August

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 25, 2015

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

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 25, 2015

Chinese Wall of Worry

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

                                                                                                    Peter Lynch

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

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

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

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

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

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

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

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

Investment Policy

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

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 12, 2015

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

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 12, 2015

Chinese Wall of Worry

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

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

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

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

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

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

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


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 3, 2015

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

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 3, 2015

Complacency in a Sea of Confusion

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

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

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

august15

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

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

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

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


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens