Stock prices, as measured by the S&P 500, rose 7.7% during the third quarter and are now up 10.5% year-to-date. These returns are generally in line with historical returns. Stock prices did jump 21.8% in 2017, but over the last 30 years, stocks have averaged 12.1% annually (1988 – 2017) with a standard deviation of 17.2%. Based on these figures, the stock market is in “business as usual” mode. It generally produces returns for which investors, at the end of the day, are rewarded for the risk they undertake.
That said, investing in the stock market (or staying invested) has always been challenging. For example, in recent memory, stocks fell 37% in 2008, 22% in 2002, 12% in 2001 and 9% in 2000. The message is that the average returns of the stock market are available, but to capture them requires a willingness to endure some discomfort and avoiding the impulse to completely disinvest.
Many people are anticipating some type of disruption, as the record bull market grows long in the tooth amidst heightened levels of political turmoil. Some are casting about for the next sign of trouble. This could be a peripheral economic indicator or an exogenous shock – something unpredicted that ends up influencing the economy and, ultimately, the financial markets.
Unknown risk factors are difficult to identify and can take control of the markets in a blink. For example, on October 19, 1987, the Dow Jones Industrial Average fell 22 percent in one day! It may have been the experimental use of portfolio insurance (program trading), inefficient stock market technology, the huge budget deficit, or who knows what else. These and other factors led to panic on Wall Street. That was thirty-one years ago, and while the stock market has evolved enormously since then, we are curiously no better equipped to predict a crash today than we were on Black Monday.
On a macro level, there are valid concerns such as the national debt and student loans. The national debt is approximately $21 trillion. Interest on the debt is rising quickly. A recent report by the Congressional Budget Office shows that the fastest-growing federal government expense is the interest on our debt. The expected bill for 2019 is $390 billion, which is 50% more than in 2017. The report projects the US budget deficit to expand from 3.5% of GDP last year to 9.5% by 2048. Student loans now rank as the second-largest category of consumer debt (behind mortgages) with a total debt of $1.5 trillion, and 10.7% of the 44 million borrowers are 90 days or more delinquent. (Forbes 6/13/18)
On a more fundamental level, the housing and banking sectors typically do well when the markets are healthy and anticipating growth. Though the stock market continues to trend higher (20 of the last 22 months), these very two sectors are demonstrating notable weakness. Weakness in the housing market is evidenced by the CaseShiller Index, which has fallen to its lowest level since March 2010. The malaise in the banking stocks may be due to troubles banks are having securing and paying for deposits – which ultimately impacts their future profitability.
On the contrary, the 2017 Tax Cuts and Jobs Act has clearly spurred a robust inflection in corporate earnings, and this is moving stock prices. Currently, the aggregate CY 2019 earnings estimates for the S&P 500 are $178. Using an 18x (trailing PE ratio) multiple on $178 in earnings, would put the S&P 500 at $3,200 at the end of 2019. Investors using these figures (based on the current quarter-end price of $2,914) expect a 10% return from stocks in the coming year, which is on par with historical averages.
In my opinion, the stock market (from a fundamental perspective) is not cheap, but it is certainly not overpriced, either. According to FactSet Research, the current forward P/E ratio is 16.8x (based on the above earnings forecasts) versus a 5-year average of 16.3x. The risk is a deceleration in earnings and/or a compressed multiple. These are not new worries – they simply feel magnified by the remarkably emotional and politicized haze through which we now view and filter news. Unable to attach market significance to odd behavior and mistruth, we will rely upon fundamental and technical factors and hold a steady course for now. 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
2018 has been a profitable year to invest in US stocks. Apart from a sudden drawdown early in the year (stocks fell 3.89% in February and 2.69% in March), stock prices have moved upward at a fairly reliable rate. August saw prices rise 3.03%, and the S&P 500 has generated a 9.94% total return year to date. In the 21-month span since the November 2016 election, stock prices have risen in 19 of those months for a cumulative return of 36.59%. In spite of a record long bull market for stocks, there is a level of discomfort, like we are playing a high-stakes game of musical chairs.
The discomfort stems from the charged backdrop. Daily news paints a picture more reminiscent of a reality TV show than what we became accustomed to growing up with Walter Cronkite and David Brinkley. The tension may only continue to increase. September is historically the worst performing month of the year and often the most crisis-riddled as well. Ten years ago, on September 15th, Lehman Brothers declared bankruptcy, setting off a months-long decline in the markets. Seventeen years ago, on September 11th, four coordinated terrorist attacks on the United States caused the stock market to close until September 17th and when it reopened, the S&P 500 lost 11.6% over the ensuing five trading days.
The strength in US stock prices since the November 2016 election can be attributed to many things, including somewhat remarkable corporate tax cuts, a hands-off regulatory approach, low interest rates, low wage growth and a period of global economic stability. These factors have all led to a remarkable inflection in corporate earnings. During the period 2013 through 2016, earnings grew, but at a modest 2.4% rate. According to FactSet Research, earnings are expected to grow 20% in 2018 and 10% in 2019. Wall Street analysts who forecast earnings are maintaining their optimistic outlook for the future.
From a fundamental perspective, as impressive as this growth cycle has been, the forward P/E multiple on the market is 16.8x, only slightly higher than the 5-year average of 16.3x. We have a situation where stock prices are hitting record highs, but stocks are not overly expensive from a fundamental viewpoint. This, like so many aspects of investing in the stock market, is nuanced. The relative attractiveness of a stock, or the stock market as a whole, is tied to investors’ subjective interpretation of the marketplace.
In the shadow of the market’s recent strength, there are some indications change we are watching closely. The Federal Reserve continues to normalize (raise) interest rates and de-lever its balance sheet. Often times, a rising rate environment can be challenging for stock prices. 2019 GDP forecasts have fallen. Much of what caused the recent surge in economic activity has now run its course. Markets around the world are beginning to show signs of slowing. The emerging markets have been in a bear market territory for months and a high US dollar will challenge their ability to repay dollar denominated debt.
Some investors have pre-emptively begun to transition to more risk-averse positions in defensive stocks with low valuations and high dividends. While not unreasonable, the growth stocks that anchor our investment style have led the market in 2018 and I expect this to continue, for the near term. We will watch closely on September 26th when the industry classifications for many influential stocks will be changed, thus effecting the industry makeup of the S&P 500. Stocks such as Alphabet and Facebook are leaving the technology sector, and Netflix will leave the consumer sector to become part of the new communications services sector. Prices may experience some turbulence while the ETFs and mutual funds are rebalanced.
At this juncture, I think the best course of action is to watch closely and review our target asset allocation. The atmosphere on Wall Street is a juxtaposition of fear and unconstrained optimism. This is often referred to as climbing the wall of worry. I suggest we stay close to our target allocations to stocks. For many this may involve some profit taking, as many of our growth stocks have seen outsized returns over the last few years. In the meantime, please feel free to call if we have not been in touch recently.
Bruce Hotaling, CFA
The stock market is all about earnings. Corporate earnings and their level in relation to stock prices is the fundamental basis, the keystone, of stock valuation. US stocks have been enjoying an unprecedented period of earnings growth and price appreciation. Much of this stems from the stock friendly behavior coming out of Washington DC. In general, corporate America could not be more pleased with the US corporate tax cuts and the across the board emphasis on de-regulation.
For the month of May, this symbiotic relationship continued to self-reinforce, and stocks responded with a total return of 2.41%. The solid returns for the month brought the S&P back into the black for the year. May’s positive returns and moderate volatility (only three of 21 trading days had price moves +/- 1%) were a welcome relief for investors after two stressful months with sharply negative returns in February and March.
While stock returns are modestly positive this year, it’s a shadow of the 8.8% return through May of 2017. I do not expect the S&P 500 to return 22% again this year. Signs of trouble are brewing. Few asset classes are faring well. Most larger foreign markets are down (Brazil -11.9%, Germany -4.2%, China -4.6%). Gold and silver, and almost every maturity level across the fixed income spectrum are also down year to date.
It’s a challenge to make forward looking determinations on how best to position the portfolios in the face of so much media noise and misplaced commentary. In my opinion, there are two overhangs to the market that are threatening to spoil what has been an intoxicating run for stock investors.
One of the supportive backdrops for the upbeat market in 2017 into 2018 has been coordinated global growth. The idea behind this concept is a stronger global economy supports improving demand for US goods and services, and spurs corporate profits. The US$ had been low, amplifying the effect. Suddenly, this growth driver is under assault, and isolationism and protectionism are on the rise.
Further, tension on the Korean peninsula, threats of a trade war with China, tariffs on steel and aluminum imports from Canada, Mexico and the Eurozone, and the US’s withdrawal from the Iran nuclear deal have led to a destabilization of the world political-economic order. This is thin ice.
Much of the anticipated global growth was fueled by debt. Now, global debt has reached levels never seen before, equivalent to 225% of global GDP (according to the Economist 4/24/2018). China is guilty of leveraging up to sustain its economic growth. This is similar to the US tax cuts that will push the US deficit over the $1 trillion mark. Emerging markets are suffering with many of their obligations issued in US$s (Argentina, Turkey). Growth, measured by GDP has slowed. The question here is whether we have come to that point, the tipping point, when things begin to change, while no one wants to believe that is truly the case.
The question isn’t so much if there will be trouble, but when. I do not think any changes in asset allocation need to be made, yet. I do expect returns to bonds to be minimal, and stocks to be in the average range. I am pleased the market continues to reward growth over value. This is a tailwind for our portfolios. Our core approach to investing is referred to as GARP or growth at a reasonable price. Growth stocks continue to outperform value stocks at the large, mid and small cap levels, by notable margins. The two highest returning sectors are technology and consumer discretionary, both sectors where we hold overweight positions.
One of the clearest reasons to take a more cautious posture toward stock investing is because many, possibly too many investors and market commentators are overwhelmingly positive. They tend to tick down the list of supportive economic or consumer data points. There is a lot of cool-aid being consumed out there. I’m not a contrarian, but I’m also not one to get sucked into the vortex. The best course of action today is to avoid getting drawn in to owning too much stock. We need to stay well invested, while hovering one foot over the break.
Bruce Hotaling, CFA
April was a “backing and filling” month for investors. This is a stock market term that applies to prices as they attempt to digest a large run up. After a monstrous 5.6% jump in prices in January, the return to stocks in April, measured by the S&P 500, was a mere 0.27%. Year to date, returns have fizzled and are now down 0.38%. These results mask some eye catching day to day price moves. For example, out of the 21 trading days in the month, 9 involved an up or down move in prices of greater than 1%.
This volatile yet sideways pattern is likely a byproduct of last years extended rally in stock prices that led so many investors to the trough of complacency. Fifteen months of positive returns will attract a lot of attention – suddenly investors began chasing returns, and taking on more risk. It had become too easy. A reflection of this mindset was the craze over bitcoin. That was an extension of the high risk-taking mentality that consumed investors worldwide.
On January 26th, stock prices hit their 14th record high of the year. Over the next couple of weeks we experienced a full on reversal of the prior year’s blind optimism and things turned ugly. By February 9th, stock prices had fallen over 10% on an intra-day basis. The dust settled, and things seemed ok, until April 2nd when prices went right back down to those uncomfortable levels. The origins of this sudden shift in market direction initiated a raft of media speculation as to what might have gone wrong. Was it the US 10-year Treasury nearing 3%, the looming Federal Reserve interest rate hikes or possibly saber-rattling talk from Washington about trade wars? When market trends change, it is often unclear what precipitated the change. For us, the more important question is the emerging trend – what does the slope of the developing trend in prices look like?
As an investor, it’s important to focus on and identify investment goals, particularly long term. The big considerations are, what are we working toward and what is the best path to get there? Trouble often shows itself in the short term. While things that come up admittedly do not normally have any bearing on long term goals, or the agreed upon path, they can be un-nerving to the point investors retreat. There are times when owning stocks is flat out uncomfortable.
After years advising people how best to position their financial assets, one thing clear to me is how easy it is for investors to become disillusioned. Admittedly, there is some concern the world at large is sliding down a slippery slope. This may be true, or it may not. In my opinion, though we perceive a tenuous backdrop today, there has always been a long list of things that could go wrong. Often, we did not know there was a monster under the bed. I suspect our current cautious awareness puts us in a better position to look ahead and acknowledge risk. Stocks are inherently high risk, high return, and when investors dismiss this we are collectively on thin ice.
Our goal is to guide our investors in a way that allows them to hold quality investments during challenging times. As active investment managers, this requires our constant attention and a balance of art and science. We use analytical tools and fundamental analysis, along with a considerable dose of experience. We also use a risk-on, risk-off approach to profit during the good times and temper the effect of the difficult periods. This is in stark contrast to passive index strategies or a blind reliance on asset allocation models.
My expectations are for the recent surge in volatility to continue, though tempered somewhat. I also expect stock prices to move higher by the end of the year. Earnings have been strong through the first quarter and analysts’ forecasts through the year-end are high. I do not expect stocks to deliver anything close to the 20%+ returns we saw in 2017. Considering the backdrop, we ought to expect it to remain challenging. We are constantly asking whether the choices we are making today are additive to your long term goals. At the moment, I am optimistic we are well positioned for the year ahead, but I am also prepared to change course if need be. I invite you to call if you have concerns.
Bruce Hotaling, CFA
Let’s hope March of 2018 was an anomaly. Just as signs of spring were beginning to appear, folks living in the northeast and mid-Atlantic encountered what was likely their first ever cyclone bomb. Exhausted from shoveling snow, they were then clobbered by three more nor’easters in a three week span. It could be we need to place more trust in Punxsutawney Phil’s early February predictions.
The unpredictable nature of these storms reflects closely the unsettled activity in Washington, which is becoming so chaotic it looks to be finally having the effect on financial markets many had feared back in November 2016. Stock prices, measured by the S&P 500, have begun to mimic both the unforgiving nature of recent weather – and the chaos inside the beltway. Stocks fell in March by 2.7%. This is on the heels of a 3.9% decline in February. Year to date, stock prices are down 0.76%.
For some context, over the last 30 years, the S&P 500 has produced an average return of 12.2%, with an annual standard deviation of 17.3%. There have been 5 years (17% of the time) when the return to stocks was negative, and in those years, stock prices fell on average 16.6%. After a larger than average 21.8% return in 2017, stock prices may be reverting to the mean.
On a more granular level, the stock market looks to be attempting to assess the potential damage from a trade war. Old school protectionism is the latest contrivance out of Washington in hopes of making America great again. Restrictive trade, whether it leads to a trade war, will put the brakes on the positive effect foreign competition has on holding down price inflation.
The recent stock price volatility highlights the concern that fractured global supply chains may negatively impact US corporate margins. Free trade is proven to stimulate economic growth. Higher tariffs will eliminate the process of comparative advantage that allows all parties to benefit from globalization. If the root of the problem is infringement of intellectual property rights, then that needs to be addressed directly, without the random and damaging effects of trade warfare.
Recent economic data has not been compelling and the nine year expansion is long in the tooth. Employment levels are high, so high investors have been on alert for signs of inflation. The brutal stock sell-off in early February was ignited due to clear signs of inflation based on reports of increasing wages. Stock investors are well aware, if a cycle of higher inflation has begun, the Fed will continue to raise interest rates.
The yield curve has shifted upward, and flattened. This is a mixed signal. It may well be telling us growth expectations have deteriorated. The Federal Reserve has raised rates now for the sixth time since the first 0.25% hike in mid-2015. Expectations are for 3 hikes this year and 3 more in 2019. Ambitious fiscal spending, at this late point in the economic cycle, will support the Fed’s hawkish position. The ballooning deficit, continued deficit spending and higher interest rates will raise the probability of a slowdown (recession) sometime in the near future.
The other curiosity I’ve discussed before is the perpetual weakness in the US$. It has been in a steady decline since the November 2016 election. The higher interest rates available in the US would support buying dollars. On the contrary, global investors have been selling US$s, and buying yen and euros. It’s not clear what is causing this, though it’s likely related to increased tariffs, restrictive immigration and rising deficits. The persistent US current account deficits are spurring talk the US$ may not be the safe-haven it once was.
The current backdrop is mixed. Earnings estimates remain high and stocks are not excessively expensive with the forward P/E multiple in the 16x range. Volatility has risen, making stocks harder to own. From a contrarian perspective, this is constructive. Yet, if the earnings forecasts falter, for whatever reason, this will spell trouble for stock prices. With the high level of volatility, and two successive down months in stock prices, we are taking a more constructive stance, and will become more cautious if conditions persist. Please feel free to call us if you would like to discuss further or if your investment parameters have changed since we last spoke.
Bruce Hotaling, CFA