US dollar
Nor’easter
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
Managing Partner
Mish Mash
Investor behavior has been by and large complacent. The market commentary has been Pollyannaish. The combined effect has been an extended period of positive returns and low volatility. Stock prices, measured by the S&P 500, rose for 15 consecutive months, something they had not done in over 20 years. Then, in February, stock prices fell by an uncomfortable 3.69%. Sharp price drops, 4.1% on the 5th and 3.75% on the 8th, echoed swings felt prior to the onset of the financial crisis.
The market backdrop looks to have shifted. A trend change cannot be extrapolated from one month’s returns. Just the same, it may be that the majority of the market friendly changes (tax cuts, regulatory roll-back, loose spending) are baked in. If this is the case, the return/risk profile stocks offer may have begun to seesaw. Here are some observations worth your consideration.
The dominant factor influencing stock prices is earnings. 4Q 2017 was one of the strongest earnings seasons in the last 20 years, according to Bespoke Research. The “inflection” in earnings is remarkable, as they had been flat. We tend to extrapolate data forward, and expectations going forward may be too high.
The surge in US corporate earnings has been bolstered by an up-swell in economic growth around the world. Manufacturing PMI’s around the world are simultaneously rising, and although Europe’s emergence from the global debt crisis lagged, it’s now the catalyst for a full-fledged global economic revival.
Another boost to earnings has been a weakening US$. This allows for a currency translation bump, when earnings from abroad are repatriated. This tailwind has been in effect since November 2016, as the US$ has fallen roughly 15% against the Euro.
The current administration’s weak US$ policy is apparently intended to cure the trade deficit. Curiously, the trade gap widened in January to the highest level since October 2008. The recent imposition of tariffs on various imports may help offset the trade deficit but the true economic result will more likely be a decline in domestic growth – the opposite effect from the intended goal of making America great (protecting US industry).
The recent emphasis on fiscal policy and deficit spending is a significant concern at this point in the economic cycle. It’s inflationary by definition, and the budget deficit may well exceed $1TN in 2018, something last accomplished in the dismal recovery from the financial crisis. The looming cost of financing increased government debt levels is a large reason for the sharp increase in longer term interest rates.
Wages are also going up, which is good for workers earning the $7.25 federal minimum wage, but this too is a source of inflation. Last month’s inflation data was the spark that ignited the February stock market sell-off. The Fed has signaled it will raise rates three to four times in 2018. Long term, there is a good likelihood the Fed (rising interest rates) will take the blame for triggering the next recession – not the ambitious policies that catalyzed the need for higher rates.
Finally, volatility is back. This is a reflection of these disparate factors. Stock prices move up and down and this normally tempers investor behavior. When price volatility is low, investing in stocks becomes too easy. The spike in volatility in February was only the second time the “fear” index hit those levels since the 2008 financial crisis.
Often times the stock market is not reacting to an event, as many TV commentators attempt to explain, rather it is signaling. Stock prices are a leading indicator. Along these lines, the sudden jump in price volatility (the VIX) may well be foreshadowing change. The stock market may be telling us inflation is here and the Fed’s response will be to raise interest rates. Four rate hikes may be the equivalent of taking away the punch bowl. In my opinion, a raised level of caution is healthy here. We have to be able to live with the ups and downs, and to do this may require owning less of the risky asset. We have been repositioning portfolios to reduce oversized positions and address our view of the trend going forward. If you would like to review this with us in more detail, please don’t hesitate to check in.
Bruce Hotaling, CFA
Managing Partner
Animal Spirits
Happy New Year! I wish you a peaceful and prosperous 2018. Looking back, 2017 was prosperous for US investors, as stocks generated a total return of 21.8%, measured by the S&P 500. It was a good year, by historical standards. Over the last 30 years, stocks have averaged a total return of 12% with an annual standard deviation of 17%. Other years with big returns, such as 2009, 2003 and 2013 to some degree, were classic rebound years. Then, there was the stratospheric run in the late 1990’s when stocks averaged 28% returns for five consecutive years.
What drove stock prices in 2017? There were several things that cumulatively led to a “perfect storm” for stocks: the US $ weakened against most major currencies, oil prices moved back into a range supportive of normal capital spending, OECD countries collectively grew, US corporations experienced double-digit earnings growth after several flat years, the prospects of corporate tax cuts stirred animal spirits, interest rates remained low and the Federal Reserve was somewhat accommodative, all with a general backdrop of full employment and improving consumer sentiment.
What should we look for in 2018? According to FactSet Research, Wall Street analysts are forecasting S&P 500 earnings growth to continue at an 11.8% clip, with energy, materials, financials and info tech leading the way. Stocks with higher international exposure generated superior earnings growth in ’17 and this is expected to persist in 2018. Analysts’ estimates are for continued double-digit growth and $146.60 per share in 2018 and $161.30 in 2019. Stock investors are thrilled to move on from the meager 3.2% pace of growth from 2012 to 2016.
The tax cuts recently passed by Congress have long been anticipated by investors. They will fuel investor optimism for a time – until the true benefits to corporate earnings and household wallets start to pencil out. Sadly, elected officials in Washington have given up on any sense of fiscal discipline. The federal deficit is north of $20 trillion. Tax cuts will unnecessarily increase the deficits (both financial and environmental), lead to higher interest rates and inflated costs (housing) and cause more sensible governments in the future to have to raise taxes to account for this generation’s need to have it all, now.
On the immediate horizon, there are flashing yellow lights – things to watch for that may stall the stock market juggernaut. Unemployment is low, and the number of job openings is near record levels. Labor force growth, a critical element in the economic equation, continues to decline. With no constructive immigration policy, higher wages will ultimately spark inflation and hamper profits. In response to an uptick in inflation, the Federal Reserve will likely raise rates, making credit more expensive.
We are also faced with a chaotic backdrop that many people cannot embrace. There is a lingering feeling of apprehension continually poked by twitter trolls and divisive memes. The trend is troubling and mirrored to some extent in the Bitcoin bubble – an emerging tendency for people to put more faith in computer code than human institutions. Technology is driving change that we are only beginning to understand in retrospect – there is risk these uncharted waters continue to disrupt.
My view is we have to rely on what we can measure. The market has been trending higher, so like a good angler, the trick is to play out slack. I think we have to defend against complacent thinking and remain disciplined. Early this year we will be busy resetting asset allocations that have become stock heavy over the past 18 months. This will require trimming some of our big growers, and repositioning to allow for more growth/value balance in your portfolio. Capital gains taxes have not changed, and this works to our advantage.
There is an old stock market truism, “pigs get fat and hogs get slaughtered”. As is the case, with heightened returns come animal spirits. Our job, at the moment, is to defend against greed trampling common sense. I have confidence in our process, and would be happy to review your asset allocation with you, necessary cash levels and tolerance for capital gains, as we start the New Year.
Bruce Hotaling, CFA
Managing Partner
Taxing
It’s been a taxing year in many respects, but clearly not for investors in US stocks. Year to date, the total return to stocks (measured by the S&P 500) is a robust 20.5%. With the exception of a modest miss in March, returns have been positive for 13 consecutive months. This is the longest period of consecutive returns, and with the lowest month over month standard deviation, going all the way back to 1982.
The goodness extends beyond the US. Year to date, stock markets in most major countries around the world have produced handsome returns. These markets include traditional economic juggernauts (Germany +27%), old line economies experiencing difficulties with their neighbors (UK +16%) and even economies no one else seems to like all that much (Russia +1%).
In spite of the soap opera in Washington, there are a number of factors propelling our stock market: earnings growth is inflecting upward, oil prices are stable, economies around the world are echoing our economic expansion, central banks around the globe are withdrawing stimulus (inflation trade) and Wall Street’s animal spirits are running wild with anticipation of the benefits from tax-cuts for corporate America.
Seasonal return patterns tell a story. Since 1982, December is clearly the best month for stocks, with a positive return (batting average) 77% of the time and a net average return of 1.75%. The next best month is April, with a 72% average and a net average return of 1.64%.
Stock prices have risen, and are no longer cheap. According to FactSet Research, the trailing P/E ratio for the S&P 500 is 21. For context, at the apex of the dot com bubble, March 2000, the market’s P/E ratio was a healthy 30. In contrast, at the low point of the financial crisis, March 2009, the market’s P/E ratio was 10. So, best of times, worst of times – today we are smack in the middle.
The overarching issue on everyone’s mind is taxes. The drama is playing out inside the Beltway, but the repercussions are being felt on Wall Street. The effort is to spin a new tax code, lowering taxes and simultaneously spurring future growth. Investors are licking their chops. Income taxes were briefly imposed in 1861 to help pay for the civil war. The 3% tax was repealed in 1872. In 1913, the 16th amendment gave Congress the authority to levy a federal tax on income. At that time, only a small number of people actually paid.
Our current progressive system has taxpayers with incomes over $200,000 paying nearly 60% of all federal income taxes. Based on early analysis of the bill, the majority of tax cuts will benefit folks in this income group, and more so for higher income groups.
The last time a tax cut was proposed, in 2001, the Congressional Budget Office projected a $5.6 trillion surplus over 10 years. Today, the budget office forecasts deficits will total $10.1 trillion over the next decade. The deficit is expected to top $1 trillion a year in 2022. Federal debt held by the public is at the highest level since shortly after World War II, at 77 percent of GDP. (NYT 9/28/17) The political imperative to cut taxes has now superseded any view toward fiscal prudence.
We’ve done some analysis, and a reduction in corporate taxes will boost earnings for stocks. The puzzle is which stocks, and to what degree. Our working assumption is that some benefit is already priced into stocks, and there is the potential for more, though this will require clear and well communicated legislation.
At some point, I expect the market to revert to the mean. Consumer confidence is high, as is confidence in the stock market. These can be yellow lights. Since Thanksgiving, the market has begun to rotate, away from the year’s big gainers, and into “safer” low growth names. We have been anticipating this shift in leadership from growth to value. If the rotation persists, we will look to take more profits in our highest performing stocks before the end of December. If we wait until the new tax year to rebalance, we may be faced with a multitude of investors with the same clever thought. My preference is to stay in front of the pack, and if we owe capital gains, to pay them from this year’s generous profits. Please feel free to check in if you have any concerns.
Bruce Hotaling, CFA
Managing Partner
Narrative
October ends with Halloween. Apart from All Hallows Eve, and the Day of the Dead, there is a distinctly scary tone to the way Americans choose to celebrate the holiday. It has somehow evolved into something folks just do each year, and it carries a frightening narrative.
Outside of the world of fabricated ghosts and goblins, there is a broader narrative at play, driving strength in the financial markets. The underpinning of the narrative is the high level of anticipation in improved GDP figures (job growth and higher wages) with stimulus from tax cuts (both personal and corporate) and incentives to capital spending anchored in a renewed emphasis on active fiscal policy.
So far, we have not seen evidence this is anything other than a story. But the stock market has another view and continues to march on. Stocks, measured by the S&P 500, returned 2.2% for the month of October, and are now up a cumulative 16.9% year to date. If we look back to the beginning of 2016 (a 22 month window) stocks have been up 16 of those months (a .727 batting average) and have generated a total return of 30.9%.
It’s hard to determine how much of this story is already priced into the markets. Certainly, influential people in the system are perpetuating it, as the Treasury Secretary recently threatened a dramatic drop in stock prices if tax cuts and reforms were not enacted as prescribed. From my perspective, the strong returns to stocks is principally the result of a remarkable recovery in US corporate earnings.
We are in 3Q17 earnings season, and according to FactSet Research, as of 10/27/17, 76% of S&P 500 companies have reported positive EPS surprises and 67% positive sales surprises. The blended earnings growth rate for the S&P 500 is 4.7% for the quarter, well up from the previous estimates in the 3% range, and without the hurricane related hit to the insurance industry, the blended earnings growth rate is 7.4%.
As the market is a discounting mechanism, meaning it extrapolates future outcomes, the current behavior of stocks implies a rosy future. This is supported by the collective outlook of stock analysts’ predictions for future earnings. Most people do not realize that between CY14 and CY16 S&P 500 earnings ground to a halt. Mired at 119, earnings were dead flat for a three year span. Today, according to FactSet Research, analysts are projecting near double-digit bottoms up earnings growth for the S&P 500: 130.8 for CY17, 145.8 for CY18 and 160.3 for CY19.
The underpinnings of this growth inflection are tied to several existent factors. Synchronized global growth is spurring demand at multi-national companies. The low value of the dollar is making US exports more affordable. The continued stabilization in oil prices is allowing the energy industry as a whole to recover. There is some confidence that the new leadership at the Federal Reserve will continue to prudently manage monetary policy. All of this is taking place in spite of considerable concern that the tax reform and cuts that will ultimately spur the economy (and thus further corporate earnings growth) may never be implemented.
Then, there is the scary Halloween narrative. We collectively keep telling ourselves nothing is the matter – there is not a monster under the bed. We try and put on a brave face, but the fear is there. Washington is in disarray, and we often hear the monster either via Twitter, or bombastic claims in news reports. The level of doubt rises. This flies in the face of optimistic analyst earnings forecasts and stock returns we do not want to give up.
As we approach year end, we can take satisfaction in an extended period of stock price appreciation. There will inevitably be an unsettling event that sparks selling. Over the next few months our effort will be to take some profits in stocks that have outsized positions in portfolios, to lock in returns and raise some cash to allow a degree of comfort going forward. Please feel free to check in if you would like to discuss further. We are also taking a close look at realized capital gains, though I have to say there are not many off-setting losses after the period in the markets we have had.
Bruce Hotaling, CFA
Managing Partner