Suddenly, its fall. Investors tend to be wary this time of year as two of the most famous stock market crashes took place in October. In fact, September is historically the most uncooperative month of the year. In spite of that infamous past, returns to stocks in September were essentially unchanged. Stock prices fell, though ever so slightly, but the dividend was enough to give stocks a modest positive total return for the month, and a 7.8% year to date return. The bull market that began in March ’09 may be aged, but it continues to lumber on.
I think the most critical hurdle in front of us are upcoming earnings. We need to see strong reports for 3Q and 4Q in order for prices to move up from here. I am not the only investor keying in on earnings, so if they fail to deliver I would expect sellers to emerge. After five consecutive quarters of declining S&P 500 earnings, everyone is anticipating a rebound with help from some stability in the price of a barrel of oil and a much tempered US$ exchange rate.
A more cumbersome hurdle is the upcoming election. Front and center in virtually everyone’s mind, it will likely prove to have been a huge emotional distraction when we look back. Election campaigns always get people’s juices flowing but this election is moving the enactment of our democratic process into a new place. The media, technology and of course money, are playing change-agent roles like never before. At the moment, it looks like the stock market is expecting a Clinton victory. We will monitor events closely, and if it looks as though the outcome will effect investor confidence, we will take appropriate measures.
The interest rate conundrum has reached a nadir. Rates around the world have been falling for years and some now in Europe and Japan are negative. Here in the US there is a good chance the Federal Reserve will hike rates later this year. And, similar to the rate hike last December it will likely be a .25% hike, and it will likely un-nerve the markets for a period of time. We should expect this. My guess is the upset will only last as long as it takes for the market participants to realize .25% will not hamper corporate earnings growth potential.
Many people may not realize it, but some rates have already been rising. For example, 3-month Libor, a base rate upon which some consumer loans and adjustable rate mortgages are based, has risen to 0.85% – up 0.50% in the last 12 months. After a nearly 15 year cycle, adjustable rate mortgages have begun to reprice upwards. This is something to watch closely. Margin interest rates will also begin to tick up in line with the rest of the market. Too much leverage in a rising rate environment can lead to a real cash flow pinch, or worse.
The path of interest rates is critical to banks’ potential profitability. Even more critical is the viability and integrity of our financial system. The financial crisis in ’08 was largely the result of under-regulated banks left to their own profit seeking ends. Ironically, the Dodd-Frank legislation was put in place to avoid another fracture in the financial system, and yet two of the biggest headlines today are the threats to the solvency of Deutsche Bank, and the unabashed consumer fraud at Wells Fargo.
The baseline today, though somewhat twisted, is navigable. Importantly, we should expected lower than average returns from most asset classes for the next 12 months. Bonds in particular are not offering up much return and with the outsized returns to bond mutual funds this year, we have been taking some money off the table. Better in our pocket than the other guy’s. MLP’s and REIT’s, fixed income proxies, have recovered nicely from the difficult times they faced last year. Stocks remain the asset class of choice. As you know we are growth stock investors and the market has been testing for us this year. We continue to focus all our energies on quality domestic stocks with attractive growth potential and a dividend. The bull market remains in place so my sense is any disruptions are buying opportunities.
As is always the case, we would love to hear from you. If you have concerns and we have not spoken, please feel free to check in. In the mean time we will be watching as events unfold into the end of the year.
Bruce Hotaling, CFA
US Banks – Why the malaise?
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.