January

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS January 26, 2015

on Monday, 26 January 2015. Posted in 2015, January

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS January 26, 2015

Crosscurrents = Uncertainty = Volatility = Opportunity

The world outside the United States is becoming more uncertain both economically and politically. Instability from the sharp decline in energy prices, ultimately benefitting consumers worldwide, has created a vacuum for high cost producers and countries largely dependent on oil and other commodities for their economic existence. The budget shortfalls of major oil producing countries are well-documented, but less unknown is most emerging market countries have been beset with lower commodity prices and depreciating currencies against the dollar, leaving them uncompetitive in world markets. The disruption in the energy and commodity markets will be, on balance, a benefit to our domestic economy. Last week the announcement of massive bond buying to begin in February by the European Central Bank is a positive for European and US equities. This QE program with purchases of Sovereign and selected corporate debt at 1.1 billion euros is higher than had been anticipated. Results will be evaluated in terms of increased liquidity and an acceleration in inflation. Already, there is skepticism based on the US experience with QE’s. But now US growth rates are higher than Europe and a deflation spiral never approached reality. As investors, we welcome European QE, knowing that “all other things equal” asset prices will rise.
Since the beginning of 2015 the Dow has fluctuated more than 200 points on every trading day despite no major change in fundamentals. Lower oil prices, declining interest rates, and the strong dollar are a positive for equity prices. While early in the earnings cycle, according to FactSet, the first 90 S&P 500 companies reporting earnings for 4Q2014, 79% are above the mean estimate, for revenues, only 54% are above the mean estimate. Stocks are valued on future earnings and estimates are declining. For 2015, the forward 12-month P/E ratio is 16.6x and above the three most recent historical averages: 5-year (14.6x), 10-year (14.1x) and 15-year (16.1x). This rise in the forward 12-month rate reflects a drop in earnings, rather than a rise in price. The decline anticipates weakness in the Energy sector from the 50%+ decline in oil. Since December 31, the 12-month forward EPS estimate for this sector has fallen 27.3%, increasing the P/E ratio to 22.4x from 16.6x. These crosscurrents affect the S&P 500 estimates by bringing down the 2015 earnings growth rate by 40%. Assuming a 10% Energy sector earnings weight/market cap of the S&P 500, Energy is a 4% drag on overall S&P 500 earnings. Today, 2015 S&P 500 earnings are estimated at $125, a 5.9% increase over 2014. Therefore, ex-energy expected earnings growth remains close to the 10% prior level. The Table below shows the latest full-year estimates by major S&P sector.

 1 26 15 earnings

The benefits of falling oil prices which have driven energy earnings and stocks lower should begin to show up in 4Q2014 GDP data as increased personal consumption expenditures. Over time lower fuel prices will result in stronger retail sales, but for now what has occurred is a cutback in capital spending by energy-related companies. (Energy-related capex is only 10% of total.) Although the US economy is growing faster (3%) then it had in 2010 and 2011 (2%) earnings growth is slowing. Multinational companies are adversely affected by dollar appreciation. The dollar has risen about 15% against the currencies of many of our major trading partners. Historically, currency fluctuations are treated as temporary, but a continued strong dollar will eventually result in lower share prices. Dollar appreciation negatively affects American exports and with Europe bordering on recession, China growth decelerating, South America a disaster, large multinationals have limited upside visibility.
After a weak 2014, consumer spending is poised to accelerate in 2015. The problems inherent in 2014 have mostly disappeared and the sharp decline in gasoline prices giving sentiment a boost will in turn increase discretionary consumer spending. Last year can be characterized as another retrenchment for low-to-middle income consumers. Much of the spending during 2012-2013 was by wealthy consumers’ spending patterns that followed equities higher. Anecdotal evidence shows that the spending growth of the wealthy consumer slowed in 2014. As employment continues to increase and wage and salaries grow, low and middle class consumers are reassured of a better economic and personal financial outlook. Adjusting for lower energy prices, consumers entered 2015 with growing aggregate income and declining expenses. According to the University of Michigan Sentiment Report, in December sentiment of the bottom third of the income group rose 233% year-over-year. As we move through this year, consumer purchasing patterns will become more apparent, but for now the durable goods category, particularly basic goods, are preferred. Included are used light trucks, up 13.3% in the second half of 2014 as compared with the first six months, along with audio equipment, telephones, televisions, and new domestic autos. On the services side it is motor vehicle leasing and travel.
The housing market remains range bound as investors withdraw and potential first-time and existing homeowners slowly transition into purchasers. Existing home sales remain weak and housing starts are about 50% below their historic average. Mortgage rates are back near record lows, consumer confidence is rising, affordability remains high, and recent changes at FNMA and FMAC should help first-time buyers. Inventories are low, resulting in higher prices thereby further reducing the supply for potential purchasers. As the consumer sector accepts the transition to a financially secure economy we expect a more “old normal” housing recovery.
Looking at the stock market, earnings estimates are coming down and with the crosscurrents discussed above, may track lower into mid-year. For now lower energy prices and a stronger dollar are more negative than positive. The banks are suffering under additional regulation and low net margin spreads. Low interest rates place a floor on equity prices. The dividend yield on the S&P 500 is above 10-year Treasuries, an indicator of relative value favoring equities. The stronger dollar will attract capital, keeping rates low and lower earnings growth will set a ceiling in stock prices. Over the course of 1H2015 economic data will reveal the unevenness of the economic cycle that has been heightened by these crosscurrents. Within this range there will be volatility until there is moderation in the slope of oil prices, interest rates, and the dollar. A range-bound market does not mean individual stocks will not outperform. We, as investment managers, look for value in individual companies that not only have good earnings but those that surpass expectations.
Our investment policy remains optimistic on Large Cap domestic corporate equities. As the US dollar strengthens we would avoid companies highly dependent on Europe and until stability returns to the commodities markets, energy and raw material producers, particularly those in Emerging Markets. 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.


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS January 5, 2015

on Monday, 05 January 2015. Posted in 2015, January

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS January 5, 2015

Fools Rush Out, Not In
“The main purpose of the stock market is to make fools of as many men as possible.”
Bernard Baruch

As 2015 begins, the outlook for the economy, and in turn the stock market, remains favorable. Historically, fundamental economic trends closely correlate with the long-term trends in equity prices. At the end of the year and thus far into 2015, the market has traded lower, evoking January seasonal lore to predict full-year market performance. In 2014 stocks registered above-average returns after the outsized gains of 2013. The S&P 500 and the NASDAQ rose 11.3% and 13.4%, respectively. The gain for the NASDAQ puts it in striking distance (10%) of the “tech bubble” record high of 5,048.62 in March 2000. The Russell 2000, comprised of many mid and small-cap stocks, underperformed the other major averages. The 3.5% increase reflects revaluation of many of these companies after a 37% gain in 2013. For full-year 2014 upwards of 70% of money managers underperformed the benchmark S&P 500 Index. This was largely due to a 26% rise in the Utility sector and a 10% decline in the Energy sector. (For most professional money managers, quasi-bond utility stocks are underweighted in institutional portfolios.)
Last year, like most years, had its share of surprises negatively affecting market performance, but none of these could be characterized as a Black Swan. Among these were:
 Decline in 10-Year Treasury yields – hardly anyone would have predicted that 10-Year Treasuries would end the year yielding 2.2% after trading at 3.0% in January 2014. (As of this Report, the rate is down to 2.04%.)
 The sharp drop in oil prices and a decline in overall commodity prices. Oil has fallen over 50% from their summer highs and the selling has continued into the New Year.
 Strength of the US dollar – the dollar is at its highest level against the euro and the yen since 2006 and 2007, respectively.
On balance, these interconnected trends are beneficial to US equities and substantiated by US stocks outperforming all major markets, excepting Shanghai and India. We anticipate the trend of lower interest rates, reduced energy prices, and the strength of the US dollar to be a floor for equity prices. Disinflation is good for the market and has been a catalyst for rising equity prices since the turnaround in March 2009.
Future stock market performance will be dependent on the growth in earnings of US corporations. The economy continues to expand as evidenced by three straight quarterly gains in GDP, averaging nearly 4%. While there are vague signs of a slower December (ISM), the economy added three million jobs over the past 12-month period with no sign of wage-push inflation. Coinciding with the drop in gasoline prices is the return in discretionary spending of a reliquified consumer. But as we all learned last year, the consumer of today is more conservative and will withdraw quickly.
The problems associated with crude prices are concentrated in the energy sector and on balance favorable to the overall economy. In fact, oil and gas exploration is only 10% of the energy sector and employs 225,000. However, the increased volatility in the energy markets has flowed into the stock market. Energy producers have been shifting investments within the sector and lowering capital expenditures. Because of the suddenness and severity of the crude price decline, traders have been forced to sell other assets, including equities to cover losses, resulting in an across the board increase in volatility. Adding to the stock selling is the taxable investor wanting to defer paying capital gains taxes into 2016. Having already decided to sell, there is no reason to hold the stocks in a declining market.
Investors will have to carefully evaluate the impact of the oil price shock on overall earnings. According to FactSet, the earnings of the S&P 500 are estimated to rise only 2.6% for 4Q2014, down from 8.4% at the start of the quarter. Most of the decline is from the energy sector which is forecast to fall 17% compared to an estimated increase of 8.1% on September 30. There were also downward revisions for the Financial and Industrial sectors. For the full-year 2015 S&P earnings are estimated to increase 8.1%, down from 12.4% at the end of September. The earnings of the Energy sector are forecast to decline 23% compared to 6.9% for the same period.
The situation in Europe has been cited recently as a negative for the US markets. As Greece moves away from the European Union (EU), the problem does not even appear to have an effect on the rest of Europe. The EU is poised to implement a watered down version of QE within the foreseeable future. After the 2012 crisis, the European Central Bank initiated a policy allowing the Bank to purchase Sovereign debt with the unstated goal of buying time to reduce the threat of contagion. The recent comment by German Chancellor Angela Merkel and German Finance Minister Wolfgang Schauble that Greece’s departure from the EU would be manageable confirms that the goal has been reached. Greece elections are scheduled for January 26.
Our investment policy remains optimistic on Large Cap domestic corporate equities. As the US dollar strengthens we would avoid companies highly dependent on Europe and until stability returns to the commodities markets, energy and raw material producers, particularly those in Emerging Markets. 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.


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens