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Touch Bottom

The long bull run in US stock prices has been thrown off track, at least temporarily. Stock prices, measured by the S&P 500 fell 2.6% for the month of September following a 6.2% drop in August. Prices are down 5.29% through the end of 3Q15. Two consecutive months of negative returns and I opt to toe-tap the brakes. In fact, I have been raising cash since the stock market began acting up mid-summer.

Often times, stocks record back to back down months, and that’s that. Then, there are times like the Summer of 2011, when prices fell for five consecutive months. When the dust settled, prices were down 18%. So, if the slope of the market remains negative, I will continue to lean away from the falling prices, and raise cash. The other edge of the sword is that prices often recover sharply – October 2011 saw prices jump 10%. Caution is key at this point, but as conditions improve, we will want to move quickly back into stocks.

The initial drop in US stocks began when China devalued the yuan. As market forces took the yuan down on subsequent days, stock prices cascaded lower. The concerns hinged mainly on decelerating growth out of China, the world’s second largest economy, and the economic ramifications of currency wars among export and commodity dependent emerging economies.

Contrary to what many have been citing in the news media, the health of the global economy is a large factor in the well being of our domestic economy. While the Federal Reserve’s mandate is full employment and price stability, global influences can dramatically alter the strength of our economy. In my opinion, while the data is difficult to rely on, China is not crash landing, rather transitioning from a manufacturing based economy to a consumption based model.

The list of ills is long. Though China may be the poster child, low energy prices have led to a domino effect of issues hampering stocks.   Profits for most energy companies have been cut dramatically and for some their dividends, capital expenditures, and even their ongoing viability is in question. FactSet Data Systems (Earnings Insight 9/25/15) noted that “If the Energy sector is excluded (from the S&P 500 3Q2015 estimates) the estimated earnings growth rate for the S&P 500 would jump to 2.9% from -4.5%.”

In addition to the immediate impact on overall earnings, there are secondary effects. For example, industrial companies that manufacture equipment, metals and mining equipment, and banks that lend to the oil patch are all being pinched. There has been an echo effect on many other sectors of the market. For example, the MLP’s, which transport and store oil and gas, have also come under immense price pressure. In my opinion, this is an over extrapolation on the part of naïve investors and will correct itself in due course. Nonetheless, the oil glut has been a boone for $2 a gallon at the pump, and a confusing snarl for companies unprepared for the first and second derivative fallout.

In my opinion, US stocks remain the best asset class in that they offer a reasonable expected return for the risk of owning them. Good growth stocks have outperformed the market as a whole, and are well ahead of value stocks. Investors tend toward the value category when they become less sure of themselves. There has been no place to hide this year – no asset classes have offered up easy or obvious returns. It’s been tough sledding almost everywhere you look.

Between now and the end of the year, some things ought to become more clear. Concerns related to China’s growth rate and how it opts to handle its currency will temper. The Federal Reserve will likely raise interest rates, even though the economic data does not support a rate hike. Finally, 3Q earnings ought to paint a clearer picture as to the valuation of stock prices and the marginal outlook for growth heading into the coming year. As the negative impact from the drop in energy prices fades, the earnings outlook will correspondingly improve.

There is a lot of noise out there. Today, the concern is Volkswagen fudged emissions measurements on 11M of its diesel motors. If you remember, only last fall a wave of fear struck the country over the Ebola virus and the likelihood of airborne transmission. These things tend to pass. Luckily for us, the Pope visited Philadelphia recently and lifted everyone’s spirits, if only for a moment. This is proving to be a more challenging year than the last two. Some patience and fortitude are required. If you are not comfortable moving forward then I suggest we meet and review you portfolio.  Please feel free to call.

Bruce Hotaling, CFA, Managing Partner

Disclaimer:
The views and opinions stated herein are those of Bruce Hotaling, are of this date, and are subject to change without notice.   Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed.  Investments are subject to market risk, including the possibility of loss of principal.  Past performance does not guarantee future results.  The S & P500 is an unmanaged index of 500 widely held stocks.    Investors cannot invest directly in an index.   The PE ratio (price/earnings) is a common measure of relative stock valuation.

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