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Hurricane Dorian

For days now Floridians have been in a state of suspension – the massive hurricane Dorian sitting just off the coast. It ravaged the Bahamas and is now making its way slowly northward. Much as they try, meteorologists (and presidents) cannot truly predict the direction or the intensity of a hurricane. So, Floridians are more or less forced to brace themselves, and then wait it out.

In many ways, this tension is precisely what investors in the equity markets have been facing. For the trailing 12 month period, stocks have generated a total return of 2.92%. This was hard-earned, as during that period of time, stocks fell during 4 months, and in each case, by an average 6%. Year to date, stocks have rebounded off their 2018 year-end low for a total return of 18.34%, as measured by the S&P 500. In stormy August, stock prices fell 1.81% and were down on 10 of 22 trading days. The worst damage was from three days in particular, when prices fell nearly 3%, and those happen to be the three worst trading days of the year so far.

There are a lot of things investors in stocks and bonds are fixating on. High on the list is the trade war the administration boldly initiated, and the resultant economic fallout around the globe. Economic fundamentals are beginning to erode and it’s not clear how some aspects of the global economic mosaic will repair itself. For instance, distribution channels have been shut, supply chains cut and re-routed, hours worked in manufacturing are on the decline and corporate (S&P 500) revenue growth has fallen from 8% a year ago to 2%. Corporate leaders are less likely to make capital commitments related to trade as long as Washington is unreliable.

While Washington has taken to brow beating the Federal Reserve Bank in an attempt to influence policy, it is not clear monetary policy functions as it once did. We are late in the economic cycle and rates have been low for a long time. The 10-year US Treasury note, which anchors many aspects of the borrowing markets (student loans, mortgage loans) is now at roughly 1.45%. It is nearing the record 1.36%, the lowest level ever, set in July of 2016. The Federal Reserve Bank and the European Central Bank are both expected to lower their respective benchmark rates later this month by 0.25% and 0.10% respectively. Neither of these amounts are significant, economically, apart from the symbolic messaging. People, and companies, are unlikely to change their behavior due to a 0.10% drop in rates.

Fallout from the protracted low interest rates is evident in the banking system. This is most apparent in Europe, where many banks have arguably never recovered from the financial crisis in ’08, and the sovereign debt crisis that followed in ’10. In the US, commercial banks have recovered, but they still cannot overcome the business challenges of perpetual low interest rates which pinch profit margins, and sow doubt in borrowers minds that rates may go lower. There is the fear rates are under pressure only to stave off recession. For monetary policy to work, bank lending is key, and people have to have a degree of confidence to borrow.

Based on our work, I continue to focus on select stocks that screen well for their growth characteristics, constraints on capital spending and strong levels of free cash flow. We are watching, though have not begun to own more defensive or value oriented stocks. As we’ve discussed, (the market) the S&P 500, is selling for 17x forward earnings ($178 per share). In general terms, for stock prices to move higher, either the multiple, or earnings, must rise. At the moment, the factor allowing the multiple to rise has been falling interest rates. Corporate earnings estimates have been declining, since Q1 19, as analysts have been revising their forward estimates down. Select stock picking, and judicious timing is the way forward.

The big question today is, how does this curious backdrop begin to disentangle itself? With no clear path forward, we have to continuously monitor the underlying activity in the markets and stock specific fundamentals for signs of real change. When we have some greater degree of clarity we will act accordingly. In the meantime, please feel free to check in if we have not spoken. I hope you are enjoying both the start of the new school year and the onset of fall and the cooler weather it will bring.

Bruce Hotaling, CFA
Managing Partner

Tariffs and Taxes

Stock struggled in May.  As measured by the S&P 500, prices fell 6.58%, and the year-to-date return to the benchmark now totals 10.74%.  This comes as something of a shock after four successive months of hefty   returns.  The market’s historical pattern of giving steadily, and taking-away quickly, is clearly evident.  Since the November 2016 election, on three occasions, stocks have somewhat violently taken back virtually all the prior period’s gains.  Stocks were routed in February 2018, in December 2018, and again in May of 2019.  On one hand, this could be considered normal volatility in the market place.  On the other hand, this “triple top” formation is considered a warning sign by technical analysts. 

The 800 pound gorilla investors around the world are now contending with are tariffs.  Since the 1930s era Reciprocal Tariff Act, successive administrations have used their authority to liberalize trade, promote economic growth and strategically de-risk regions and relations.  This has all changed.  The justification now being distributed is that increased tariffs will help the US win, they are a counter to national security threats, and they will force our foes to the bargaining table. 

The consequences for the American consumer is they either forego buying certain products, or pay more for them.  Tariffs are a burden on US businesses in multiple respects, through higher input costs, loss of market share, or the elimination of businesses as the tariffs make them unprofitable to continue.  Farmers, particularly soy beans, pork and cotton, have seen their businesses stall.  The sad truth is that the bounty from the Tax Cuts and Jobs Act of 2017 is now lost, as Americans are being taxed, indirectly, to support a global war on free trade.

It’s not at all clear the trade overhang will lift.  This will require cooperation and agreement with trade partners, as opposed to standing on their dog leashes.  We ought to expect this to be a lingering presence in the marketplace, until at least November 2020.  The White House will game, talking up economic growth and stock prices while whirling the politically potent trade stick.  Some of our research providers project the damage from the tariffs could be as much as 5% of earnings.  This would ostensibly wipe out the forecasted earnings growth for the current year.  A valid question, in the face of this degree of uncertainty, is how much can investors continue to digest?

Separately, market fundamentals are not alarming, but they are also a long way from anchoring confidence.  Several April economic data points were down.  Q22019 GDP is now expected in the 0.6% range, the weakest since Q42015, the last time we had an earnings recession.  The slowdown in growth began in advance of the recent trade news with respect to China, Mexico and Canada.  Interest rates and inflation look to me as though they will remain low and range bound well into the future.

Today, based on current earnings expectations for the S&P 500 of roughly $180 per share (12 months forward) stocks are selling for a little over 15x earnings.  This is slightly below the 25 year average.  Expected returns, from this valuation level, are roughly 10%, which is also in line with historical averages.  The Goldilocks outlook is that barring any surprises, these earnings levels can be attained, and the multiple does not erode any further.

On our end we are pleased the market continues to favor growth stocks over values stocks.  The S&P 500 Growth index (IVV) is up 13.32% ytd versus the S&P Value index (IVE) up 8.18% ytd.  We are concerned with the recent anti-trust talk directed at stocks such as Google, Amazon, Apple and Facebook.  Other factors investors use to assess stocks such as size, valuation, dividend yield, etc., are not additive at this time.  We are taking a much more idiosyncratic approach and are targeting stocks with strong secular growth, innovative management teams and limited supply chain exposure to foreign trade. 

I expect the tension we see in the markets to continue, and it will remain challenging to own stocks.  I also think the best opportunities for investment gains remain in select stocks, versus owning the market or making sector bets.  This makes good quality stocks the best game in town and one we pursue with vigor.  Please feel free to check in in if we have not spoken recently.

Bruce Hotaling, CFA 

Managing Partner

Santa is Checking His List

Consider it an early Christmas present.  In the month of November, the S&P 500 rose 1.79% bringing its gains to 5.11% for the year.  The reversal from the prior month was pivotal.  After October’s -6.94% beating, we needed this positive result to avoid having to take an even more cautious stance and raise cash levels.  The stock market has been challenging.

I anticipate that it may take more time for the market to digest the selloff that began in early October. My hope is that we have seen the worst of it, but the 200-day moving average is in a downtrend, and that is not a healthy indicator.  I also expect some earnings revisions to begin to temper investor enthusiasm, possibly spurred by the poorly performing energy stocks and fall-out from the trade war.

There are a handful of disparate circumstances unfolding that may become problematic.  The oil patch is in disarray, and oil prices are in a freefall.  Over the last month, prices have fallen by 25%.  However, according to FactSet Research, the energy sector is expected to report the strongest earnings growth (+24%) for 2018 of the 11 S&P 500 sectors.  That’s an interesting contrast.  Historically, there has been an extremely high correlation between oil prices and earnings estimates from the energy sector. Therefore, oil prices are possibly foreshadowing a notable decline in the earnings forecast from the energy sector.

The housing industry may already be in a recession, with all manner of housing-related data (new home sales, housing starts, buyer traffic) showing signs of weakness.  Housing stocks have done poorly.  The mortgage lending business is now dominated by non-bank lenders, which are responsible for more than 52% of the $1.26 trillion in originations in the first nine months of 2018 (WSJ 11/22/18).  The affordability of certain markets has made buying difficult.  Further, the interest rate increases by the Federal Reserve are causing many potential buyers to take pause.

Corporate debt is another concern. The volume of corporate debt has more than doubled since the financial crisis of a decade ago.  Credit rating agencies (Moody’s and S&P) have been actively downgrading debt issues to low or below investment grade.  The primary concern is the waterfall effect from rising downgrades and defaults.  The recent plight of GE is a poster child for this issue, and this is a problem that could spread like the plague.

While investors have celebrated recent US profits and economic strength, the above-trend growth rates are unsustainable. Growth rates in 2018 (20%+ EPS and 2.8% GDP) are skewed by tax changes, government stimulus, and other non-recurring impacts.  Importantly, a growth reset (5-8% EPS and 2.4% GDP) should be more than sufficient for markets to continue to advance.  In my opinion, 2019 will deliver growth for stock prices, though expectations will need to be tempered.   Dividend yield may become a more important component of the total return than in 2018.  

My thinking is to remain focused on US growth stocks but to pare back some of the higher-growth and higher-priced names.  The style that may be most suitable for a flat or even declining earnings growth environment is referred to as growth at a reasonable price (GARP).  We intend to focus on stocks that have stable growth rates, pay a reasonable dividend, and are not overpriced (on a P/E basis) in relation to both their peers and the market as a whole.

US financial assets have dramatically outperformed the rest of the world in 2018.  Many investors are convinced that investing funds in regions, sectors or asset classes for the sake of diversification is a good thing.  On the contrary, I believe it’s is more important to make investment decisions utilizing reliable information on the companies that we believe have merit and closely monitoring our exposure.

As we close out 2018, we are actively reviewing portfolios to take advantage of tax loss selling.  It has been a challenging year, and we have purposefully taken gains in stocks that have outperformed over the last several years.  We are all available to discuss this with you or to review your portfolio if we have not been in touch recently.  We wish you and your family a wonderful holiday season and best wishes for a prosperous and peaceful new year.

Bruce Hotaling, CFA

Managing Partner

Like a Hawk

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

Managing Partner

Change is Coming

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

Managing Partner