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The Deal

One of the more newsworthy things about November was the surge in Wall Street transactions.  Approximately $70bn in deals were announced, including Charles Schwab & Co.’s purchase of TD Ameritrade, LVMH’s agreement to buy Tiffany & Co. and Novartis’ acquisition of The Medicines Company.  In the spirit of the moment, Xerox made an attempt to buy the much larger HP Inc. (the old Hewlett-Packard), but was swatted away by the board.   

This flurry of deals came on the heels of what had already been a busy year, particularly among some of Wall Street’s financial titans.  For example, JP Morgan Chase bought InstaMed Inc., BB&T purchased SunTrust Banks and both Morgan Stanley and Goldman Sachs got in on a wave of corporate deal making.  It’s not perfectly clear what is driving the move toward more deals.  We can speculate it represents the last gasps of the bull-run in stocks, or possibly more worrisome, the current administration’s lax oversight and dismissive view toward financial regulation. 

You may remember that some misaligned interests, both in Congress and in the savings and loan sector, led to aggressive deregulation of the S&Ls in 1982.  Within a few years, this led to a collapse of over 1000 banks, and a tax payer bailout in excess of $130bn.  It was a disaster second only to the thousands of banks that closed in the Great Depression.  While a lot of people bristle at the Dodd-Frank Act implemented in the shadow of the 2008 housing crisis and the Great Recession, we may be entering the next chapter of low/no regulation.

The surge in deals may also be a product of the low interest rate backdrop.  It’s inexpensive to borrow money today.  The Federal Reserve’s decision to lower the Fed Funds rate three times (for a total of 0.75%) this year, after it raised rates four times in 2018, may have sparked a borrowing spree.  After rate cuts in July, September and October, animal spirits are running high.

Also key to the current merger boom are the record high stock prices.  Companies often use their stock as currency when they look to make acquisitions.  Companies with high P/E ratios seek out companies with lower P/E ratios, as this can be accretive to earnings, an instant way for management to shine.

Amidst the flurry of corporate activity on Wall Street this November, stock prices, as measured by the S&P 500, rose a smart 3.6%, and are now up 27.6% for the year.  The last year with returns this big was 2013.  The last three years have produced 14.8% annualized returns, and during that span, stock prices fell in only 6 of 36 months.  That’s an extremely high batting average (percentage of positive months).  One of my concerns is that the down months have been dramatic, dropping by an average of 5%.  That is a jarring number.  Sharp drops in stock prices tend to freeze investors – as they hope for prices to rebound or struggle to recalibrate their expectations.  There is a touch of complacency with the market’s recent strength, and I don’t want our accumulated gains to be snatched away due to the deer in the headlights effect.

Sensational headlines day after day desensitize us to the nuance of the information being reported.  In my opinion, a trade war with China cannot be won; the global market place is interdependent and isolationism does not work.  Though fear of recession has receded, forward earnings forecasts are only modest.  The view from the c-suite is cautious as measured by recent capital spending surveys.  Fundamentals are stagnant and the change in stock prices this year has been driven by higher valuations (P/E’s).  The deal is, we are on thin ice; the economy is not nearly as robust as stock prices would like us to believe. I expect we will see consistently higher volatility (making stocks more challenging to hold) which means next year may require more effort, for less return. 

Investors have banked some nice returns this year, and in my opinion it is a good time to take some profits. We find it’s always more attractive paying capital gains taxes with realized investment gains.  In relation to historical levels, current capital gains tax rates are a gift we want to take full advantage of.  Stocks remain the best game in town, but we have to anticipate lower expected rates of return going forward.  Please don’t hesitate to call 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

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

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