2015

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS December 14, 2015

on Wednesday, 16 December 2015. Posted in December, 2015

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS December 14, 2015

It’s All About the “Short” Term.

“In investing, what is comfortable is rarely profitable.”
                                                              Rob Arnot

While bulls await Santa and his rally, bears focus on yesterday, today and one or two days forward. Historically, last week was the peak for tax loss selling, but this current market is consumed by Fed uncertainty, energy and raw material prices, deteriorating technicals, and the widening of the junk bond yield spread. October gains have been largely retraced and volatility continues to climb. Shorts dominate and permabears have tilted the weight of commentary to the pessimistic side. China has been pushed to the background as the inevitable Fed 25 basis point rise starts the gradual process of rate normalization. According to the bears, the policy shift will mark the beginning of the slide of the economy into recession. Let’s look at the major short-term concerns from a longer term perspective.

Fed Policy Initiative

The most telegraphed 25 basis point increase in history is priced into stocks. But on a day-to-day basis traders take sides. The anxiety level has increased as discussion focuses on currencies, particularly the US dollar, commodity prices and global growth. A quarter of a point move will not affect the economy in any meaningful way, but as we all have to learn, “fear can far exceed reality.” The increased volatility (VIX) is the barometer of this fear. High junk bond yields have led some to draw comparisons with subprime loans, in our opinion it is more of a head fake similar to the Puerto Rican bankruptcy and the ensuing contagion. One only has to look at the carnage to see it is almost entirely limited to energy-related high yield bonds.

Further complicating the situation is Third Avenue Management’s ceasing and barring redemptions in its junk bond fund, Focus Credit Fund ($789 million). This is interpreted wrongly by many as in indicator of overall conditions in the junk bond market. However, subsequent to the barring of withdrawals a list was circulated of bonds offered for sale by a single seller believed to be the Focus Fund. Most hedge funds passed on the list citing the illiquidity of the unrated deeply distressed bonds and private equity investments. The fact that Third Avenue does not have the cash to meet redemptions is Focus Credit Fund specific and not reflective of the situation for the High Yield Market. The ripple affect should be minimal as Third Avenue is not Lehman Brothers or even Bear Stearns, where there were multiple layers of leverage linked to the financial system.

The good news is by Wednesday afternoon the speculation on the move will become reality. Unfortunately, despite numerous statements to the contrary by the Fed, bears focused on the potential of too much too soon, after Wednesday they will shift the rhetoric to the timing of the next rate increase and its dire consequences. We have long believed that the best strategy with regard to Fed action is listening to the Fed. In our opinion, it would take a reversal of the 25 basis point increase to question the Fed’s credibility. Short-term volatility will increase around this week’s rate rise, but there should be little or no long-term reaction.

Oil Oversupply

The problems of oversupply and rapidly declining oil prices will not be solved short-term. In fact, until a surprise increase last week, US oil inventories rose seven straight weeks. A continuation of the oil surplus should push equilibrium further into the future, but the laws of supply and demand still work. Demand has been stimulated by lower prices, oil demand is up about one million barrels a day, benefitting consumers and reflected in the increase in consumer spending but at the expense of slower corporate earnings. The recent decision to continue all-out production by OPEC led to the sharp decline in the price of crude over the past week. The budget problems of many Middle East oil producers, along with Russia and Venezuela, preclude any supply reduction. Contrary to any economic theory, when dependent on oil revenues to fund government spending, these countries pump at full capacity despite losses. In addition, other oil producing countries with reserves set aside are rapidly depleting these funds.

Lower overall commodity prices benefit consumers at the expense of corporate earnings. Consumer spending is hampered by higher rent and healthcare costs, but this is more than offset by lower energy prices and rising wages. Oil price equilibrium is farther out than expected only a month ago, adding confidence to consumers and translating into spending. Unfortunately, commodity producers bear the brunt of this transition. Additionally the strong dollar has lowered revenues and earnings to multinational corporations. Traditional retail, particularly department stores, is losing out to online retailing. Withexcess capacity and low margins, corporations lack pricing power. Rising unit labor costs as employmenttightens and rising interest rates will benefit consumers more than the average corporation.

Potential for Recession

Under the present circumstances there is no reason for a business cycle downturn. Remember, all recessions result in bear markets, although all bear markets do not lead to recessions. Those forecasting recession, the numbers have been increasing lately, believe that with only 2%-2.5% real growth, any loss of economic momentum will result in negative real growth. Not true. Even slow growing economic recoveries do not end until excesses create imbalances. Most often these excesses begin with rapidly rising inflation. An exception was the Financial Crisis of 2008-2009 was attributable to excesses and imbalances in Wall Street and the banking system. Today, our financial system is healthy and corporate and consumer debt are currently at very manageable levels. If there are any excesses it is federal spending.

Unicorns – Not the Mythical Variety

Unicorn is the term for a one billion dollar plus tech start up. Google, Amazon, Microsoft, Intel and Cisco never approached that valuation until after going public. An article appearing in the January 22, 2015 Fortune Magazine listed 80 Unicorn companies. In a recent update (August 25, 2015), the number grew to 138 Unicorns. This is in sharp contrast to only one, Facebook in late-2013. According to Fortune, “Smartphone, cheap sensors, and cloud computing have enabled a raft of new Internet-connected services that are infiltrating the most tech-adverse industries.” The characterization of these disruptors sounds eerily similar to the rhetoric of the 1997-1999 dot.com bull market.

Changes to previously accepted ground rules were made by the Unicorns to facilitate additional capital. Foremost is an insurance policy for late-stage investors. The risk to these investors is lessened by guaranteeing a specific return on investment if the next round of funding, an IPO, or a sale comes in lower than their round. Approximately 30% of the Unicorns have such an agreement for IPO’s, with lowerround employee shares diluted to satisfy out of the money investors. To protect employees from a down round, companies on average stay private longer (7.7 years) compared to 2011 (5.8 years). However, the extended time period increases the risk of a lower valuation from a market downturn and opens the possibility for potential competition. Mutual funds are rethinking and restructuring their strategy for these high valuation private investments. Lower valuations resulting from greater focus on earnings, as opposed to revenues, may be the beginning of a reclassification of the highly vulnerable Unicorn market. The threat of shrinking funds from private investors make Unicorns a leading indicator of potential problems for technology in general.

Investment Policy

The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. The current problem with the market is valuation as corporations work through a strong dollar, tighter margins, and inventory liquidation. Expect volatility into 2016 as corporations shift to satisfy increased consumer demand in an environment of uncertainty. The transition to a more consumer-oriented economy is in its early stages. After the Fed raises rates, stocks should perform better throughout the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for select Large- Cap Consumer Discretionary and Technology companies.

Merry Christmas and Happy New Year. We will see you in early 2016.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS December 14, 2015 (Copy)

on Wednesday, 16 December 2015. Posted in December, 2015

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS December 14, 2015

It’s All About the “Short” Term.

“In investing, what is comfortable is rarely profitable.”
                                                              Rob Arnot

While bulls await Santa and his rally, bears focus on yesterday, today and one or two days forward. Historically, last week was the peak for tax loss selling, but this current market is consumed by Fed uncertainty, energy and raw material prices, deteriorating technicals, and the widening of the junk bond yield spread. October gains have been largely retraced and volatility continues to climb. Shorts dominate and permabears have tilted the weight of commentary to the pessimistic side. China has been pushed to the background as the inevitable Fed 25 basis point rise starts the gradual process of rate normalization. According to the bears, the policy shift will mark the beginning of the slide of the economy into recession. Let’s look at the major short-term concerns from a longer term perspective.

Fed Policy Initiative

The most telegraphed 25 basis point increase in history is priced into stocks. But on a day-to-day basis traders take sides. The anxiety level has increased as discussion focuses on currencies, particularly the US dollar, commodity prices and global growth. A quarter of a point move will not affect the economy in any meaningful way, but as we all have to learn, “fear can far exceed reality.” The increased volatility (VIX) is the barometer of this fear. High junk bond yields have led some to draw comparisons with subprime loans, in our opinion it is more of a head fake similar to the Puerto Rican bankruptcy and the ensuing contagion. One only has to look at the carnage to see it is almost entirely limited to energy-related high yield bonds.

Further complicating the situation is Third Avenue Management’s ceasing and barring redemptions in its junk bond fund, Focus Credit Fund ($789 million). This is interpreted wrongly by many as in indicator of overall conditions in the junk bond market. However, subsequent to the barring of withdrawals a list was circulated of bonds offered for sale by a single seller believed to be the Focus Fund. Most hedge funds passed on the list citing the illiquidity of the unrated deeply distressed bonds and private equity investments. The fact that Third Avenue does not have the cash to meet redemptions is Focus Credit Fund specific and not reflective of the situation for the High Yield Market. The ripple affect should be minimal as Third Avenue is not Lehman Brothers or even Bear Stearns, where there were multiple layers of leverage linked to the financial system.

The good news is by Wednesday afternoon the speculation on the move will become reality. Unfortunately, despite numerous statements to the contrary by the Fed, bears focused on the potential of too much too soon, after Wednesday they will shift the rhetoric to the timing of the next rate increase and its dire consequences. We have long believed that the best strategy with regard to Fed action is listening to the Fed. In our opinion, it would take a reversal of the 25 basis point increase to question the Fed’s credibility. Short-term volatility will increase around this week’s rate rise, but there should be little or no long-term reaction.

Oil Oversupply

The problems of oversupply and rapidly declining oil prices will not be solved short-term. In fact, until a surprise increase last week, US oil inventories rose seven straight weeks. A continuation of the oil surplus should push equilibrium further into the future, but the laws of supply and demand still work. Demand has been stimulated by lower prices, oil demand is up about one million barrels a day, benefitting consumers and reflected in the increase in consumer spending but at the expense of slower corporate earnings. The recent decision to continue all-out production by OPEC led to the sharp decline in the price of crude over the past week. The budget problems of many Middle East oil producers, along with Russia and Venezuela, preclude any supply reduction. Contrary to any economic theory, when dependent on oil revenues to fund government spending, these countries pump at full capacity despite losses. In addition, other oil producing countries with reserves set aside are rapidly depleting these funds.

Lower overall commodity prices benefit consumers at the expense of corporate earnings. Consumer spending is hampered by higher rent and healthcare costs, but this is more than offset by lower energy prices and rising wages. Oil price equilibrium is farther out than expected only a month ago, adding confidence to consumers and translating into spending. Unfortunately, commodity producers bear the brunt of this transition. Additionally the strong dollar has lowered revenues and earnings to multinational corporations. Traditional retail, particularly department stores, is losing out to online retailing. Withexcess capacity and low margins, corporations lack pricing power. Rising unit labor costs as employmenttightens and rising interest rates will benefit consumers more than the average corporation.

Potential for Recession

Under the present circumstances there is no reason for a business cycle downturn. Remember, all recessions result in bear markets, although all bear markets do not lead to recessions. Those forecasting recession, the numbers have been increasing lately, believe that with only 2%-2.5% real growth, any loss of economic momentum will result in negative real growth. Not true. Even slow growing economic recoveries do not end until excesses create imbalances. Most often these excesses begin with rapidly rising inflation. An exception was the Financial Crisis of 2008-2009 was attributable to excesses and imbalances in Wall Street and the banking system. Today, our financial system is healthy and corporate and consumer debt are currently at very manageable levels. If there are any excesses it is federal spending.

Unicorns – Not the Mythical Variety

Unicorn is the term for a one billion dollar plus tech start up. Google, Amazon, Microsoft, Intel and Cisco never approached that valuation until after going public. An article appearing in the January 22, 2015 Fortune Magazine listed 80 Unicorn companies. In a recent update (August 25, 2015), the number grew to 138 Unicorns. This is in sharp contrast to only one, Facebook in late-2013. According to Fortune, “Smartphone, cheap sensors, and cloud computing have enabled a raft of new Internet-connected services that are infiltrating the most tech-adverse industries.” The characterization of these disruptors sounds eerily similar to the rhetoric of the 1997-1999 dot.com bull market.

Changes to previously accepted ground rules were made by the Unicorns to facilitate additional capital. Foremost is an insurance policy for late-stage investors. The risk to these investors is lessened by guaranteeing a specific return on investment if the next round of funding, an IPO, or a sale comes in lower than their round. Approximately 30% of the Unicorns have such an agreement for IPO’s, with lowerround employee shares diluted to satisfy out of the money investors. To protect employees from a down round, companies on average stay private longer (7.7 years) compared to 2011 (5.8 years). However, the extended time period increases the risk of a lower valuation from a market downturn and opens the possibility for potential competition. Mutual funds are rethinking and restructuring their strategy for these high valuation private investments. Lower valuations resulting from greater focus on earnings, as opposed to revenues, may be the beginning of a reclassification of the highly vulnerable Unicorn market. The threat of shrinking funds from private investors make Unicorns a leading indicator of potential problems for technology in general.

Investment Policy

The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. The current problem with the market is valuation as corporations work through a strong dollar, tighter margins, and inventory liquidation. Expect volatility into 2016 as corporations shift to satisfy increased consumer demand in an environment of uncertainty. The transition to a more consumer-oriented economy is in its early stages. After the Fed raises rates, stocks should perform better throughout the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for select Large- Cap Consumer Discretionary and Technology companies.

Merry Christmas and Happy New Year. We will see you in early 2016.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 30, 2015

on Monday, 30 November 2015. Posted in November, 2015

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 30, 2015

Is the Real Santa Claus on the Internet?

“There are three stages of man’s life: He believes in Santa Claus, he doesn’t believe in Santa Claus, he is Santa Claus.”                                        Author Unknown

The major equity indices remain near all-time highs set earlier in the year. Technicians and market strategists assert that a close above these record levels is a necessary precondition for the continuation of the bull market. These are the same analysts who during the August and September correction, were touting “death cross” and global recession. Today, many of the conditions present when the S&P 500 was down 12.5% from its high of 2,134.72 on May 20th, still exist. China and Emerging Markets are faced with excess capacity and deflationary pressures, oversupply plagues the Energy and Materials markets, the US dollar remains strong, US economic growth in 3Q was 2.1%, and 4Q2015 year-over-year earnings forecast is negative for the third consecutive quarter. Our investment strategy prior and through selloff was “In the short-term, there is potential for a selloff which will offer a tactical buying opportunity.” (Compass 7/20/15) Whether or not Santa brings a rally in December, or did we already have it in October, has no bearing on the fact the US economy is not going into recession and the shift to more consumer-oriented spending will keep real GDP in the 2.0%-2.5% range. It is a stock selection market as this transition unfolds.

Back to the Consumer

The shift to a more dominant consumer comes at a cost to corporate earnings. Shackled by energy and a strong US dollar corporate quarterly earnings will remain below historical growth levels at least through 1Q2016 and maybe beyond. In 2Q2016, the energy weakness will have lapped the sharp declines of 2015. However, the US dollar has strengthened again to 1.05 euros after touching 1.16 euros in late-August. Over this same period the 30-year Treasury Bond yield rose from 2.75% to 3.00%, while the 30-year German Bund has fallen from 1.55% to 1.30%. With our two major trading partners, Canada and Mexico, the dollar strength is muted. The weakness in the euro and to a lesser extent, the Japanese yen, is the result of the respective Central Bank’s easy monetary policy. Combined with the impending increase in US rates, the unintended consequence of this easing policy will be the increased flow of foreign exchange into US dollar dominated securities. Foreign investors will have the opportunity of potential dollar appreciation and capital gains with US equity investments.

With unemployment at 5% we expect wages to accelerate above real GDP growth, and when combined with lower gas and heating costs consumers, already brandishing healthy balance sheets, will zero in on high inventory induced retail discounts. The obvious transition from in-store purchases to online will accelerate. In fact, Thanksgiving and Black Friday online sales reported by Adobe were $4.47 billion, up 18% over 2014. (The data are based on 4,500 retail websites, including 80% of all online transactions of the 100 largest retailers.) Preliminary data indicate online surpassed in-store for the first time. As labor markets tighten and with 5.5 million unfilled job openings, wages and disposable incomes will increase. Rising wages will put additional pressure on corporate profit margins, while the Internet enables consumers to become more productive by getting more for their dollar. Middle class consumer purchases will increase in nominal terms (inflation) as wages continue rising. Corporate revenues will reflect this increased spending but lower margins will affect the bottom line. Results will vary company-tocompany with Mega-Caps optimizing combined retail and technology being the major beneficiaries.  Among these companies are Amazon, Apple, Facebook, Google, Microsoft and Netflix.

Earnings

Earnings and revenues have been weak for the past two years. A combination of dramatically low energy and other commodity prices have turned the Energy and Materials sectors negative by almost any matrix.  The continued strength of the dollar has affected earnings and revenues of most companies doing business overseas. But this is changing. Crude oil prices, while not expected to rise much in the next few years,
look like they have bottomed and are finding a base near $40 a barrel. The dollar remains strong and may strengthen further when rates are normalized. More favorable quarterly comparisons for both earnings and revenues will begin to show in the first half of 2016. Corporations, ex-Financial, have $1.7 trillion in cash, with Technology (35%) and Healthcare (18%) with the largest amount. A tax solution could bring the bulk of these funds held abroad back to the US. It may happen if Congress gets around to tax reform.

113015

The Fed will shortly be raising interest rates. The most thoroughly discussed policy change in monetary history will have a beneficial effect on stock multiples if the past is repeated. The Table above shows the effect of rising real Long-Term Treasury yields and earnings multiples and an estimate for the S&P 500 Index. According to Morgan Stanley, in a study going back to 1930 multiples are positively impacted as real rates rise up to 4%, beyond that level real rates have a negative or minimal impact. Given the current slow growth environment, it will be at least a couple of years before real rates go above the historic 4% benchmark. Even with rates where they are today, a 4% real rate would require a 5.8% nominal rate. Our studies show it is at the 3.5%-4% level of inflation that equities historically react negatively. This would imply a nominal rate for Long-Term Treasuries of 7.50%-8%, an extraordinary increase in inflation given the domestic and international outlook.

Investment Policy

The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. Expect volatility as corporations shift to satisfy increased consumer demand in an environment of global uncertainty and a strong dollar. The transition to a more consumer-oriented economy is in its early stages.  Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low
inflation, will result in increased earnings and multiple expansion with continued upside for select Large-Cap Consumer Discretionary and Technology companies.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 16, 2015 (Copy)

on Monday, 16 November 2015. Posted in November, 2015

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 16, 2015

Painting with a Broad Brush - - Trends for 2016 and Beyond.

The recent correction in August-September was attributable to the modest slowdown in China, deflationary impact of sharply lower commodity prices, and anticipation of the first Federal Reserve interest rate increase. The market, after a near-record monthly performance for October, is once again revisiting these “nagging” problems. Oil is near its cyclical lows and industrial commodity prices are still falling. The terrorist attacks in France have added a new dimension to ISIS. However, as worrisome is the potential for major European and US cities this may be, rarely do external incidences similar to this have a long-term effect on world financial markets. The most recent selloff is reflective of a slowdown in corporate profits and the transition to a more consumer-oriented spending.

US Economy – a business cycle with no recession in sight.

Finally, rate normalization is about to happen. As we look ahead commodity prices will have bottomed, Asia will stabilize, rising wages will increase disposable income, and the Fed has begun rate normalization at a very modest pace. The economy will continue to grow at a 2.0%-3.0% real rate as low energy prices and technological innovation keep inflation at low levels. Some wage push will be evident as the labor market tightens putting pressure on corporate profit margins. Since the financial crisis, corporations have had near record profit margins and cash flow. But that is about to change. Real disposable income is rising as technological advances and lower costs offset rising rents and healthcare increases.

Consumers, for the foreseeable future, are the driving force as spending holds steady above the levels of the prior five years. Housing is benefitting from a more normal cycle as the market is cleared of distressed sales and foreclosures. Economists complain that a high of 3.0% real GDP growth is too low, while investors remember that equities rose throughout a six year period with 2.1% real GDP growth. Auto sales continue to surprise and are running at an 18 million rate during August and September. The high level of light truck sales indicates small businesses are doing well.

Most consumers have adapted to life on the Internet. Services which were paid for are now free. Smart phones are the lynchpin to daily living. Television, as we know, it is history as media costs are down. Unlimited movies are always available for a monthly fee for less than two movies from cable. Houses and cars are all but purchased utilizing real estate and car dealer websites, no more driving around needlessly deciding your preference. These increases in productivity include banking, bill paying, shopping, food services, and even healthcare advice. However, these services are deflationary by virtue of lower costs to consumers and loss of business in many service companies. All this makes us more productive, but does not show up in a conventional measurement of productivity.

Today the housing market is growing, but erratically. New Home Sales in September at 468,000 (SAR) are still 50% below the 2000-2006 levels and back to levels not seen since the early-1980’s. First-time homeowners are about 30%, well-below the historical average of 40%. Existing Home Sales can be expected to grow as more homeowners’ equity rises from increasing home prices. In September 2015 sales were 5.55 million (SAR), the second highest rate since February 2007, when sales were declining.
Pent up sellers are trading up or buying smaller homes as retirement age approaches.  Similar to the New Home data, first-time buyers are below historical levels. The low sales rate for first-time buyers is more a function of demographics and supply/demand, rather than secular.

We believe over the next few years these sales will rise as household formations continue and the scarcity of new homes is solved. While many housing analysts blame the change in living preference of Millennial’s as a major reason for low sales, surveys by the Federal Reserve tell a different story. Over 70% of Millennial’s want to own their own home, but at this time, low income and student debt are a constraint. Rising prices and limited inventory at the low end further complicate homeownership. This
will change as the new home market becomes more in-line with potential purchasers, remember, Millennial’s finish college later, start careers late, and marry older and have children well-beyond past generations. For these reasons the new housing market seems back loaded.

Investment Policy

The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. In the short-term, there is potential for a further selloff offering a tactical buying opportunity. Markets remain vulnerable as investors and traders continue to assess China and Emerging Market economies, a stronger dollar, and mediocre earnings. Earnings should begin more favorable comparisons in 2016. Once the Fed
raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 2, 2015

on Monday, 02 November 2015. Posted in November, 2015

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 2, 2015

Media Meddling

The dire predictions for stocks just three weeks ago were met head on by the sixth best October in market history. The major averages are back near their all-time highs. Bears are unfazed, citing weak breadth as a major reason for a reversal and further declines. Many are looking for the levels of late-August to be retested, but this seems unlikely as the rationale behind the selloff was based on questionable extrap-olation of international and domestic data. With the full participation of the financial media, the slowdown in China was spread across global economies and impending deflation would bring not only Emerging Markets, but also Developed Countries, to their knees. To us, it had characteristics of a “bear raid.” Changes in the marketplace brought about by ETF’s and an increased presence of Algorithmic Traders set the stage for sharp fluctuations in stock prices.

The growth of liquidity in passive ETF’s gives traders the ability to buy and sell (including short sales) major sectors without trading individual stocks. Other examples are; Emerging Market ETFs, Commodity ETF’s, and country ETF’s. One of the first sectors sellers gravitated to was Biotech. When drug pricing was questioned, the run on the Biotech and Health Service sectors forced many investors of individual ETF participating companies to sell, if for no other reason than the stocks continued to fall. This has happened to a lesser extent with MLP’s as oil prices declined. With media support, misguided research explaining that a China slowdown would dramatically reduce earnings for any tech business even marginally involved in Asia. For individual companies like Apple, it was a combination of a peaking in momentum for smartphone sales and its exposure to China, which would drive the stock price lower. Any company supplying Apple was also degraded. A Report by Goldman Sachs, listing US companies and their percentage of revenues from China, sent their stock prices down 30%-50%. Even after company CEO’s refuted these data, widely published by Forbes, USA Today and most national newspapers, there has been no retraction by the analyst or the media outlets.

We mention Apple because it was immediately following the release of their 3Q2015 earnings that, despite Conference Call assurance in July, momentum in smartphone sales was continuing and China was growing better-than-anticipated, the stock plunged. From its high of $132 prior to earnings, the stock sold down to the low $90’s. The point here is that somehow fundamentals were no longer a deciding factor for Apple and for many other tech stocks. Apple is a company with about $200 billion in cash and cash equivalents, or about $35 in value per share. While unknown sources convinced media that Apple was wholly dependent on smartphones and China and it was time to sell. To hell with the fact Apple is a cash machine and good fundamental analysts know the value of the company is the present value of future cash flow. Apple’s recently released 4Q2015 was more in line with the Conference Call and the stock rallied to about $120, where it is today. Apple’s December 2015 quarter guidance implies continued revenue growth in China and Emerging Markets. Also, 69% of Apple users have yet to upgrade to a larger screen. We did not sell any of our Apple in our managed accounts.

3Q 2015 Earnings

According to Thomson-Reuters, S&P 500 earnings, ex-Energy, are expected to grow 6.3% in 3Q2015. FactSet in its latest Earnings Insight shows that of the 340 S&P 500 companies reported, 76% have beaten the mean estimate and 47% have reported sales above the mean estimate. For companies with higher earnings than estimated, the aggregate beat is 5.9%. As would be expected, Energy and Materials are reporting the largest year-over-year decreases of all major sectors.

performance summery

The Table shows that only Healthcare, Infotech, Consumer Staples and Consumer Discretionary are up since the beginning of the year, although all Sectors rose for the month of October. While difficult to draw a direct correlation of the impact of earnings on October ETF prices, the companies beating estimates rose 2.2% for the four day period around earnings, double the historic 1.1% rate. Healthcare and Infotech have been showing better-than-anticipated earnings and revenues on an individual company basis. Both sectors are leaders in the rally. According to Bespoke Investment Group, the Healthcare sector is up 6.3% since 10/23/15, while the S&P 500 is up only 1.5%. On an equal-weighted basis, the rise is 7.3% with only two stocks in the sector showing declines, Stryker (-2.7%) and CR Bard (-0.2%). For this sector, this is contradiction to the weak breadth mentioned earlier in the Report.

Money Flows into Stocks

One of the indicators that we follow is Mutual fund and ETF’s net purchasers and net sellers of Mutual fund shares. Mutual fund investors have been net sellers of US equity funds going back to January 2010. Only during 2013 and into 1Q2014 were there any consistent purchases. There have been net sales of US domestic equity fund shares in 75 of the latest 80 weeks and for the past 15 straight weeks. Thus far in 2015 the outflow is $114 billion against a total inflow of $46 billion for full-year 2014. International flows are small by comparison with net flows into foreign funds of $28 billion year-to-date, compared with $11 billion for all of 2014. These data continue to confirm the absence of the individual investor, outside of money managers and company sponsored pension plans. Both domestic and international fund flows were negative for the four weeks ending 10/21/15 and therefore Mutual funds were probably not a positive during the rally. The net flows into ETF’s are more volatile. Unfortunately, the data do not break out domestic and international, but do show a $9.5 billion net inflow into equity ETF’s for the four weeks ended 10/21/15. For the last two week period, that inflow was $7.2 billion. For the year to late-October the flow into equity ETF’s was $81 billion, compared to $60 billion for all of 2014. Inflows were positive for 65 of the past 89 weeks. ETF flows are more indicative of institutional purchases and sales and given the volatility they appear more trading oriented, with individual weeks reaching $20 billion in either direction.

The US Economy

Real GDP for 3Q2015 at a 1.5% increase was inline and cannot be expected to change anyone’s investment strategy. For the market, it was priced in and has no implication for Fed action. Housing, though the recent data are mixed, is more a supply/demand problem with insufficient inventory resulting in rising prices as potential purchasers back away. Although New Home Sales were down in September, prices are up 13% year-over-year. This week will see economic data for manufacturing and retail sales. These data are not market movers but Friday’s employment report may disappoint as there has been a rise in layoffs and many skilled jobs go unanswered. Short-term, after the great October, anything can happen. Biotech research and technology improving productivity will not go away. Companies on the leading edge of medical innovation will not be regulated out of the market. The recent earnings of Apple, Google, Amazon and Microsoft affirm our belief in large cap technology companies. As 2016 approaches, dollar comparisons will become more favorable. During the recent rally, companies with more than 50% in international revenue showed better relative performance. This indicates investors are already discounting better earnings in the coming year.

Investment Policy

The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. In the short-term, there is potential for a further selloff offering a tactical buying opportunity. Markets remain vulnerable as investors and traders continue to assess China and Emerging Market economies, a stronger dollar, and mediocre earnings. Earnings should begin more favorable comparisons in 2016 and stocks, currently 16.7x estimated forward 12-month earnings are fairly valued. Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS October 19, 2015

on Monday, 19 October 2015. Posted in 2015, October

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS October 19, 2015

Back on Track?

“Dear Optimist, Pessimist, and Realist, While you guys were busy arguing
over a glass of water, I drank it.”
                                                                    Sincerely,The Opportunist (Author Unknown)

As stocks move up from the double bottom experienced in August-September, most traders agree that the world is no longer ending but, as yet, the bull uptrend has not been restored. The long-term Pessimist, or more likely, the perma-bears have taken a victory lap on a 12% correction in a 200% increase in the S&P 500 since March 2009. Only a month ago China was collapsing, Goldman Sachs predicted oil below $30 a barrel, deflation was inevitable, 3Q2015 earnings reports would confirm an earnings recession leading to an economic downturn, and stocks would break through technical support levels and fall another 10%-20%.

The rally since September 30 indicates a significant reversal in investor psychology. China data, including GDP released today, are consistent with expectations in August-early September, oil prices are at the same levels as late summer, and P/E ratios are unchanged. Stock prices, measured by the S&P 500, are only about 3% off their summer highs and 4.7% below the May 20, 2015 all-time highs. No doubt the market correction was related to perceived Emerging Market and China weakness resulting in selling out of these markets and their derivatives. As we said in our September 8 Compass:

“Traders participate in both up and down markets without any regard for fundamental economic value placed on individual stocks or indices. Computer programs react to specific trading patterns which offer the best chances of success. These algorithms are limited by a finite number of profitable trades. Volatility is the key to profit and the more the algorithmic traders, the higher the volatility. In periods like those experienced in the past few weeks, markets become casinos, increasing the possibility of flash crashes and massive losses of investment funds.”

In such times the astute investor is a Realist, stepping aside as these traders dominate. As of Friday, the S&P 500 is now above its 50-day moving average for the first time since mid-August. On a technical basis this is a necessary step in reversing the downtrend. Also, seven of ten S&P 500 sectors are above their 50-day moving averages, indicating improved breadth not seen in the rally from the August lows. According to Bespoke Investment Group, 59% of the S&P 500 stocks are back above their 50-day moving averages, the highest reading since last June. One has to wonder, who are the Opportunists?

Earnings season for 3Q2015 is underway and the majority of S&P 500 companies will report over the next two weeks. According to FactSet, of the 58 companies reported, 81% beat mean earnings estimates while only 50% reported revenues above the mean estimate. We expect revenue growth to continue to slow. With US nominal GDP only growing about 3.5%, the strong dollar, and the impact of lower commodity prices, revenue increases are hard to come by. However, good corporate managers set
themselves apart from the average and grow earnings. General Electric, which released earnings last week, held their margins and reported earnings above expectations, despite declining revenues. Intel also maintained strong margins, even with a declining PC market.

Once again, the Energy sector is the largest contributor to the overall earnings decline to the S&P 500. For 3Q2015, Energy earnings are forecast to decline 64.9% and 63.5% for 4Q2015. Earnings ex-Energy are positive for both quarterly estimates. The decline in commodity prices is reflected in the Materials sector with earnings estimated to fall 19.9% in 3Q2015 and 13.9% in 4Q2015. Overall, earnings for the rest of the year should remain subdued as the unfavorable year-over-year comparisons reflect the sharp rise in the US dollar and the dramatic decline in oil and commodity prices. More favorable comparisons are anticipated in 2016 as these anomalies in both earnings and revenues are lapped.

Lower gasoline prices have begun to have an effect on consumer spending. It is not the magnitude of the decline, but only when coupled with sustained lower prices does spending directly increase Personal Consumption Expenditures in GDP. Gas prices are now traceable in retail spending. A recent report by JP Morgan found that:

“Individuals spent $.78 on every dollar saved on gasoline, with about 18% of that going to eating out and 10% to groceries, according to the study. Other big categories included entertainment, electronic & appliances, and charitable donations.”

Spending on autos has remained high throughout the decline in gas prices and is correlated more to the length of auto loans (up to 84 months) and the historically low interest rate. However, the psychology of lower pump prices has resulted in increasing sales of SUVs and pickup trucks as energy efficient auto sales have declined substantially. This trend may continue through 2016 as oil supply is forecast to outstrip demand.

Since the closing low on August 24, the price of crude has risen 29%. Based on the accepted bull market definition, a 20%+ rally following a 20% decline, crude is in a bull market. This is bull. A recent report by Morgan Stanley stated that “The addition of new supply from Iran in 2016 will likely keep the market oversupplied and defer any need to incentivize any US supply growth until 2017…almost the entirety of added supplies in 2016 will come from Iran, Iraq and Saudi Arabia.”

oil

As shown in the Table, the annual total crude demand is forecast to rise 3.0 mb/d, or 3.8%, from 2014-2016. The total crude supply will increase 2.8 mb/d, or 3.5%, over this same period. Based on these estimates, supply will remain above demand through 2016. Taken at face value, these data imply lower energy prices into the foreseeable future. Given the potential instability of many OPEC members, it is
hard to have confidence in these data, in fact, the supply of crude from OPEC member companies could vary significantly in either direction.

Investment Policy

The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. In the short-term, there is potential for a further selloff offering a tactical buying opportunity. Markets remain vulnerable as investors and traders continue to assess China and Emerging Markets, oil prices, a stronger dollar, and mediocre earnings. Earnings should begin more favorable comparisons in 2016 and stocks, currently 16x estimated forward 12-month earnings, are not expensive. Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities.


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 21, 2015

on Monday, 21 September 2015. Posted in 2015, September

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 21, 2015

No Upward, No Onward?

“If you don’t know where you are going, any road will get you there.”
                                                                                             Louis Carroll

While the Fed decision to hold rates was anticipated, it was the reasons given that sent markets lower on Thursday and Friday. The FOMC statement inclusion of a new warning that “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further pressure on inflation near term” was a dovish shift, but a clear picture of reality. This fortified bearish arguments of a US economic slowdown spiraling into recession, lower corporate earnings, and potential global deflation. Slower growth in China is in its fifth year and by all accounts, the transition to a consumer-based economy is on schedule. However, the shift away from bricks and mortar has lowered commodity demand. As a result, short positioning in mainstream commodities is at historically high levels. With sentiment on global growth negative, the bears seized on the idea that this revelation by the Fed implies the situation is much worse and the Fed knows something not reflected in market prices. Such thinking borders on the ridiculous and takes on a life of its own when investment psychology is negative. We see nothing unusual in the FOMC decision recognizing that the year-over-year core rate of inflation is 1.6%, below the 2.0% precondition for a rate increase, may fall in the near term. It seems more reasonable that Chairman Yellen and the Board do not want to risk making this “highly symbolic” move to normalization without follow through.

The preoccupation with short-term movements in the markets has brought about a reincarnation of technicians and market timers. They have been drawn into the deteriorating global growth story which has monopolized the financial media since mid-summer. Only one problem, the US economy keeps growing. Dire reports of $20 oil, wholesale recessions in Emerging Markets, and the hard landing in China dictate day-to-day market swings. Contrary to what bears are forecasting; US stocks with 50% or more international revenue exposure and those with 100% domestic revenues have traded about the same since mid-August through mid-September. Stocks with 50%+ international revenues declined on average 8.0%, meanwhile, 100% domestic revenue companies were down 8.2%. Russell 1000 averaged a decline of 7.9% during this comparable period.

There will be low inflation in the US for years, not only from low energy and industrial commodity prices, but from rapid technological innovation and a changing labor market. Higher wages and salaries have been absent even though the level of employment is at its natural rate. This anomaly has been cited by the Fed and economists as temporary, but as yet there is no sign of an uptick. A recent study conducted by Liberty Street Economics provides data into current labor market conditions. Since unemployment rose to 10% in October 2009, the rate has declined steadily to the current level of 5.1% and is expected to fall below 5.0% by year-end. Jobs by unemployed persons have added to a net 11.3 million workers to total private payrolls. Given the magnitude of the decline in the unemployment rate and the number of new jobs added, wage and salary growth has been virtually nonexistent. Our interpretation of the Table below is that being unemployed is a significant handicap when compared to job seekers that are currently working. At employment, the unemployed, on average, receive an hourly wage 18.5% below their previous pay. The employed worker pay outstripped the returning worker by raising, on average, his earnings 6.9% over his previous job. Additionally, only 13.2% of the job-to-job workers did not receive benefits, compared with 37.3% for reentering workers.

hutchco9 21
What does this mean? Firstly, the depth of the Great Recession limited job mobility and although there were incremental pay increases,turnover was much lower. On the other hand, those returning after being unemployed, many with long-term unemployment, were more willing to settle for lower wages. In fact, data from the Study show that 40% of these workers are actively looking again compared with 23% of those who have not been out of the workforce. With so many reentrants on the employment rolls at lower overall costs (wages and benefits) to employers there seems little likelihood of any near-term wage/push inflation.

Investment Policy

The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. Earnings should begin more favorable comparisons as 2016 approaches and stocks, currently 16x estimated forward 12-month earnings, are not expensive. Markets remain vulnerable as investors and traders reassess China and Emerging Markets, falling oil prices, a stronger dollar, and fluctuating interest rates. In the short-term, there is potential for a further selloff offering a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities.


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 25, 2015

on Thursday, 27 August 2015. Posted in 2015, August

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 25, 2015

Chinese Wall of Worry

“The key to making money in stocks is not to get scared out of them.”

                                                                                                    Peter Lynch

Bears took over last week, but, as of this writing no “Black Swans” have surfaced and despite sharp downward moves in the averages, the correction remained orderly. Technicians are claiming a broad assortment of negative formations, media and CNBC are parading the permabears, and according to strategists, this selloff was a necessary prerequisite for the continuation of the six year bull market. To others this long overdue correction is a precursor to a global recession. After flirting with a 10% correction last Friday, all major averages fell sharply into negative territory at the opening on Monday. In trading resembling “flash mistakes” of the past, the market whipsawed a minimum of 300 Dow points four times in the first half hour. The VIX reached a high of 53 briefly, a level not seen since early 2009. A rally held into early afternoon, but by the close all major averages were well-below Friday and off their record highs with the Dow down 13.5%, S&P 500 -11.3%, and the NASDAQ -13.5%, all clearly in correction territory.

The Chinese Government, working through the People’s Bank of China (PBOC), on August 11th initiated a flexible currency policy devaluing the yuan 2%. The following day the yuan fell an additional 2%, but the sale of dollars orchestrated by the PBOC near the close of trading cut the decline in half. Since then the yuan has remained at these levels with PBOC interventions. Obviously, the new currency policy is part of a longer-term plan by the Chinese Government to reach a market-oriented level for the yuan. Stock markets in Europe and the United States sold off as the extent of the currency adjustment remains unknown and on speculation of the weakness of China’s economy. Recent data, released over the past two weeks, point to a more rapidly deteriorating economy, much worse than had been assumed. We believe that China’s devaluation is the appropriate policy as part of an overall economic stimulus. Since the yuan was pegged to the dollar it appreciated about 14% over the past year against the currencies of many trading partners. With exports falling and overall growth rapidly slowing, the PBOC has begun its own form of QE. China can be expected to further weaken the yuan, but at the same time must be careful to avoid a free fall.

To base future investment strategy on what is happening in China is both impossible and unnecessary. For US investors the implications of a China slowdown are clear, lower commodity prices. It has long been known that economic data from China are unreliable and therefore difficult to ascertain if China is experiencing a slowdown or an outright recession. GDP growth is officially 6%, but the “Beijing Whisper Number” is 1.5%-2.5%. So much for a closed economy. One thing is certain, the oversupply of nonagricultural commodities ranging from metals to oils is directly related to falling demand from China. We would not expect equilibrium until there is a sizeable reduction in commodity producers, most likely by default or bankruptcy. Despite the recent dialog by market bears, the effect on the US economy is marginal at best; US exports to China are less than 1% of GDP. Our imports are primary materials and contracted goods sold around the world under US company brands. Prices of these branded products will decline with a depreciating yuan, perhaps complicating the normalization policy on the data dependent Fed.

China’s problems are well-known and the Fed is going to raise rates sometime in the future. China is one of the few countries with monetary options in its arsenal and has only starting utilizing them. Today, for the second time in two months, the PBOC lowered interest rates and bank reserves, this should be interpreted as a move to stimulate the China economy, rather than support for the falling Shanghai Stock Market. Accompanying the Chinese devaluation has been an accelerated depreciation throughout the Asia-Pacific region’s exporting countries. Lower real interest rates and the push for infrastructure in China resulted in many of these countries overestimating growth and falling prey to excess investment. Deteriorating overall productivity and misallocation of capital surfaced with China’s slowdown. For the region a prolonged adjustment cycle will require a restructuring of past misallocations and reducing new investment. These Emerging Market policy makers are hindered by deflationary risks in a low or no growth environment, making it difficult for transition to a new growth cycle. However, a positive is this current account surplus for most Asian emerging countries, with only India and Indonesia in deficits of under 2.5% of GDP.

For Fed watchers, the devaluation creates confusion for timing a second-half interest rate increase. As markets approach the inevitability of the overly anticipated increase of the Fed Funds rate, the rhetoric of these “Feders” and the business press will intensify. The 10-year Treasury yield is now below 2%, reflecting a flight to safety from foreign currency denominated assets. The Fed’s move to rate normalization will be influenced by currency destabilization and falling inflationary expectations from lower commodity prices. It is the resiliency of the US economy that argues for a 2H2015 rate increase. We feel confident in the Fed and are agnostic to the timing, certainly they know better than anyone when to initiate the interest rate rise. Not unlike Y2K, the increase in interest rates will pass without chaos to markets and the bears will swiftly shift gears and speed forward to the next perceived crisis.

The current US economic recovery, now over six years in duration, remains subdued, but positive. Across the rest of the developed world, for Europe and Japan growth continues, but below US levels. Today, the global economy, or more specifically, resource-dependent emerging market countries, are experiencing recessions as raw material prices have fallen. For the BRIC’s (Brazil, Russia, India and China), only India remains unaffected. Brazil is in recession, real GDP is forecast to fall 1.7% in 2015 and prices are rising nearly 9%. Lower oil prices and a 28% decline in copper over the past year have sent Brazil spiraling downward. Russian dependence on energy exports (50% of gov’t revenues) is well-documented, but it has been the sanctions related to their “annexation” of Crimea and the further intrusion into the Ukraine that has sent the country into a deep recession. With real GDP estimated at -3.6% for 2015 and prices currently rising at 15.9%, the ruble has deprecated 45% against the US dollar. As mentioned, China’s economic pivot away from infrastructure overgrowth to a consumer economy has further reduced demand along the Pacific Rim for iron ore, coal and copper. We expect the supply/demand imbalance to continue throughout the World’s commodity exporting countries.

The US economy has added net 4.6 million jobs since the beginning of 2014 while real GDP averaged 2.2%. The closely watched Employment Cost Index (ECI) rose 0.2% in 2Q2015 and it is unlikely that any reports between now and the September FOMC meeting will present data in support of rising income. More importantly, whenever the Fed moves without inflation long-term rates do not rise, but with short-term rates rising slowly, the yield curve does not invert. With raw material prices still seeking a bottom and plagued with excess capacity worldwide, both consumer and wholesale prices remain below 2011-2014 levels. For US consumers, both business and households, the savings from a sustained period of lowered gasoline and heating costs are being used to offset additional health costs and higher rents. The new paradigm of renting rather than purchasing has resulted in a shortage of quality rentals. With low inventories home prices are rising, and along with strict mortgage requirements ensure a continuation of the rental trend. As we move further along the business cycle, housing will provide stability to growth as a “normal housing market” adjusts to tighter regulation and changing demographics.

To US investors, the recent earnings season, although better than estimated prior to its start, gives no clear picture to 2H2015. In fact, any upside to the Energy sector has been reversed during the recent drop in crude prices. According to FactSet, with about 90% of the S&P 500 reported, “73% have reported earnings above the mean estimate and 51% have reported sales above the mean estimate.” An indication of the circumstances affecting 2Q2015 earnings is revealed in a survey of Conference Calls of 415 S&P 500 companies by FactSet. The terms most used by companies show: Currency (56%); Europe (53%); China (44%); and Energy (42%) as the order of relevance. As we are now nearly two months through 3Q2015, a strong US dollar remains a problem for multi-national companies and a broadening segment of the S&P 500. At current levels the yuan will only marginally impact US exports to China for those companies already dealing with a slowing Chinese economy and a stronger dollar elsewhere. Earnings from the current quarter are shaping-up as a replay of 2Q2015.

Investment Policy

Markets remain vulnerable as investors and traders assess the outcome for China, falling oil prices, a stronger dollar, and fluctuating interest rates. In the short-term, there is potential for a further selloff offering a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 12, 2015

on Wednesday, 12 August 2015. Posted in 2015, August

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 12, 2015

Chinese Wall of Worry

“The key to making money in stocks is not to get scared out of them.”
                                                                                                    Peter Lynch

The Chinese Government, working through the People’s Bank of China (PBOC), on Tuesday initiated a flexible currency policy initially devaluing the Yuan 2%. On Wednesday, the yuan fell an additional 2%, but the sale of dollars orchestrated by the PBOC near the close of trading cut the decline in half. Obviously, the new currency policy is part of a longer-term plan by the Chinese Government to reach a market-oriented level for the yuan. Stock markets in Europe and the United States sold off as the extent of the currency adjustment remains unknown and on speculation of the weakness of China’s economy. Recent data, released over the past two weeks, point to a more rapidly deteriorating economy, much worse than had been assumed. We believe that China’s devaluation is the appropriate policy as part of an overall economic stimulus. Since the yuan was pegged to the dollar it appreciated about 14% over the past year against the currencies of many trading partners. With exports falling and overall growth rapidly slowing, the PBOC has begun its own form of QE. China can be expected to further weaken the yuan, but at the same time must be careful to avoid a free fall. Awareness of caution was exhibited when the PBOC intervened at the conclusion of trading mentioned above. It is early in the currency game and for now market technicians have turned decidedly bearish as the major averages are breaking down or flirting with important technical levels - - here come the “Death Crosses.”

For Fed watchers, the devaluation creates confusion for timing a second-half interest rate increase. As markets approach the inevitability of the overly anticipated increase of the Fed Funds rate, the rhetoric of these “Feders” and the business press will intensify. The 10-year Treasury yield is now down to 2.1%, resulting from a flight to safety from the yuan and other risk-on assets. The Fed’s much anticipated move to rate normalization will be influenced by currency destabilization and falling inflationary expectations from lower commodity prices. We feel confident in the Fed and are agnostic to the timing, certainly they know better than anyone when to initiate the interest rate rise. Not unlike Y2K, the increase in interest rates will pass without chaos to markets and the bears will swiftly shift gears and speed forward to the next impending crisis.

The current economic recovery, now over six years in duration, remains subdued, but positive. Across the rest of the developed world, for Europe and Japan growth continues, but below US levels. Today, the global economy, or more specifically, resource-dependent emerging market countries, are experiencing recessions as raw material prices have fallen. For the BRIC’s (Brazil, Russia, India and China), only India remains unaffected. Brazil is in recession, real GDP is forecast to fall 1.7% in 2015 and prices are rising nearly 9%. Lower oil prices and a 28% decline in copper over the past year has sent Brazil spiraling downward. Russian dependence on energy exports (50% of gov’t revenues) is well-documented, but it has been the sanctions related to their “annexation” of Crimea and the further intrusion into the Ukraine that has sent the country into a deep recession. With real GDP estimated at -3.6% for 2015 and prices currently rising at 15.9%, the ruble has deprecated 45% against the US dollar. China’s economic pivot away from infrastructure overgrowth to a consumer economy has further reduced demand along the Pacific Rim for iron ore, coal and copper. We expect the supply/demand imbalance to continue throughout the commodity exporting countries.

The US economy has added net 4.6 million jobs since the beginning of 2014 while real GDP averaged 2.2%. The closely watched Employment Cost Index (ECI) rose 0.2% in 2Q2015 and it is unlikely that any reports between now and the September FOMC meeting will present data in support of rising income. More importantly, whenever the Fed moves without inflation long-term rates do not rise, but with short-term rates rising slowly, the yield curve does not invert. With raw material prices still seeking a bottom and plagued with excess capacity worldwide, both consumer and wholesale prices will remain below 2011-2014 levels for years. For US consumers, both business and households, the savings from a sustained period of lowered gasoline and heating costs are being used to offset additional health costs and higher rents. The new paradigm of renting rather than purchasing has resulted in a shortage of quality rentals. With low inventories home prices are rising, and along with strict mortgage requirements ensure a continuation of the rental trend.

To US investors, the recent earnings season, although better than estimated prior to its start, gives no clear picture to 2H2015. In fact, any upside to the Energy sector has been reversed during the recent drop in crude prices. According to FactSet, with about 90% of the S&P 500 reported, “73% have reported earnings above the mean estimate and 51% have reported sales above the mean estimate.” An indication of the circumstances affecting 2Q2015 earnings is revealed in a survey of Conference Calls of 415 S&P 500 companies by FactSet. The terms most used by companies show: Currency (56%); Europe (53%); China (44%); and Energy (42%) as the order of relevance. As we are now nearly half way through 3Q2015, a strong US dollar remains a problem for multi-national companies and a broader segment of the S&P 500. Additionally, a floating yuan will negatively impact US exports to China for those companies already dealing with a slowing Chinese economy and a stronger dollar elsewhere. Earnings from the current quarter are shaping-up as a replay of 2Q2015.

Markets remain vulnerable as investors and traders assess the effects of China devaluation, falling oil prices, a stronger dollar, and fluctuating interest rates. In the short-term, there is potential for a selloff which will offer a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities.


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 3, 2015

on Monday, 03 August 2015. Posted in 2015, August

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 3, 2015

Complacency in a Sea of Confusion

When markets exhibit the action we have witnessed recently, it is best to step back and reevaluate the macroeconomics and company fundamentals with respect to perspective long-term investment strategy. Short-term confusion reigns, opening security markets to ill-conceived impediments such as Greece and China. Greece’s problems are European, although US markets reacted violently to this bankruptcy in the European Union. Since Greece has become a non-event again, European markets have risen with Germany and France, up year-to-date 15.39% and 19.0%, respectively. Meanwhile, the S&P 500 is up only 2.3% over the same period. Blame it on China, which is more dependent on the US as a trading partner, but “doomers” and momentum traders, including algorithmic firms, have jumped at the opportunity to short tech companies doing business in China.

China’s economy has weakened faster than most analysts had anticipated, moving from an economy based on government induced capital spending, primarily infrastructure, and exports. A reduction in capital spending in China has been reflected throughout the world in commodity prices, particularly in emerging markets, many of which price raw materials in currencies tied to the rising dollar. Transformation to a consumer-led economy will take time. With consumer spending only 30% of China’s GDP, the transition is in its early stages, but it will happen. Abandoning good companies that are facing short-term speed bumps may well prove a bad long-term investment. The Apple/China connection is far overblown. The reference to speed bumps by Tim Cook pertains to the drop in the highly speculative Chinese stock market and not to current transition policy. Nowhere have the bears mentioned the more than doubling in Apple’s China revenue from 2Q2014 to 2Q2015, or the fact that Apple is operating “pedal to the metal” in China.

Looking out beyond China, it will soon be the Fed tightening and the inevitable “chaos” that will accompany this much anticipated one-quarter point rise in the Fed’s fund rate in 2H2015. Already firms are talking their book on CNBC. Today, BlackRock’s Global Investment Strategists stated “the stock market could be poised for a 10% decline as the Federal Reserve gets ready to hike interest rates.” As investors, we recognize that the long-term prospects for equities are tied to quarterly earnings. This is evidenced from the recent performance of the major S&P sectors. The Table below shows the chronology of earnings estimates beginning on July 1, 2014 up through July 28, 2015.

august15

As seen on the Table, earnings have been revised down significantly since July 2014. Although not shown in the Table, as of July 28, S&P 500 earnings are estimated to fall 1.3%. Needless to say, the stock prices in the Energy sector, and to a lesser extent, Materials, have been most negatively affected. Over the past three months, Energy (XLE) and Materials (XLB) have fallen 17.7% and 11.2%, respectively. Both of these sectors are victims of a dramatic shift in the global supply/demand curve. The best performing sectors, Consumer Discretionary (XLY), Healthcare (XLV) and Technology (XLK), have shown increases in the recent earnings estimates (July 1-July 28), and stock prices have reacted accordingly. The fact that earnings are better than estimated seems to have been pushed aside by concerns on China and Fed policy, but this in no way minimizes the importance of quarterly earnings. There are always many ways to spin earnings, among these are lowered expectations, exceptional factors in energy, effect of Apple, and easy comparisons with easy bank stocks. Also, many emerging trends are evident during this earnings season. This is particularly true for energy and commodity producers whose earnings continue to weaken even as growth continues globally. Old retail has been replaced by online purchases and for food retailers, organic has displaced traditional menus. Former tech leaders are being upended by cloud-based platforms.

Moving forward past 2015, the housing cycle will continue well-beyond the Old Normal cycle. Today, home ownership rates are 63.4%, a 48-year low. This is despite a rise in the last three quarters in household formations to an annual level of 1.68 million, above the long-term average of 1.1 million and an average of 268,000 for the prior eight years.

The millennial generation (25-34) will become a force in household formation. Prior to 2014, many millennials, strapped with student loan debt, were unemployed or underemployed and for financial reasons lived at home. A new report from Pew Research shows that in early 2015, 26% or 16.3 million adults born in 1981 or later, live with their parents. This number is confirmed by the Urban Land Institute which estimates 16.5 millennials lived with their parents as of November 2014. This supply for potential household formation should gradually move onto self-sufficiency depending on the rate of economic growth. We expect the imbalance between homeownership to continue favoring multi-family rentals for the foreseeable future. However, a Survey in 2015 (Millennials - Coming of Age) by Goldman Sachs concludes “they have been slower to marry and move out on their own.” In addition the same Survey, while exhibiting an indifference to auto ownership, shows 70% want to marry and 74% want to have children. Today, 60% are choosing renting rather than buying, but 70% of those surveyed said homeownership was extremely important (40%) or important (30%).

Markets remain vulnerable as investors and traders assess the effects of falling oil prices, a stronger dollar, and rising interest rates. In the short-term, there is potential for a selloff which will offer a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities.


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS July 20, 2015

on Tuesday, 21 July 2015. Posted in 2015, July

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS July 20, 2015

Meanwhile Back at the Ranch


“Headlines, in a way, are what misled you because bad news is a headline, gradual improvement is not.”                                                               Bill Gates

As the headline noise created over Greece and China fades, the US economy and 2Q2015 earnings move back into the forefront. Bankrupt Greece, now in the European Union “bankruptcy court” and China’s misspent attempt at broadening its stock market yielded no contagion and left the major US stock averages near levels where these potential “disasters” began. Unrelated to this media blitz has been an internal correction of equities within the S&P 500. The S&P 500 is up 3.29% year-to-date as of close on Friday, and has not been more than 5% below its all-time highs this year. However, the average S&P 500 company is off about 15% from their highs and with only one-third of listed NYSE companies above their 50-week moving average, some are calling this a stealth correction. Recent moves to record highs in the NASDAQ 100 have been jettisoned by large-cap technology companies. This is borne out when looking at four leading tech companies and their performance during the July 1-17 period. Google (+29%), Amazon (+11%), Facebook (+10%) and Apple (+3%) have a market cap of $1.7 trillion and represent 30% of the total capitalization of the NASDAQ 100. Last Friday the average rose almost 1% while 60% of the 100 companies were down. Throughout this “upheaval” the volatility index (VIX) briefly flirted with 20 in early July but quickly settled back to below 12 last week. The VIX is an indication of upside and downside volatility, but longer term a low VIX level accompanies rising markets. Over the past 25 years, the VIX has had its highest increases in July, August and September.

Not unlike the old Western movies, which used a return to the ranch to segue into a new scene, we too believe we will soon return to focus on fundamentals that will determine the magnitude and duration of the current bull market. We cannot fully discount a potential definable stock market correction, but the resilience of equities has already been tested during the first-half 2015. An economic slowdown, weaker earnings, and perceived international chaos could not drive the broad-based market indices into correction territory. Astute longer term money managers continue to see value and growth with only minor interruptions from bears leaning on the algorithmic traders for downside support. The investment landscape is strewn with bearish strategists and economists who have called 20 of the last 0 corrections.

Looking forward to the next few weeks earnings will be front and center. Although early in the season, according to FactSet, 2Q2015 S&P 500 earnings are expected to decline a revised 3.7%, a slight bit better than the -4.5% estimate as of June 30, 2015. Energy, once again, is the largest contributor to the S&P earnings shortfall. Excluding the Energy sector, the aforementioned -3.7% would result in a 2.6% increase. With 61, or 12%, of the S&P 500 reported, 72% have beat estimates. For revenues the beat rate is 56% with the overall revenue decline estimated at 4.0%, the largest since 3Q2009. (This week 131 S&P 500 companies are scheduled to report.) The negative estimate (-55.4%) for the Energy sector are well-known and compensated for in overall investment strategy, but the 6.0% estimated decline in the Technology sector, ex-Apple, may come to many as a surprise. Despite better-than-expected earnings from some of the large-cap tech companies, overall Tech sector earnings will be negatively impacted by the strong US dollar and, to a lesser extent, a slowdown in China.

We expect the dollar to trade around current levels while Europe stabilizes. Should the dollar strengthen further it will endanger the anticipated pickup in 2H2015 earnings. But even under these circumstances US equities may continue to rise. In an increasing interest rate environment, stocks will be the alternative to bonds and with a growing economy, US stocks offer less risk than foreign alternatives. Under such conditions we would expect some multiple expansion. Although the economy would continue to improve, margins would rise on lower revenues and earnings would weaken. Energy remains a question mark as the WTI crude oil price has fallen sharply to $50 a barrel in July, after increasing from $47.60 to $59.47 during the second quarter. Prices during 2Q2015 averaged $58.02, 43.6% below the $102.96 in the corresponding quarter in 2014. This second quarter price increase explains the 7% upward revision in Energy sector estimates.

Our outlook for the US economy is for continued below-average recovery growth rates (2.5%-3.5% GDP), moderation in quarter-to-quarter GDP amplitude as the consumer sector and housing normalize. The Fed will act when the data dictate, but most likely later this year or early 2016. We would expect the bearish consensus to amp up the negative consequences once Fed policy is finalized. History has shown that the initiation and implementation of a Fed policy to increase interest rates almost always result in rising equity prices. As shown in the Table below, of the 14 instances of Fed policy initiatives raising rates, since the inception of the S&P 500 Index, only two resulted in declining S&P stock prices over the period of rate increases, and that was in the 1970’s. The average annual return for the S&P 500, excluding the down periods, was 9.4%.

july

Most surprising from the Table is the Fed’s ability to not upset equity markets. Granted the Greenspan Put bears some responsibility for the Tech Bubble and ensuing crash in the early-2000’s, but on balance the results no way reflect todays bearish case. Slow retrenchment from the Fed, which will lead to rate normalization, confirms to us that the economy, after more than five years on life support, is breathing on its own. One could conceivably chart the beginning of the “old normal” business cycle from this point. Bull markets do not die of old age, but rather from an impending recession. In fact, seven of the last eight bull markets ended in recession. If there is a broad consensus on the economy today, it is that there is no recession on the horizon. Recessions start on average about five years after tightening begins, but have occurred in as little as three years. Additionally, it is two years on average after wage gains of 4% and one and a half years after the yield curve inverts that the downturn begins.

Markets remain vulnerable as investors and traders assess the effects of lowered earnings amid fluctuating oil prices, a stronger dollar, and rising interest rates. In the short-term, there is potential for a selloff which will offer a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities. 


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 29, 2015

on Tuesday, 30 June 2015. Posted in 2015, June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 29, 2015

Auf Wiedersehen Greece!

“You shouldn’t commit suicide because you fear death.”
                                                                Jean-Claude Junker

Goodbye to the euro, say hello to the drachma. Greece has sealed its fate and the US stock market will shortly turn the page on this European problem. The call for a referendum vote on July 5th preceded by a non-payment to the IMF of 1.5 billion euros tomorrow will make reinstatement virtually impossible. As we have mentioned on these pages, the lack of bargaining leverage, accompanied by an inflexible position, enabled the European Union (EU) to pull the string. But more likely, it was Germany that ultimately decided Greece’s fate. In fact, it may have been the German plan since Alexis Tsipras’ election in January.

The Maastricht Treaty in 1992 creating the EU, and a few years later the euro, is without a fiscal union, leaving no mechanism for profligacy. Germany, by its size and favored position in the resulting EU bureaucracy, enhanced their trade position by exploiting the southern periphery, including Greece and the other PIIGs. Greece borrowed from European banks to propagate their spending. Today, saddled with debt at 180% of GDP, owed mostly to state lenders, Greece would have to grow in excess of 4% annually to pay the interest on the 141.8 billion euro debt owed to the European Financial Stability Fund (EFSF). This facility refinanced bank debt, reducing the possibility of contagion in the private banking sector. Additionally, the 315.5 billion euros in total Greek debt is mostly held (upwards of 80%) by the EFSF, central banks, and the IMF. Given that GDP is down 25% over the past five years even further lending would not pay down debt. The Syriza Government has vowed not to touch pensions and further reduce the budget.

There is little likelihood of contagion as government bond rates of the other weaker countries (Italy, Portugal and Spain) have been little impacted by the current situation. The withdrawal by Greece from the EU may have a positive longer-term impact on these other marginal countries. The Grexit should serve as a clarion call to the other profligate countries that austerity is alive and well, and there is no blank check from the EFSF. For Greece it is devastation. If the ECB seizes the government deposits used for collateral as stated in the agreement, Greece will not recover for a generation. Younger workers are leaving an already aging population and as unemployment, currently at 26%, rises and GDP will collapses. A member of NATO since 1952 and with one of the best outfitted militaries in the Alliance, Greece may look to Russia or even China to restore solvency. However, the message from Germany is clear, a default by any other name in Greece is a default.

Investment Strategy

As Europe works through the current problems, US equities should be afforded a premium relative to other developed countries. The widespread Greek selloff will not trigger more than an overdone reaction for US stocks, and depending on the magnitude, result in a buying opportunity, as short-term trading adjustments from fast money investments are reallocated and losses taken. Also, one has to question the efficacy of the timing of the Commonwealth of Puerto Rico’s $73 billion in debt classified as non-payable. Aside from being imprudent, it certainly drew a media response tying US debt vulnerability to Greece. But earnings season is around the corner and the economy is tilting to more growth in 2H2015. Housing is rapidly gaining traction and the earnings pressure from the oil breakdown and stronger dollar has reversed. A financially healthy consumer is returning, and given the level of interest rates and low inflation, we expect stronger spending as the rest of the year unfolds. With the prospect for economic growth improving, the possibility of a definable 10% correction is slowly evaporating. While many expect a Fed rate increase to add instability to the financial markets, we anticipate a Y2K type event.

Once the Fed raises rates, stocks should perform well during the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and limited multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective Large-Cap domestic corporate equities.


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 15, 2015

on Monday, 15 June 2015. Posted in 2015, June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 15, 2015

Bond Market Volatility – It’s Greek to Us.

No discussion of today’s securities markets is complete without prefacing Greece and the volatility in the bond markets.  For Greece’s new government there is little room for an agreement.  In fact on Saturday morning the news from Greece was that Prime Minister Alexis Tsipras stated he is “willing to accept unpalatable compromises to secure a deal with international creditors.”  Sounded like he has finally realized Greece has no further leverage, either accept what is offered or default.  Not so, talks in Brussels on Sunday ended with “large gaps” in the negotiations.  The next attempt will be on Thursday but EU leaders are becoming annoyed at the Greek stonewalling.  By Thursday both sides could possibly reach an agreement keeping Greece in the euro but not solving the longer term problems.  In actuality, Greece should not matter except to traders and a few European banks, most everyone else owning Greek debt and related securities has had three years to insulate themselves.  Even if an agreement is not reached and Greece defaults, so what!  

The volatility in the bond market is no less meaningful to US equities than Grexit.  As Central Banks implement their customized version of QE their purchases limit liquidity in Long-Term bonds.  This attracts traders using leverage seeking to profit from short-term moves based on market internals, rather than on fundamentals.  There is no economic rationale for these almost daily fluctuations.  Incorporating potential negatives of Fed interest rate policy and Greek default into the short-term outlook results in more volatility in a leveraged illiquid market - - a traders Utopia.  The prospect of any clarity on Fed interest rate increases from the meeting will dominate discussion early in the week and without any agreement with Greece, be prepared for continued instability.  All of this with technicians bantering about a ten year chart of the 10-year Treasury showing a “big, inverted head and shoulders bottom pattern,” WOW!

Economic Insights

Since the completion of QE3, the US economy has gradually moved toward self-sustainability.  However, without a viable consumer, growth has been erratic and more influenced by external events, such as weather, falling energy prices, and the strengthening dollar.  Both retail spending and housing are showing clear signs of a consumer returning from hibernation.  Consumer sentiment has improved as employment rises and wages begin to reflect some labor tightening, but also a new segment of non-savers having additional purchasing power are entering the market.  

While one month does not make a trend, the data for May retail sales certainly was welcome.  The comparison with the prior month shows an increase of 1.2%, but comparing month-to-month with year-over-year data gives a clearer picture, as the effect of declining gas prices is included, and the inadequacies of seasonal adjustments is limited in the twelve month data.  

Retail Sales Investing
                                 Source:  US Census Bureau


The Table shows an interesting trend over the past year as the lower-end consumer remains reluctant or unable to spend.  On a 12-month basis, Merchandise Stores, including department stores and discount retailers, remain flat despite a savings reduction of up to 40% from gasoline.  Auto sales are the largest contributor to rising total retail sales as they have been during the past few years.  In May, dealers reported auto sales at an annual rate of 17.7 million, the highest level in nine years.  Hard to fathom the savings at the pump is a determinate of auto sales, but it is in an unconventional way.  Looking at Auto Sales year-to-date through May 2015 shows total new car sales, both domestic and imported, down 3.1% from the same period in 2014.  Total truck sales (which includes SUVs) are up 10% with SUV sales +13.9%, led by luxury SUVs +25.7%, followed by mid-sized SUVs +16.9%.  The all-important pickup category rose 9.9% over the past five months.  Of the top 20 vehicles sold in May, the more reasonably priced cars show a distinctive downtrend, less reflective of cheaper gasoline mileage than the lower-end purchaser, Chevy Cruz (-26.7%), Honda Accord (-18.3%), and Toyota Camry (-11.6%) show the largest declines.  The higher-end consumer remains the bulwark of retail sales.  

While most analysts have been awaiting the consumer to turn gasoline savings into spending, we have stated that the savings to the average consumer will result only in a marginal increase in spending.  A recent report by the New York Federal Reserve Bank modeling supply and demand oil shocks back through the 1980’s concludes that the “expansionary oil supply shock of late-2014 and early-2015 will have a relatively modest stimulative impact on economic activity, which will peak around mid-2015, and the effect should dissipate significantly by early-2016.”   Aside from looking for increased consumer spending from energy savings, the most recent employment data offer an insight into where consumer spending may begin to make a meaningful impact on economic growth.  In May 2015, labor force participation rate rose to 62.9% but only slightly above its March 2015 all-time low of 62.7% and well-below the 66.4% high in December 2006.  What is interesting is the under-25 age category accounted for 96% of the 392,000 net new entrants into the labor force.  According to the Household Survey, of the 272,000 net employed last month, 76% were in this demographic.  The hiring of these new employees is an indicator of labor market tightening.  With a record 5.38 million available jobs a full employment level in 2H2015 at 5.0% seems attainable.  We anticipate some wage pressure at these levels and with job openings at record highs a further increase in participation rates.  

As retail sales await rising employment and a tighter labor market to ignite purchases by a more financially sound consumer, the housing market in April 2015 is picking up where it left off in 2013.  The transition away from foreign and investment purchasers to the traditional first-time buyer and existing homeowner upgrade is slowly evolving.  

•    Housing Starts – At 31.6% increase in April over March to 103,600 starts is the highest monthly total going back to October 2007.  Also permits were up 15% month-over-month, the best level since June 2008.  Multi-family starts remain about 33% of the total as the rental market for many potential first-time homebuyers is the only alternative.  Also, Millennial’s are moving into cities where they are working, and without family commitments, savor convenience over home ownership.  This trend in multi-family building should remain intact as permits rose 21% month-over-month in April.  

•    Existing Home Sales – Once again, existing home sales came in below expectations.  Although up 6.4% above April 2014, mortgage restrictions, low inventory levels, higher prices and limited equity for existing home owners have all impacted current sales.  This is the category most affected by the withdrawal of investors and foreign purchasers.  

•    New Home Sales - Month-over-month April 2014 new home sales were 8.9% above March and for the first five months 21.4% above 2014.  However, these levels remain 45% lower than the early 2000’s.  Builders have shunned this market moving instead to multi-family or building single family homes above the level of affordability for many first-time homebuyers.  Overall inventory remains low, but the level of housing starts indicates a current level of housing starts that availability will increase.  Also, the proposed easing of mortgage restrictions will draw first-time buyers even as rates rise.  

Markets remain vulnerable as investors and traders assess the effects of lowered earnings amid fluctuating oil prices, a stronger dollar, and rising interest rates.  In the short-term, there is potential for a definable technical correction which will offer a tactical buying opportunity.  Once the Fed raises rates, stocks should perform well during the rate normalization process.  Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and limited multiple expansion with continued upside for equities.  Our investment policy remains optimistic on selective Large-Cap domestic corporate equities.

 


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 1, 2015

on Tuesday, 09 June 2015. Posted in 2015, June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 1, 2015

Dissecting the Sectors

“The future is no more uncertain than the present.”
                                                                          Walt Whitman

Overview

Since 2008, we have followed ETF’s. ETF’s provide money management an asset offering diversification by style and country allocation. The investment research function at both buy-side and sell-side firms is aligned by sector. Performance by most institutional investors and fund managers is reported by sector. For analysis, the major S&P sector ETF’s are unique investment entities, each responds differently to change whether economic, political, or fundamental. These circumstances may be recurring, such as reaction to changes in the complexion of the business cycle or external events such as the strengthening dollar, or changing energy policies. The investment decision on the sector ETF’s is ultimately decided on the fundamentals of the stocks comprising the ETF. The Table below highlights recent data on these ETF’s.

6 1 15

In the Table are the Relative Strength Indicator (RSI), the 6-Month Correlation of Returns, and the performance of the major sector S&P ETF’s. Correlation is the measure of strength and direction of the relationship between two price series, in this case each S&P Sector ETF and the S&P 500 (SPY). Prior to the financial crisis, from 1994-2008, half of the sector funds had a correlation to the S&P of 0.7 or less. Since then and up to today this number has been greatly reduced. This is due, in part, to a recovery phase in the overall markets. As shown in the Table, only the Energy ETF (XLE), Materials ETF (XLB) and the perennially-low correlated Utility (XLU), are below the 0.7 level. Missing are Consumer Staples (XLP) and Healthcare (XLV), both of which were considered defensive sectors and having lower correlations to the S&P 500. Over the past three years, the average return of 15.3% for the XLP and the post-Obamacare XLV at 26.2% outperformed the SPY (11.5%). Healthcare has dominated sector ETF performance since the passage of the Affordable Care Act in 2010, and has benefited more recently from the upsurge in biotechnology, where gains of over 100% in selected biotech stocks are commonplace. In fact, the S&P Biotech ETF (XBI) is up 80.1% over the past year. It will be some time, if ever, that Healthcare is considered once again a defensive play.

Despite average Real GDP growth of about 2% over the past five years, the economy-sensitive Consumer Discretionary (XLY), Industrials (XLI) and Technology (XLK), have consistently outperformed the SPY. Corporate profits continued to rise into 2014, but the trend began slowing in the XLY and XLI by mid-year. Financials were hurt by write-offs, legal expenses and government fines. By late summer, the drop in oil prices were being taken seriously as was the rise in the value of the US dollar. Forward earnings estimates were revised down, but equity markets after a brief but sharp selloff in early October continued into record territory by May 2015. By mid-February oil prices fell by 50% as the value of the dollar rose by 30% against the euro into mid-March. Since then, oil has risen modestly and the dollar has fallen from its high. Falling crude oil prices decimated 2015 earnings for the Energy sector and the rising dollar was felt by not only multi-national corporations but also domestic importers. Earnings growth was projected to be negative in 1Q2015 and 2Q2015 with FY2015 flat or up slightly from 2014. However, once again earnings surprised to the upside and were positive in the first quarter.

The Utility sector was a leading gainer into year-end 2014 reflecting the widely unexpected drop in interest rates from late-spring. With prospects of a rate rise almost certain during this year, Utilities have fallen nearly 6% in the past three months - - back to playing defense. Healthcare continues to outperform and seems to be gaining momentum from expanding employment, new conventional immunology therapy for cancer treatment, and cost cutting on medical equipment through technological advances. The upcoming Supreme Court decision on Obamacare could temporarily derail this upside momentum. Continued strength in Consumer Discretionary, up 5.8% in the last three months is based more on expectations than reality. Retail sales remain weak, housing is marginally gaining strength, and the gas savings are proven more fiction than fact. There is too much dependence on the prospect of wage increases buoyed by rising consumer confidence. Healthcare and Technology, both outperformers in 2014 and thus far in 2015 are capable of sustainable earnings growth in a choppy environment. Looking forward to 2H2015 overall earnings should begin to recover.

Markets remain vulnerable as investors and traders assess the effects of declining earnings amid fluctuating oil prices, a strong dollar, and below consensus economic data. In the short-term, there is potential for a definable correction which will offer a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during a rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and limited multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective Large-Cap domestic corporate equities.


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 18, 2015

on Monday, 18 May 2015. Posted in 2015, May

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 18, 2015

A Growing Interest in Bonds

Will the volatility in fixed-income markets continue to lead the wide fluctuations in global equity and currency markets? After the dust settled last Friday, the 10-Year Treasury, which traded with a 1.80% yield in mid-April, reached 2.40% on Monday, only to fall back to a 2.15% yield by week’s end. The German 10-Year bund, which only a few weeks ago was yielding a barely positive 0.08%, saw yields rise above 0.75% before declining to 0.65% on Friday. This rise in the bund came as the ECB continues its aggressive bond purchases. The euro continues to rise against the dollar. Since its lows of 1.03 in early-April, the euro climbed to 1.14 by week’s end. US stocks reacted by falling over 1% early in the week, but by Friday the S&P 500 was up 0.31%, a new record high. The Dow and the NASDAQ finished up 0.45% and 0.89%, respectively, and remain in striking distance of record highs.

Explanations abound over these fluctuations, but the truth is elusive. One factor is that fixed-income markets are thin with trading volumes about half of the pre-2008 crisis levels. Government policy (Dodd-Frank) and the forced exit of proprietary trading desks at large brokerage firms and banks left dealer inventories at an estimated 10% of prior levels. Trading is now concentrated and without adequate dealer inventories, a repricing of bonds to more realistic levels results in wide spreads. In retrospect, European Bonds were irrationally priced as the Central Bank QE policy reduced the likelihood of deflation. For most of this year, momentum traders have moved between oil, the dollar, and bonds which seem to rise in lockstep. Oil prices, which reached $110 a barrel in mid-2014, fell to $42 at its lows in January. Until recently, there was an overwhelming consensus that the dollar would reach parody with the euro as the euro fell to 1.03 while at the same time oil reached its lows on its way to $30 a barrel. European Bond prices rose after the ECB buyback was announced and yields of most of most bonds under ten years were negative. Traders and hedge funds piled into long-term bonds as markets priced in permanent deflation in Europe and disinflation in the US. Participating traders believed fundamentals supported these moves. But markets reversed, and many of these hedge funds along with algorithmic traders, were caught on the wrong side of the trade. Last week the sudden turnaround reached the equities markets as stocks fluctuated widely in response to the bond selloff. In our opinion the sharp selloff in equities reflects a need for dollars to cover trading losses and margin calls.

The recent volatility distracts from the real problems for bond investors, fixed-income mutual funds. Year-to-date through May 3rd equity mutual fund outflows were $51 billion dollars, compared to a $1 billion inflow over the same period last year. Meanwhile, domestic fixed-income bond funds had $52 billion in net inflows year-to-date. More interesting is the net outflow from domestic equity funds has continued for 19 consecutive weeks, while US taxable bond funds have experienced 20 straight weeks of net inflows. Many of these retail investors switched out of equities during the latter stages of the stock market collapse in 2008-2009. Since that time taxable bonds have remained in a bull market. Unfortunately, this bull market is about to end, even if rates move up slowly. We do not expect any immediate flood of withdrawals from these funds until losses begin to accrue in the accounts and are mirrored in quarterly statements. Bond fund inflows remain strong, but it is important to watch for a slowdown in the net inflows. Remember, the job of the bond mutual fund manager is to manage along the yield curve, not to time the market.

As often stated on these pages the US economy is presently in no danger of a cyclical recession. Data for 1Q2015 are weak and the marginal growth of 0.2% in real GDP will be revised to a negative when the second estimate is released on May 29th. The most recent economic data show no marked pickup in activity thus far in 2Q2015. This is somewhat disconcerting as weather, particularly in the Northeast, is often the reason given for a weak 1Q2015. The long-awaited return of the consumer remains uncertain, as retail sales in April were much weaker than consensus. Last week the University of Michigan Consumer Sentiment Index fell much more than forecast. The decline was widespread, covering all demographics and regions. Noteworthy, for the first time in recent years, consumers lowered expectations for a faster recovery. According to the data source, consumer disenchantment witnessed in the 7.6% decline in the May Sentiment Index remains consistent with a 3% PCE. Our position has been that personal consumption expenditures (PCE) is far less important to overall economic growth (38%) than to real GDP final sales (68%). In addition, housing remains lackluster as the supply of affordable new homes is less than demand, resulting in higher prices. In a report today, the National Association of Home Builders claimed “Consumers are exhibiting caution, and want to be on a more stable financial footing before purchasing a home.” However, the average loan is $315,670 for a newly-built home as builders focus on higher-end buyers, not entry level.

The positives of the oil price decline has yet to work its way back into the economy. The negative effect on capital spending, employment, and earnings in the Energy sector far outweigh the benefits. According to economists there is little need to worry because there is a lead-time of 12-18 months for the full impact of increased consumer spending and business saving to be realized. Time is running out, crude oil is already 43% above its February lows and at the pump, gas prices have risen 37.3% to $2.80 per gallon, well-above their late-January lows. Retail gas prices are now back to levels last seen in November 2014. Any consumer savings on energy has been spent on increased costs for necessities, including the rising payment for Obamacare. With an economy expected to grow in the 2%-3% range for full-year 2015, the question is; where will the growth come from? Market strategists focus on increased employment and the eventual uptick of wages and salaries, but without pricing power, corporations are reluctant to raise wages. According to a study by the Chicago Fed, it will take an increase in employment of at least 800,000 to ignite wage push inflation. Even the much awaited income tax returns for 2014 are lower than normal and tax payments have risen above expected levels. A rise in the PCE above the average 2.5% is unlikely for some time and during this cycle may never reach the sustained 5.0% seen in previous recoveries.

Stocks are up, albeit at low single digit rates, despite the current economic slowdown, the consequences of a rising US dollar for US corporate growth and earnings, perceived risks related to Fed policy, and stretched stock market valuations and various geopolitical risks. The economy is growing slower than had been forecast a few months ago, but it is growing. The dollar has stabilized and oil prices are at a more sustainable level. Although impossible to model the ideal level for oil, the US dollar, and bond yields, all are moving closer to equilibrium. Oil normally sells at a price where the marginal producer can make a normal profit. According to “experts,” this is between $60 and $80 a barrel. A rising dollar attracts foreign funds offering positive currency translation and appreciation in underlying securities, US equities markets are the recipient of this shift in capital flows. Bonds reflect inflation expectations, which at current levels of 1.5% and offering a real return of 1%, make a 10-Year Treasury yield of 2.5%-3%. Signs of increasing growth should begin to appear as we move through the summer. Stability in energy, currency, and fixed-income markets will give the stock market the underpinning for further upside.

Markets remain vulnerable as investors and traders assess the effects of declining earnings amid fluctuating oil prices, a strong dollar, and below consensus economic data. In the short-term, there is potential for a definable correction which will offer a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during a rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and limited multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective Large-Cap domestic corporate equities.


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

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