2016

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 29, 2016

on Monday, 29 August 2016. Posted in 2016, August

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 29, 2016

American Consumer – Healthy and Wise, Part II   

Jackson Hole - “Much Ado About Nothing.”    

Media attention for Chair Yellen’s speech last Friday began on Monday as headlines forecast “Markets on hold until Friday,”  ridiculous yes, unexpected no.  The main thrust of the much anticipated speech was that the economy is strengthening and therefore so has the case for a 1/4 point rate increase.  That should come as no surprise.  As discussed on these pages for the last couple of years, a second rate increase in over nine years is a small step toward a 2% Federal Funds rate.  Even at 2%, the rate is well-below the 5%+ average rate over the past 35 years.  When the QE3 taper was announced in May 2013, the bond market reacted immediately and the 10-Year Treasury spiked to 3%.  Today, the 10-Year Treasury is at 1.56%, unchanged from before Yellen’s talk.  The S&P 500 fell 7.5% to 1,560 during June 2013 and quickly reversed, by early 2014 it was up 18.6%. The taper, which began in December 2013, was completed in October 2014.  The first 1/4 point increase came 14 months later after the December 2015 FOMC meeting.  Another increase would be welcome as the move to normalization will be slow.  Since 2009, it seems that after every FOMC meeting the interpretation of Fed speak only works to the disadvantage of investors who listen.   
At the beginning of 2016 there were many Fed “experts” forecasting a potential of four rate increases this year, now many are saying only one in December.  Whether the Fed moves in September or December, expect a reaction in the equities markets.   Any meaningful selloff is a long-term buying opportunity.  With the weak seasonal months of September and October coming, expect a continued media dialog of the consequences of Fed policy and its negative implications for the stock market.  Additionally, the bears will give attention to Brexit, oil prices, stronger US dollar, and China debt, but realistically keep a sharp eye on the US economy and the healthy and wise consumer.    

Consumer in Transition 

Since the December 14, 2015 Compass, we have been commenting on the cautious consumer transitioning to a more active spender.  The low returns for retirees and those looking toward retirement have had to readjust their spending patterns.  Since the financial crisis, Baby Boomers save more and work longer.  With Boomers not retiring, Millennials were faced with the aftermath of the Great Recession and the lack of job openings from a normal generational cycle.  Only recently have Millennials found increased job opportunities and are starting families and beginning to spend. After navigating the unchartered waters of the past few years, the cautious consumer is emerging financially healthy.    

Consumer Liquidity – According to a report from the Federal Reserve Bank of NY, household debt increased 0.3% in 2Q2016, primarily from increased auto and credit card activity.  With the length and duration of auto loans (72 and 84 months) enticing marginal buyers, these loans have grown to 9.0% of total debt, approaching the record 9.5% in 2002.  Mortgage debt has declined by 50% and student loans remain flat as the integrity of for-profit colleges is questioned.  Overall, delinquency rates have declined, the proportion of loans delinquent 90-days or more for all consumer loan categories (auto, student, credit card and mortgage) fell from 1Q2016 to 2Q2016 as total debt fell from 3.6% to 3.3%.  Recent Consumer Sentiment Reports (Michigan and Conference Board) reflect a more aggressive consumer, a reversal from 2015 when sentiment fell.  High income household spending is driven by stock market performance and improving economic outlook, whereas middle income consumers are dependent on current wages and home value.  And, for the lower-end consumer, gas prices are the prime driver.  All of these catalysts are presently in force.     

Housing – July Existing Home Sales fell 3.2% from June 2016 and down 1.6% from year-ago levels in a report from the National Association of Realtors (NAR).  Existing sales represent the largest category of the housing sector and has been constrained by lack of inventory.  The NAR explains “Retailers are reporting diminished buyer traffic because of the scarce number of homes on the market…”  Total inventory in July was 5.8% lower than a year ago and is at a low 4.7 months.  The median home price was 5.3% higher than July 2015. Over time the market will adjust to the supply/demand imbalance.  However, the regulatory constraints for potential buyers will continue.  Many first-time homebuyers and distressed sale owners will be challenged for some time.  Overall, 2016 is shaping up as the best year for existing home sales since 2007, but at levels almost 30% lower than the record 2005.  Expect the slow upward trend to continue as more Millennials and current home owners with increasing equity upgrade as incomes rise.    

The most recent data on New Home Sales reflect the continued inconsistencies in the housing market.  These sales were up 12.4% in July 2016 to a nine-year high of 264,000, according the US Census Bureau.  Year-over-year July sales 31.3% higher and at a median price of $294,600, below the $296,400 in July 2015.  This lower median price may indicate a shift to lower-priced starter homes, a category where sufficient supply has been absent in recent years.  Inventory is at a low 3.7 months, well-below historic levels.  |
 
Investment Policy  

Our investment policy remains optimistic and favors a strategy based on slow economic growth and improving 2017 quarterly earnings. The transition into a more consumer-oriented economy is on schedule, but not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap consumer and technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.  We would avoid companies deriving substantial revenues from Europe until the currency translation become favorable.

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September, 27th 2016

on Tuesday, 27 September 2016. Posted in 2016, September

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 27, 2016

And in this Corner…
 
“Democracy is being allowed to vote for the candidate you dislike least.”               

                                                                                                                 Robert Byrne 

With the Fed meeting behind us and the Fedwatchers in semi-seclusion until mid-October, the focus shifted to the Monday night debate.  Objectivity when discussing politics is always difficult and our Reports have made a concerted effort to remain on the sidelines.  This election cycle, unlike most others, could have an impact on the securities markets in the short term.  Rarely are two candidates so markedly different, both personally and philosophically.  As the debate approached, stocks began to reflect the uncertainty of a possible Republican victory.  Up-to-date polling showed a tightening and momentum shift.  Fear of the unknown lifted volatility and equities retreated.   In actuality, the US securities markets are more comfortable with a known quantity.  This was illustrated after the Monday night debate, as overnight stock futures rose as Clinton proved the aggressor even though chances are high that the needle was not moved much in either candidate’s favor.  After all the hype given prior to the event, it was a letdown.  With two more debates scheduled, the polls should remain close right up until Election Day.  Only if the recent gains by Trump hold or improve will the market volatility increase as the impact of policy initiatives is assessed.  
 
Major policy changes in the immediate aftermath of the election are rare.  Three out of four election scenarios result in a divided government.  A Trump win and holding control of the Senate and House is more of a possibility than a Clinton victory and winning both Chambers of Congress.  Two of Trump’s policy initiatives, tax reform and trade policy, could move forward quickly with a sweep.  Tax reform would be welcomed in a Republican House.  In concert with Speaker Paul Ryan, prioritizing tax reform could fast track and give across the board tax cuts to individuals and reduce the corporate tax rate from 35% to 15%.  The problem remains the size of the federal deficit which will balloon from current levels (about $20 trillion) and increase an additional $10 trillion over ten years.  Of course with the Government there is always an alternative way to account for the deficit increases and bring it closer to “revenue neutral.”  Enter “dynamic scoring” which allows law makers to reduce the unfunded costs by assuming that the tax cut revenues from the growth in the economy would offset the deficit rather than using normal accounting.  Hence, Trump’s 4.5% real growth yields only a $3 trillion deficit over ten years. 
 
Trade reform, or protectionism, would carry a much greater risk.  Under the articles of NAFTA, the US could withdraw with six months’ notice.  One has to worry that Trump may try to leverage NAFTA to get Mexico to pay for the wall.  The President has broad powers to regulate trade if justified by economic or security reasons.  Add in the cost of immigration reform, defense spending, domestic initiatives such as childcare and education reform, and you create greater tail risk and Wall Street does not like big tail risk.  Clinton on the other hand, champions more of the same, big ideas with limited results.  A study by Morgan Stanley going back to 1933 shows that less than 25% of campaign promises are made into law if both Chambers are controlled by the other party.  The figure jumps to close to 50% if the parties are split in the House and the Senate.  Only with a sweep would Clinton be able to exact her tax increases.  The Morgan Stanley study also shows a less than 60% passage rate with a majority in Congress.  Given the hostility between both parties over the past 12 years even these figures seem too high.  
 
Earnings
 
Closing in on 3Q2016 earnings season the outlook opens the possibility of a much anticipated recovery after five consecutive quarters of year-over-year declines.  According to FactSet, S&P 500 earnings are estimated to decline 2.3%, this is below the estimated earnings growth of 0.3% at the beginning of the quarter (June 1).  Energy, once again shows the largest decline (66.4%).  Excluding Energy, the estimated total earnings growth rate improves to +0.9%

Investment Performance

Although not shown on the Table, Information Technology is the only sector to show an increase in earnings estimates since the end of 2Q2016.  Overall the lowered estimates reflect a smaller percentage decline when compared to the immediately preceding five quarters.  Analysts are looking to 4Q2016 for S&P earnings to be positive (5.7%), but given the historical precedent of forecasted earnings moving lower into the actual quarter, a decline of estimates into December 2016 would not be unusual.  Using S&P 500 stock performance there is evidence that earnings estimates are a key variable for stock prices.  Improving earnings in 4Q2016 and for 2017 are being discounted in recent sector stock prices.  The overall S&P 500 Index is up 5.9% year-to-date through September 23, 2016, with 3.3% coming since the end of June 30, 2016.  Sectors with declining prices in 1H2016, Financials, Healthcare and Information Technology are now all positive for the year.  All are estimated to have double-digit earnings increases next year (see Table).  
 
Meanwhile Back at the Fed
 
For now, Real GDP for 3Q2016 is tracking in the 2.5%-3.0% range.  Recent August data were mixed and the 3.5% GDP projection reduced.  Auto sales in August dropped 5.0% to 17.0 in SAAR million units.  A plateau in sales despite incentives is a headwind to GDP.  The disappointing Employment Report brings 2016 average monthly employment to a lower level than in the previous three years.  But it was the ISM Manufacturing Report and Retail Sales Report that drew the most attention.  In August, ISM Manufacturing Index published by the Institute for Supply Management, declined to 49.4, well-below the consensus estimate of 52.0 (a level below 50 signifies a decline in manufacturing).  All major components of the major index were lower.  As this is a survey it should not be interpreted as a leading indicator of a recession but, attention should be given going forward.  In mid-September, the Census Bureau reported August Retail Sales (ex. autos and gas stations) declined after being flat for July.  In addition, the University of Michigan’s Index of Consumer Sentiment was below estimates for September.  On September 27, 2016 the Conference Board reported that their Index of Consumer Confidence climbed to 104.1, up from 101.8 in August and the highest level since August 2007.  Housing remains erratic but clearly on an uptrend.   These data should keep Fedwatchers busy as the November meeting approaches.  We would welcome a 1/4 point rise by the Fed in December if for no other reason than to send the Fedwatchers and the Carry Trade packing.  
 
Investment Policy
 
Our investment policy remains optimistic.  Short-term volatility related to the election may happen, but should not interfere with long-term investment strategy.  The recent weakness in economic data confirms that we remain in a 2% growth cycle, but with better earnings on the horizon and a healthy and vibrant consumer.  The transition into a more consumer-oriented economy is on schedule, but not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select domestic Large-Cap consumer, industrial and technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

Robert Byrne

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS July 5, 2016

on Monday, 20 June 2016. Posted in 2016, July

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS July 5, 2016

Brexit – Overrated?

Defying most predictions and polls, Britain on June 23 voted to leave the European Union (EU). Choosing independence over economic and financial uncertainty, global markets reacted violently. At the epicenter the British pound fell 11% intraday against the US dollar, setting a 30-year low, and 5% against the euro. At its low on Monday, the S&P 500 was 5.6% below its close on June 22. US Treasury yields fell across all maturities as foreign funds sought safety. By close of the market on Monday, the Volatility Index (VIX) dropped from 26 to near 20 as equities firmed. From the lows until the close on last Friday the S&P 500 regained almost all losses from the Brexit shock. While this rapid reversal surprised most doomsayers, a note from S&P Capital IQ found “that shocks normally cause stocks to bottom in six days or less, with a median drop of 5.3%. The fourteen shocks since WWII took a median of 14 days to recover all of its losses.” Investors should not be fooled by this rapid market turnaround. Uncertainty remains and traders stand ready to take advantage of the summer doldrums. We remain cautious as 2Q2016 earnings season begins. (See Investment Policy)
Immediately following the vote, the European markets went into panic mode. Traders caught on the wrong side of the referendum quickly unwound or hedged their positions. Taking a page from the Sovereign Debt crisis, only negatives were discussed in the media and financial blogs. Mention of a global slowdown and a European recession was a logical consequence. Little or no mention was given for the timeline for the exit or for any potential negotiating leverage by Britain. As the market rallied, it became more apparent the problems are European centric and largely Britain’s. The process will take at least two years from the irreversible notification to withdraw as set forth in Article 50 of the Lisbon Agreement. The Article also allows extensions. Against the wishes of the EU leaders to move swiftly, the UK will wait until a new Prime Minister is chosen. Piling on, Moody’s and Standard and Poor’s downgraded the UK sovereign debt on Monday June 27. The likelihood of a recession in Britain is high, but Central Banks are tailoring intervention. The Bank of England is set to cut interest rates and the European Central Bank (ECB) stands ready to introduce more stimulus. The Federal Reserve has already stepped back from raising rates pending the outcome.

Politics

The current risk to markets is not the “what or when” the agreement between an independent Britain and the EU is reached, but rather the political posturing and its effect on economic growth. Britain is rudderless at least until October. By the time a new Prime Minister is chosen, the country may already be in recession. For the EU there is declining member support in country Parliaments and among the general EU population. This fragmentation underscores the potential that other countries may exit the Eurozone. Greece is at the top of the list along with Austria, France, Italy and the Netherlands. Currently, there are no signs of contagion, as protest parties must first assume leadership and only then initiate a process culminating with a referendum. The political risk premium will be in the market until formal negotiations begin and to a lesser extent, as the long, long exit process continues. For investors, the risk will remain in Europe, but recent history has shown European problems are somehow always perceived as global.

Trade

Pushing aside the politics of London and Brussels shows a declining portion of world trade attributable to the EU. Needless to say this is due to the growing role of developing nations, primarily China. According to the US Census Bureau, in 2015 the UK was 3.8% of the Total Export Value for US Goods. A slowdown or
recession in the UK would barely move the needle for US growth. Imports from Britain, which now are
cheaper given the relative strength of the dollar against the pound, are 2.5% of US imported goods. It is quite
possible that this number will rise as additional cheap imports create value for US consumers. Inside the EU,
according to Eurostat, Britain is the third largest importer and the sixth largest exporter. Only France and
Germany are bigger intra-EU importers. Britain will highlight in the negotiations that 54% of their imports are
from EU members, while exports account for 47% of total EU exports. The EU has an ongoing problem that
may tilt the scales during negotiation more to Britain’s favor than is generally anticipated. Economic
stagnation has reduced the value of leading EU companies. Of the 50 largest companies by capitalization in
2015, only seven are European, compared to 17 in 2006. US companies lead with 31 and eight are Chinese.
Against a diminishing role for the EU, how ready is Brussels to forsake Britain’s size and stature? For now,
trade is second to a unified EU. The opposition is led by a broad consensus in Germany not to grant the UK
single market status (unfetted access to EU markets, also known as the Norway Agreement). Even if there is
any possibility it would come with a “freedom of movement” acceptance, an anathema to the “Leavers.”

Financial Services

According to the most economists, financial services are the most vulnerable to Brexit. This problem is limited
at this time to Britain. Most troubling is that financial firms in London will no longer easily serve EU members.
Companies with offices within the EU have “passports” enabling them to do business with any other EU
country without setting up local branches or subsidiaries. According to “TheCity UK,” there are 250 foreign
banks and 200 law firms in London, most of which are doing business via passports. For US banks, the
question is where is the office now headquartered in London to be located? JP Morgan warned that up to 25%
of the jobs in Britain will disappear. Sounds bad, but this equates to 1.7% of the current 237,400 total
employees. Morgan Stanley is rumored to be moving 2,000 investment bankers to Dublin and Frankfurt.
Goldman Sachs, with 6,000 of its European staff in London, already has a presence in Frankfurt. The shift to
Ireland and the Netherlands has been mentioned by global banks as preferable to Germany or France, because
of more flexible labor laws. The mechanics of the shift are clearly set out and for US financial institutions, the
two year clock, when started, should give ample time for a smooth transition. Meanwhile, Britain is faced with
the possibility that it may no longer be the financial capital of Europe.

Investment Policy

Our investment policy is short-term cautious as the effect of Brexit works its way through the financial markets. Today, there is no reason to be overly bullish or overly bearish. Markets will resolve the problem and a buying opportunity will result, but for now “Sit and Wait.” The seasonal light volume of summer with the concentration of money in large traders (algorithmic and hedge funds), periods of volatility are to be expected, we view any selloff as a buying opportunity. The transition into a more consumer-oriented economy is on schedule but not fully reflected in corporate aggregate earnings. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies. Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends. We would avoid companies deriving substantial revenue from Europe.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS July 18, 2016

on Monday, 18 July 2016. Posted in 2016, July

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS July 18, 2016

It’s Still a 2% Economy  

As of the close last week, the S&P 500 was 19.4% above the lows in early February, and up 5.8% year-to-date.  This most recent rally, which began on June 27, has taken the S&P 500 above the all-time highs of May 2015.  Both the Dow Industrials and the NASDAQ are also in all-time record territory.  As often happens when markets surge, there is no obvious catalyst.  In our July 5 Compass, we stated that there was “no reason to be overly bullish or overly bearish.  Markets will resolve the problem (Brexit) and a buying opportunity will result.”  Over the past few weeks this opportunity presented itself and the averages blasted through old highs.  The low level of interest rates accompanying the immediate post-Brexit selloff and the concerted Central Bank easing helped fuel the rally.  With the high level of institutional cash, performance-lacking managers could ill-afford not to participate in the momentum buying.    

Economic growth was better in 2Q2016 with real GDP expected in the 2%-2.5% range, compared to 1% in 1Q2016.  The current earnings season will be higher than analysts’ expectations, confirming an earnings bottom in 1Q2016.  Looking out into 2017, two major impediments to current earnings growth will diminish.  Dollar stability will yield a more favorable currency translation for multi-national corporations and the 70% increase in the price of oil since February will confirm a trough for Energy sector revenues and earnings. The recent increase in stock prices assumes a 2% growth environment and a Federal Reserve that will not raise rates until at least 2017, and probably not until 2018.  However, if retail sales and employment growth recorded in June continues, Fed officials may revisit a late 2016 rate increase.  We would welcome such an increase as that would be a clear sign of increased economic growth.   The increase in growth in 2Q016 is in line with the pattern of the last few years. Similar to the recent experience, there is no indication of above-trend growth or a sustained increase in the rate of inflation.  Even as growth slows in Europe and the Emerging Markets, the US will not slip into recession.     

Consumers are now driving the economy as capital investments and exports remain subdued.  Consensus forecast is for a decline in capital investment in 2Q2016, this is the third consecutive quarterly decline, a succession normally reserved for recessions.  With employment below 5%, wage increases are positive, providing support for consumer spending.  Realistically, the 200,000+ monthly net employment increases should begin to fall into 2017.  Coupled with election uncertainty, the savings rate will remain elevated.  Household balance sheets are highly liquid, but there are signs of overextension in segments of consumer credit, i.e., rising delinquency rate for auto loans.  Housing remains fundamentally sound despite low inventory and persistent increases in home prices.  Housing starts will slow, but this will be in the multifamily units.  Capacity utilization at 75.4% is where it has been for the past five years.  There is too much slack in the economy for any lasting trend of increasing prices.  Even if wages rise in the desired 2%-3% range, part of the gain will be offset by productivity increases.   

 In summary, the current economic environment supports a dovish Fed without a mandate to raise rates for the foreseeable future.  In a 2% economy lacking productivity increases, capital investment, fiscal stimulation, and slowing global growth, it may be as good as it gets.  At this stage of the business cycle, even with lower capitalization rates, with the improvements in earnings the appropriate strategy is diversification into dividend paying Large-Cap value.  

Investment Policy  

Our investment policy is more optimistic and favors a strategy based on slow economic growth and improving quarterly earnings.  The seasonal light volume of summer with the concentration of money in large traders (algorithmic and hedge funds), periods of volatility are to be expected; we view any selloff as a buying opportunity.  The transition into a more consumer-oriented economy is on schedule but not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap consumer and technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.  We would avoid companies deriving substantial revenues from Europe until the currency translation become favorable.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September, 13th 2016

on Tuesday, 13 September 2016. Posted in 2016, September

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 13, 2016

Here We Go Again

“Whenever you find yourself on the side of the majority, it is time to pause and reflect.”  
                                                                                                                      Mark Twain 

Stocks and bonds have once again succumbed to the uncertainty of Federal Reserve interest rate policy.  On cue, the Fed watchers have come out in force to question and criticize the unknown outcome of the Fed September FOMC Meeting scheduled for next week.  Prior to the meeting and the quiet period, which began on Tuesday 9/13, Fed FOMC members hit the road expressing their opinion on a potential 1/4 point rate increase.  As has been the case before, the opinions vary and in the end only add confusion to the potential outcome.  Enter the Traders.  With the stock market near all-time highs and bond yields at the low-end of the 2016 range, any prospect of a September rate rise results in increased volatility and a short-term selloff.  Last week the volatility index (VIX) was below 12 and has risen to over 18 in three trading sessions.  Over this period stocks, measured by the S&P 500, have fallen 2.3% and the 10-Year Treasury yield has risen from 1.53% to 1.73%.  Rising volatility is the preferred trading environment for hedge funds and algorithmic traders who comprise up to 80% of volume under these conditions.  

Three Card Monte is a card scam found in cities where the dealer challenges any passerby (the Mark) to choose the red suit card from two black suit cards.  The slight of hand of the dealer makes it virtually impossible to choose the red suit card.  This is a generalized description of the street game, but for most Fed watchers, the prospect of determining Fed interest rate policy yields a similar wrong choice.  This has been ongoing since the taper ended in October 2014.  Drawn by Fedspeak the Mark (the economists and strategists) have almost universally been wrong on future Fed policy.  But unlike the passerby in Three Card Monte, the Fed watcher refuses to walk away and with increasingly sophisticated models, double-down on their bets.  In financial markets, despite serial miscalculations, they continue to reset and trade on erroneous conclusions.  

Many Fed watchers believe that a benign 1/4 point increase is a policy mistake and highly risky, even at these near zero levels.  From late-October 2014 it took until December 2015 to start the tightening cycle with the first and so-far last 1/4 point Fed Fund rise.  Handicapping before and after the Fed meetings has become a full-time profession doomed to failure over this 18-month period.  The market verdict is that it will be very difficult for the Fed to embark on a policy of steadily rising rates.  Although the August employment number, at 151,000 was below the assumed Fed minimum number, it was strong enough to support a rate increase.  The 1.0% increase in 1H2016 Real GDP was less than the targeted minimum, however, 3Q2016 growth is tracking slightly over 3.0%.  Core inflation is rising slowly but still below the 2.0% level.  Wages have begun to move up but based on “data dependent” criteria, September seems to be a no-go.  But, there are no disruptions overseas, although implementation of Brexit is yet to happen, and both bond and currency markets remain stable.  While the outlook for the economy remains slow growth, a 1/4 point move may not be a policy mistake and definitely not precipitate dire consequences forecast by traders.  It might be time to tweak the data dependent criteria.

Longer term rates will increase, but as Ben Bernanke has stated, “The Fed cannot do it alone.”  The regulatory response to the financial crisis has limited financial intermediation by reducing risk-taking and leverage at the same time restricting economic growth.  Fiscal stimulus has been absent, the victim of partisan politics and now dependent on the outcome of the election.  Though hard to digest, we are still in the aftermath of the financial crisis.  Deleveraging of household debt (Compass 8/29/2016) is almost finished but credit demand and wage growth are below historical levels.  Housing is recovering but nationally prices remain about 10% lower than the pre-crisis peak.  Productivity, or output per hour, has been negative for four consecutive quarters (2Q2015-2Q2016).  This is a result of increasing labor costs and the effects of lower capital expenditures.  With the move to normalization will prove to be the tonic to rid the addiction to record-low interest rates.  A slow-but-steady increase in rates will increase the value of the dollar and may marginally impact the earnings recovery anticipated in 2017.  As employment costs rise and margins become squeezed, companies will shift away from stock buybacks and bring dividend increases in line with earnings, thereby freeing funds for investment in productive resources, i.e., increased capital spending.  

Investment Policy

Our investment policy remains optimistic and favors a strategy based on slow economic growth and improving 2017 quarterly earnings.  As long-term investors the repetition of these current conditions can be unnerving and result in second guessing a portfolio’s structure.  However, over the past year these selloffs, whether from Fed policy uncertainty, falling oil prices, China’s slowdown, a rising US dollar, and more recently Brexit, have all provided a buying opportunity.  During the downturns, our investment policy was cautious and to sit back and wait, turning optimistic after Brexit.  Many of the problems which surfaced in 2015 have lessened or are gone.  The S&P 500 as of this writing is 17.7% above its February 2016 lows.  Oil, which is drawing attention again, is still 70% above its bottom, also in February.  China’s economy has improved, along with many developing market economies and the US dollar has stabilized.  Only Brexit remains alive, as the withdrawal process from the EU has yet to be put in motion.  Additionally, after four quarters of lower earnings, a bottom appears to have been reached.  

The transition into a more consumer-oriented economy is on schedule, but not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap consumer and technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.  We would avoid companies deriving substantial revenues from Europe until the currency translation become favorable.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS December 12, 2016

on Wednesday, 14 December 2016. Posted in December, 2016

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS December 12, 2016

Be Prepared for Reality
 
“Reality is that stuff which, no matter what you believe, just won’t go away.”        
                                                                                                    David Paktor

Markets rose every day last week and the Dow ended within 1% of the media-hyped 20,000 level.  All major broad-based averages set record highs last week.  A Trump rally, based on expectations of more favorable growth policies from Washington, is the widely circulated catalyst.  But the forecast of low taxes, less regulation, and stimulative infrastructure spending comes on the heels of realistic improvement in economic fundamentals and a trough in quarterly earnings.  The more favorable economic data guarantees a Fed rate hike next week, removing this perceived negative from the equities markets.  Stocks, measured by the S&P 500, are up near 6% since the Trump upset and 10.6% thus far in 2017.  The small-cap Russell 2000 has risen 22.2% in 2017 with more than 13% coming in the month since the election.   
 
Our optimism with stocks is based on the economic outlook prior to the election and the potential of realistic improvement from a more pro-free market Trump Administration.  Getting beyond the hyperbole may disappoint many current supporters as expectations are translated into reality.  President-elect Trump has 100-day agenda, but aside from Obama’s executive orders there will be many bureaucratic hurdles requiring multiple steps.  Repealing Obamacare, renegotiation of trade treaties, and the enforcing of immigration laws will take well-beyond the 100 days.  Further on will be immigration, abolishing the Iranian Treaty, ISIS, and the building of the wall.  Frustration will surface both from the new Administration and Trump followers.  Already Trump has backed off some of his populace rhetoric.  Stocks will need an economy growing above the current 2% level to satisfy the basic revenue needs to pay for the paired down programs coming out of Congress.  Many of the programs will never be implemented.   
 
The sector rotation since the election is clearly more bullish for the economic outlook.  As pointed out in the last Compass (11/28/16), the move into Financials was immediate and now has broadened into the other economic sensitive areas.  This has resulted in year-to-date gains for Financials (22.2%), Industrials (18.7%), Materials (17.7%) and Technology (12.9%).  Energy, which had risen 11.4% with the 70% rise in oil prices, increased 24.6%.  The rotation to these economic sensitive sectors is typical of the early stages of a business recovery rather than a signal of an impending slowdown, as expounded by those who believe bull markets are determined by the calendar.   
 
The move toward interest rate normalization will get a boost when the Fed raises rates.  While there are some comparisons to the rate increase of last December, circumstances are much more accommodative than last year.  The manufacturing ISM is above 53 and was below the 50 expansion level and falling in November and December 2015.  Both employment and wages are much different.  The unemployment rate at 4.8% is nearing historical lows and job claims are at the lowest level since the series began.  Wage increases are trending up giving a lift to 2% inflation compared to a declining 1.5% inflation level in 2015.   
 
Rising inflation expectations and higher bond yields from current rates are not disruptive to equity markets.  Since 1950, stocks have risen every year the annual growth rate and the S&P 500 earnings exceeded the 10-Year Treasury bond yield.  With the 10-Year Treasury yield currently at 2.48% and the earnings recession ending, there is scant chance that yields will rise above earnings growth in the foreseeable future.  The current yield has risen from 1.80% to the current level in one month, an 85% increase.  Prior to this rise the S&P 500 was up 2.0% and as of last Friday’s close it had climbed an additional eight percentage points.  Examples of sharp spikes in the 10-Year Treasury are in 2003 when the yield rose from 3.07% to 4.67% in two months.  In 2003 the S&P 500 was up 26.4%.  The same pattern occurred in 2010 when the 10-Year yield rose 2.33% to 3.74% in four months, the S&P 500 rose 12.8% for the full year.  As recently as 2013 the 10-Year Treasury yield jumped from 1.61% to 3.04% in seven months and for the year the S&P 500 stocks rose 29.8%.
 
Earnings
 
Going forward into 2017, earnings should provide a firm base for rising stock prices despite the recent strength of the US dollar.  The US Dollar Index (FX) has risen 10.9% since May 3rd until the recent high on November 25th, with most of the strength following the election.  Unless there is a reversal, this dollar appreciation will limit earnings expectations for companies with a high percentage of revenues overseas.  There will be indications of the extent of the decline when Fourth Quarter earnings are reported beginning in January.   For the average S&P Large Cap 100 company this is 39% of total revenues and for the Small Cap 600 company foreign revenues are only 18%.  This explains in part the recent outperformance of the Russell 2000.

Annual S&P 500 Earnings and Prices 

The Table above is a comparison of the earnings and stock prices over the past five years incorporating optimistic, but achievable, earnings for 2017.  The estimates for 2017 reflect a $132.00 a share consensus a share for next year plus a $13.00 average for analysts’ potential benefits of implementation of lower regulation, tax reform, and a stimulative spending program.  The data assumes a steady P/E ratio at the current level but no multiple expansion or contraction.  To fully realize these estimates the economy must move beyond the 2% real growth to a base of 3% or higher real GDP.
 
Investment Policy
 
Our investment policy remains optimistic.  Transitioning to a new Administration may increase volatility short term, but should not interfere with long-term investment strategy.  Realistically the positives from expansionary policies will take more time than generally expected.  A more dominant consumer-oriented economy is evolving, but not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, financial, industrial and technology companies.  To mitigate the potential of higher-than- expected inflation and multiple compression, portfolios should include value companies exhibiting sustainable earnings growth and dividends.    

 

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 28, 2016

on Monday, 28 November 2016. Posted in 2016, November

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 28, 2016

A Boost to Normalization
 
“Change is the law of life and those who look only to the past or present are certain to miss the future.”                      

                                                                                                                                   John F. Kennedy

The stock market has reacted favorably to the election of Donald Trump.  The opinions of Clinton voters and those who did not vote do not matter.  A program of infrastructure renewal, lower taxes, deregulation, and better healthcare has “Trumped” protectionism for now.  Presidential honeymoons do not last long and it will be imperative for definitive plans to quickly replace speculation.  Already most economic forecasts have been revised upward for 2017, and interest rates have risen in anticipation of the Fed meeting in December.  It is the bond market where the bleeding is happening.  As mentioned in our last Compass, it is too early to declare the “Great Rotation” from bonds into stocks, but when the yield of the 10-Year Treasury rises 67% from mid-July, every economist should take notice.  The increase in overall rates since the election has precipitated a shift out of fixed-income Mutual Funds and bond ETFs.  More than $1 billion has flowed out since the election as rates rose 50-basis points for the 10-Year Treasury.  For many investors the full effect will not be apparent until they receive their November or December statements.   
 
Before the election it was a widely held belief that a Clinton victory was assured and investment managers accepted a continuation of the status quo.  A large federal government positing overregulation, higher taxes, and rising healthcare and education costs was deemed a manageable investment climate.  The 2% economy had prevailed since 2010 and the stock and bond markets remained in bull mode.   All of this is changed.  The economy has the opportunity to be better, inflation will return and interest rates will rise as fiscal policy accelerates to normalization.  Rotation in the stock market away from Utilities, REIT’s, and Consumer Staples into Financial and Industrials was immediate on the day after the election.  Some adjustments have been made, the move into drugs has been tempered after realizing that responsibility for rising prices were market forces rather than potential broad-based price regulation.  Industrials are falling victim to a rising dollar, lowering foreign earnings offsetting the positives of the effects of an infrastructure buildout.   This is all occurring in an economic environment that has many of the characteristics of a market bottom as compared to a market top.  Consumers and corporations have deleveraged, US productivity is at a post-War record lows, and unused capacity is plentiful.   
 
The Economy
 
Even prior to the pro-growth mindset the economy was showing consistent improvement in concert with our forecast of longer-term consumer-led economic growth accompanied by low rising interest rates and moderate inflation.   With the election this outlook received a substantial boost, now the magnitude and duration of the bull market has much more potential.   
 
The Consumer:  The consumer and the housing market are poised to continue their growth in 2017.  Household formations are growing about one million annually, a trend that is expected to continue as more Millennials (87 million) settle down to family life.  The major problem for housing has been the inconsistency in sales due to low inventory.  The most recent October 2016 Existing Home Sales from the National Association of Realtors were 5.6 million, up 5.9% above year-ago levels and the highest since February 2007.  The median existing home price is $232,000 a 6.0% increase from October 2015, and the 56th consecutive monthly year-over-year price increase.  Unsold inventory is at an historically low level of 4.3 month supply.  A large number of lower-end single family homes and condos were purchased by investors following the financial crisis.  Many of these were converted to rental units.  At year-end 2015 there were 17.5 million renter occupied single family homes, compared with 10.7 million in 2000.  With rising rents and price appreciation, investors are holding these longer, but eventually most will be sold adding to supply.  Also, more Baby Boomers are aging in place and downsizing at a much later age.  This has created a surge in home improvement spending, but lessens the supply of existing homes.  New Home Sales were 560,000 in October 2016, lower than the estimate of 590,000, but up 17.8% year-over-year, and the best October since 2007.  Supply remains low at 5.3 months.   
 
The impending Fed increase in interest rates should only have a marginal impact on real Disposable Personal Income.  Consumers balance sheets, unlike in other periods of rising rates, are more countercyclical.  Almost 75% of outstanding household debt is in fixed-rate mortgages with roughly 90% at an average 3.8% rate.  Other fixed-rate instruments (including auto debt) account for an additional 15% of household debt, leaving less than 10% of debt at a variable rate.  The November 2016 University of Michigan’s Index of Consumer Sentiment, sharply increased following the election.  The overall Index rose 6.6 points to 93.8, the largest month-over-month gain in three years.  Notable is the 8.4 point rise in the sub-Index of Consumer Expectations.  This trend was confirmed by Holiday sales over Black Friday through Cyber Monday.  Housing and real Personal Disposable Income should be positively impacted as the low unemployment rate and slower job growth result in rising wages and salaries.   
 
Earnings
 
Forgotten over the past two weeks is the positive for corporate earnings from an expansive fiscal policy.  Initially, infrastructure spending will benefit a select group of companies and should have a multiplier effect on consumer spending.  Tax cuts will take longer to pass, if for no other reason than government moves at government speed.  The unwinding of Obama Executive Orders will have a positive short-term impact on costs for many small companies, banks, and the energy sector.  JP Morgan estimates a $15 increase in 2017 S&P 500 earnings and most other estimates fall in the $10-$12 range.  These estimates would bring the 2017 consensus earnings P/E of 17.0X down to a range of 15.0X-15.5X.  Corporations will have more freedom to control their destiny, that in itself should add to earnings.   
 
Investment Policy
 
Our investment policy remains optimistic.  Transitioning to a new Administration may increase volatility short term, but should not interfere with long-term investment strategy.  A more dominant consumeroriented economy is evolving, but not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, industrial and technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.     

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 15, 2016

on Tuesday, 15 November 2016. Posted in 2016, November

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 15, 2016

The Scales Tip to Growth

Surprise, Candidate Trump is now President-elect Trump and beating odds of more than 20 to 1, Congress remains with the GOP.  The lopsided victory, after markets had risen over 2% following nine straight days of decline, caught investors flatfooted with allocations in the wrong sectors.  A Clinton victory was assured and no one shifted portfolio allocations that reflected more regulatory pressure from Washington on banks, healthcare and energy.  But in one fell swoop the regulations on banks are reduced, Obamacare repealed or greatly modified, and price controls on drugs limited.  Attaining energy independence becomes a reality.  Immediately after a Trump victory became apparent late last Tuesday, the world of “fast money” began reorienting portfolios and stock futures fell over 800 points.  But the biggest impact was in the bond market, where yields rose sharply and the benchmark 10-Year Treasury closed to equal levels of last December.   
 
Two days following the election many of the perceived negatives of a Trump presidency were reinterpreted as positives.  Tax reform, deregulation, infrastructure renewal, and more competitively priced healthcare were all stimulative before the election and remained stimulative after the election.  One has to wonder why the doubt ever existed?  In reality, a wall across the US southern border may be impractical as is the banning of all Muslims coming into the country.  The economic and security programs are inflationary and come at a time when a Fed move will be welcomed.  By last Friday the benchmark the 10-Year Treasuries at 2.25% had surpassed the forecasted yield (2.14%) for year-end 2017.  Certain stocks, which act as bond proxies became an endangered species, particularly the Utilities and Telecom sectors.  For income-generating companies exhibiting growth in a non-regulated environment, dividends are part of total return and with higher earnings, these companies will grow beyond rising interest rates.   
 
Economy
 
No doubt the Trump proposals, even without details, are stimulative for the economy which is exactly what the markets are telling us.  Most political achievements of incoming new Presidents are moderated compared to campaign promises because of the reality of compromise required to secure Congressional approval.   Therefore, it is premature to discuss the extent of potential growth or the negatives of a more restrictive trade policy.  However on balance, the US economy should grow in 2017 beyond the post-financial crisis average of 2%.  Our optimism for US equities has been based on a vibrant and financially secure consumer.  Just prior to the Trump victory, Morgan Stanley reported on November 7, 2016 that “The latest employment data suggest that wage growth is heating up in middle and high wage industries….sustained it could a long way in supporting a stronger trend in aggregate wage growth.”  Average hourly earnings rose 0.4% month-over-month and 2.8% year-over-year in October, the fastest annual growth since June 2008.   
 
The most recent retail sales data for October 2016, published by the US Census Bureau, confirms a strengthening consumer sector.  US real retail sales rose 0.8% last month and up a revised 1.0% in September from 0.6%.  These month-over-month increases are the largest two-month rise since early-2004.  Year-overyear October sales were up 4.3%, led by non-store retailers (predominately online purchases) which increased 12.9% from the 2015 level.  On the back of these data 4Q2016 GDP forecast will most likely be revised upward with many moving above the 3% level.   
 
The Role of the Federal Reserve
 
The Fed bookies are touting an 80% chance of a 25 basis point increase at the December FOMC Meeting.  Should markets continue to rise until the meeting FedSpeak will center around a quarter point being “too little too late.”   However, this increase will be well-received by markets fearful of rapid inflation.  Higher rates have had an immediate strengthening of the dollar as the euro at 1.13 prior to the vote fell sharply and is now at 1.07.  The Mexican peso fell about 10% immediately following a Trump victory and President Enrique Pena Nieto has already expressed a willingness to work with President Trump on revisiting NAFTA.  Perhaps most affected are the non-commodity exporting emerging market countries.  Stocks of these countries (EEM) are down close to 8% as the dollar has risen.  A continued strengthening will prey on those developing countries with a heavy sovereign debt burden denominated in US dollars.   The Fed will have to get in front of any acceleration and carefully monitor the magnitude of the infrastructure spending and budget negotiations to take place in the spring of 2017.  Complicating the situation will be a Trump Administration critical of the current FOMC members, especially Chairman Yellen.   
 
Earnings
 
According to FactSet, with 91% of the S&P 500 reported, 71% beat consensus estimates.  Overall earnings rose 6.5% ending five quarters of declining year-over-year earnings.  On the top line only 55% beat estimates with aggregate sales up 0.5%.  For 2017, total S&P 500 earnings are estimated to grow 11.4% with only Energy (331.8%) and Materials (15.1%) outperforming the total Index.  Recent events may have something to say about the sector breakdowns.  We have and remain optimistic on corporate earnings going forward through 2017.  However, the extent of inflation and the accompanying higher rates creates a dilemma.  Earnings growth (nominal dollars) drive stock prices higher but rising interest rates compress P/E ratios, but sustainable growth should lessen the impact of moderate rate increases.    
 
Go or No Go Rotation
 
As the stock market rotates between various sectors in anticipation of a new Administration’s economic agenda, it will be the other rotation, from fixed-income into other assets including equities, which will garner investor attention.  Mutual funds have had 70 consecutive weeks and 128 out of 133 weekly equity fund outflows.  For calendar years 2014, 2015 and thus far in 2016 (11/4) equity fund outflows total $387 billion.  Bond mutual fund inflows over the same period totaled $173 billion.  Money in bond mutual funds has accumulated for much of the bull market for fixed-income which began in 1981 and accelerated over the past decade.  We will continue to follow these data which may well-prove the indicator of the “Great Rotation.”
 
 Investment Policy
 
Our investment policy remains optimistic.  Transitioning to a new Administration may increase volatility short term, but should not interfere with long-term investment strategy.  A more dominant consumer-oriented economy is evolving, but not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, industrial and technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.   

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS October 31st 2016

on Monday, 31 October 2016. Posted in 2016, October

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS October, 31st 2016

A Peek into 2017

Where stocks end the year is anyone’s guess, but peeking into 2017 should reignite optimism.   Since July, stocks have been in a narrow range that is getting more narrow as next week’s election approaches.  The campaigns of both candidates have been a race to the bottom.  Given the choice, American voters would rather choose between Mike Pence and Tim Kaine rather than Mr. Trump and Mrs. Clinton.  Perhaps the best outcome is continued gridlock, which seems a certainty if Wall Street’s choice, Mrs. Clinton, does not sweep.  Markets can live with a 2% economy, a Fed policy of slowly raising rates, moderate inflation, and increasing corporate earnings.  Short term things may get ugly as the mood of America is reflected in the election results.
 
Normally presidential elections do not have a long-term impact on the financial markets, and this time will be no different.   Throughout the post-election period politics will be an overly analyzed input to the proverbial “Wall of Worry.”  As mentioned often in our Reports, the US is a 2% real growth economy with no catalysts to break above this sluggish level.  Earnings season is winding down and the market will turn its attention to the Fed and a December interest rate rise.  Recent economic data, on balance, show some upward momentum and Friday’s employment number should be in line with recent reports.  The wages and weekly earnings data from the report may prove the determinant for Fed action.  Inflationary pressures are beginning to surface and the last thing the Fed wants is to be behind the curve.  As mentioned markets, measured by the S&P 500, remain in a tight range (2,193.91 – 2,114.72) since the beginning of the third quarter.  As of last Friday, the S&P 500 was only 1.3% above its June 30, 2016 close.  Although only down 3.1% from its all-time high on August 16, 2016, only 32.7% of the S&P 500 companies are above their 50-Day moving average.   
 
Earnings  
 
Going into the third quarter earnings season FactSet estimated S&P 500 earnings to decline 1.3%.  As of October 28, FactSet reported its blended earnings (reported plus estimated) growth rate for the S&P 500 is +1.6% with 74% of the 294 companies reporting earnings above the mean estimates.  Thomson Reuters also estimated earnings to decline 1.3% prior to the actual reporting.  Data from Thomson Reuters and published in Fundamentalis show S&P earnings beginning 3Q2015 through 2017 when quarterly earnings turned negative year-over-year.

 10 31 table

The Table shows a return to profitability beginning in 3Q2016, along with the diminished negative impact of the Energy sector.  Although not shown on the Table, the estimated level of growth is in part due to weak comparisons but at rates comparable to 2011-2012, years of substantial stock market appreciation. Depending on the level of inflation, with earnings reported in nominal terms, these levels could change meaningfully in either direction.   
 
Economy
 
To successfully reach the current estimated level of earnings growth, the economy must maintain minimal real growth at 2%.  No doubt, there are many unanswered political questions but the economic tailwinds are picking up.  Looking into next year we see positive growth in personal income and relatively low delinquency rates supporting consumer fundamentals.  Stronger than anticipated payroll growth suggests solid consumer spending.  As expected, the tighter labor market has resulted in a slowdown in employment from an average monthly rare of 251,000 in 2014 to 229,000 in 2015 and to 178,000 through September 2016.  Accompanying this tightening labor pool has been a recent increase in average hourly earnings, from 2.4% in August to 2.6% in September.  Personal income rose 0.3% in September after falling 0.2% in August. Consumer spending rose 0.5% in September, after declining 0.1% in August.   
 
Consumer sentiment appears to be influenced by the uncertainty of the upcoming election and the added problems of the “de facto” bankruptcy of Obamacare.  This is reflected in the 5.7% elevated personal savings rate in August.  Home prices rose 5.1% in July, positively affecting household net worth.  The tight supply of homes is expected to continue but price increases are forecast to moderate.  This scenario has been in place for some time as supply has been limited by the lack of new starts of moderately priced homes.  Sales of new single family homes rose to 563,000 in September, a 30% increase over year ago levels, but only 3.1% above a downward revised August 2016.  Home inventory remains at an historically low 4.8 months.  Real consumer spending ex-autos rose 2.7% in September 2016, up from 2.1% in August, and up 2.4% from a year ago September.  Leading the sales were non-store retailers (90% online), up 10.6%, once again coming at the expense of Department Stores which were off another 4.8%.
 
Investment Policy
 
Our investment policy remains optimistic.  Rising volatility related to the outcome of the election and the potential Fed policy may continue in the short term.  This should not interfere with long-term investment strategy.  The recent economic data confirms that we remain in a 2% growth cycle, but with better earnings on the horizon and a healthy and vibrant consumer.  The transition into a more consumeroriented economy is on schedule, but not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, industrial and technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends. 

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS October 17th 2016

on Monday, 17 October 2016. Posted in 2016, October

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS October, 17th 2016

Confusion not Uncertainty
 
“Volatility is noise.  The short-term trader bets on the noise; the long-term investor listens to the signal.”                

                                                                                                        Peter L. Bernstein

After setting a new all-time high on August 15, 2016, the S&P 500 is down 3.0% from that record-closing level.  The S&P 500 has remained in a narrow trading range since July.  More recently the tech and energy heavy NASDAQ made new highs.  Over the past three months, the market has weathered the Fed indecisiveness, signs of economic weakness in August, a strengthening US dollar, a forecast of a sixth quarter of lower earnings, and last week a return of Brexit and weak Chinese import and export data.  Throughout this period, the emerging markets, buoyed by rising commodity prices, gained strength and measured by various ETF’s, outperformed the equities and fixed income of major developed countries.   
 
Despite low volatility, US market internals reflect a shift in sector preference.  While not a definable rotation from growth to value or value to growth, but a shift to more economic sensitive sectors from defensive/income (dividends) stocks.  Market leaders in the first half of 2016 were Utilities (+21.1%) and Telecom (+22.6%) while Technology (-1.0%) and Financials (-4.7%) were the losers.  Since June 30, the former leaders have shown persistent weakness (Utilities -9.1% and Telecom -10.2%) as Technology (+11.6%) and Financials (+4.5%) rallied.  Although early in earnings season, the large banks reporting have beaten on both revenue and earnings.  Technology earnings will come the next few weeks.    
 
The economic data have been erratic and most estimates are for 2%-2.5% real GDP growth in 3Q2016, down from 3%-3.5% earlier in the quarter.  Population, and more importantly labor market growth rates in the US are among the highest of the developed countries.  A favorite of Fedwatchers, the JOLTS Survey, showed a near-record job postings, along with weekly employment claims at 246,000, levels not seen since 1972, points up the underlying strength of the job market. The weak link is productivity, but with a 2% economy and overcapacity there is reluctance to increase plant and equipment spending beyond technology.  Consumer spending and housing remain strong.  Auto Sales have plateaued despite dealer incentives.  Millennials are the driving force for home sales, but with a low inventory of starter homes and somewhat different preferences than prior generations selection is limited.  Mortgage terms remain restrictive, but longer term, earnings increases will close the affordability gap.  The Energy sector, which has been in recession for over two years, is showing signs of stability.  The rig count bottomed at 480 in early-March 2016 and as of last week had increased to 539 operable rigs.  This is a far cry from the record 1,920 units operated in December 2014.  Even with crude over $50 a barrel, it will take time to bring the sector to profitability and even longer to initiate new capital investments.   
 
The Healthcare sector will be the focus of government regulation no matter who wins the election.  As it stands today, Obamacare will implode without dramatic changes.  Costs are out of control and exchanges are failing as young healthy people shun the system and only the sick sign up.  Cost controls and rationing will be viable options as retirees increase and strain the already technically bankrupt Medicare system.  Longer term look for the trend of lower discretionary spending as dollars are shifted to healthcare.   
 
Once again, the Chinese economy is being discussed as a potential negative for the US economy and in turn, US equities.  The most recent negatives on Trade ignore some encouraging data on the transition to a consumer-oriented economy. We have discussed this subject at length over the past two years in our Reports and have concluded no game-changing events are forthcoming from China.  The same can be said of Brexit.  The US dollar remains in a very narrow range against all major currencies accepting the British pound.  Listening to the bears, one would think that the dollar is about to rise in line with the increases in 2014-2015, this is not the case.  Favorable earnings comparisons will begin for US international corporations in 4Q2016 as the sharp upward thrust of the dollar is lapped.   
 
Specifically the clock on Brexit does not even begin until Article 50 of the EU Treaty is triggered.  As it stands, the earliest that this will occur is May 2017.  Pending are two legal challenges questioning the legitimacy of the democratic ballot.  Both suits claim the ultimate decision to leave the EU resides with Parliament.  At the very least, the Brexit divorce will not be final for more than 2 1/2 years.  The immediate consequence of the vote has been the depreciation of the British pounds against most of the major currencies.  It was not dollar strength that resulted in a 17% decline against the dollar since the June vote.  Ironically, over the same period the FTSE Index of listed companies traded on the London Exchange has risen about 17.5%.  This indicates that many British companies not only do the majority of their business internationally, but that the lower price for exports will favorably affect these companies’ earnings.  Domestically, the lower value of goods and services may cause problems, as inflation rises and growth slows, making recession is a distinct possibility.  However, Britain accounts for only about 5% of global GDP and the problems should remain in Britain without any fear of contagion.       
 
Investment Policy
 
Our investment policy remains optimistic.  Volatility related to a confluence of recurring international misinterpretations and potential Fed policy may continue in the short term.  This should not interfere with long-term investment strategy.  The recent weakness in economic data confirms that we remain in a 2% growth cycle, but with better earnings on the horizon and a healthy and vibrant consumer.  The transition into a more consumer-oriented economy is on schedule, but not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, industrial and technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 20, 2016

on Monday, 20 June 2016. Posted in 2016, June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 20, 2016

Brexit – What Happens in Europe Stays in Europe

With the Brexit referendum coming on Thursday, any changes in momentum in either direction will result in market overreaction. The vote will alleviate the uncertainty of “Remain or Leave” the EU by Britain. Markets should react in accordance with the vote with only the aftershock affecting US securities. Not unlike the sovereign debt crises of 2010-2012, the dire consequences for Britain and Europe are predicted to spread across the global economy. This time consequences include financial chaos, a UK recession, loss of freedom of residency across the EU countries, and a breakdown of cross border trading between Britain and remaining EU countries. For now any disruption will be short-term and mainly centered in Britain. The UK financial sector appears vulnerable, but this should be only temporary as employment and regulatory matters settle out. For the US economy the affect should be negligible, as only 2.9% of total S&P 500 revenue is from the UK. Last week the Volatility Index (VIX) rose above 20 for the first time since February as traders have taken sides on the outcome. This is reminiscent of only a few years ago when a Greek default was going to bring the world banking system to its knees.
Over the weekend polls showed a shift to staying in the EU. This has resulted in short-term covering today as traders around the globe unwind or hedge their positions, but with two full days before the vote, uncertainty remains. No doubt the confusion from last week’s Fed meeting has added to the market’s volatility and there always exists the potential for a violent reaction to Brexit. In our opinion, this would create a significant buying opportunity for US equities similar to what followed the last EU crisis. Immediately following the October 2011 announcement of QE by Draghi, the S&P 500 rallied and was up 32.3% six months later.

Fed Up

Even as the Fed FOMC meeting left rates unchanged as expected, it was the implied lack of future rate increases that shook the financial markets. It is hard to believe the weak jobs data is the major contributor to this abrupt shift in rate trajectory. Most likely it was the decline in bond yields signaling a drop in inflationary expectations. Unfortunately, central bankers still believe that low interest rates or even negative rates stimulate economic activity. There is scant evidence to support this policy as a long-term accelerator. More plausible is the rapid decline in yields. Many believe that as Europe and Japan rates fall negative, foreign investors turn to the US for yield, but more likely it has been hedge funds and algorithmic traders taking advantage of uncertainty.
At the last meeting the Fed completely reversed its policy implementation plan intimating that monetary stimulation has run its course and it cannot do anymore to stimulate GDP growth beyond 2% or increase inflation above 2% annually. Historically, fiscal policy, limited by high debt levels following a financial crisis, results in a long period of stagnation with normal growth not returning for as long as a decade. For equities this is not all negative. An economy growing at 2% and inflation approaching 2% and 2% from
dividends give stocks a total return of 6%. The unknown is earnings, P/E and margins, all of which should improve in the second half of 2016.

Amazon vs. Walmart

The growth of online shopping has disrupted retail sales beyond comprehension only a few short years ago. Established retailers, led by Walmart, are attempting to reinvent themselves as e-commerce competitors are accommodating the traditional brick-and-mortar consumer. Walmart, the champion of the “Big Box” stores is circling the wagons and attempting to upend its traditional model to compete with this new retail paradigm. The long-term success of Walmart has been its unrivaled scale resulting in “everyday low prices.” The Walmart culture has been unchallenged and its low prices and broad range of products sustained its leadership until the e-commerce disruptor Amazon challenged.

Amazon

According to a recent report by Morgan Stanley for all US retailers, online sales in the US grew 15% in 2015 against 14% in 2014. Amazon sales increased sales increased 29% in 2015 compared with 25% in 2014. Over the same period, traditional retail fell across all major categories; Specialty Apparel 10%-7%, Department Stores 19%-14%, Broadlines (Big Box) 29%-23%, and Hardlines 26%-21%. Many reasons can be cited for the decline but the competition from Amazon and other e-commerce retailers has accelerated the shift. Amazon’s low prices, broad product offering, and Prime membership limit potential growth of “old retail.” In addition, Amazon can withstand razor thin core GAAP EBIT margins (0.5% in 2015). The 84 million millennials, not particularly selective over apparel, are channel agnostic, with a preference for speed and convenience. Only off-price retail stores, catering to an entirely difference consumer, seem to be insulated from the shift to e-commerce.
Amazon not only competes on price and range of products, but also on accessibility. Walmart offers a broad range of products at reduced prices under many roofs. Amazon offers the same, but saves time. The free two-day shipping on almost anything for $99 annually gives buyers an easy decision to max out with Amazon. Surprisingly, Amazon is the second largest seller of clothes. Cowen & Company expects Amazon to overtake the leader Macy’s in 2017. A recent spinoff of Prime, Amazon Dash competes with Walgreens and CVS for common household products. To better compete for lower average income shoppers, Amazon is offering a $10.99 monthly payment for Prime. The challenge for retailers in the e-commerce era is to protect sales and profits. Because of the pressure to offer free shipping and competitive prices these retailers must continue to be profitable at the higher margin existing stores. Expanding sales online increases technology spending, and in the end the retailer may end up selling to the same customer online for a lower price. Both technology spending and online sales squeeze margins further.

Walmart

For decades, Walmart was the undisputed disruptor of American retailing. But Amazon is the new disruptor. In 2015 Walmart’s $485 billion in revenues was 3.5x Amazon’s. A pretty healthy margin but this year Walmart’s revenue will be flat while the consensus forecast for Amazon is an increase of over 25%. Walmart is attempting to disrupt its own model in additional to making current operations more efficient. Walmart is spending over $1 billion this year to improve its e-commerce technology. This follows $10.5 billion last year spent on information technology. According to the company the goal is to merge physical and online retail. Closing smaller stores and opening more supercenters does not qualify as self-disruption and sounds like doing more of what it always did.
Amazon and Walmart are examples of a retail disruptor creating a new paradigm and the largest “Big Box” store which must disrupt its own current model to compete. However, the cost for Walmart may be too high to go head-to-head with e-commerce Amazon, which may in part, explain the reluctance to self-disrupt and rely upon more conventional adjustments that have worked for decades. No doubt consolidation will continue in the retail space forced by increasing e-commerce shopping. Millennials, a generation bent on convenience, will continue to do everything possible over the internet. The costs for many conventional retailers will be prohibitive and many will close, sell only online, or channel the products through large broadline e-commerce retailers. Consumers are the ultimate beneficiary, as they continue to get more value for less cost, a trend likely to accelerate even during slow overall economic growth.

Investment Policy

Our investment policy is cautiously optimistic as the economy and earnings reflect our outlook for 2H2016 and into 2017. The seasonal light volume of summer with the concentration of money in large traders (algorithmic and hedge funds), periods of volatility are to be expected, we view any selloff as a buying opportunity. The transition into a more consumer-oriented economy is on schedule but not fully reflected in corporate aggregate earnings. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies. Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends. 

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 6, 2016

on Monday, 06 June 2016. Posted in 2016, June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 6, 2016

Is That a Light at the End of the Tunnel?  

The equities markets, measured by the S&P 500, continue to trade in a narrow range since the recent April high of 2,111.  While the 2,100 level receives much media attention it is meaningless from anything other than a psychological benchmark.  The S&P 500 is only about 1% below the 2,134.72 all-time high of May 20, 2015.  The Index has failed on numerous attempts to surpass this high, leading bears to forecast a push to new lows.  Our assessment is that the market will set new highs rather than selloff to levels of midFebruary.  Many of the problems cited for the February lows have lessened, or in some cases, turned positive.  Among these were the elevated US dollar, low crude oil prices, and the prospect of a hard landing in China.  Of course the “Wall of Worry” is replete with headline risks and always enough to make a bearish case for the market to roll over.  When there is nothing else there is the potential market reaction to Fed interest rate policy.  In our last Compass, we discussed the Fed move toward normalization and its effect on stocks.  The conclusion is that zero interest rates do more harm than good and even despite the low jobs number, the sooner the move toward normalization the better.  It is highly unlikely that a data dependent quarter point move will disrupt the economy.  In fact, the increases will recreate an arsenal for potential Fed action should growth falter.    

Short term the potential of Brexit will be resolved by a vote on June 23, 2016.  The vote appears too close to call, but no matter what the result, the impact of Britain withdrawing from the EU will be largely confined to Europe, with little likelihood of this being a game changer for the US economy or the stock market.  Any negative reaction in US markets should be viewed as a buying opportunity.  Another negative being mentioned is the Presidential election.  It is far too early with too much uncertainty surrounding both candidates to rationally affect equities.  No matter who wins, from a regulatory perspective things could not get much worse and Congress has the lowest approval rating in history, but stocks are challenging all-time highs.  We will wait until after the summer conventions to assess potential impact of the candidates.  

The May employment report showed a net increase of only 38,000 new jobs in May and the employment rate fell to 4.7% as 400,000 left the workforce.  Needless to say the results are confusing.  The ADP Report seems more realistic at 173,000 net new jobs.  The BLS report does not reconcile with job openings (JOLTS) at eight month highs and the lowest layoff rate in five years.  Another explanation is the low jobs number suggests employers are adjusting to the slowdown, giving credibility to the BLS report as a lagging indicator.   Adding to the confusion is the BLS explanation that the margin of error for the data is plus or minus 100,000.  Either way, the data bear watching and was pivotal in Chairman Yellen’s speech today in Philadelphia.  It is highly likely the next increase in rates will happen in the fall.  A reset of the timing of the increase will not affect the longer term trend in stock prices.    

The most recent economic data indicate a slight acceleration in 2Q2016 growth.  The GDPNow Model (FRB Atlanta) forecasts real GDP at 2.5% and the NowCasting Model (FRB New York) and a close 2.4% in 2Q2016.  These forecasts are as of June 3 after the employment report.  The ISM Manufacturing Index rose to 51.3 in May, a 0.5% increase.  This was above expectations and marked the third consecutive month of expansion.  Consumer spending in April rose at the fastest rate in seven years, posting a 1% month-over-month increase.  Personal income rose 0.4%, indicating a drawdown of savings to finance current expenditures.  May auto sales for US manufacturers were below forecasts however, combined

domestic and foreign manufacturers reported 17.45 million SAAR total sales, stronger than the 17.3 million estimated. The May University of Michigan Consumer Sentiment Index increased 5.7 points compared to the April report.  Highlighted was the optimism toward auto and housing sales due to low interest rates.  As more and more purchases are made online, consumers get more for less and will continue to expand e-commerce sales.  Consumers are being fiscally responsible even as consumer credit outstanding rises to record levels.  Debt payments as a percent of disposable income are below the low levels of the 1980’s, and at 10.1% of disposable income in 4Q2015, substantially lower than the 16.4% record rate in 1Q2004.    

It is generally conceded that stock gains are limited by valuation.  With a 4Q2016 forward P/E for the S&P 500 of 17x, well-above historic levels, analysts seem reluctant to raise estimates.  Most recently Energy and Materials have had subtle upward revisions in earnings estimates for 2016.  Also, the US dollar remains below levels of last year and should show up in increased earnings of multinational corporations as 2016 progresses.  Because of these factors, earnings may result in an upward surprise sooner than analysts forecast.  The trailing 12 month S&P 500 P/E is 24.3x, a dangerous level according to the bears and a limiting factor for stock prices.  Often missing from this conversation is that the historical long-term average over the past 35 years is 24x, leaving room for a multiple expansion should earnings surprise to the upside.  Once again the question becomes what, if anything will boost corporate earnings to a sustainable level in a 2%-2.5% GDP environment?  Our answer is consumer spending and productivity gains.  Combined with increased household formations a fiscally sound consumer will be the lynchpin to sustainable GDP growth and in turn rising quarterly earnings.     
 
Investment Policy  

Our investment policy is cautiously optimistic as the economy and earnings reflect our outlook for 2H2016 and into 2017.  As the seasonal light volume of summer approaches and with the concentration of, money in large traders (algorithmic and hedge funds), periods of volatility are to be expected, we view any selloff as a buying opportunity.  The transition into a more consumer-oriented economy is on schedule but not fully reflected in corporate aggregate earnings.  Longer term we believe that consumerled economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.   

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 23, 2016

on Tuesday, 24 May 2016. Posted in 2016, May

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 23,2016

Expect the Unexpected – A Contrarian View  

After surviving an earnings recession, a couple of definable market corrections, an energy crisis, global commodity deflation, potential China hard landing, US dollar appreciation, and of course the impending spiral down of the US economy into recession, equities, as measured by the S&P 500, as of last Friday were 4.1% below their all-time May 2015 highs.  Stocks have declined for four consecutive weeks, but the magnitude of selling pales (S&P 500 down 2.2%) in comparison to declines in August-September 2015 (-12.5%) and January-February 2016 (14.4%).  However, the stubborn permabears are no less enthusiastic on an ensuing debacle.  Reluctance to accept reality and the fact that almost all of these “dire circumstances” have reversed or lessened has not driven markets higher.  Oil prices have bottomed and stabilized, the US dollar is no longer in freefall, and multinational companies will show favorable earnings comparisons beginning with 2H2016.  Earnings should bottom in 2Q2016 and improve going forward into 2017.  Stocks should end the year above current levels.    

Moving Toward Normalization  

This improvement does not necessarily guarantee a renewal of a “full-fledged bull market.”  The most recent impediment to a market move above the 2015 record highs is the Fed policy of rate normalization overhanging financial markets since QE3 terminated the asset purchase program in October 2014.  The first step toward rate normalization was a 25 basis point increase in the Fed Funds rate in December 2015.  Recent Fed statements point to a second increase in rates either at the June or July Fed Open Market Committee (FOMC) meetings.  Our opinion is that speculation on Fed initiatives is of little value but listening to the Fed, particularly Chairmen Yellen and FOMC members has value.  Such is the case now.    
Immediately following a weak April employment data, Fed watchers discounted any rate increase until the fall.  After the release of the April minutes last week, the outlook changed.  Odds now favor a rate increase sooner rather than later.  According to the minutes:    


“Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen and inflation making progress toward the 2% objective, then it likely would be appropriate for the FOMC to increase the target range for the Federal Funds rate in June…Participants generally agreed that the risk to the economic outlook posed by global economic financial developments had receded over the intermeeting period.”    

Subsequently to the minutes, individual Fed officials publicly outlined their expectations for an increase in rates sooner than the market had expected.  To date, the reaction in the financial markets has been more talk than reaction, perhaps in recognition that the domestic economy is healthy and that the global outlook is improving.  As we have stated on these pages many times, the markets will react positively as the move to normalization moves forward.  Why then is this Fed policy taken by many as a negative in stocks?  

US economic growth is expected to improve during 2Q2016.  Forecasts for real GDP fall within the 2.0%-2.5% range of the past five years.  Many traders and investors assume that raising rates will negatively affect economic growth.  However, under current conditions rising rates gradually ensures
short rates will remain below the annual rate of inflation and therefore will not restrict growth.  A Fed Funds rate of 100 basis points lower than 2% inflation will not constrict economic growth.  In fact, slowly rising short rates is a positive for economic growth as savings increases, raising overall earnings.  Also, modest increases in mortgage rates will not impact housing as the current market problems are more restrictive mortgage qualifications, low inventory and rising home prices.  Retail prices are highly competitive as consumers continue to purchase more for less.  It is hard to believe a 25 basis point increase on a 17.5% credit card rate will defer purchasers.  Auto loan rates remain low and the extended term loans is more of an incentive than current loan interest payments.  Additionally, moving to a more realistic interest rate restocks the Fed arsenal to combat future economic disequilibrium.    

The impact of low rates has been widely documented.  The near-zero interest rates at most Central Banks has overvalued financial assets on historical basis.  The S&P 500 as a forward 4Q estimate of 16.6X and we would expect it to rise should earnings begin to increase above analysts’ expectations moving through 2017.  In an environment where the economy is growing at a subpar 2.0%-2.5% pace these higher earnings will more than offset wage push inflation and the accompanying slowly rising rates.  Those who are negative on equities going forward cite historically high valuations and foresee little earnings growth as rising rates slow the economy and ultimately bring about a cyclical downturn.  Our expectations are for modest increases in inflation and a slow ramp in interest rates.  As earnings accelerate, P/E multiples will expand.    

Investment Policy  

Our investment policy is cautiously optimistic as the economy and earnings reflect our outlook for 2H2016 and into 2017.  As the seasonal light volume of summer approaches and with the concentration of money in large traders (algorithmic and hedge funds), periods of volatility are to be expected, we view any sharp selloff as a buying opportunity.  The transition into a more consumer-oriented economy is on schedule but not fully reflected in corporate aggregate earnings.  Longer term we believe that consumerled economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.  

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 09, 2016

on Monday, 09 May 2016. Posted in 2016, May

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 09, 2016

Hard to be Patient.

“A man who is a master of patience is a master of everything else.”
George Savile

Yes, we are still in a bull market for stocks. Stocks, measured by the S&P 500, remain about 3% below the May 20, 2015 record high. After correcting in late summer – early fall 2015 and again in early 2016, stocks have challenged the record highs only to fall back to technical support levels. Through last week, the S&P 500 index was up 0.65% for the year and 2.79% below the year-ago level. Volatility, although not approaching the correction levels of August – September 2015 has remained historically elevated. The major negatives of last year and into early February have lessened but not disappeared. China has regained some traction in its transitional economy, oil is up 70% from its February 11th low, and the US dollar is down about 8% from its highs. Economic data on balance remains positive with little or no chance of a recession on the horizon. But the economy, measured by real GDP, continues to grow annually in a 2.0%-2.5% range, close to the 2.2% annual average since the end of the 2007-2008 recession.

While many short- term uncertainties remain, there has been progress on a number of fronts. Among these are:

Stability and Emerging Markets (EM) – Raw material prices have risen recently and for many EM countries this has been translated into higher equity prices. Even with the slowdown in China, many EM countries were in better financial condition to withstand a substantial decline in exports. In addition, the weakening of the US dollar has alleviated pressure from the dollar-dominated sovereign debt issued during the boom years. Stock markets have reflected this turn of events as the MSCI Emerging Market Index rose 6.1% year-to-date through April.

Oil Bottom – While it is impossible to determine the magnitude and short-term direction for crude oil, the February 11th rally off of the $26 a barrel crude price seems certain to hold. There is reason to question that at $45 this rise has been too much too fast. Inventories remain high and production is off only marginally. Demand continues to rise, but is nowhere near equilibrium. The fires in Alberta and the war in Libya may have temporarily kept prices elevated, but this has been more than offset by increased production in Iran.

China Improvement – Data are mixed but there are signs that the transition to a consumer economy is gaining momentum. Most recently the Chinese PPI bottomed. This indicator has historically shown a high correlation to Chinese GDP. Also, the increase in the Baltic Dry Freight Index from 300 to 700 indicates a movement of raw materials and most certainly including China.

Fed Policy – The most recent employment data will most likely push any interest rate increase back into early fall. Thus far current quarter economic data do not give any clear indication of acceleration in overall growth. Manufacturing remains positive, but only marginally, and one of the more robust sectors, Autos, looks to be topping.

Earnings
Earnings season is near completion and the results have not provided a catalyst to raise stocks above the record highs of 2015. According to FactSet, with 87% of the S&P 500 companies reporting results for 1Q2016, 71% had earnings above estimates. Revenues for these companies were only 53% above forecasts. At the sector level, Materials (84%), Consumer Staples (83%), Consumer Discretionary (82%), and Healthcare (81%) had the highest EPS beat rates. With the exception of Healthcare, companies in the other three sectors have outperformed the S&P 500 Index year-to-date through May 6th. The blended earnings decline for 1Q2016 is -7.1%, making it the first four consecutive quarterly year-over-year decline since 4Q2008-3Q2009. Also, the 7.1% decline is the largest since 3Q2009 of -15.8%. There is little reason for optimism in the current quarter. Analysts are forecasting a 4.7% drop in S&P 500 earnings for 2Q2016. Should oil prices and the dollar remain near current levels the 2Q numbers appear too low. FactSet reports that for 3Q2016 and 4Q2016 earnings are estimated to increase 1.4% and 7.5% respectively. Revenues are forecast to follow a similar trend, turning positive in 2H2016.

Housing
Disappointing data for New Home Sales and Starts have put in question the strength of the US housing recovery. New Home Sales have been lackluster, missing expectations in March by 1.7%. Single unit starts are up 22.2% in 1Q2016, maybe warmer weather, but most likely a reaction to low inventory. A shift back to a more balanced single unit/multiunit ratio may be evolving. The trend in rental housing over homeownership seems to be reversing as indicated by an increase in rental vacancy rates to 4.5% in March 2016 from the lows of 4.2% last summer. Housing demand is highly dependent on household formations. According to the most recent Housing Vacancy Survey, the average annual household formation increased from 450,000 in 4Q2015 to 540,000 in 1Q2016. As more millennials moved through their 20’s and into their 30’s, the demographic transition will drive household formation and homeownership. The slow but increasing trend in wages, 2.5% in 1Q2016 preliminary GDP Report, will support this transition from renter to owner.

Investment Policy
Our investment policy is less cautious and should move toward outright optimism as the economy and earnings reflect our outlook for 2H2016. The transition into a more consumer-oriented economy is on schedule but not fully reflected in corporate aggregate earnings. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies. Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS March 21, 2016

on Wednesday, 23 March 2016. Posted in 2016, March

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS March 21, 2016

A Rally to Nowhere

After a five week rally, as of Friday’s close the S&P 500 and Dow Jones Industrials were positive for the year, but are below the May 2015 all-time highs.  The NASDAQ Composite and the Russell 2000 remained in the red.  The Volatility Index (VIX) steadily declined from mid-20’s to a more moderate level of 14.  Since the selloff began in January there has been a shift away from growth into value.  Large-Cap stocks continue to outperform Small-Caps, and without earnings growth equities are bumping into a valuation ceiling.  Leadership has shifted away from Healthcare (-7.1%) and Financials (-4.6%) into the more income-oriented Consumer Staples (+4.2%) and Utilities (+12.4%).  Energy (+5.6%) and Materials (+4.2%) have outperformed in reaction to rising oil and raw industrial commodity prices.  The S&P 500 now stands where it began the year.  

Much of the volatility experienced in 1Q2016 underscores the sharp selloff in the role of hedge funds and algorithmic firms trading on short-term indicators.  These market participants, which add no economic value to investing, distort the fundamentals on the long and short side of the trade.  At its mid-January lows, only 10.6% of the S&P 500 stocks were above their 50-day MA, and last Friday this number rose to 92.3%.  The same trend is apparent with the 200-day MA, which fell to 9.6% and was 57.5% last week.  Earnings for 4Q2015 were near forecasted levels and the economy, despite perma-bear recession forecasts, grew at a 2% level.  In fact, improvements in employment, consumer spending and housing were better than forecast.  Stocks traded on short-term technicals, reacting to oil price movements and to a lesser extent fluctuations in the US dollar.  The issues continue to be oil prices and the US dollar with an eye to volatility.  Until there is a clear reversal in the energy and dollar trend, corporate earnings will remain under pressure.  

A barrel of WTI crude oil rose over this five week period from a low of $26.10 to over $40.00.  This over 50% retracement of crude prices had short-term significance for the stock market, but in the context of the decline from $110 a barrel, the reversal is minimal.  The oil surplus continues, and with the increase in demand only slowing, an equilibrium price remains elusive.  The dramatic 76% decline in US rig count brought the number down to 386, levels not seen since December 2009.  Lost production has been more than offset by Iran’s increase to 3 million barrels a day, up from 1.5 million with intentions to reach 4 million by year-end.  In reality, the decline in oil rigs has had a more negative impact on US energy company earnings and employment than on overall supply.  The shift in refinery blend for summer driving normally leads to a temporary rise in inventories.  Should the reaction to the seasonal shift lower oil prices, it would be only temporary but reestablish focus on oversupply.  

Emerging Markets

Emerging Markets (EM) currencies were weakened by the Fed rate hike in December.  The EM economies are saddled with excess capacity from the over-investment during the 2013-2014 commodity bubble and have been plagued by tightening financial conditions from reduced exports and increased funding costs.  Many of these countries issued US dollar-dominated sovereign debt and are now faced with repayment or refinancing at much higher costs due to their currency’s depreciation against the US dollar and the Fed rate increase.  (The estimate for this debt runs as high as $3 trillion.)  It is too early to tell if the recent rise in commodity prices will alleviate pressure on these countries, but the adjustment will be longer than initially anticipated.  China, the main driver of Asian-Pacific commodity demand, continues to rebalance but at a pace more gradual.  Downward revisions to GDP will be the barometer for estimating a timetable for EM return to growth.  Investors should be aware of EM problems, but for now there are no meaningful consequences for US equities.

China’s economy appears to have stabilized.  Real GDP growth is forecast at 6.5% for 2016 and 2017.  Monetary policy should remain accommodative, although continued easing weighs on the currency and accelerates capital outflows.  The transition to a consumer-oriented economy continues apace as infrastructure growth, manufacturing, and exports decline as consumer spending, including housing, accelerates.  The net effect of this shift is a slow deliberate yuan depreciation.  This weakening of the currency leads to further outflows and may result in strong capital controls.  What happens in China will continue to have a short-term impact on US markets beyond reality as only earnings translations and its effect on US multinationals matter.  

US Consumer

In our last Report we discussed the housing sector and its potential as a driver of a longer-than- anticipated economic growth.  This conclusion is based on a financially healthy consumer in an era of rising employment opportunity and wage gains.  However, this 2016 consumer is more cautious.  Conditioned by high unemployment, lower real income, a housing depression, foreclosure and personal bankruptcies, the current consumer is more defensive and weary of a repetition of 2008-2009.  US households increased spending 3.1% in 2015, the largest annual increase since 2005.  But unlike other high-spending cycles, it is estimated that only 70% of disposable income (including gas price savings) was used in purchases.  The savings rate reached 5.2% last year, up from 4.8% in 2014.  Strong employment gains at the lower-end of the pay scale, not wage increases, have been a major contributor to spending.  The lower fuel costs are reflected in increased spending for motorcycles, pickup trucks, SUV’s, tobacco, and eating out.  Middle to upper income spending has recovered but is more dependent on wage and salary increases, which only recently are showing signs of acceleration.  A risk to luxury spending is volatility in the stock market similar to 1Q2106 resulting in a negative wealth affect.  

Investment Policy

Our investment policy remains cautious.  The recent rally has not changed our outlook as it is short-term technicals (triple bottom) coinciding with a bounce from the mid-$20’s in crude oil.  The problems we foresee are cyclical and not systemic, but they may continue further into 2016.  Unless earnings surprise to the upside, the dismal outlook for 2Q2016 and beyond could negatively affect current stock prices. The transition to a more consumer-oriented economy is in its early stages and not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.  We reiterate our strategy expressed in early January, “sit back and wait.”

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

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