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Unchartered Water

Returns to investors in both stocks and bonds have been surprisingly positive this year. We are only one third of the way into the year, yet stocks and bonds have already generated returns the equivalent of what many were hoping would be the final result for 2017.  What surprised many, a post-election growth buzz, seems to now have run its course.  It remains altogether unclear whether stock prices moved as they did due to unfounded optimism, or in anticipation of what may be a remarkable upturn in corporate earnings. 

After a slight falter in March, the S&P 500 returned to its winning ways in April, advancing 0.91% for the month.  Through the end of April, the benchmark has generated a total return of 7.16%.  In my opinion, the sturdy year to date returns have mostly to do with earnings (including a tempered US$, stronger exports, steeper yield curve and a normalized $/bbl oil).  There was evidence of an inflection in Q42016, and Q12017 results have been remarkable, to say the least.  The blended earnings growth rate is 13.5%, which if it holds will be the highest year over year earnings growth for stocks since Q3 2011.  According to FactSet Research, as of May 5, 2017, 75% of S&P 500 companies had beaten Wall Street analysts’ mean earnings estimates.

As is typically the case, not all stocks are in favor at the same time.  Since the beginning of the year, companies with growth characteristics have been outperforming companies with value characteristics, largely reversing the value tilt the market adopted early in 2016.  For investors like us, this is a tailwind, as we have traditionally focused on US companies that for various reasons are able to sustain an above trend growth rate.  Sectors reporting the best earnings include information technology, health care and the financials.

The primary drivers of the earnings renaissance, and thus the accelerated returns to stocks, are many.  First is the employment backdrop.  Jobless claims are the lowest they’ve been since the early 1970s.  This in turn may provide a platform for wage growth.  Wage growth is critical, especially in certain segments of the economy, such as improving the ability of millennials to form new households.  An uptick in spending ultimately could light the fuse for some future inflation.  Rising asset prices are “normal” and expected in a growing economy and incent consumers to act.  The Federal Reserve has signaled its intent to continue to hike short term rates, indicating it supports this thesis.  Finally, the tempered strength in the US$ has helped as there is evidence of improved exports to some of the strengthening economies around the globe. 

The other side of the coin is akin to North Atlantic shipping lanes clogged with icebergs.  On a fundamental level, stocks are nearly fully priced.  Earnings must continue to expand.  Expected returns to bond investors, in a rising rate environment, are likely already in hand.  Geo-political risks, though hard to quantify, must be nearing a high water mark.  The typical safety net of leadership and statesmanship is not apparent based on the news flow, an odd place for a country like ours to find itself.  The much manipulated growth narrative is suffering from policy paralysis – there is no game plan – nothing is getting done – and no one knows what to do about it.

I think it is a prudent time to take a more cautious stance, and as I have said before, drive with one foot on the brake.  While I do not think we should re-allocate (as stocks still have the highest expected returns) we ought to take profits in positions with outsized returns.  My preference is to pay some capital gains taxes on realized gains, rather than allow the market to take those gains back.  Our emphasis remains on a more discerning investment management approach, utilizing our fundamental and quantitative tools to help select individual opportunities to make money, versus owning the market, or segments of the market that may, or may not maintain favor. 

I ask that you please call us if we have not spoken recently.  It’s an appropriate time to review your asset allocation and we can take some time to have a more detailed discussion as to the best path for you going forward.

 

Bruce Hotaling, CFA

Managing Partner

Suspension of Disbelief

Looking back at 2016, US stock investors earned an 11.9% return, as measured by the S&P 500.  That figure puts last year’s returns somewhere close to the historic average.  Yet last year was no average year.  Through the end of October 2016, stock prices had managed a return of only 5.8%.  At that point, expectations were low – prices had been flat to down since the end of July, the only month to deliver any true incremental returns.  Skepticism was running high and investors were holding higher than normal levels of cash, just in case.  On election day, the unthinkable happened.  Markets collapsed in panic, then normalized, and then managed to rally (returns jumped nearly 2x) into the year end.  I don’t think anyone could have made this up.

 The first question that comes to mind is, how did we get here?  There is a clear movement around the globe from old school civic patriotism toward a more base nationalism.  This was clearly evident in the June 23 Brexit vote.  Similar rumblings have been taking place in Italy, Austria, France and Turkey to name a few.  The primary drivers are economic disenfranchisement among white men, a growing sense of nationalism / xenophobia, and long simmering suspicion of political elitism at the top.  Now the US has picked up the baton and is off and running.

The second question is, where do we go from here?  Sadly, this is something akin to a leap of faith.  My concern is that we experience spaghetti-throw leadership.  My hope is the way forward involves thoughtful policy, with balanced leadership, clarity and purpose.  At the moment, I’m shocked by the shaming of corporate leaders on Twitter.  In my opinion, this form of demagoguery is antithetical to the spirit of US capitalist democracy.

The headwinds are there, but difficult to evaluate.  An overly strong dollar and trade disputes will temper US corporate earnings and generally weigh down global growth. A border tax – would raise prices on most goods – and likely be damaging to a lot of the US technology industry.   On the cup half full side, the ability of US firms to repatriate large sums of cash held outside the US is favorable.  Lower corporate tax rates would in theory be additive to EPS, unless lowering the deductibility of interest on corporate debt acts as an offset.  And, deregulating industry, the financial and energy complex, will likely be a tailwind, though important questions as to how, and when, may not be known for some time.

Talk is of expected higher economic growth.  This is likely braggadocio.  The fact is, productivity may well be crimped if the technology industry in the US comes under fire.  Technology is one of our most important, and global industries. Labor, another primary factor of economic growth, may also stall, considering the full-employment economy, and a professed resistance to immigration.  Some analysts have raised the possibility of a recession in 2018.  In my opinion, it’s overly optimistic to assume a dramatic breakout in growth in the US.

I think the return/risk assessment favors stocks, but only with the premise they be held for a longer period of time.  The near term risk of owning stocks is higher than has been the case in a long time.  Overall, stock prices are full.  Consensus EPS estimates for 2017 are in the $133 per share range.  At a 17 multiple, that prices the S&P 500 at roughly 2,260, or approximately its current level.  The market is ahead of itself, having pulled forward returns from 2017 into the tail end of 2016.

Sectors holding some interest are energy, financials and industrials.  I assume oil prices remain in a range, and the energy sector continues its recovery.  Financial stocks will see margin improvement with a normalized yield curve.  Industrial stocks will generally benefit from stable energy prices, a focus on infrastructure and technological innovation.  I am more inclined to own domestic stocks with a leaning toward value and smaller market capitalization.  Our focus will remain on quality investments with strong fundamentals. 

As 2017 unfolds, certain aspects of policy may develop clarity and hopefully become investible.  Until that time, I believe a cautious stance is the most prudent.  Please feel free to call so we can exchange thoughts and review the best course going forward.  

 

Bruce Hotaling, CFA

Managing Partner

Ignorance is Bliss

Much of the activity in the stock market since November 8th, both in the US and around the world, has been a speculative response to the election results. The surprise optimism was evident in November, as stock prices measured by the S&P 500 rose 3.7% (0.7% prior to the election and 3.0% after).  Year to date, stock prices have risen 9.8% and by most standards, 2016 has been a reasonably good year for stock investors.  Historical returns for the S&P 500 average 10% per year, and recently stocks returned 1.3% in 2015 and 13.3% in 2014.

Amidst the frenzy of tweets and conjecture, many investors are having trouble developing an actionable thesis.  So, the immediate question is, what facts do we have to work with?  First, interest rates have risen on the long end of the curve in anticipation of higher growth and inflation.  Unemployment is hovering in the 4.6% range, low enough to spark wage inflation among the prime-age workforce.  Consensus is the Federal Reserve will raise rates at its December 14 meeting.  The US$ is higher today versus the Euro than any time since ’03.  Historically, energy prices and the US $ are inversely correlated.  And, since November 8th, technology (de-globalization) and health care (elimination of affordable care) have underperformed, while financials (higher interest rates and de-regulation) consumer discretionary (tax cuts) and industrials (fiscal spending and infrastructure) have been bid up smartly by investors.

The cup half-full view of what’s to come is compelling.  Some fiscal spending may give the economy the boost it has long yearned for.  Lower tax rates are a pure windfall, and the combination of the two may well lift GDP above its recent 2-2.5% ceiling.  The last time GDP was north of 3% was ’04-’05 and north of 4% was ‘’97-’00.  Many aspects of US infrastructure are in urgent need of attention, from roads to levees, electric transmission to water.  Some investment here would spur growth, improve our quality of life and longer term well-being.  Increased inflation, historically integral to growing economies, will help avert the dreaded deflationary spiral, and also help Congress navigate out from under the ever growing $20 trillion gross national debt.

On the other side of the coin, there are a number of things to watch for, akin to unintended consequences.  As I noted, the value of the US$ has skyrocketed.  A high US$ will be a drag on US multinationals’ earnings.  It will also exacerbate the trade deficit and pressure GDP downward.  The rising yield curve and higher interest rates will make credit more expensive, raising mortgage rates and slowing growth.  Higher inflation may well push down the already elevated P/E ratio on the stock market.  Unless earnings can reverse their malaise of the last few years, prices are ripe to revalue downward at the first hint of trouble.  The flow of funds into stocks (out of bonds) has been pronounced.  This means more investors are taking on more risk, at the very point in time when the risk of an unanticipated event is high, extremely high. 

With so little facts to work with, markets have been jumping at shadows.  My thought at this point is to underweight fixed income.  I think rising rates will allow us to buy better yielding bonds.  At the same time, bond mutual funds are slightly less attractive, as they behave poorly with the threat of higher rates.  Stocks remain the highest potential-return asset class, though we should be wary of getting caught up in a momentum trade.  Valuations are high, and the “tail-risk” present in the markets today is unquantifiable.  Investors have shifted their focus to value stocks this year.  Growth stocks, historically our preferred type of stock, have had a more difficult time this year. For example, technology and health care and many consumer stocks have been under pressure since the election. We are working hard to rebalance our holdings to best reflect our view of the present landscape. 

 Finally, we are preparing for year-end, and doing our best to limit realized capital gains.  I think we have to be both patient, and attentive.  We are long term investors, and before making strategic changes to our portfolios, I prefer to see some evidence of actual policy, footprints in the snow so to speak.  If you like, please feel free to check in, and I can explain in greater detail.

Bruce Hotaling, CFA

Managing Partner

Labor

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

Managing Partner

En Garde

Stocks, measured by the S&P 500, generated a total return of 3.8% for the first six months of 2016. By most accounts, this is a below average year for stocks, and the sub-par returns in hand have been hard fought.  From the get go stock prices fell, and (cumulatively) did not turn positive until March 17th.  The S&P 500 inched its way higher (toward its 2,130 all-time high set in May 2015) until the Brexit vote surprisingly knocked 5.4% off prices in two painful days.

Stock price declines (5% two-day declines) are not uncommon, except when the market is trading within 1% of an all-time high.  As noted by Bespoke Research, before the Brexit vote the S&P 500 was 1.6 standard deviations above its 50-day moving average and two days later it was 3.2 standard deviations below.  The two day swing was the steepest on record over a period spanning close to 90 years.  Much of this was “noise” thanks to computer driven trading in ETF’s and futures.

Investors were clearly caught off guard by the Brexit vote and then sucked into a vortex of misinformed commentary.  As much as Brexit captivated the world’s attention and whip-sawed stock prices, I think it will prove to be both a local issue and a political bone in the craw of an older generation.  I would expect longer term it will hamper an already sluggish UK economy and spur another Scottish secession vote.  Near term the implosion in the value of the pound will be a tailwind.

In my opinion, we are better served focusing on some of the more obvious risks to both the global and US economies.  One critical factor is China.  As we saw last August, concerns over slowing economic growth, and the steady devaluation of the Chinese currency (the RMB), are true global risks as China is the largest contributor to global GDP growth.  I suspect these concerns have not been put to rest.

The outlook for S&P 500 earnings for the second half of 2016 is favorable, largely due to low interest rates, a tempering US$, and higher oil prices.  The US 10-year is yielding around 1.4% and due to macro factors, rates may well surprise and trend lower as global capital seeks safe haven.  The US$ has stabilized (stopped rising) which will provide a huge tailwind to US companies repatriating foreign based earnings.  And, oil prices, the culprit for much of the turmoil markets have suffered over the last 18 months, have stabilized.  A good sign is inventories appear to be on the decline.  Supply and demand will come together.  With oil prices in the $50 bbl range, volumes of economic activity will come back on line, and with it, $’s of lost earnings.      

Overall, the undercurrents of the market have not changed since the start of the year.  For the time being, large cap value is outperforming growth, and small and mid cap stocks are generating stronger returns than large cap stocks.  Dividends (REITs, utilities and most consumer staple stocks) have been the big attraction for investors this year.  They have become expensive.  While I expect the interest in dividend yield to continue, I think the growth stocks will come back into fashion when the S&P 500 begins to show evidence it is breaking out of its long running earnings slump.

Though confusion reigns from time to time, I think we can take heart in a brighter long term outlook.  The millennials (born 1981-1997) are now the largest generation, at roughly 75 million, and are the largest share of the American workforce (Pew Research Center).  The millennials are just starting to get married, buy homes and have children.  The US is on the verge of a tremendous demographic dividend as the largest share of the population for the coming years will be young, highly educated, and ready to consume (Bespoke Research). 

Over the years, common sense and an attentive hand have allowed us to navigate some challenging markets.  Our approach is to anchor on facts, take a long term view of what we’re all about, and to acknowledge (and refine) an effective process.  We are here to serve you.  In these curious times, if you would like to share your thoughts or schedule a review, we would love to hear from you.

Bruce Hotaling, CFA

Managing Partner