Trick or Treat
October, the month of Halloween and two of the most memorable stock market crashes, can be a scary time. Fear is often considered the most powerful and uncontrollable human emotion. When it ignites, the primal human survival instinct takes over and reason and logic go out the window. This year’s October was no exception, and investor fear levels are clearly on the rise once again.
Stock prices for the month of October fell 6.94%, bringing the year-to-date total return of the S&P 500 down to an unsatisfying 3.01%. For some context, February (-3.89%) and March (-2.69%) were also difficult months in which to own stocks. From January 26th to the April 2nd low, stock prices fell over 10%. The recent drop, from September 20th to the October 29th low, was 9.8%. Both were uncomfortable drops in price and can be labeled corrections. Seasoned investors often consider corrections a necessary evil when one chooses to commit financial assets to the stock market for the long run.
The market’s behavior in October was unusual. For example, of the 23 trading days in October, 16 saw negative returns. There were 5 days on which prices rose more than 1%, and 5 days when prices fell more than 1%. According to Bespoke Research, October 30 marked the end of a 28-day run for the S&P 500 without back-to-back days of positive returns; the preceding occurrence of this phenomenon dates back to World War II. Stocks have recently struggled mightily and lost ground. My concern is stock prices themselves are often considered the most telling indicator of future stock prices.
Of course, the stock market is made up of a vast array of companies occupying different sectors of the economy. Different stocks have characteristics that cause them to respond differently to the same events. For example, stocks that fared best during October were ones that had the highest dividend yields, the highest level of international revenues, and the poorest Wall Street analysts’ ratings. Consumer staples and utilities were the only two sectors with positive performance.
In my opinion, the increased agitation in stock prices may be an early signal of an earnings deceleration. This will likely be coincident with slowing economic growth and possibly even a recession. For example, expectations are for earnings growth of 10% in 2019. This is a reduction by 50% of the 20% growth we’ve experienced in 2018. By mid-2019, investors will fixate on earnings projections for 2020, and those figures will probably be impacted by several factors. For example, the trade war is causing higher costs for some US companies as a result of higher tariffs, longer lead times, and broken supply chains. In addition, hints of inflation and indications that wage pressure is building will likely lead the Federal Reserve to continue on its current course of restrictive monetary policy.
Consumer confidence (at the moment) remains extremely high, both historically and in absolute terms. This is a good thing, at least for now. The confidence levels reflect the fact that jobs are available and people with jobs are out spending money. There is still some punch in the proverbial punch bowl, and that could extend what has already been a prolonged economic run. Given that we live primarily in a service-oriented economy, the historical cycles of older industrial economic cycles do not necessarily work as a barometer. There may well be more room to run, but according to Bespoke Research, when consumer confidence has peaked historically, we tended to be at the early stages of a recession.
In my opinion, stocks are still the asset class of choice. The backdrop is the same as when the speed limit on the freeway drops from 75 to 55 and suddenly you feel like you’re crawling along; the freeway still beats the back roads for a long road trip. We will need to quickly become accustomed to the new rate of economic growth and the new market place and likely pivot to a more value-oriented stock selection approach. Expected returns from stocks may well be lower going forward than they have been since 2009. Our work is to choose the best stocks to own as the future characteristics of the market become clearer. I am happy to discuss this with you in greater detail if we have not spoken recently. Please feel free to reach out.
Bruce Hotaling, CFA
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
Take a Step Back
For the month of April, stock prices measured by the S&P 500 nudged incrementally higher, up 0.27%, and are now in 1.74% above where they finished 2015. These modest numbers mask a lot of price movement, speculative news flow and investor angst during the first third of the year.
Recently, the market has been shape shifting. For example, after a long period when growth stocks outperformed value stocks, the tide has turned. The S&P 500 growth ETF (IVW) is -0.74% for the year, while the S&P 500 value ETF (IVE) is 4.23%. The spread in favor of value is even greater for the mid cap and the small cap segments. And dividends are the thing, today, as the DJ Dividend ETF (DVY) is up an eye opening 10% year to date. This is a sudden and complete reversal of the trend in 2015 when the growth IVW returned 5.37% while the value IVE returned a -3.29%.
There are multiple reasons for the u-turn in the return characteristics of the market. Core CPI is in the 2% range, and holding. With the US 10-year Treasury currently in the 1.8% range, the real yield is negative, pushing investors to own higher yielding assets, including dividend paying stocks. Dividends are generally taxed at a much lower rate than traditional fixed income, increasing the appeal.
Another reason is investors are generally bearish, marginally outnumbering bullish investors, as measured by the American Association of Individual Investors. This bearishness in conjunction with a declining Consumer Sentiment Index does not historically represent a lot of upside for stock prices. The numbers are leading investors’ intent on staying in the market to lower their perceived risk, by owning dividends and stocks with lower valuation metrics.
Seasonality often comes up this time of year – the May through September window is historically not the most profitable. In my opinion, the old wives tale to sell in May is not actionable. While returns are generally lower, they are also generally positive. In addition, it’s difficult to justify realizing capital gains (paying taxes on profits) to buffer some near term volatility, when in fact these are stocks with attractive long term growth potential.
Q1 earnings reports are coming in and by and large the results have been slightly better than expected. One exception has been large cap technology stocks (Apple, Microsoft, Alphabet) have surprised with reports below expectations. In my view, Q1 is the turning point, and I expect the trend in earnings to recover, aided by the stabilization in the US$, which had been a headwind, and from a recovery in oil prices by the end of 2016.
Some patience is key to successful investing. There have been roughly six pull-backs in stock prices since 2010. These have trampled the unhealed nerves of investors still recovering from the financial crisis. The Flash Crash in July ’10, Europe in October 2011, the Taper Tantrum in June 2013, Ebola in October 2014, China in August 2015 and Oil in February 2016. Unnerving points in time such as these reveal the importance of a solid strategy and continued monitoring of factors effecting the markets.
In that light, we have been shifting our portfolios into stocks with more value characteristics. According to Empirical Research, growth and value stocks are traditionally non-correlating. In today’s market, the focus is more on stability, and thus, the dividend as a key factor. The value tilt we are enacting is in an attempt to capture the heart of the market. According to Empirical Research, the value shift is one half complete based on historical trends. We are not jumping in with both feet, as I believe the tilt will revert later in the year.
In response to the demand for yield, we have launched two new models (Dividend 5 and 10). The intent is for them to complement a traditional growth portfolio, and act as somewhat of a replacement to traditional fixed income. We will be happy to discuss how these “sleeves” might complement your investment portfolio going forward.
Finally, with tax season behind us, we can all take a step back and assess. The shifting characteristics of the investment landscape will remain a challenge. Further, with the market regime shifting, we have taken more capital gains than is typically the case. I am happy to review these and other topics with you if we have not already done so.
Bruce Hotaling, CFA
After a less-than-impressive return from stocks in 2015, things have taken a turn for the worse in the early part of 2016. For the month of January, stock prices measured by the S&P 500 fell 4.96%. Of the 20 days stocks traded, they fell in 9 instances, each day by an amount in excess of 1% (3 in excess of 2%). Not a pleasant way to start the year.
Large cap stocks tended to fare better than mid cap, and small caps simply fell apart. There was little differentiation between growth stocks and value stocks. Sector wise, financials and materials had it the worst. Consumer staples and utilities, both considered defensive sectors, actually had positive returns. There was nowhere to hide either. Stocks from every primary global market, including oil, gas and commodities all fell in value. The one bright spot, gold, silver and fixed income (particularly US Treasury bonds) did show positive returns.
So, where do stocks go from here? The answer, at the moment, hinges on oil. Stock prices have begun to trade in lockstep with the price of a barrel of oil. Oil prices did bounce off a 13 year low on January 20th and have rebounded nearly 14% since that date. In classic thinking, lower oil prices were considered a boon to the economy. Lower energy brings down the cost of production, transportation and ultimately puts more money in consumer’s pockets.
Historically there is not a strong correlation between stock prices and oil, until now. So what has changed? One variation from the old paradigm is we import far less oil today. On top of that, there is little clarity with respect to true global demand and talk of a recession. Some analysts feel the direction of the trade-weighted dollar starting in 2014, was the key driver of the price of oil. US monetary policy began to diverge from the rest of the world, oil depreciated as the action took liquidity out of the system.
There may be more fallout from the drop in the price of oil than anyone could have foreseen. Sovereign wealth funds which had been overflowing in accumulated oil profits may well be raising funds to support budget deficits. The world’s sovereign-wealth funds together have assets estimated in the $6-$7 trillion range, (US GDP in 2015 was approximately $18 trillion). More than three quarters of these assets are in funds from emerging market countries, many based in the Middle East and Asia, and naturally the assets easiest to sell are their global stocks and bonds.
The oil patch has developed a knack for talking its own book. For example, T Boone Pickens, in a June 13, 2014 CNBC interview said oil prices could hit $150-$200 a barrel. Today, only 18 months later, several noted global banks are saying prices could drop to as low as $10-$15 a barrel. The unfortunate truth is no one really has any idea where the balance between supply and demand will be struck. Once oil prices stop falling, many other financial assets will follow.
The general economic backdrop is mixed. Talk of a global recession looms, but in the US, the housing and auto sectors continue to perform well and the jobs numbers are strong. 4Q GDP came in at 0.7% with a notable bump from consumer goods and services. While the industrial manufacturing sector slumps consumer confidence remains above its long term averages.
According to FactSet Research, the 2016 bottom-up estimates for the S&P 500 are $123.3 (versus $117.7 in 2015). This is the true foundation for the market, and stocks are trading in a reasonable range of 15.4x forward earnings. Energy remains the primary issue as returns have nearly evaporated dropping from $8.38 in Q1 2015 to $1.36 in Q1 2016, a drop of over 83%. Earnings for materials and industrials have also dropped, in large part due to oil.
In my opinion it’s most prudent to remain prepared to back away from risky assets. We did this back in August 2015 and we may find it prudent to do the same in February 2016. Many of our favored stocks are selling at attractive prices. This does not mean they cannot become even more attractive, if conditions take a turn for the worse. So, for the moment, we are watching cautiously.
Please feel free to reach out if you would like to review with us. In more difficult times such as these, it is important for us to remain in close communication.
Bruce Hotaling, CFA