Stocks, as measured by the S&P 500 rose a surprising 7.87% for the month of January. This was the best start to the year since 1987, according to the Wall Street Journal. January’s remarkable stock returns were a generous “bounce” that largely offset the disastrous 9.18% loss that stocks suffered in December to close out last year. Now, with 4Q18 earnings season underway, we’re faced with the difficult task of assessing stocks, with an eye toward determining which ones will do the most work for us this year.
On a macro level, the forces that had been driving stock prices have shifted. After the November 2016 election, stocks went on a manic run; 15 months of positive returns. Wall Street suddenly had a man in the White House that was going to give it just what it wanted. From November 2016 through January 2018, stocks returned 31.4%. Then things changed. Starting in February 2018 the market stumbled. Over the ensuing 12 months (through January 2019), stocks fell 1.23%. During that span of time, stocks fell in four of those months for a total of -22.1%. These sharp drops in price radically changed the tenor of the market. They reflect the market’s foreboding of change on the horizon.
Near term expectations are for more of the same. There is little prospect of Washington acting in any constructive way with respect to fiscal policy. More to the point, my hope is Washington will refrain from causing further harm. The trade war, for instance, is clearly hurting the bottom line of many US corporate and agricultural businesses, based on recent earnings reports. According to the IMF, the US led trade war with China and the related protectionist tactics may lower global GDP in 2019 by as much as 0.5%. The threat of another government shutdown looms. The 35 day shutdown that began late last year damaged the economy and will show up in lower economic growth rates. FactSet Research’s review of earnings transcripts shows 33% of the companies that reported to date have made mention of the shutdown.
The elephant in the room, as always, is earnings. More than any other factor, stock prices reflect forward earnings. At the moment, 2019 earnings expectations are being revised downward. While not uncommon, the fear of course, is that continued downward earnings revisions will potentially lead to lower stock prices. Current FactSet estimates for CY 2019 project earnings growth of 6.3%, but that may be fleeting, and some analysts are quietly suggesting 0% growth for the coming year. Whether the forecasts hold up or deteriorate further, it will be a huge deceleration from the 19.9% earnings growth in 2018.
Though it’s a stock market, from our perspective, it’s a market of stocks. In 2018 our style and technique for selecting stocks worked extremely well. Of course, every year the backdrop and the factors influencing stocks and stock prices changes unpredictably. We are stock pickers, and we do not subscribe to the suggestion that a low-cost ETF is as good as one can do. In fact, we strongly believe in the value of thoughtful analysis, tactical buying and selling, and full utilization of the vast technical and analytical tools available to us today. Our focus remains anchored on the unique potential of each of the stocks we choose to own.
Finally, the roller-coaster start to the year was so distracting I nearly missed Groundhog Day. I’m glad to report Punxsutawney Phil did not see his shadow early on February 2nd, which means we ought to expect a shortened winter. This is good news though there is some concern with the reliability of Phil’s predictions. In fact, the NOAA says that Phil is right about 40% of the time and does not have any predictive value. This all leads me to Michael Lewis’ most recent book, The Fifth Risk. In it he discusses many of the valuable aspects of the federal government, including its immense ability to collect and store various forms of data (economic, weather, census, seismic, soil temperatures, etc.). With all this information now on the cloud, and vast computing capabilities at our fingertips, one of our most challenging tasks is to thoughtfully begin to ask the right questions to which we want answers.
Please feel free to reach out if we have not spoken recently. We are happy to discuss our expectations for the coming year in more detail, or any of your life circumstances that may have changed since we last met.
Bruce Hotaling, CFA
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
Labor Day is here. For some, along with Memorial Day, it bookends the summer, and that’s that. It represents the end of the heat, and the beginning of another school year. In fact, the date became a national holiday in 1894 to recognize the incredible achievements of the American worker. This was around the time the AC motor, the radio, the gasoline engine and a plethora of other economic dial-movers were discovered. It was a period of dynamic technological change. Today, robotics, drones, AI and the like are transforming the world and how we work.
Labor (productivity) is important today as one of the two primary components of economic growth along with population growth. Population growth is on the decline, so the emphasis is on technological innovation to make the U.S. laborer more efficient. Curiously, the U.S.’s total output, measured by GDP, has been growing at a lackluster rate ever since the Great Recession. Payroll numbers have been growing steadily for years now and the unemployment rate is at a low 4.9%, but GDP growth has not been able to pick up.
Last year (2015) U.S. GDP measured 2.4% and stock returns, measured by the S&P 500, were 1.4%. This year, despite equally low-growth, stock prices have been rising. I suspect there are several things happening here. One is the market may be anticipating stronger growth and increasing estimates for Q4 2016 and 2017. With the election coming up, the market seems to be anticipating a change in the use of fiscal policy. It would appear that ideology aside, policy makers (not the Federal Reserve) realize they are the ones that can make a difference. Little if anything constructive has been done to spur economic growth since the American Recovery and Reinvestment Act of 2009 – far too long.
Another change the market may be anticipating has to do with how corporate America allocates its prodigious cash flow. Traditionally, spending by businesses large and small is oriented around research, innovation, capital investment and expansion. These are factors that have traditionally propelled the future growth of American industry. Recently, much of the surplus cash has been oriented toward pleasing investors on Wall Street in the form of higher dividends and stock buybacks. This may be good for the board room and bonus calculations, but it is not the correct route to sustainable growth.
Last, but not least, the most evident driver of the strong stock market this year (stocks have generated a total return of 7.66% year to date as measured by the S&P 500) is the search for yield. For multiple reasons, bond yields are as low as they have ever been. On top of this, demand for yield is off the charts, as our sovereign counterparts, Germany and Japan, are paying negative yields on their debt. This makes the current 2.1% yield on the S&P 500 look extremely attractive to income investors, and not just U.S. investors – there is evidence of huge demand for U.S. equities from Europe and Asia.
Stock sectors known for their dividends, such as utilities and telecom, are up 20% year to date. It’s no surprise that high dividend payers and value oriented stocks such as these continue to outpace growth stocks. The shift from growth to value, as I have discussed before, began in December 2015 and accelerated into 2016. I am making a somewhat contrarian bet that a positive inflection in earnings growth in the coming months will allow growth stocks to return to the head of the pack.
It’s hard to grasp the degree to which the world has changed since 1894. The role of labor and the importance of technology are as critical as ever, though they bear little resemblance to what they were. I have to say, the recent dust up between Apple, Ireland and the EU reflects just how critical innovation in the labor force has become. A recent Fortune list of the largest technology companies around the globe showed that of the top 25, 14 are from the U.S., 8 are from Asia-Pacific (China, Taiwan and South Korea) and only 3 are from the Euro-zone (Germany, Sweden and Finland). That says a lot.
Please feel free to check in if we have not spoken recently. The last few months have been smooth sailing, and often times that means there’s a storm somewhere on the horizon, even if we cannot see it yet.
Bruce Hotaling, CFA
For the last five months, stock prices have more or less surprised investors, continuing to edge higher amid a flow of unsettling news. On top of that, we experienced two points this year that had many reaching for the emergency brake. First was the harrowing start to the year, which saw stock prices fall 10.27% after only 28 trading days. Second was the remarkable post Brexit snap that saw stock prices lose 5.4% over two days in late June. In spite of this, stock prices have soldiered on, with little regard for the often event-driven mentality, and closed out July with the S&P 500 at 2,173, 7.6% above where they started the year.
This year is unusual because all the asset classes we utilize are putting up solid returns. Stock prices are on the rise because investors expect improved earnings reports. Fixed income (US corporate and municipal bonds) has done well largely due to a recovery in credit, particularly energy and a tailwind from falling interest rates. Another reason bonds have rallied is the flight to safety trade – investors have continued to buy bonds hoping to stay out of harm’s way. REITs are having a strong year due to a stable financial backdrop and their high yields. And finally, the pipeline MLPs are putting up attractive returns as the price of oil has stabilized and quarterly distributions look to be secure.
Stock prices have been struggling through an “earnings recession.” Q2 2016 is expected to be the fifth consecutive quarter of year over year declines in earnings. From 2012-2014 earnings growth was north of 5%. Then, in 2015 earnings fell 0.8% and are expected to fall another 0.3% in 2016. The decline was largely a byproduct of the drop in oil prices. Starting in mid-2014, a barrel of oil dropped in price from over $111 to below $40. This had an immense impact on a vast array of businesses with both direct and indirect exposure to the energy patch. While motorists saw heaven at the pump, stock investors cringed as returns from stocks, across most sectors, began a protracted sideways move.
Today, with the possibility for improved earnings on the horizon, stocks are priced at a P/E of 17x expected earnings. Analysts currently forecast bottoms up S&P 500 earnings of 134.4 for 2017. A valuation in this range is not unreasonable in light of the extremely low interest rates and inflation. In my opinion, there is an avenue for stocks to return 6-10% over the next 12 months. Of course, things will need to go well. The market is expecting an earnings recovery, and stock prices are being bid up in anticipation of this outcome. Currently, the dividend yield on the S&P 500 is 2.3% – #paidtowait.
Something we are watching closely is the shift in the type of stocks generating returns this year. Growth stocks have outperformed value stocks for years. Then, late last year, the market began rewarding value stocks, and this shift has been in effect all year. When earnings growth is scarce, dividends become more attractive. The push into value stocks has driven their prices up, currently trading over 115% of their historical P/E. Although we have tweaked our models to take advantage of this shift, we prefer not to chase expensive stocks. I expect the market to turn its attention back toward growth with improved S&P 500 earnings later this year and into 2017.
Our advisory approach rests on three principal tenets: utilize quality assets where we are confident in a reliable information flow, insure our investors have a high level of transparency and communication, and all assets must be readily salable. We have adhered to these guideposts for over 20 years. During times like these, with an absurd political narrative, and heightened incidents of terror, our principals are more important than ever. When fear rises, it is generally difficult to rein in. We will watch closely as events unfold, trimming overpriced assets, and remain prepared to raise cash if need be.
I hope you are enjoying the long days and have had a chance to slow things down. If you would like, please feel free to check in. It’s a good time to take a few minutes to review your portfolio. There is a lot of noisy commentary which makes investment decisions more complex. We are happy to work with you to make sure you are enjoying your summer time to the fullest.
Bruce Hotaling, CFA
Low Interest Rates – Good today, but bad tomorrow?
Blog by Jean M Rosenbaum, CFA, Hotaling Investment Management, LLC
Borrowers typically find low interest rates very attractive because it reduces the amount of money they have to repay to their lender. Think about the impact of lower interest rates on your mortgage or your auto loan!
Savers on the other hand, find them less attractive as lower interest rates means lower earnings on their savings such as bank deposits, CDs or bonds. Have you seen the rates on bank “interest” checking and savings accounts?!
While a brief period can be positive for consumption, an extended period of low interest rates can cause some long term problems. The longer rates remain low, the more difficult it will be to generate income and savings needed for future consumption. The lower rates mean lower earnings for pension funds which rely on investment gains to meet their obligations. Insurance companies may also find it increasingly difficult to meet their obligations as the return on their investment portfolios continues to fall below previous assumptions. When the obligations for these firms were first established years ago, the assumption was the investment portfolio would grow and in some cases, the growth is critical to their ability to meet the future obligations. This situation could result in individuals receiving less money (or even no money) from sources they had previously believed were secure.
Taking this a step further, many European debt instruments are yielding negative rates. Negative interest rates means that investors pay to hold debt obligations as opposed to a positive rate environment where investors get paid to take risk and hold the debt of another entity. In the case of an investment portfolio that holds negatively yielding instruments, the investment portfolio will shrink! These companies cannot abandon the bond markets as they are regulated by their respective governments. The basic operating assumption of these organizations is that they can take in money and then generate a positive investment return and meet or exceed their obligations. This assumption has now been turned upside down as investment returns are meager at best.
The low interest rates helped consumption at a time when the sales of consumer durable items (houses, cars, etc.) were at very low levels. These sectors have recovered, but the ongoing environment of ever lower rates could cause more serious long term damage. Workers that have entered retirement may need to find a new source of income which could be very difficult. New workers will need to save even more money than expected to counteract the inability to generate a positive return or accept greater risk and/or volatility in their investment portfolios. With one part of the population saving more and another receiving less income, the outlook for consumption growth looks difficult. The economy could remain in a slow growth or even deflationary environment due to the “medicine” that has been used to try to counteract the problem of low economic growth.