nearly as robust as stock prices would like us to believe. I expect we will see consistently higher volatility (making stocks more challenging to hold) which means next year may require more effort, for less return. 

Investors have banked some nice returns this year, and in my opinion it is a good time to take some profits. We find it’s always more attractive paying capital gains taxes with realized investment gains.  In relation to historical levels, current capital gains tax rates are a gift we want to take full advantage of.  Stocks remain the best game in town, but we have to anticipate lower expected rates of return going forward.  Please don’t hesitate to call if we have not spoken recently.

 

Bruce Hotaling, CFA

Managing Partner

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

Haunted House

Amidst a torrent of unrest around the globe, the US stock market has essentially reacted with a shrug, racking up returns of 20.55% through the first three quarters of the year. September, often a challenging month for stocks, returned 1.72%. Historically, when stocks have done as well as they have at this point in the year, they tend to finish out the year with positive results. On the other hand, here we are in October, the month of Halloween and also the two worst months in recent stock market history: October 2008 and October 1987.

In my opinion, the backdrop is something akin to a haunted house. The fear people sense is related to the shenanigans in Washington DC. Controlling the narrative, manipulating the average person’s view, is the tool in traditional and social media. The goal is to sway the popular viewpoint. With November 2020 looming, one powerful tenet dating back to 1992 is “it’s the economy, stupid”, meaning one’s election fortunes are closely tied to the economy, and by extension, the stock market. The conviction that everything will be done to buoy the stock market may well be the foundation investors are building their hopes on for the coming 12 months.

While stock prices are up over 20% year to date, it’s more or less a return to baseline. Everyone is avoiding the fact that at the start of the year, stock prices had just fallen nearly 20% from their late summer 2018 highs. Today, if we consider the trailing 12-month returns of the S&P 500 (instead of the year to date) stocks are up 4.25%, less than ½ the long term historical average.

Fundamental concerns for investors at this juncture are related to upended global trade and business activity in disarray, the Federal Reserve’s next move, and the all-important earnings for 4Q2019 and forecasts for 2020.

The trade war the administration has undertaken with China, Mexico, Canada and the Euro-zone is not benefitting US business. To the contrary, it’s a significant factor in the deceleration of global growth. Without constructive policy and a predictable rules-based system, the current backdrop causes businesses to withhold investment. In the coming years, there is a good chance we will experience economic fallout in the form of low growth and negative interest rates due to lack of business investment today.

The Federal Reserve may not be able to jump-start an economy that is principally under pressure from erratic policy from Washington. Since 2008 and the financial crisis, many cite monetary policy has become a far less effective tool. I would argue that the economy in fact needs targeted spending (fiscal stimulus) and public/private partnerships to jump-start largely stalled economic growth. The deficits resulting from the 2017 tax-cut will of course make stimulus more challenging.

Earnings are clearly the elephant in the room. At the moment, according to FactSet Research, estimated earnings for 3Q 2019 are expected to decline 4.1%. This will mark the third successive quarter of year over year earnings declines. Heading into the end of the quarter, more and more companies have been issuing negative guidance. The 12 months forward earnings estimates (through 9/30/2020) for the S&P 500 are 181.66. The S&P is currently in the 2,900 range, implying a 15.9x forward P/E multiple. From here, for stock prices to rise, earnings growth must resume.

October is typically not the time of year to taunt the stock market with anything that might frighten investors. At the same time, U.S. corporations, up to this point, appear to be making their way through the corn maze. This is the foundation on which our guarded optimism rests. Stocks remain the most attractive investment option. We are still finding growth opportunities, though it is clearly a market for stock pickers. Quality U.S. corporate names with solid fundamentals and prospects for steady earnings make up the universe of names we keep on our short list.

As we approach year end, we will be reaching out to you to make sure we have addressed your concerns, capital gains constraints, or any other aspects of your financial life. Please feel free to reach out to us if you have any concerns in the meantime.

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