February

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS February 23, 2016

on Tuesday, 23 February 2016. Posted in 2016, February

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS February 23, 2016

Market Held Captive by Oil

Over the past few months we have discussed the shift in consumer spending and the challenges to corporate earnings from the collapse in oil and raw material prices, the strong US dollar, lower exports, and a deflationary impact of global oversupply.  Equity prices remain highly correlated to the change in the price in a barrel of crude.  China, which we have discussed at length, seems to affect our securities markets despite no clear evidence of cause and effect to the US economy.  At its lows two weeks ago, crude was down over 70% from its June 2014 highs.  Companies comprising the S&P Energy sector are down 42.2% over this period and earnings are forecast to decline 52.9% in CY2016, after dropping 60.5% in CY2015.  Throughout this period, production, particularly US fracking, has declined but not nearly enough to lower prices in line with increasing supply.  

While lower energy prices benefit the consumer, it creates dislocations much broader than the 10% representation in the US economy.  That being said, the recent rally from $26 a barrel was initially attributed to short covering, although it is hard to believe shorting was a rational decision as oil fell below $30.  The magic $20 a barrel, put forth by Goldman Sachs, may still be reached, but in reality will not be at that level for very long.  Further complicating the investment landscape is the debt in China and the European banking sector.  European banks have not rebuilt their asset base as have the US banks, despite the near-panic conditions in 2010 and 2011.  European bank stocks are at recession levels and credit default swaps are approaching prices last seen in 2011.  (The Europe 600 Bank Index is down 27% since the beginning of the year.)   Over the most recent period, S&P 500 earnings have fallen three consecutive quarters and revenues have declined four consecutive quarters.  Real GDP for 4Q2015 was a lackluster 0.7% and a below trend 2.4% for 2015, the same as 2014.  While the global economy slows, estimates are for 3% emerging market growth in 2016, the US economy outpaces most developed countries.  This year may be a year of upside surprise for US equity investors if price stability in oil can be achieved, but with gasoline demand slowing in China and with little likelihood of a cutback in supply, investors will have to wait for market stability in economic growth and positive quarterly earnings.  

Corporate Earnings

With 87% of the S&P 500 having reported for 4Q2015, 68% have reported earnings above mean estimates.  Overall, S&P 500 companies have beaten year-end estimates by 0.3 percentage points.  As the Table below shows the 4Q results by major S&P sector, the estimate beats are driven primarily by Healthcare, Discretionary and Technology sectors.  The beat on these earnings is due, in part, to the sizeable downside revisions prior to earnings season.  

It is obvious from the Table that the Energy and Material sectors are responsible for the earnings decline for the S&P 500.  Information Technology (78%) and Healthcare (73%) led the increases in overall sector earnings, while Consumer Discretionary, Industrials, and Materials were slightly above (69%), the S&P 500 (68%).  As of last Friday, all sectors remained in correction territory, but only Energy and Materials were in a bear market.  Given the slightly better-than-expected results in the latest earnings data, stock prices do not reflect any noticeable improvements for Information Technology, Healthcare, and Consumer Discretionary.  The price declines are discounting 1Q2016 estimates, where only Consumer Discretionary (+11.4%) and Healthcare (+3.5%) are currently forecast to show positive earnings growth.  For CY2016 estimates are coming down quickly and although too early to fully discount these negative revisions, not until there are signs of renewed economic growth a ceiling has been placed on stock prices.  On the other hand, any broad-based pickup in economic activity beyond the weak consensus will result in an upward revaluation in stock prices.  Should the dollar stabilize at current levels, even with the supply/demand for oil in disequilibrium, a firming dollar will prove a positive for multinational company earnings.

S&P 500 4Q2015 Sector Earnings and Stock Prices

Sectors Earnings Growth Sector Prices
  12/31/15 Estimates 2/19/16 Actual High to 2/19/16 Year-to-Date
Consumer Discretionary              5.6% 8.6% -11.2% -7.1%
Consumer Staples            -2.9        -0.9          -1.1            0.5
Energy          -67.6      -73.7        -42.2            -4.8
Financial              8.1          0.4        -18.1          -12.2
Healthcare              4.8          9.4        -14.9            -8.7
Industrials            -4.7        -4.3        -10.6            -3.8
Info Tech            -6.1        -2.1        -10.8            -7.1
Materials          -25.4      -20.2        -21.7            -8.4
S&P 500            -3.9        -3.6        -10.6            -6.2

Source: FactSet, Hutchens Investment Management

Much ado about Fed policy

To a large extent, volatility in the US securities markets has been placed on Federal Reserve interest rate policy.  Many argue that the Fed was behind the curve with its interest rate increase, although it’s hard to believe a 25 basis point rise could result in the panic selling witnessed this year.  Previous first rate increases have rarely coincided with the end of bull markets.  In fact, of twelve instances of first rate hikes since 1933, only in two was the bull market terminated in one year or less.  The average was 3.1 years for a continued bull market.  Since 1977, there have been five initial rate increases, with the bull market averaging an additional 3.7 years, with the shortest 3.3 years and the longest 6.1 years.  We cannot underestimate market regulation that has removed the liquidity of proprietary trading.    

Investment Policy

Our investment policy remains cautious.  The recent rally has not changed our outlook as it is short-term technicals (triple bottom) coinciding with a bounce from the mid-$20’s in crude oil.  The problems we foresee are cyclical and not systemic, but they may continue further into 2016 than in previous post-2008 selloffs.  Since late-December, there have been no meaningful rallies as buyers are transfixed on oil prices.  Earnings season was in line with the lowered estimates and given the dismal earnings outlook for 2Q2016 and beyond will not positively affect current stock prices.  We reiterate our strategy expressed in early January, “sit back and wait.”  

The US economy will grow below trend for the first-half of the year, but with little chance of recession in 2016.  Recent data confirm employment growth, rising industrial production, increasing retail sales, and an erratic housing recovery.  Inflationary pressures are building in wages and housing, alleviating deflation fears.  For the stock market the problems are well-documented but solutions will take time.  Lower earnings will carry through the second quarter as corporations work through lower energy and raw commodity prices, a strong dollar, tighter margins, and inventory liquidation.

Expect higher volatility during early-2016 as companies shift to satisfy increased consumer demand in an environment of geopolitical uncertainty and an impending presidential election.  The transition to a more consumer-oriented economy is in its early stages and not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS February 2, 2016

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

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS February 2, 2016

Is the Sky Really Falling?


Investment Policy

Our investment policy is cautious.  With all the pessimism in the markets there will be opportunity.  However, good news is bad news and bad news is just that.  The problems we foresee are cyclical and not systemic but, they may continue further into 2016 than in previous post-2008 selloffs.  Since late-December, there have been no meaningful rallies as buyers are transfixed on oil prices and reluctant to commit to new positions, instead raising cash on any up moves, even if intraday.  Earnings season will add clarification but chances are results will not push equities above the November highs.  What is going on today is more of a mid-cycle adjustment.  The 2H2016 should reward caution and patience.  We reiterate our strategy expressed in early January, “sit back and wait.”  

The US economy continues to grow, but below trend for first half of the year with little chance of recession in 2016.  For the stock market the problems are well-documented but solutions will take time.  Lower earnings will carry through the second quarter as corporations work through a strong dollar, tighter margins, and inventory liquidation.  Expect higher volatility during early-2016 as companies shift to satisfy increased consumer demand in an environment of geopolitical uncertainty and an impending presidential election.  The transition to a more consumer-oriented economy is in its early stages and not fully reflected in corporate aggregate earnings.  Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies.  

Oil and Stocks

Crude oil and stocks remain highly correlated and until some balance between supply and demand is approached, expect this relationship to continue in an atmosphere of high volatility.  As yet, there are no signs of stabilization.  Oil, for what it is worth - - not much these days - - has debunked the experts.  The oversupply has added a new dimension to forecasting price and invited short-term adjustments based on here-to-fore useless indicators.  Supply and demand data vary by source.  Political considerations are bypassed as the rich and poor oil producing countries pump full tilt.  This is no short-term phenomenon.  Crude prices peaked at $110 in mid-2014, after holding above $100 a barrel for three consecutive years.  The China slowdown and the refusal by Saudi Arabia to risk loss of market share resulted in a steady decline approaching the mid-$20’s in January.  The recent sharp reversal in stock prices followed a jump in crude oil last week was in reaction to unfounded rumors of an OPEC initiative calling for a production cutback.  Today, experts are forecasting crude falling to the low-$20’s and for stocks to retrace to the recent correction lows.  In this trader-dominated environment, any move in either direction is possible therefore, fill your tank and “sit back and wait.”  

The effect of falling energy prices on earnings is well-known and documented.  Should there be any doubt, look at earnings, and more importantly future earnings estimates for 2016.  According to FactSet, thus far 4Q2015 blended earnings for the Energy sector are -78.6% year-over-year.  Excluding energy company earnings, the overall 5.8% decline in the S&P 500 blended earnings would improve to a 0.5% increase for 4Q2015.  For CY2016, Energy sector earnings are forecast to decline 42.8%, this is a dramatic reversal from the 9.2% increase in the earnings estimate made at the end of 3Q2015, or even the -9.8% estimate at year-end 2015, barely a month ago.  One does not have to look very far to pinpoint the pessimism in 2016 earnings.  Overall estimates reflect a longer-term negative outlook for Energy.

After the unsubstantiated rumor last week, oil prices once again fell back below the $30 level.  The “experts” are talking up $20 and stocks are reacting accordingly.  Fortunately, the laws of supply and demand will work.  Data show that global supply has declined about 2.5 million barrels per day.  Recall that last summer’s oversupply was estimated by the IEA at 1 million barrels, based on this official data, we would be well-past equilibrium.  Aside from Russia, major non-OPEC production has declined.  OPEC production has continued to rise as Saudi Arabia pressures members to expand market share and Iran brings more production online with Venezuela and Nigeria pumping at any price.  Internationally, overall gasoline demand continues to increase.  In the US, miles driven rose over 4% year-over-year in December 2015 as travelers substituted driving for air travel.  Recently, unseasonably warm weather has reduced the need for heating oil.  For the foreseeable future, stock prices will move in tandem with oil.  How long is anyone’s guess, but equity prices will decouple as oil nears a bottom.   Under current circumstances, temptations to make portfolio decisions on the most current market outcome become harder to resist.  Markets are irrational over the short run and astute investors must reexamine fundamentals and if the reasons for those investments still hold, sit back and wait.   

Chicken Little in China

In our September 8, 2015 Compass, “How Do You Say Gotcha in Chinese?” we asked rhetorically “Whether the problems in China will spill over and affect US economic growth? Briefly stated.  No,” and went on to state our reasoning.  Once again slowing China growth is affecting global markets well-beyond the extent of the slowdown.  The Chinese transition to a new growth model is proceeding on course.  The service sector grew at an 8.3% pace in 2015, higher than the once dominate industrial sector (manufacturing and construction) at 6%.  Services accounted for 50.5% of GDP in 2015, well-above the 40.5% for industrials.  The growth of services is tied closely to employment increases, requiring about 30% more jobs per unit of output than the industrial sector.  

All has not gone smoothly during the transition because of financial setbacks, stock and currency mismanagement and a flight of capital.  Well respected hedge funds are positioning for a yuan devaluation.  But it is China’s huge foreign currency reserves that provide a buffer against a currency crisis.  China has about $1 trillion in dollar-denominated liabilities, according the Bank of International Settlements, of which half were drawn over the past year.  With $3.3 trillion in foreign currency reserves, this debt has more than three times coverage, much greater than the rule of thumb of one-to-one.  China continues a large current account surplus.  China is a Chicken Little story, just stand back and watch, there is no need to wait, the sky will not fall.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens