2017

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS December 13, 2017

on Wednesday, 13 December 2017. Posted in 2017, December

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS December 13, 2017

Buckle Up, Some Turbulence Before Clear Skies 
"A good conscience is a continual Christmas."
                                                           - Benjamin Franklin

As year-end approaches, market watchers are focused on the Fed FOMC Meeting, Tax bill amendments, potential budget stalemate, Bitcoin futures, and a grand parade of 2018 forecasts. All these short-term issues appear to make a Santa Claus Rally unlikely but remember, it's Santa. Markets were off in 1Q2014 and 1Q2015, but rallied in 2016 after the election. Many bears are playing out a similar scenario as seen in 2014-2015 for market weakness early in 2018 as markets sell off and the economy slows. All because of a flattening yield curve and unknown Fed policy. In fact, with the exception of a brief selloff from August 2016 into the election, the major averages have been straight up without any broad-based correction. As discussed on these pages for the past few years, it has been the underlying strength of the economy that has accompanied stocks higher even though earnings, primarily Energy sector losses, were flat to down marginally over much of the 2014-2015 period. Longer-term, from January 1,2012 through December 31,2016 the S&P 500 rose 94% while total S&P 500 earnings were up only 20%. Over this period astute stock investors saw progress in the transition to a more normal business cycle and understood the weakness was external; Europe, oil, and China.

Corrections can happen any time and for almost any reason. But there has never been a bear market when Developed and Emerging country growth is steadily rising, oil is up well-above recession levels and China is improving faster than even the most optimistic outlooks. Contrary to the negative headlines, the Fed remains accommodative and even without fiscal stimulus, other than reduced regulation, the economy, measured by GDP, is up over 3% for two consecutive quarters and is forecast above that level for 4Q2017. Inflation and interest rates remain low with an overanalyzed flattening of the yield curve. Presidential politics is just that and as long as the short-term distractions do not tilt the economy to slower growth, markets will not experience a 10% correction.

The current uncertainty in markets has led to a premature rotation out of Technology and into Financials and Consumer Staples. The potential of rising interest rates and the reworking of Dodd-Frank are contributing to the shift for banks. Staples are investments in a safe sector, particularly with a spending consumer, a retail rally off recession levels, and potential corporate tax reform. Technology, the performance leader is the least positively affected sector by the best guessed resulting Tax bill. According to Ned Davis Research, technology companies pay on average 21% in corporate taxes. The Table shows selected Sector effective tax rates. Clearly Technology and Healthcare have the least to gain from a reduction in the tax rate as it is currently structured. Interestingly, these are two of the higher performing sectors since the start of 2017. Other aspects of the plan favor Technology, such as the 100% immediate write-down, and the potential for a workable repatriation of overseas funds. Given the earnings outlook, demographics emerging market growth, the outlook for Technology remains positive for the longer-term.

Wealth Management - Financial Advisors

The addition of a late amendment in the Senate-passed bill includes an Alternative Minimum Tax (AMT) for corporations at a full 20% rate. (It was expected to be repealed for corporations.) The unintended consequences of the AMT will be to nullify the R&D tax credit which directly benefits Technology, Healthcare and the Industrial sectors. Additionally, the Repatriation Tax on accumulated retained foreign cash earnings is 14.5% in the Senate version and 14% in the House bill. This is well-above the 10% initially proposed. Technology companies hold nearly two-thirds of the estimated $2.5 in foreign funds. S&P 500 technology companies account for $950 billion, according to Goldman Sachs. Four companies, Apple ($261.5 billion), Microsoft ($133.0 billion), Cisco ($70.5 billion) and Oracle ($54.4 billion), hold over 50% of that total. With the tax holiday rate much higher than anticipated, it will no doubt result in lower repatriation and limit the positive affect on corporations, particularly tech companies.

We expect the tax reform to be more favorable for corporations than individuals but because of fiscal restraints, phase-in and phase-outs, and in an effort to firm up vote count, acquiescing to individual GOP Senators. The bill will pass but in a much more moderate version because of the compromises. The weakened bill will attract attention as bears flaunt its inability to stimulate growth. Readers of the Compass are aware of our belief that except for earnings and stock prices, the economic value to the Tax bill, particularly for individuals, is limited. However, in retrospect it will be concluded that at this stage of the economic cycle, it was a positive on balance and did no real damage. Our hope is that we can move forward beyond the politics of unnecessarily satisfying campaign promises. The continued growth to the economy is already back loaded particularly for Housing and Capex, but the Tax bill will get credit. That's life in the Swamp.

Perpetual What?

One of the more recent discussions of the movement among the various sectors in the market questions the role of ETF's and low market volatility. In an analysis published in Seeking Alpha titled "The Black Hole: How passive investing became the new QE," investing with the belief that passive flows (ETF's) are distorting markets by creating self-fulfilling price appreciation. It assumes active management holds large positions in top performers, i.e. FAAMG (Facebook, Amazon, Apple, Microsoft and Google) and sit back as Passive Funds are forced to purchase the underlying stocks. By not selling, the Report claims the creation of a "Perpetual Motion Machine." It also creates a new breed of investment, "Smart-Beta Funds," which hold a small number of these Large Cap companies. Of course firms such as Goldman, disagree as they parcel funds to these investments. Wells Fargo suggest that buy side money managers have decided to be overweight in Technology with the best strategy to hold since over the past couple of years, they have no doubt regretted selling these shares. By not selling they participate in the Perpetual Motion Machine.

Most recently, 25% of passive investing dollars went to tech purchases, up from 20% at the beginning of the year. In today's market where upwards of 70% of volume is computer generated, it is not too hard to envision these "Quant traders," with a time horizon of minutes to days, throwing a monkey wrench in the Perpetual Motion Machine. For whatever reason, valid or not, when selling occurs algorithmic traders will move first, leaving active managers to cope with the damage. Computer-generated trades lack fundamental reasons for buying and selling and can result in whip-sawed active managers holding these stocks in contradiction to their stated strategy. An example of possible potential breakdown of the Perpetual Motion Strategy occurred in the Biotech sector beginning in July 2015. After the IBD reached its high at $133, the ETF fell rapidly back below $100 only to reverse up to $115 and then selling off into the mid-$80's. At that time there were clear indications that the volatility on the underlying stocks was a result of satisfying positions of Passive Funds. (Portfolios at Hutchens Investment Management are not and never have been participants in the Perpetual Motion Machine Strategy.)

 

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. 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 Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 27, 2017

on Monday, 27 November 2017. Posted in 2017, November

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 27, 2017

Market Cleared for Takeoff
“To know what you know and what you do not know, that is true knowledge.”
                                                                                           Confucius

 As of this past Friday’s close, the S&P 500 surpassed the 2,600 level, setting once again, a new high. NASDAQ also closed at a record. Climbing the Wall of Worry has enabled almost all US broad-based indices to be at or near all-time highs. Despite an improving economy and 10% earnings growth, bears, since 2011, have consistently searched for reasons for a bear market selloff. Most recent is the flattening yield curve. Highly respected by institutions, Ned Davis Research warns investors about “jumping to conclusions and making premature portfolio changes because of the slope of the yield curve.” The analysis examines the six instances when the spread between the 10-year Treasury yield and the 6-month T-Bill flattened to less than 100 basis points and a recession followed. It took an average of seven months of yield curve flattening to inversion and the S&P 500 rose in all but one instance. From inversion to the start of recession took an average of 14 months (range 8-23 months). Best performing sectors during the flattening were Energy and Technology with defensive stocks best performer when curve inverted. Spiking oil prices have been the primary cause of the inversion and it is doubtful that it will happen during this current cycle. Based on the findings of Ned Davis Research, there seems no rush for the exit (the spread as of last Friday was 90 basis points). We will most likely see the spread narrow over the coming months as the Fed raises rates. Low inflation and low yields are also a contributor to the flatter curve, currently the German 10-year Bund is at 0.34%. Needless to say we will continue to monitor the spread, but for now there is no indication of imminent inversion.

China Economics 101

Markets around the world continue to rise in response to global growth. China, which only two short years ago was forecast by many to bring the US stock market to its knees, continues to grow above all major countries as the value of their exports increases and the transition to a consumer economy responds to government policy. The worst fears of the debt/deflation cycles are over, and with it go the chances of financial shock predicted to shake the world’s stock markets. Even US foreign policy seems to be more cordial, but far from embracing. The MSCI Share Price Index shows China up 55.6%, and Hong Kong rising a respectable 32.2% year-to-date. The EM Index for Asia is up 35.0% and all countries are positive. If a weakened China was forecast to dramatically alter the global markets, it seems logical that the emerging strength would form a strong foundation for growth, particularly in the Asia/Pacific region.

China’s progress has been much faster than anticipated, even among those optimistic just a few short years ago. The macro environment of stable growth, manageable inflation, and improving debt management characterizes the current economy despite tight monetary and fiscal policy over the past year. The improvement is the result of a counter-cyclical growth policy. By weakening nominal GDP, accompanied by rising debt, external demand eventually recovers, and capacity utilization improves giving pricing power to corporations. As a result thus in 2017, the ratio of incremental debt to incremental GDP is at 3.2%, down from its high of 5.5% in 2015. The slowdown in credit growth reversed non-commodity deflation in October 2016 and prices have been rising about 2.5% since the
beginning of 2017, giving a boost to nominal GDP. Export growth has recovered to 7.4% year-to-date over 2016 and well-above the 3.8% decline in 2015. The lower debt-to-GDP ratio is inversely correlated to low import growth.

The transition to personal consumption continued throughout the 2014-2016 policy adjustment and continues to outpace the broader economy. Real consumption growth surpassed the investment growth in 2016 and now accounts for a record 54% of GDP. This rise is attributable to higher incomes due to the strength of corporate revenues and nominal GDP growth. Higher income growth allows consumers to move beyond the bare necessities and shift to discretionary spending facilitated by a broad sophisticated e-commerce infrastructure. Spending on consumer staples is a declining share of spending as durable goods, such as home furnishings and autos, has risen. Preference for foreign brands has grown as well, with over 60% of Sportswear sales in the largest cities having foreign labels. Also, the growth in services, including travel and gaming, no longer are only for the wealthy.

The shift to private consumption, particularly in the rural areas, has been underwritten by an expanding e-commerce platform. Online retail sales have been growing about 25% annually. Retail penetration, or the share of online as a percent of total sales, was at 19.5% during 3Q2017, up from 16% in 2016. For the US, the Commerce Department estimates retail penetration at 9.1% in 3Q2017, which we believe is too low. The extent of e-commerce spending was dramatically illustrated recently on “Singles Day” when Alibaba and JD.com reported sales of $25.4 billion and $17.8 billion, respectively. This far outdistances US Black Friday and Cyber Monday combined. China is currently in the early stages of a countrywide build out (100 Gb transmission) for the provinces. 

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. 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 Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 15, 2017

on Wednesday, 15 November 2017. Posted in 2017, November

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 15, 2017

Tax Reform; Myth or Reality?
“Get your facts first, then you can distort them as you please.”
                                                                     Mark Twain

 

Recent market activity has once again brought up the potential for a serious correction in equities while stock prices hover near record highs. Of particular interest has been tax reform. Last week a modest selloff in equities (S&P 500 -0.21%, NASDAQ Composite -0.20%) was attributed to heightened concerns about tax reform, which by the way, is not supposedly reflected in equity prices. In our opinion, the only meaningful parts of the legislation will come from the reduction of corporate taxes, including lower rates for small businesses, repatriation of overseas corporate funds, and full depreciation of Capex. Once again the “Wall of Worry” is causing fear, rather than rationality, to dominate the media. The “bearish clowns” reverberate the same rhetoric; overvaluation, Fed policy, political uncertainty, and bearish technical and sentiment indicators signaling unsustainable euphoric momentum. For investors, the political posturing is a distraction, rather than a game changer, although short-term downdrafts in stock prices bring fear of a substantive selloff. Investors sell for no other reason than stocks are up and it’s been a long time since a 10% plus correction. As mentioned numerous times on these pages, a correction (10%+) will eventually occur, but not for the reasons of longevity of a bull market. Bull markets end because the economy is moving to recession and inflation is increasing above tolerable levels (3.5%-4.0%) in a rising interest rate environment.

The Earnings Catalyst

As earnings season moves to conclusion, the S&P 500 has handily beaten consensus estimates. According to FactSet, with 91% of the S&P 500 reporting, “74% have reported positive EPS surprises and 66% have reported positive sales surprises.” (Both earnings and sales are above 5-year averages.) According to Fundamentalis, “removing Energy, which is still lapping easy comparisons from 2016, and the Financial sector with a decline of 7.3% in 3Q2017, S&P 500 earnings grew 8.1%.” Our own proprietary preliminary earnings survey of 700+ companies shows equal-weighted earnings above 10%. Technology, with a 26% weighting in the S&P 500, leads all sectors with earnings growth in 3Q2017 with 23.5% year-over-year. Investors in Technology have been rewarded as reflected in the 37.1% year-todate appreciation in the S&P 500 GICS Information Technology sector.

A recent analysis (11/11/17) by Bespoke Investment Group found that the reaction of the S&P 500 to 3Q2017 earnings has been weak, as S&P 500 stocks fell on average 0.33% on earnings reaction day. Overall, 47% of the companies reporting a positive earnings surprise had an average decline of 3.6% over the next four trading days. Bespoke concluded, based on the 0.33% decline that this is a concerning “sign.” We do not concur. With estimates moving up for earnings in 2018 and 2019, 3Q2017 earnings reports may have been already priced in prior to earnings season. Quarterly earnings are discounted. The S&P 500 rose 8.2% in 1H2017 and an additional 4% in 3Q2017. What is more interesting from the 3Q2017 price reaction is the absence of a corporate tax cut. Our conclusion that tax legislation is not priced into earnings is borne out in comments on 3Q2017 from Conference Calls of S&P 500 companies published in the most recent FactSet “Earnings Outlook.” Of the 445 S&P 500 companies, only 93 (21%)
cited the term “tax reform” during their Conference Calls, and only 34 companies expressed positive sentiments.

The tax package, including a 25% tax rate for corporations in either 2018 or 2019, should increase earnings 8%-12% in the first year. The benefit of tax reduction may also result in multiple expansion. According to UBS in their November 14,2017 “US Equities Strategy” there is a value disconnect; “higher rates are priced in, higher expected growth is not.”

 Wealth Management

The estimate for 2018, including the 21.0 P/E and earnings adjusted for 20% corporate tax rate, may seem outlandish. However, these estimates do not even include any repatriation of funds from abroad or benefits from individual spending from tax reform. The lowering of the rate for S-Corporations is packaged as a corporate benefit, but in essence will spur consumer spending.

Broadening of the Economy

There are numerous indications of a broadening of the economy which had begun prior to the election last year. Thus far, the current administration has ridden the coattails of an eight year recovery from a financial crisis and from a series of Fed induced stimuli. Asset prices, particularly financial assets, were artificially driven higher, but today the real economy is approaching equilibrium with many of these assets. As the economy continues to gain traction, equities in particular will lead a sustainable recovery.

Productivity – is finally beginning to increase. After nearly a decade of subpar productivity growth, there are clear signs of positive inflection. The major drivers are higher labor costs and decreased Fed stimulation, particularly the end to QE. Rising productivity has positive implications for asset prices and GDP growth. With the economy approaching full employment, the rising cost of labor relative to capital incentivizes capital investment. This trend, along with the write-off provision if passed, the tax bill should stimulate capital spending with a decided emphasis on technology.

Capital Spending – Capex, or as referred in government data, “Real Residential Fixed Investment” is showing early signs of returning to more normal business cycle levels. Historically, profit growth has led Capex by about one year. With a recovery in the 2015-2016 earnings recession in 2H2016, earnings have risen to double digit levels and are forecast to continue through 2018 into 2019. The credit cycle favors a pickup in Capex internationally, in line with synchronous growth we are experiencing today. A 100% write-off provision in the draft tax legislation, most likely with a sunset clause, may be retroactive.

Three experiences of write-off’s in the past 15 years (2003, 2009 and 2015) all led to a sharp ISM Manufacturing increase. Today, the ISM Index is at a high level and may not show dramatic rise but, with Capacity Utilization low, it is a favorable cost environment with a long runway. Also,
the level of Capex with full expensing should bring on higher investment than experienced with a 50% level in the prior years. Once again, Technology should be a major benefactor of Capex.

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. 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 Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS October 30, 2017

on Monday, 30 October 2017. Posted in 2017, October

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS October 30, 2017

Mid-Cycle Review
“Risk is good. Not properly managing your risk is a dangerous leap.”

                                                                          Evil Knievel

Strength in the stock market is driven by an expanding economy, not by the prospect of tax cuts. There will be some stimulative effect if the Tax Bill passes, but the immediate value will be more psychological than quantitative. That being said, there is nothing on our radar at this time to preclude a continuation of the bull market fueled by a favorable economic cycle and accompanying higher corporate earnings. In fact, new highs for the S&P 500 and the NASDAQ should not surprise, given the current 3Q earnings reports and the optimism for the coming four quarters. The most recent rally is led by earnings of the Technology sector with prices up nearly 3% last week and 34.6% this year, far outdistancing Healthcare at 19.2%.

Since the election, all major averages are up over 20%, while the S&P 500 and the tech-heavy NASDAQ Composite have risen 23.8% and 33.1%, respectively. Beginning in 2017, corporate earnings have strengthened and were up over 10% in 1Q and 2Q. Our proprietary earnings model (Ogden Research) has equal weight 3Q2017 preliminary earnings for 184 companies, up 12%. This trend is reflected in the S&P 500 earnings reported in FactSet and Thompson Reuters. Going forward, the S&P earnings are estimated to rise 11% for all of 2017 and 12% for 2018. These would be the best years since the 15% earnings growth in 2011. Additionally, it has been widely accepted that the $142 current estimate for 2018 could rise $10-$12 if tax cuts and overseas cash repatriation occur. The prospect of a gradual reduction in the corporate tax rate to 20% should have a minimal short-term effect on the market. Even with these estimates and a 3% economy, the stock market is not immune to a correction. The broad-based global recovery, with Europe and Japan growing over 2%, and India and China showing sustained growth, it is more likely a 20% correction would come from an exogenous shock outside the economic world.

Over the past eight years since the Great Recession real GDP has grown 19%, compared to 39% during the 1980’s and 43% in the 1990’s. The magnitude of the post-crisis growth has been ignored as many economists and market strategists predicted recession in 2015 when the Fed stimulation ended. Richard Bernstein notes:

“Stock market returns are not as extreme as some might suggest…The last five years’ return fall far-short of the typical end of cycle ‘blow-off rally.’ The last five years’ return of 14.8% is wellshort of the median return of 21.4% that occurred in the five years leading up to prior bull market peaks (December 1930-July 2017).”

The valuation of the current market is 18X forward 4Q estimates in this, the third longest bull market in history. The bearish argument, once again cites valuation and longevity of the economic cycle and the bull market to conclude it is time to reduce equity holdings. Remember that those who ignored these dire predictions over the past few years are now better off today. Technically, stock market breadth continues to confirm price gains. (The cumulative A/D over the past 12 months reached a new record high on October 20th.)

Economic Rundown

Recent economic data remain positive.

  • GDP – Real GDP grew at a 3% annual level for 3Q2017 beating most economic models. The often quoted Atlanta Fed predicted 2.5% while the New York Fed was at 1.5%.
  • Consumer Sentiment – University of Michigan Survey rose to 100.7 in October, the highest level since January 2004. The Current Conditions Index was 116.5, up from 111.7 in September. Who needs a tax cut?
  • Personal Income and Outlays – Personal income in September rose 0.4% month-over-month, compared with 0.2% in August. Wages and salaries, the largest component, also rose 0.4%. Consumer spending in September was 1.0% higher than August, as a 2.1% increase in durable goods largely reflected the hurricane-related vehicle replacements. Both PCE Price Index (+1.7%) and the Core (ex food and energy) PCE Price Index (+1.3%) remain below the Fed 2% inflation goal.

Housing

New Home Sales rose 18.9% year-over-year in September 2017, the highest level since October 2007. Regionally the South, which represents 60% of total sales which rose 25.8% due to hurricane deferred purchases. All other regions also grew; Northeast 32.3%, Mid-West 10.8% and the West 2.9%. These sales account for about 20% of total housing purchases. The lack of supply of existing homes may be driving buyers into this market. However, prices of a new home averaged $385,000, highest in history going back to 1963. High prices excluded most first-time buyers, as only 13,000 of the 667,000 SAAR new homes sales were priced $200,000 or lower. Existing Home Sales fell 1.5% to 5.4 million SAAR units in September. Supply was 4.2 months, down from 4.5 months one year ago (6 months is considered a healthy inventory.) Median number of days on the market is 34, compared to 39 in September 2016. While the median price is $245,000, inventory is limited.

The housing market is plagued by a lack of affordable homes. With new homes prices at $385,000 and existing homes at $245,000, housing remains out of reach for most first-time buyers. According to the National Association of Realtors, nearly two-thirds of renters believe it is a good time to buy a home, but weakening affordability and few choices in their price range have made it difficult. These comments are borne out in the data which show first-time homeowners representing 29% of purchases in September 2017, down from 34% a year ago. While many economists interpret the erratic home sales as a negative and late-stage phenomenon of the housing market, it is a supply problem. An equilibrium level will be reached by adding more affordable housing and/or rising wages for consumers. As a balance approaches a clear upward trend in housing will emerge, more indicative of early stage of the housing cycle rather than the late stage.

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. 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 Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS October 16, 2017

on Monday, 16 October 2017. Posted in 2017, October

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS October 16, 2017

Stock Market Temperature - - 98.6°

The equity markets remain in record territory as both consumer and business sentiment rises to prefinancial crisis levels. The optimism is supported by a resilient 2% economy showing signs of increased growth through 2018. Earnings have responded to consumer demand and the synchronous global recovery. The most recent Manufacturing data for August puts the ISM Index at 60.8, above the forecast of 58.1, and over 60% for the first time in sixteen. The ISM Service Index was 59.8, well-above the 55.5 estimate, the highest level since August 2005. The Bureau of Economic Analysis revised 2Q2017 Real GDP rose 3.1%, rebounding from the lackluster 1.2 in 1Q2017, giving an average growth of 2.15%, the same slow-but-steady trend of the past few years. The effect of the hurricanes is yet to be determined, but with Harvey in 2Q and Irma in 3Q, there may be downward adjustments. However, any negatives should be quickly reversed in ensuing quarters as rebuilding and recovery go forward. Markets continued to set new highs throughout this period.

The big question for the markets is what will, if anything, bring about a much anticipated correction? Bears have stated for years that the current valuations are too high and given the duration of the bull market, a correction is long-overdue. The response by the market bulls, given the current level of interest rates and low inflation, stocks are the best investment. This is particularly true as the economy gains additional traction from fiscal policy and earnings are not sidetracked by unforeseen external events, such as the oil glut in 2015-2016. Our outlook has been that equities are a long-term investment based on future economic growth and rising earnings and not necessarily vulnerable to a definable correction (10% or more). This viewpoint requires a more comprehensive understanding of the bull market that began in March 2009. The financial crisis resulted in policy initiatives not previously tested. Stocks rose because Federal Reserve policy created a favorable environment for financial assets through a series of three Quantitative Easings and a Repurchase Program that kept interest rates near zero by flooding financial markets with liquidity that artificially boosted stocks. It was labeled the “New Normal” and many believed it would be the future. For years investors castigated the Fed believing that there would be a catastrophic ending to these policies. But, by March 2013 the S&P 500 surpassed the October 2007 record of 1,565.

To some, setting new highs ended the recovery phase and began the bull market. Whether or not this is a correct assumption, it does segment the recovery. In the March 10, 2013 Compass we wrote “What then does our analyses tell us to expect…” summarized, it was as follows:

A. Fed reliquification works. QE programs undertaken by the Fed, Bank of Japan, and the ECB have had a positive effect on equity prices. US stock prices, measured by the S&P 500, have risen significantly during each of the programs; QE 1 (+42%), QE 2 (+24%), Operation Twist (+20%), and QE 3 (?).

B. Markets are not cheap, but they are not expensive. P/E rates (15.2X) are expanding and will continue to do so during the bull market. Corporate earnings are rising despite analysts downward revisions….we expect earnings to strengthen as we move into the latter half of 2013.

C. Consumers will not go away. The slowdown in consumer spending, forecast almost universally by economists over the past two, years has yet to occur.

Our investment strategy, at that time, was for a full position in equities. The S&P 500 Index rose 29.4% in 2013 and with this rise it became obvious that the economy had begun its transition away from the “New Normal.” QE officially ended with the Fed meeting in October 2014, a more appropriate date for the return to the traditional business cycle.

Using March 2013 as a start date, the S&P 500 has risen 63.1% through October 13, 2017. The S&P 500 has risen 40.2% since the low on October 14, 2014, immediately following the Fed meeting ending QE. The Table below shows the 5% or more selloffs since March 2013. The percentage of S&P 500 stocks below the 50-Day Moving Average is a proxy for the breadth of the decline.

Wealth Management

The selloffs in the Table show only the S&P 500 Composite Index, but many sectors including Energy, Tech, Retail and BioTech have suffered bear market corrections of 20% or more. In fact, from mid-2015 through February 2016, the median price of S&P 500 stocks fell more than 25%. In addition, bear market corrections occurred in the Russell 2000 (-27%), the DJ Transports (-32%) and Small-Cap BioTech (51%). Internationally, Crude oil fell 76%, Japan (-29%), China (-49%) and Emerging Markets (-40%). The recovery of most of these sectors and country averages has been the result of a more optimistic economic outlook, along with increases in earnings and raw material prices. These data do not lesson the possibility of a short-term correction, but do show that markets have corrected when looking beyond the broad-based indices.

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. 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 Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 25, 2017

on Monday, 25 September 2017. Posted in 2017, September

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 25, 2017

Back to the Future…Again
“It takes considerable knowledge just to realize the extent of your own ignorance.”
                                                   Thomas Sowell

As equity markets flirt with new record highs many market analysts again turn bearish as overvaluation, the Fed, and perception of a slowing economy with a flattening yield curve signal a market top. The September to mid-October period is historically weak as managers review portfolios and tax considerations are implemented. The lower 3Q2017 earnings estimates are fortifying the bearish convictions. The so-called “Wall of Worry” grows higher but as has happened many times in the not-toodistant past, forecasting the death of the secular bull market will prove premature.

The bears began the attack in 2013 after the resurrection of a weakened Europe and slowing economies of China and Japan threatened global recession. US markets ignored the dire predictions and the S&P 500 Index rose 29.6% on the back of rising earnings (+11.5%) and a 2% economy. In 2014, oil prices fell 46%, and along with a rising dollar, the end of Fed tapering, the S&P 500 Index rose 11.4%. Our view throughout these two years was for slow but continued growth (averaging about 2%), led by a transition to a healthier consumer supplemented by falling energy prices. The 9.8% market selloff during the September 19, 2014-October 15, 2014 quickly reversed, and by December 5, 2014 the S&P 500 was 14.2% above its October lows. The Compass Reports during that time stated our optimism that the Fed was employing the correct policy, oil sector weakness would not bring down the 2% economy, and the financially healthy consumer would anchor the next phase of growth moving forward.

Throughout the 2013-2014 period, the bears overreached in their analysis of the record levels of margin debt, China and Japan economic weakness, and once again, overvaluation. The real experts, Permabears, believe they added to their credibility by including the views of “some of the brightest minds in finance sounding the alarm about a stock market bubble,” (CNN Money, 8/19/14). Joining the chorus was Noble Prize winning economist, Robert Shiller’s valuations at “worrisome levels,” hedge fund king Carl Ichan’s belief that “we are in an asset bubble,” and former Treasury Secretary Robert Rubin’s comment that the “excesses caused by artificial interest rates could create another financial crisis.” A centerpiece of the bearish argument was the ineffective policy advocated by the Fed which was proven wrong and discussed in the Compass entitled “Market Listens as Chicken Little Speaks” on August 4th 2014:

“Underlying the bearish argument is the assumption that after tapering concludes, any Fed policy actions will fail as inflation will rise well-above expectations and interest rates are forced higher than anticipated. The prospect of tightening would create broad selloffs in both stocks and bonds and may even result in a bear market depending on the extent of economic weakness. As investors it makes little difference whether the Fed raises interest rates in early-2015, mid-2015 or late-2015. Last week the Fed stated that it will be a “considerable” time before rates are raised. Even if the Fed begins to raise rates 25 basis points at every other meeting, it would take 2 years to reach 2%. Traders are obsessing when
the Fed will begin to increase rates, but to investors it is a sign the economy is normalizing and not an unintended consequence, but Chicken Little Lives.”

Going forward into 2015, earnings were dominated by losses in the Energy sector. By mid-July the S&P was up only 2.4%, but had reached its highs for the year. A correction of 12.5% from July highs resulted in a double-bottom in August and September, stocks then rallied to close the year with the S&P 500 down 0.3%. All major indices fell with the exception of the NASDAQ Composite (+5.7%) led by Technology and Biotech. Needless to say, Fed interest rate policy, the weakness in oil, contagion from a possible Greek default, and China’s deteriorating economy put the bears in charge. Technicians were claiming a wild assortment of negative formations, the Permabear elite (Roubini, Faber, and Rosenberg) were all over the media predicting the next global recession. Our Investment Policy became cautious in lateMarch 2015 based on the slowing economy and the outlook for earnings. Markets were dominated by high volatility as evidenced by caution in our October 19, 2015 Report written after stocks had rallied. High volatility exacerbated the market weakness as traders dominated. At that time we stated:

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

Stocks began 2016 with selling dominated by high volatility that once again resulted in a double-bottom in January and February. The S&P 500 declined 14.5% from its highs in early-November. Sentiment deteriorated to levels not seen since 2009. Oil fell from $37 a barrel at year-end 2015 to $26 a barrel on February 11, 2016. Traders were still shorting at these ridiculously low levels as rationality in the pits was non-existent. Stocks became closely correlated to oil as the downward spiral accelerated, indicating to bears that the global recession was now on the horizon. US corporate earnings were forecasted to decline through mid-year and the economy was slowing, and deflation would soon follow.

With oil and stocks joined at the hip our strategy “To Sit Back and Wait” in early January was reaffirmed. Our cautious outlook continued through most of 1Q2016 however, as we stated repeatedly throughout the chaos, long-term investors should consider any corrections as buying opportunities. Skies began to clear and by late-April the markets regained nearly all losses and as markets began to discount the improving economic and earnings outlook. Since February 2016 the S&P 500 is up 38.5%, oil has doubled, earnings turned positive in 3Q2016 reaching double-digit growth in 2Q2017. Interest rates remain low and inflation remains below 2%. Global growth is estimated by UBS at 3.7% for 2017. For these reasons and document in the Compass, our strategy moved to outright optimism in early-May 2016.

The purpose of this exercise is to focus on the inability of bearish analysts to go beyond the short-term and put forth a rational long-term strategy. Some, like Marc Faber and Jim Rogers, have been bearish for decades, others (Roubini, Shiller and Rosenberg) have not been right since calling the bear market prior to the financial crisis, with substantial lead-time. Should the current weakness in technology stocks spread to the broad market and continue for more than a week, bears, as well as the reconstructed Fed naysayers, will once again dominate financial media harping on overvaluation. In isolated instances bears have correctly called small corrections, but tend to remain focused on the cause even when the effect is minimal. Tunnel vision has limited their ability to see only short-term negatives, extrapolating them into a bear market often accompanied by an economic recession. Permabears will be right at some point, but most likely after they turn bullish.

Energy Redux

Markets have been at or near record highs for much of 2017. Year-to-date the S&P 500 has risen 11.8% and the NASDAQ Composite is up 19.4%. Large-Cap Technology stocks (XLK), although volatile recently, have risen 19.3%, followed by Healthcare (XLV) +18.0%, Materials (XLB) +13.8%, and Industrials (XLI) +13.6%. Energy (XLE) is the biggest loser, down 9.4%. However, over the past two weeks, the XLE has been the biggest winner, up 5.5% despite a sharp reduction in 3Q2017 earnings forecasts. Caution is advised for investors when looking at the Energy sector because of its international geopolitical exposure and rapidly improving technology in fracking, which has dropped break-even prices per barrel on average below $45. Inventories are still high and there is an abundance supply “on the high seas.” With crude prices over $50 and holding for about two weeks, money has flowed into these stocks as if the supply/demand equation will soon balance, but future prices will be determined by innovation. With more oil and gas between the rocks than under the sand prices will depend on free market principles, rather than OPEC. Why else would Saudi Aramco be planning an IPO for 2018?

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. 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 Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 12, 2017

on Tuesday, 12 September 2017. Posted in 2017, September

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 12, 2017

US Equities – Hurricane Edition 
“It’s difficult to make predictions, especially about the future.”
                                                   Yogi Berra – Philosopher

Looking beyond the short-term considerations for US equities has become lost in geopolitical problems (North Korea) and Washington dysfunction, however, peeking into 2018 the outlook for stocks decidedly outweighs the alternatives, i.e. fixed income and cash. The most recent economic data, published prior to hurricanes Harvey and Irma, put the economy closer to “normal” growth than any period since the financial crisis. Equities have reacted positively to these improvements. Stocks, measured by the major averages, are all within striking distance of new highs. The short-term consequences of the two major hurricanes will no doubt have mixed effects on the data through year-end empowering the permabears to once again yell “impending recession.” The economy will eventually fall into recession, but with current underlying strength accompanied by low interest rates and minimal inflation, it will not be for a while. Additionally, the economic world is experiencing synchronous global growth.

Before moving beyond 2017, investors should carefully assess the impact of the short-term effect of the recent hurricanes. With such external events, overall economic growth initially may show a slight decline as the non-productive aspects of the hurricanes (business closures, cleanup, hours worked and aggregate weekly earnings) moves through the recovery process. The total costs from the two hurricanes vary, but well-over $120 billion is reasonable. Most of the funds will go to the recovery. There will be a positive boost in GDP beginning some time in 4Q2017 extending into 2018. This lagged stimulus will come from restocking, rebuilding, and replacement (homes and autos). After Katrina (2005), there was about nine months of recovery in replacement and overbuild of housing before a return to trend. Following Sandy (2012) auto sales reached new highs and used car prices rose. Non-residential construction, home improvement and building material companies should benefit. Residential flood losses, mostly uninsured, will far outdistance wind losses, putting more costs to the consumers and government.

The economy entering 2018 will benefit from the tailwinds of the hurricanes, craftsmen along with anyone who can handle a hammer, will earn excess income, boosting consumer spending as part of the tailwind. No doubt 3Q2017 and 4Q2017 earnings will be affected for many of the S&P 500 companies. The impact will vary in magnitude and duration. The oil sector, already lowering estimates prior to hurricane Harvey, will show the most earnings volatility. Quantifying lost sales is subjective in the refinery business but precise in the damage and totaled autos. Companies have perennially used weather as an excuse for lower earnings. Over the past few years it has been with winter storms. Expect more confusion during 3Q2017 earnings season centered among retailers, restaurant chains, and travel and leisure. According to FactSet, the estimated S&P 500 earnings growth rate for 3Q2017 is now 4.9%, below the 7.5% at the end of June. Many of the negative adjustments to earnings will improve demand beyond the near-term. Company specific fundamental analysis will provide more focused estimates of storm-affected earnings than ETF sectors.

Stock Market Estimates

The stock market is a discounting mechanism. The Table below illustrates the potential S&P 500 Index with an expanding domestic economy, low interest rates, increasing corporate earnings, and moderately rising P/E rates. Also, the current consensus earnings estimates do not reflect tax reform.

Wealth Management

According to the Ogden September 2017 Monthly Strategy, relative to the past decade’s normal relationship, stocks are fairly valued, versus 10-year US Treasury Bonds. At this time there is no reason for a reallocation to bonds. Only at yields above 3.5% for the10-year Treasury would bonds be more attractive than stocks.

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. 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 Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 28, 2017

on Tuesday, 29 August 2017. Posted in 2017, August

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASSAugust 28, 2017

Elementary, My Dear Watson
“The data strongly suggests that very good years in the stock market are followed by more good years.”

                                                                               Barry Ritholtz 

Historically, stock prices, measured by the S&P 500 Index and the NASDAQ Composite, show since 1950 and 1971, respectively, these indices have both fallen an average of 0.5% in September. For the S&P 500 it is the only month with an on balance decline (30 up, 36 down). NASDAQ is positive for all 12 months. With only three trading days remaining in August the S&P 500 is off 1.3% and the NASDAQ Composite is down 1.0%. The months of August, September and October are seasonally weak months cited by bearish forecasters. The S&P 500 and the NASDAQ Composite have both fallen about 3% since their record highs in late-July, and given the seasonal history, are expected to fall further. Among the other reasons given to justify a selloff in addition to seasonality are; high valuations, political uncertainty, the upcoming budget battle, the length of the bull market, and the recent breakdown in the technical condition of stocks. Not mentioned is the economy or the upcoming 3Q2017 earnings.

From January 1, 2017 through last Friday, the S&P 500 has risen 9.1% as the NASDAQ Composite climbed 16.4%. Over the same period, the S&P 400 MidCap (+2.9%) and the S&P 600 SmallCap (-1.2%) underperformed. According to many analysts the most recent selloff in the MidCap (-4.8%) and the SmallCap (-5.8%) since late-July are a justification that tax reform will not pass this year. From a valuation standpoint the forward P/E of the MidCap (17.3X) and the SmallCap (18.6X) are reasonable when compared to the S&P 500 (17.4%). The bears response to such comparison is that the S&P 500 at 17.4X forward earnings is overvalued given the historical ten year 14.6X and the five year 15.4X. Additionally, much has been made about the rise in the S&P 500 attributable to FANG + Apple & Microsoft. It is interesting to note the valuations of these companies in terms of their P/E’s; Facebook (36.2X), Amazon (238.6X), Netflix (204.2X), Google (33.0X), Apple (18.3X) and Microsoft (26.8X). Given the 12% weighting of these stocks in the S&P 500 a recalculation of the remaining 492 companies would bring the resulting P/E closer to the five year average of 15.4X. Stocks trade at higher P/E’s when interest rates and inflation are low. Today, stocks are at normal risk premiums to bonds and cash. A downturn for a lengthy period would need a decline in earnings, a further rise in the US dollar, and a more aggressive Fed raising interest rates. None of these conditions are evidenced in the markets today.

Almost daily it seems that the financial media cannot understand how the market continues to rise in spite of all the geopolitical events and the chaos being generated by the White House. Onee would think that the lesson has been learned over decades. For example, President Kennedy’s assassination on November 22, 1963 proved only a short sharp one day drop in the averages and afterward markets climbed through December and stocks were up for the full-year 1964 (+13%). More recently, the Greek bankruptcy, China growth, the oil price crash, Brexit, terrorist attacks, and North Korea, have created a media firestorm without any significant changes in market direction. To conclude, geopolitical events have little meaning for the markets until they become an economic crisis. From a different perspective, in today’s world people who move large sums in the financial markets do not give a damn who is in the White House. Maybe the upcoming budget authorization and the increase in the debt ceiling will be different this time,
but we all know the answer. A budget will pass but may require an interim spending bill. Unfortunately, the downside of a budget delay will push back the tax bill, but tax reform is no longer priced into the market.

A case has been made that this is a mature bull market. It has been a mature bull market according to the permabears for many years, but because valuations are higher than historical norms does not portend lower valuations. Fundamentals, the economy and individual company earnings determine stock prices. GDP growth is only beginning to break above the 2% level and corporate earnings are the strongest since 2014 and forecast to grow through 2018. The mature stage of a bull market is characterized by rising inflation, increasing interest rates, and speculative excesses, none of which are present in the current environment.

Global growth is in sync. Overall global economic growth is expected to be 3.8% led by India at 7.2% and China at 6.8%. Even Japan at 4.0% is once again growing. Industrial metal prices are up an average of 22% in 2017, while consumer sensitive energy, agricultural products, and soft commodities are down. The rise in industrial commodities represent the broad-based growth in developed and developing countries. Stock markets around the world reflect this growth. Data published by Yardeni Research Inc. show the extent of this synchronous bull market. The MSCI All Country Index is up 12.6% thus far in 2017 when measured in US dollars. Below are the highlights for major areas and countries for 2017 through 8/25/17.

A. Emerging Markets are up 25.9%, led by China (38.8%), India (25.9%), Argentina (48.5%) and South Korea (30.2%). B. Developed Markets are Europe (20.1%) led by Greece (33.5%), Spain (26.4%), Italy (24.2%), France (19.4%), Sweden (18.0%) and Germany (16.3%). C. Falling below the average global performance are; Australia (11.0%), Japan (10.5), US (9.3%), UK (7.9%) Canada (5.4%) and Russia (-12.6%).

In total, over 90% of the country stock markets are positive thus far in 2017.

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. 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 Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 14, 2017

on Monday, 14 August 2017. Posted in 2017, August

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 14, 2017

A Geopolitical Exercise

Today, August 14th, stocks are rallying as headlines read “Markets rally as North Korean tensions ease.” This should not surprise long-term market followers as most instances of geopolitical fears quickly abate. While there is no timetable for the return to “business as usual,” the uncertainty subsides. This is not to say that the events leading up to the geopolitical uncertainty have disappeared, but rather digested by the market. The real change is in the perception of the geopolitical threat. The reaction of the market to the saber rattling was classic. Momentum-oriented traders reassess their positions and risk is repriced. The pricing exercise results in a multiple compression of P/E’s and shares are liquidated. Non-committal momentum traders sell as prices rarely matter nor do the fundamentals of the underlying companies. None of the technology or biotech stocks sold last week had any economic involvement in the Korean crisis. Bear markets result from economic deterioration, not from geopolitical events. More selling may return as headlinehungry media focuses on impending war and its aftermath, but barring actual confrontation, any selloff will be short lived. Each geopolitical crisis is different depending on market valuation and perceived risk of holding these momentum stocks.

That being said, stocks should continue to rally as geopolitical tensions decline. There will be some shift away from more speculative smaller companies as well as caution with Large Cap technology and biotech companies. We would expect the Industrial and Financial sector to benefit from the reallocation. Retail remains weak but in fact, it is more of a shift away from low tech brick and mortar to Internet convenience. This trend will continue until a profitable balance is reached. Store consolidation will accelerate, along with changes in merchandising; it may take years to reach equilibrium. Consumers, particularly Millennials, will dictate the timing for retail spending in a world of both online and offprice. The FANG stocks have been tainted as Amazon and Alphabet (Google) disappointed on 2Q2017 earnings. Other companies priced to perfection, such as Tesla and Nvidia, cannot afford any mistakes. Excessive optimism reflected in current valuation may be justified for companies with accelerating corporate profits through 2018. Additionally, low interest rates justify higher than historical P/E’s.

Corporate Earnings: Locked and Ready

Earnings of S&P 500 companies rose over 10% in 2Q2017. Revenues were up a surprising 5.1%. According to FactSet, 73% of the companies in the S&P 500 reported EPS above estimates. For sales, 69% of the companies were above forecasts. Both earnings and revenues were above the 5-year average. As shown in the Table below, 10 sectors have reported year-over-year earnings growth in 2017, led by Energy, Information Technology, Utilities and Financials. The Consumer Discretionary sector reported a decline in earnings of 0.3%. Amazon reported EPS of $0.40 for the quarter, down 77.5% from 2Q2016. Excluding Amazon, the EPS for the Discretionary sector would be a positive 1.8%.

8 17 table

The forward 12-month P/E for S&P 500 companies is 17.4X, above the 5-year average 15.4X and the 10-year average 14.0X. Based on consensus earnings estimates the bottom-up 12-month target for the S&P 500 Index at the current P/E is 2,705, which is 10.9% higher than the 8/11/17 close. We anticipate earnings higher than as currently forecast.

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. 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 Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS July 31, 2017

on Monday, 31 July 2017. Posted in 2017, July

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS July 31, 2017

More for Less in a 2% Economy

“Technology makes the world a new place.”

                                    Shoshanan Zuboff

 

The 2% economy chugs along; earnings moved double digits, major averages set new highs, tech with some bumps continues to dominate, and the Wall of Worry gets higher.  The recently released 2Q2017 GDP report shows real growth at 2.6%, and when averaged with 1.2% for 1Q2017, gives 1.9% for 1H2017.  Estimates for the second-half 2017 remain in the 2%-2.5% range.  The inflation rate remains below the desired 2% and interest rates remain lower than had been expected.  The Fed FOMC meeting left interest rates unchanged, but gave indications of a balance sheet unwinds in the not-to-distant future.  Another sharp selloff in the tech-heavy NASDAQ brought the technicians to claim an “Outside Reversal,” signaling an intermediate top with a possible reversion to the 200-Day moving average.   
 
As intelligent investors know, stocks do not go up in a straight line forever.  Although looking at the charts of the major averages since the lows in February 2016, it certainly did over 17 months.  From those 2016 lows until its record highs last week, the S&P is up 37.2%, while the NASDAQ Composite rose 53.5%.  Over the same period, the S&P 500 Information Technology Sector rose a staggering 74%, followed by Financials at 60% and Industrials up 45.3%.  Prior to the early-2016 correction, Healthcare was the undisputed sector leader.  But, since early-2016 it rose a paltry 23%.  Over this time the economy, measured by real GDP, grew at 1.9%.  Earnings and revenues flatlined in 2016 as energy prices fell and then rose modestly and the dollar strengthened.  Throughout this period, Volatility, as measured by the CBOE Volatility Index (VIX), remained in a 10-12 range before falling to a record low 8.8 last week.   
 
The combination of new record highs and a period of low volatility is taken by many as a prescription for a pullback, particularly for sectors in “extreme overbought” territory.  This seems to be the reasoning for the recent sharp sporadic downturns in tech.  The selloff in late-June/early-July for tech reversed and set new record highs.  But once again, last week into today the NASDAQ again is selling off.  One of the reasons cited by investors negative on equities is the lack of buying power in the form of potential inflow.  As evidence, bears mention that cash holdings at Charles Schwab are at a historically low 11.5%, compared with a historical average of 15.6%, concluding that the market is near a peak.  However this conclusion does not address the possibility of rotation out of fixed income into equities, a strong likelihood as rates begin to rise.  According to Morgan Stanley, net exposure to equities of their Prime Broker Content (Hedge Funds) is at 46%, reflecting a lack of commitment.  Additionally, Mutual Funds are 54% equities, below the 59% in 1999 and 56% in 2008.  Moreover, a combined outflow of equity Mutual Funds and stock ETF’s was $29 billion in the past month.   
 
Over the last few years, our Reports have discussed the back-loaded consumer.  The financial condition of households is in the best shape since the 1980’s.  But this consumer has become accustomed to convenience and productivity at a lower price.  This preference shift has created shocks to retailing and many aspects of everyday life.  How many people could go more than a day without a smart phone?  Getting more for less is not only redefining consumer spending, it is pervasive and affects all sectors of
the economy.  This is one reason for our long-term outlook for low inflation in a full-employment environment.     
 
Technology advances are the reasons for excess capacity utilization, particularly in manufacturing.  With levels below 80% there is less pressure to raise wages and build additional plant and equipment.  This is more evident in retailing with a rapid growth of the Internet, it is directly responsible for the closings of malls and big box stores.  These Internet retailers are expanding into urban areas, utilizing less space and catering to the lifestyles of the tech-centric millennials.  Free standing ATMS and Uber and other ride sharing services, have increased convenience and lessened demand for bank branches and car ownership.   
 
What appears to be a secular bear market for commodities limits the potential for inflationary pressures.  Technology affects all commodities, with sophisticated location equipment or highly technical extraction machinery.  This reduces costs and has created over supply for most minerals and industrial materials.  Advances in agriculture have increased output and limited the effects of droughts and floods, but nowhere are the changes more evident than in energy.  Advances in solar have lowered costs to an acceptable level and along with other renewable sources, approach 10% of energy consumption.  Fossil fuels best illustrate the effects of technology.  From a world of rapidly depleting oil and gas reserves, the introducing of fracking and other geological and related technologies has created a global supply glut never imagined only 20 years ago.  Oil and gas fracking continue to provide a disruptive force as supply is available at manageable costs.  Inflation in the energy sector is limited by technology and consumers and corporations benefit from more for less.   
 
As mentioned earlier, 2Q2017 earnings are better than even the more optimistic forecasts.  While traders focus on short term valuation, this earnings season shows the potential for rising corporate earnings going out through 2018.  Despite disappointment with Amazon and Google, Technology is leading the trend in continued earnings growth.  Combined with Financials, these two sectors are about 38% of the S&P 500 and are forecast to lead earnings growth through 2018.  FactSet reports that with 57% of the S&P 500 companies reporting, 73% of both earnings and revenues have beaten the mean estimates.  Overall, 10 of the 11 sectors are above forecasts.  Looking out into 2018, these two leading sectors are expected to grow earnings in double digits, along with Consumer Discretionary, Industrials, Energy and Materials.  Earnings are in the early quarters of elevated growth.  More important than the 2% real growth economy will be the balance among various sectors.

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity.  It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted.  Realistically the positives from expansionary fiscal policies will take more time than generally expected. 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 July 17, 2017

on Monday, 17 July 2017. Posted in 2017, July

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS July 17, 2017

Amazon Skews the World

“If consumers make better choices, the marketplace will change.”

                                                    Mike Huckabee

 

After a brief selloff stocks resumed their upward move with most of the broader averages setting record highs last week.  The NASDAQ remained 0.4% below its June 9th record after falling 4.2% in late June/early July.  This compares with a 2% downdraft for the S&P 500.  The Tech sector (XLK) closed 1.3% lower than its record high, also set on June 9th.  The turnaround in tech stocks was led by the LargeCap favorites, FANG + APPL + MSFT, all of which had fallen double-digits.  The selloff resulted in a reawakening of the permabears and the Fed watchers, while most bullish market-strategists focus on a shift away from Tech into Financials.  This is a normal rotation away from higher-priced growth stocks to value.  Large bank earnings thus far justify this strategy as the S&P 500 Bank sector (KBE) has rallied.  The after earnings Conference Calls have not confirmed the long-term earnings optimism as regulation, low inflation, and a flattening of the yield curve remain.  The KBE is up 5% over the past three months and 37.4% above year-ago levels.  It outdistances the XLK, which has risen “only” 26.4% year-over-year.  It is important to note that from a trader’s prospective, many of the leading tech stocks have not broken above their former highs, and therefore remain in a trading range.
 
In our opinion there is little likelihood of a bear market related to an impending recession.  The current bull market is in its ninth year and officially one of the longest in history.  For many investors the duration of the bull market and the accompanying P/E’s substantially above historic norms, leave them to constantly reevaluate risk.  With the negative media attention, investors remain anxious in spite of rising prices.  Fear that stocks are overpriced results in an instinctive reaction to sell in order to avoid the upcoming swift selloff in the beginning of the bear market.  Remember bear markets result from economic distortions or euphoria as experienced during the Internet bubble in 1999.  Although some economic imbalances in housing and energy exist today, they are manageable.   
 
Last week Amazon held Prime Day, the annual event was for 30 hours and sales were 60% above yearago levels.  According to data from the Consumer Intelligence Research Partners, 45% of Amazon’s 40+ million customers in the US have Prime.  Amazon collects $99 annually for a membership that yields an average of $1,500 in annual sales, compared to only $625 for non-members.  In an attempt to offset potential loss and market share, other retailers including Wal-Mart and Best Buy, competed with Prime Day.  Unlike Amazon, these “brick and mortar” retailers sell from their own inventory.  But Amazon, in addition to acquiring and selling merchandise on its own, offers a service called “Fulfillment by Amazon” that handles third-party sellers.  Amazon’s success is well-recognized, but our research leads us to believe it is not fully reflected in the retail data published by the Census Bureau in its monthly Retail Sales Report and utilized as an input for Personal Consumption Expenditures (PCE) and GDP.
 
Unfortunately for data consistency, Amazon only reports net sales however, data from the 1Q2017 earnings release shows retail third party sales were up 34% for year-ended 1Q2017.  According to a study
done by Taxjar, in 3Q2013 third party sellers “were generating more than $17 billion of Amazon’s $32 billion gross merchandise value.”  Our own unsophisticated survey conducted on Prime Day showed that the third party fulfillment merchandise was 54% of all sales.  This percentage varies greatly within the various retail categories.  Amazon tends to sell more of the $200 and over items with only 30% being sold by outside suppliers.  Since Amazon does not report Gross Merchandise Sales in its financials, where then does the Census Bureau get their numbers?  Even if Amazon reports sales, it would be for Amazon itself and not the tens of thousands of third party suppliers (fulfillment is another income category).  As the number one or two retailer for most categories (books, clothing, electronics and furniture), if unrecorded the absence of these sales are significant.   
 
According to Morgan Stanley, Amazon accounted for 38.5% of the growth in 1Q2017 retail sales.  Data reported by the Census Bureau are from a probability sample of 4,700 employer firms selected from the Monthly Retail Trade Survey, all the monthly data are benchmarked to a larger annual survey for the previous year.  Aside from sampling error, non-sampling error can occur for “insufficient coverage for retail business.”  The Census Bureau claims the Retail Sales Report includes sales from pure-play ecommerce and retailers, but third party suppliers could easily fall between the definitional cracks.  It has been our contention that these sales may be uncollected and therefore absent from consumer purchases.  Healthy consumer balance sheets, full employment, low gas prices, and the level of consumer sentiment do not justify PCE for GDP at an historically low 2.0%-2.5%.  As consumers continue to get more for their money, the 2% real GDP growth does not justify 10% increase in quarterly earnings.  We will carefully monitor for an increase in the July Retail Sales Report to see if Prime Day significantly moves the needle.  
 
A vibrant consumer seems to be lost in the data which does not reflect the rapidly changing demographic and the seismic shift in retail.  As we have stated, the Gross Output is a better indication of economic activity rather than final sales (Compass 09-15-14.)  Corporate earnings are more reflective of Gross Output as it takes into account all goods and services used in the production process, including intermediate production rather than final consumption.  In this measurement PCE is only about 38%.

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity.  It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted.  Realistically the positives from expansionary fiscal policies will take more time than generally expected. 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 June 26, 2017

on Monday, 26 June 2017. Posted in 2017, June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 26, 2017

Everything in Moderation

“Moderation is the secret of survival.”

                       Manly Hall

 

Stocks continue to set new all-time highs.  All major averages (Dow Industrials, S&P 500, NASDAQ Composite and the Russell 2000) recently made new highs, accompanied by highs in breadth.  Since the beginning of the year the NASDAQ is up 16.4%, reflecting the 19.8% increase in the S&P 500 GICS Technology sector over the same period.  The S&P 500 rose for the seventh straight month in a row in May and has recorded 24 record closes for 2017.  Despite the move to new highs, the recent rate increase at the Fed’s June 14th FOMC meeting and unveiling of their plan for unwinding its balance sheet has diverted attention back to Fed policy and the recent flattening of the yield curve.  The flattening yield curve is often interpreted as a leading indicator of an economic slowdown and eventual recession.  This past week the yield of the 10-Year and 3-Month Treasuries approached their one-year low.  However, according to the Bespoke Investment Group, this is not a forecast for falling stock prices.  They stated that “Instances since 1990 in which the yield curve of the 10-Year and 3-Month Treasury is at 52 week lows the return for stocks was surprisingly good.  The S&P 500 averaged 2.24%, 5.33%, and 9.33% over the next one, three and six months, respectively.”   
 
The bearish view anticipates a flattening of the yield curve to be a precursor of inversion.  The rate increases by the Fed are too slow in an economy experiencing excesses; this is far from the situation today.  The low rate of inflation has misled bears to misinterpret the current moderate flattening.  In this environment we expect that Fed policy will remain data dependent to adequately negotiate the current slow growth situation.   
 
The Moderate Economy
 
The US economy remains at 2% real growth.  There are many different factors limiting the upside, some of these are regulatory and demographic, but in large measure it is the technological advances in the marketplace allowing consumers to purchase more for less.  It has taken nearly 10 years to restore a sense of balance in the economy.  Both banking and housing were, and still are, affected by government banking regulations.  The rise of the largest demographic, 85 million Millennials, is becoming fullfledged participants in the economy and the impact of innovation on everything consumer.   
 
Banking – The enactment of many restrictive regulations during the Great Recession to limit the farreaching “destructive power” of large banks, curtailing risk but at the expense of slow economic growth by the government assuming the role of the private banking system in the recovery.  The current review of Dodd-Frank may lessen some of the more onerous regulations, but a full repeal seems unlikely.  The most recent “Stress Test,” which all banks passed, opened the door of opportunity for banks to seek approval
from the Fed to raise dividends and to initiate new or increase stock repurchases.  This may in part, explain some of the recent flow of funds into the banking sector.   
 
Housing – remains the largest asset for most consumers, but securing the “American Dream” is much harder today than prior to the 2000-2009 fiscal crisis.  The housing market is far from stable.  Needless to say, things are slowly improving as the supply/demand imbalances continue to impede steady growth.  Among these problems are:
 
A.  Regulations.  Mortgage qualifications are much harder on potential homeowners, this has severely impacted first-time buyers.  Building regulations have added up to 25% of the builder’s costs, and to some extent created a shortage in the supply of labor.  This lack of skilled labor has affected primarily small contractors who are unable to continue building houses and have left the market.  This is, in part, the result of the expansion of government disability rolls immediately following the collapse of the housing industry in 2008.  Federal checks in hand, many tradesmen found additional sources of income that enabled them to remain on government assistance.  With the industry in depression for years there were no new workers trained.  Today, a short supply of skilled construction workers are driving builder’s costs higher, not all of which is passed on to home purchasers.   
 
B. The Cost of Homeownership.  With the median prices for new and existing homes at record levels, the percentage of homeownership is at historic lows.  The median price for a new home in May 2017 is $345,800, and for existing homes $254,600, respectively up 16.9% and 5.8% over May 2016. Inventory for new homes is 5.3 months and 4.2 months for existing homes.  The level for existing homes is exceptionally low and has resulted in bidding wars reminiscent of the 2005-2006 housing boom.  Renters are avoiding purchasing homes because of the high prices and according to the National Association of Realtors, only 52% of potential homebuyers feel it is a good time to buy now, this is down from 62% a year ago.  Instead of buyer demand creating supply, the high home prices have created disequilibrium.  Lower priced or starter homes are in short supply as builders target first-time homebuyers rarely pricing homes below $200,000.  Investors take advantage with cash offers to buy lower-priced homes for single-family renters.  An inadequate supply of affordable housing is the problem and although housing data will remain positive, the upward trend will be erratic.
 
 Oil Prices – once again lower prices of crude oil are being touted as an indicator of slower economic growth.  But unlike housing, the problem is oversupply.  OPEC plus non-members led by Russia agreed in May to extend production cuts to reduce global supply by 2% through March 2018.  Since then, overall production has increased as crude has fallen into a bear market.  Today, WTI closed at $43.47 a barrel, down 20.2% from its peak of $54.45 a barrel on February 23, 2017.   US crude rig count peaked at 1,609 in October 2014 and hit a low of 316 in May 2016, the lowest level since the 1940’s.  As of June 23, 2017 the rig count is back to 758.  Breakeven levels continue to fall with about 40% of the decline coming from lower costs from equipment providers.  Technological innovations in fracking have improved decline rates, meaning wells are lasting longer, producing more and fewer wells are needed to increase current output.  Wells are producing below $40 a barrel with some as low as $20 breakeven.  Competition is Saudi Arabia which produces at $23 a barrel.  Aside from lower cost, the improved regulatory environment will add to US production and transport, opening up export opportunities.  Consumers are the major beneficiary, as gasoline demand has risen while maintaining lower prices.  Unfortunately, the Energy sector (XLE) is down 14.7% so far this year.

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity.  It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted.  Realistically the positives from expansionary fiscal policies will take more time than generally expected. 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 June 13, 2017

on Tuesday, 13 June 2017. Posted in 2017, June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 13, 2017

Chicken Little; Short Seller

“The sky is falling.”

                       Chicken Little

 

The selloff that began in technology stocks on Friday and continued through Monday has elicited a broad range of opinions from market strategists.  Those negative on the market seized on the idea that it is a drawdown of the FANG+AAPL+MSFT that is long overdue.  The real bears are not stopping at technology, they believe this trend will broaden beyond to other sectors and expose the “weakening economy and the slowing earnings growth.”  Permabears are already stepping forward to claim the title “I told you so.”  Seems to lack as much credibility after 10 years as Chicken Little did claiming the “sky is falling.”  The conditions initiating the Tech selloff began after noted “activist short-seller” Andrew Left issued a report on chip maker Nividia (NVDA), concluding overvaluation as the primary reason that the chip stocks would go down.  He shorts the stock prior to the report released through his firm Citron Research.  No doubt by conventional fundamentals, NVDA carries a lofty P/E (41.1X), along with a 238% price appreciation over the past year and 50% over the past three months.  Whether the argument on value is valid has little to do with the trade.  Left already alerted other short sellers after taking his position.  For those who missed his call, he had an exclusive interview on CNBC’s “Half-Time Report” on Friday.  By the close, NVDA was down 10%.     
 
This was not Left’s first report on NVDA overvaluation.  In December 2016 he predicted the stock to fall at $90, but it rose to a high of $165. Persistence, capital, and in Left’s, case broad media exposure, are the tools of his trade.  The fact he has made some credible calls on questionable company practices does not always spill over into valuation calls.  But timing is everything.  The Citron report follows Citi, Merrill Lynch and UBS, raising target prices up to the $180’s over the past few days as their previous targets were surpassed.  As mentioned on these pages many times, 85% of hedge fund money is with 5% of the managers.  With about 8,000 hedge funds, that leaves 7,600 managers competing for 15% of the remainder.  Many of these funds are trading firms, including algorithmic and flash traders.  These funds trading long and short and accentuate the movement in both directions.  Performance under these circumstances requires quick moves, getting in early and out before a turnaround.  Smart money has already been made in NVDA.  With all the hype of the recent FANG+2 stocks, it is not surprising for short-sellers to apply the subjective term of overvaluation to tech stocks that have run up nearly 50% over the past year.  There have been rumblings of similarities to the 2000 tech bubble for some time.
 
With regard to the FANG+2 stocks it has come to pass that without overweighting these favorite LargeCap growth stocks, it is virtually impossible to outperform the S&P 500.  While this is true to some degree, but generalization does not take into account that the 50 largest winners in the S&P 500 were up 8.35% year-to-date through April, while the 50 worst performers were off 6.57% over the same period.  It is also interesting that for year-to-date through last Friday, the Equal Weight S&P 500 rose 8.62%, while the Cap Weight S&P 500 was up 8.25%.  Whether the large tech valuations are ahead of fundamentals is a subjective judgement and not a primary consideration for momentum traders.  Academics believe that
an efficient market for stocks exists however, people like Andrew Left have shown value is in the eyes of the beholder or short-sellers.  Others note that the S&P 500 has not had a 5% selloff since July 2016 - - the longest time period since 1996.   
 
The immediate response to the Tech selloff among the many professionals was a reorientation of portfolios away from Tech and into Financials.  This is not readily apparent although there is rationale to such a rotation.  Since the beginning of the year through last Friday, the S&P 500 GICS Financial sector was up 4.1%, while Tech rose 18.6%.  The Fed is expected to raise interest rates 25 basis points this week and, the Comprehensive Capital Analysis and Review is being released by the Federal Reserve on June 28 and many expect the report to show the benefits of lessened regulation; giving economic rationale to rotation.  Also, money managers and individuals hold outsized profits in Large-Cap tech stocks (S&P 500 GICS Technology Sector is up 32.0% year-over-year), an incentive to taking long-term capital gains at current levels.
 
Whatever the reasons for the selloff in the Tech Sector, the companies that have gained 40% or more since the beginning of the year are correcting.  But it will not be long before 2Q2017 S&P earnings are reported.  According to FactSet, current estimates are for a rise of 6.6% for earnings and 4.9% for revenues.  Nine sectors are estimated to show earnings growth, led by Energy (+404.3%), Technology (+9.3%) and Financials (+7.2).  All sectors except Telecom are expected to have revenue increases.   The current Tech selloff should not broaden to other sectors and it is more likely that any rotation will increase purchases in economic sensitive companies rather than out of equities.  The companies experiencing the rapid price depreciation are for the most part, innovative/well-managed and profitable with a growth outlook.  Readjustments of equity prices and sector rotation are common characteristics of bull markets working in conjunction with the business cycle.   
 
By Tuesday, most of the affected Tech stocks have stabilized and reversed course.  There is no guarantee that the selloff is exhausted.  There is a growing recognition that many of these Large-Cap Tech stocks are long-term winners.  The sharp declines on Friday and Monday morning are characteristic of algorithmic trading.  After three days, NVDA is at $150, down from its closing high on June 8th of $160, a day prior to the Citron report.  

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity.  It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted.  Realistically the positives from expansionary fiscal policies will take more time than generally expected. 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 May 30, 2017

on Tuesday, 30 May 2017. Posted in 2017, May

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 30, 2017

Down the Road to Normalization

“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.”  

                                                                                                                      William Arthur Wood

 

Through last Friday the S&P 500 was up 7.9% year-to-date, meanwhile the mid-cap S&P 400 and smallcap S&P 600 rose 4.0% and declined 0.5%, respectively.  Unlike the S&P 500, which set a new record high last week, these other indices reached their highs earlier in the year.  Narrowing breadth reflects these returns for the S&P 400 and 600 indices.  The gains in the S&P 500 are the result of the top 15 stocks generating over half of the increase this year.  As earnings growth estimates continue to rise and investors believe the gains are achievable, expect a broadening in the markets.   
 
The narrow breadth is mirrored in lower volume and low market volatility.  High volatility is most often indicative of a declining market but, the Volatility Index has remained at historic lows since mid-April.  The only exception was the brief sell off in mid-May.  Technicians talk of this low volatility as a sign of complacency and as a precursor to a correction.  However, others have cited the increased use of index ETFs as a contributor to the current low volatility.  According to the Investment Company Institute, over the past ten years about $1.4 trillion flowed into domestic equity index funds.  Over the same period, $1 trillion flowed out of active managed mutual funds.  Today the top 50 ETF’s (2% of total) control twothirds of ETF assets, while the top 100 control 84% of the assets.   
 
The US markets are benefiting from a pro-business sentiment. To date, the 2% economy remains as underlying strength improves.  So far, buying into geopolitical fear, even if it comes about, has proven to be wrong.  The recent rally which brought broader averages to new highs is about positive change, synchronous global growth, solid 1Q2017 earnings, and low interest rates.  There is a change in attitude as individual investors are beginning to shift away from fixed income.  Funds are being invested overseas in ETFs for Europe and Emerging Markets.   
 
The Misrepresented Consumer
 
Over the past two years, our Reports have discussed at length, a “backloaded consumer” as the lynchpin to sustainable economic growth.  Consumers are now in the best financial health since the Great Recession.  But, interpretation of a report on consumer debt questions that outlook.   
The New York Federal Reserve Bank recently released its “Quarterly Report on Household Debt and Credit” for 1Q2017.  Aggregate household debt increased by $149 billion in 1Q2017 to a record $12.73 trillion, above the previous peak of $12.68 trillion in 3Q2008.  Economists, market analysts, and the media jumped on the headlines and implied the debt cycle is once again in full swing.  In reality, the raw data overwhelmingly show the strength of the consumer balance sheet, rather than focusing on the increase in liabilities.  For example, not reported is the fact the debt reaching a new peak is about 103% of disposable income, down from record 133% in 4Q2007.  This is the lowest level of the debt-to-income
since 2002.  More importantly, the level of debt is more manageable as the quality of the average borrower has risen to a 700 credit score, a level not seen since 2005.   
 
A shift in borrowing patterns, particularly with tighter regulation for home mortgages (68% of total debt), has reduced the level of risk significantly.  Using credit scores as a barometer of borrower ability to pay, the quality of loans has increased dramatically.  This is true across a broad range of consumer debt, with the exception of student loans.  At the height of the housing depression, in 1Q2010, 8.9% of mortgage loans were delinquent over 90 days.  Today that number is 1.7%.  For credit cards the same pattern exists, delinquent loans of more than 90 days were over 13% in 2010-2012, but has since dropped to 7.5%.  Both home equity and the “other” category, which account for 7.7% of the total loans, show the same pattern.   
 
Auto loans (10% of the total) are somewhat troubling.  However, the problem is being attended.   Auto loan delinquencies are only at 3.8% of the $456 billion of the auto total.  The length of the loan is more troubling because during the 2012-2015 period the overall credit quality of borrowers was low.  Recently, credit quality has improved, raising the 720+ credit score for borrowers up to the 60-65% for new loans compared with the lower quality borrowers (below 720) which dropped below 40% after accounting for  60% or more over the past few years.  Given the loan mix until 2016, it seems reasonable to assume many of the 6-7 year loans will fall into delinquency and repossession.  This does not take into account the likelihood that many cars may not last the duration of the loan.  If there is good news, it is that the current $17.2 billion delinquent is only 0.135% of total household debt.   
 
Student loans are a well-known problem that is priced into the debt equation.  Totaling about 10% of all household debt it is difficult to foresee a favorable outcome.  With a delinquency rate of 11%, over 50% of these loans are for students who attended “for profit” colleges and have not graduated.  Without a degree it will be almost impossible to collect these funds.  This should not have a direct effect on the average consumer.   
 
In conclusion, the record level of debt has been misrepresented as a burden for the consumer and a negative for the economy.  Further examination shows a more robust consumer on the verge of increased income and better opportunities as full employment approaches.  The rise in home prices and the stock market have been major contributors to the lowered ratio of household debt to net worth from a financial crisis high of 25.4% to 15.8%.

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity.  It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted.  Realistically the positives from expansionary fiscal policies will take more time than generally expected. 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 May 8, 2017

on Monday, 08 May 2017. Posted in 2017, May

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 8, 2017

Earnings Trump Swamp

The major problems of attempting to input politics as a significant variable in determining investment strategy is “politics by definition is irrational.”  Excepting external events such as war or financial crises, markets quickly adjust to changing political conditions.  It is best to ignore the short-term political dysfunction and take a longer term view from the direction of the economy.  This is particularly important today as political chaos reigns in the media, but more importantly, the underlying economy continues to improve.
 
As of last Friday the S&P 500 was up 7.2% year-to-date, and just about at its record close on March 1, 2017.  The major difference is that the net new highs as a percentage of the S&P 500 is only 10.6% compared with 26.3% at the record high.   Although the S&P 500 breadth shows near-record levels, the net new highs are more concentrated in Technology and Consumer Discretionary, and more specifically the FANG stocks plus Apple and Microsoft.  These six stocks comprise 13% of the S&P 500 weighting and are all near or above 2017 highs.   Money managers, over the past two years, have had a difficult time beating the S&P 500 without being overweight these companies.   Also, the recent selloff in energy stocks has lowered the percentage of net new highs.   
 
Corporate Earnings
 
With the contentious Healthcare bill sent over to the Senate, tax reform moves center stage.  Healthcare has no significant financial impact and tax reform will be pushed well into the second half of 2017 or even 2018.  First quarter 2017 earnings have surpassed most estimates in breadth and quality.  FactSet’s Earnings Insight shows that as of March 5th, with 83% of the S&P 500 reporting, 75% have beat the mean EPS estimate and 66% have exceeded on revenues.  Overall, 1Q2017 S&P 500 earnings are up about 15% over 1Q2016.  For 2Q2017 estimates are forecast to rise about 8.0% and revenues 5.0%.  The most recent Forward 4-Quarter Growth rate is 9.8%, higher than all recent estimates creating a floor for S&P 500 prices moving forward.  (These estimates do not assume any tax relief whose primary beneficiaries are Energy, Technology and Healthcare the most.)  
 
InfoTech is the leading S&P 500 GICS Sector with a 16.5% price increase year-to-date through May 5th.  According to Thompson Reuters, with 85% of market cap of InfoTech reporting, 96% were at/above estimates.  Overall earnings were 6.3% above estimates.  For Consumer Discretionary, the sector average is up 10.8% year-to-date and with 64% of market cap reporting, actual earnings are 11.3% above 1Q2017 estimates.  A GICS sub-industry, Retail Internet leads a troubled Retail sector with actual earnings up 22.4%.  Energy shows a different picture.  Earnings are at/above estimates by 24% in 1Q2017 but prices for the Energy sector is off 10.7%.  This reflects the price decline in WTI which began in early-March and fell from $54 a barrel to below $44 a barrel last week.   
 
For market bears this recent decline in the price of oil is an indicator of slowing global growth.  However, there is reason to believe the WTI may no longer have any major role as an economic indicator.  Oil prices are now more reflective of technological advances, resulting in greater efficiencies and lower prices.  US Shale is the swing producer, offsetting OPEC reductions.  US Production forecasts have been rising since last year.  In April 2016, production was 8 million barrels per day and has risen to a current level of 9.2 million for April 2017.  Fracking is profitable for most US drillers over $50 barrel.   Production is expected to rise as break-even levels continue even lower.  Lower oil prices will be positive for lower input costs and for consumers, gasoline prices.  We continue to believe oil will track in a $45$50 a barrel range for the foreseeable future, even following the expected OPEC extension of production limits in June.  Also, the high yield market does not reflect any concern similar to 2015-2016.  

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity.  It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted.  Realistically the positives from expansionary fiscal policies will take more time than generally expected. 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

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