August

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 29, 2016

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

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 29, 2016

American Consumer – Healthy and Wise, Part II   

Jackson Hole - “Much Ado About Nothing.”    

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

Consumer in Transition 

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

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

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

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

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

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 1, 2016

on Tuesday, 02 August 2016. Posted in 2016, August

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS August 1, 2016

Shifting Dynamics 

Stocks, as measured by the broader averages, had a banner July, sending the Dow, S&P 500 and NASDAQ clearly into positive territory for 1H2016.  The July rally was led by Technology as higherthan-anticipated earnings and M&A fortified prices.  Energy, which had been a leader since the bottom in crude prices early in February, was the weakest S&P sector in July, falling 2%.   The fall in energy stocks reflects a steady 20% decline in crude oil prices in July.  For year-to-date, the Energy sector is up 12%, but once again the bears are claiming the drop in oil is a sign of impending economic slowdown.  The 1.2% rise in real GDP for 2Q2016 added confirmation to this assertion.  In reality, the decline in oil prices reflects a seasonal cycle, although for much lower levels than historically.  Oil prices regularly rise through the spring as gasoline production increases in anticipation of summer driving season, peaks in early June and falls into late October.  After all the attention given to oil volatility over the past year, in a slow news environment attention is refocused to the dangers of another freefall.   
Corporate Profits and GDP 

It was almost immediately reported in the media and echoed by market analysts that GDP data released by the Bureau of Economic Analysis (BEA) on Friday confirmed a weakening economy.  The lower real GDP then estimates was ascribed to a larger-than-expected decline in inventories at the finished goods level.  Had inventories remained stable, GDP would have been up 2.4%, in the range of most estimates.  Low inventory numbers in this instance do not positively impact corporate profits to the extent of the adjustment back to normal levels. As we have written on numerous occasions since 2014 it is Gross Output (GO) that fully reflects what is going on in the economy.   

Unlike GDP, GO is defined by BEA “Measures the combination of both final product (GDP) and the industry input that is purchased by other industries for use as inputs to their own production.”  The criticism of GO is that it involves double-counting, as it takes into account all goods and services used in the production process to produce rather than for final consumption measured as GDP.  The Go is indicative of the total activity of the entire production process.  The Table below shows annual and the most recent quarterly data.   

Aug 2 2016 Investment Management Weekly

The data on the Table show the relationship of GO to Personal Consumption Expenditures (PCE) to be consistent, the private industry output tell a different story.  Although not shown on the Table, the Total Output of Private Industry fluctuate quarter-on-quarter.  These data show a sharp slowdown in 4Q2015 and a below-average increase in 1Q2016, an indication of inventory buildup being worked off.  

 Although the consumer is the lynchpin for GDP growth, when looking at the overall economy GO must be part of the analysis.  Corporate profits are more reflective on total output, this is particularly the case for industrial companies producing intermediate goods for final production.  A stronger US dollar, foreign trade, inventory adjustment, and productivity are outside the scope of PCE.  A trend of increasing personal consumption assures growth in consumer related products, but masks of a full picture for corporate earnings.  For example, dislocations, such as sharply falling energy prices, positively affects consumer spending but negatively affects energy companies and ancillary industries.  In other words, a pickup in PCE, while a positive for selected equity sectors, may not be reflected in overall corporate profits.   

Productivity weakness has been another factor for subpar corporate profits. Since late-2010, capital spending has trended down as capacity utilization remains below 75%.  After increases in Nonresidential Investment in 2014, mostly structures, a low level of capital spending increases continued until turning negative in 4Q2015 through 2Q2016.  Only the intellectual property component has remained positive but at subdued levels.  Low interest rates are supposed to stimulate investment, but longer term these low rates face a lack of demand as savers are penalized without a return on investment or consumption.  It is implicit that the Fed raise rates to normalize the credit cycle.  The economy has not reached this point of rising unemployment but the current range of 180,000-200,000 monthly job additions may soon become unsustainable.   

2Q2106 Corporate Profits 

According to FactSet, with 63% of the companies in the S&P500 companies reporting earnings for 2Q2016, 71% have reported above the mean estimate and 57% have reported revenues above the mean estimate.  Our proprietary research shows equal weight quarter average EPS is up 5%.  At the sector level, Healthcare (81%), Information Technology (79%) and Consumer Staples (78%) have the highest percentage beating mean estimates.  Morgan Stanley research shows that earnings of 312, or 74%, of S&P 500 companies reporting, 91% are at/above estimates, but only 41% with revenues above estimates.  By individual sectors the leaders by percentages above estimates are; Financials (7.4%), Information Technology (7.4%), Industrials (6.2%) and Consumer Discretionary (5.6%).  Energy sector earnings are 22.9% below estimates.  For all sectors, earnings are 5.0% above estimates while revenues are only 0.6% higher.   

Over the past three months all of the 2Q2016 earnings leading sector stocks have risen, but only Information Technology with its stocks rising 10.3% has outperformed the S&P 500 composite (5.2%).  The recent stock performance shows a shift away from defensive sectors to more economic sensitive sectors.  The larger tech companies, with a concentration on consumer tech have produced consistently better-than-anticipated earnings and performance.  One thing these companies have in common is a continued high level of capital spending in the absence of stock repurchase plans and no dividends.  Alphabet (Google) and Facebook aptly fit the conservative definition of growth companies.  Amazon continues to invest heavily in its distribution infrastructure and in addition has built a cloud storage business reported to have over 50% of this rapidly growing important subsector.  Google is another leader in this area but with only 5% of the available market.     

Investment Policy 

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

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

Shifting Dynamics  
Stocks, as measured by the broader averages, had a banner July, sending the Dow, S&P 500 and NASDAQ clearly into positive territory for 1H2016.  The July rally was led by Technology as higherthan-anticipated earnings and M&A fortified prices.  Energy, which had been a leader since the bottom in crude prices early in February, was the weakest S&P sector in July, falling 2%.   The fall in energy stocks reflects a steady 20% decline in crude oil prices in July.  For year-to-date, the Energy sector is up 12%, but once again the bears are claiming the drop in oil is a sign of impending economic slowdown.  The 1.2% rise in real GDP for 2Q2016 added confirmation to this assertion.  In reality, the decline in oil prices reflects a seasonal cycle, although for much lower levels than historically.  Oil prices regularly rise through the spring as gasoline production increases in anticipation of summer driving season, peaks in early June and falls into late October.  After all the attention given to oil volatility over the past year, in a slow news environment attention is refocused to the dangers of another freefall.    
Corporate Profits and GDP  
It was almost immediately reported in the media and echoed by market analysts that GDP data released by the Bureau of Economic Analysis (BEA) on Friday confirmed a weakening economy.  The lower real GDP then estimates was ascribed to a larger-than-expected decline in inventories at the finished goods level.  Had inventories remained stable, GDP would have been up 2.4%, in the range of most estimates.  Low inventory numbers in this instance do not positively impact corporate profits to the extent of the adjustment back to normal levels. As we have written on numerous occasions since 2014 it is Gross Output (GO) that fully reflects what is going on in the economy.    
Unlike GDP, GO is defined by BEA “Measures the combination of both final product (GDP) and the industry input that is purchased by other industries for use as inputs to their own production.”  The criticism of GO is that it involves double-counting, as it takes into account all goods and services used in the production process to produce rather than for final consumption measured as GDP.  The Go is indicative of the total activity of the entire production process.  The Table below shows annual and the most recent quarterly data.