January

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS January 30, 2017

on Tuesday, 31 January 2017. Posted in 2017, January

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS January 30, 2017

Draining the Swamp Reveals Alligators

“One of the key problems today is that politics is such a disgrace, good people don’t go into government.” 
                                                                                                                                Donald Trump (2000)

Since year-end through last Friday the broader markets, as measured by the S&P 500 (+2.50%), and the NASDAQ Composite (+5.16%), continued to add to the outsized gains since the election.  Unlike the 2016 increases which were led by Energy (+27%), Financials (+22%) and Technology (+20%), the leading sectors thus far in 2017 are; Basic Materials (+6.4%), Technology (+5.9%) and Consumer iscretionary (+4.6%).  The stock performance for Materials reflects the increase in commodity prices while Technology is in response to better estimated earnings for 2017 and improving economic fundamentals.  Somewhat misleading is the rise in Consumer Discretionary which includes Amazon.  With only 34% of the S&P 500 reporting earnings, 65 had actual EPS above the mean estimate with actual earnings rising 2.7%.  Technology and Materials earnings at 88% and 70% are above the S&P 500 totals while Consumer Discretionary at 63% is slightly behind.  
 
Stocks remain in an upward trajectory with expectations of a continued improving economic environment during 2017. Traders are negative for the short term citing low volatility, high multiples and the uncertainty of Trump policy initiatives.  Such is the Executive Order for a temporary ban on entry into the US of immigrants from seven predominantly Muslim countries as a reason for selling.  Issued on Friday, all hell broke out over the weekend and stocks were down sharply at the open on Monday.  But then again this is typical Trump confusing politics and does not flow over into the real world of economy and investment.  There is a short-term reaction, without any meaningful market significance.  
 
There are many positives that will affect the economy and the securities markets over the next few months.  In addition, markets have risen beyond the better economy prior to the election. Listed below are all the issues currently under discussion requiring Executive Orders or Congressional approval:

  • Repeal and replace ObamaCare,
  • Major tax reform,
  • Repeal of regulations,
  • Immigration reform (including enforcing of current laws),
  • Renegotiate existing Trade Agreements,
  • Restoration of pipeline projects,
  • Infrastructure restoration,
  • Build a wall across the US southern border, and
  • A Border Tax
This is an incomplete list of programs already started or under discussion.  From an economic prospective, tax and regulatory reform and trade policy are of leading importance for investors, while immigration and healthcare top the list for social reform.  The role of these above policies will have results negatively impacted by unintended consequences.  For example, tax cuts and infrastructure spending will add to an already high $10 trillion deficit.  Any fiscal policy without a revenue offset will result in higher inflation, rising interest rates, and ultimately a business cycle downturn.  Border taxes will raise costs to consumers increasing inflation.  Economists favoring this tax claim that the increase in import prices would be offset by a rising dollar offsetting the tax.  How smoothly legislation moves through Congress will impact investor sentiment.  There is reason to expect negative reactions from the Trump Administration if legislation is stalled or rejected.  There will be little or no Democratic support on most issues, so managing a contentious Republican Congress will require more time than the new Administration is likely to deem necessary.  
 
Markets have moved up well-beyond and more rapidly than anyone expected since the election.  Much of this movement is borne out in recently released economic data.  With the exception of preliminary 4Q2016 real GDP, the year is off to a solid start.  Earnings for 4Q2016 are beating estimates, but by no means “knocking the cover off the ball.”  It is still “wait ‘til next year,” except it is “now next year.”  According to Fundamentalis, data ignored by most main stream media show the trend in year-over-year earnings growth rising. 

  
1 30 17 table
 
These earnings began to rise prior to the election.  According to numerous sources, including Citi and Goldman Sachs, implementation of announced stimulative policies by the Trump Administration could add 10%-12% to the above latest 2017 estimates.  
 
Investment Policy
 
Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors see limited visibility for economic improvement from new 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 January 17, 2017

on Tuesday, 17 January 2017. Posted in 2017, January

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS January 17, 2017

Economic Growth Trumps Frustration
 
The election shock resulted in a boost for stock prices as potential economic benefits of Trump’s economic agenda were objectively analyzed.  Through last Friday, stocks, measured by the S&P 500, rose 6.3% since the election, while the NASDAQ is up 7.3% and the broader-based Russell 2000 had a 14.2% increase.  Interest rates measured by the 10-year Treasury rose from 1.80% prior to the election to reach 2.60% in December, but fell back to 2.35% as of the close on Friday.  The Volatility Index (VIX), often defined as an indicator of fear, was 11.23% as of close last week, not far from the 5-year low of 10.28% in early-July 2014.  Many of the market strategists who had forecast a major sell off if the Democrats lost the election have returned with a decidedly negative outlook.  Bearish technicals are beginning to emerge and will gain credibility on any market weakness.  Brexit has reappeared as Europe’s latest problem as Italy’s banks rotate into the background.   
 
Over the past year our Reports have focused on the longer-term trends in the economy.  Primary has been a gradual improvement in the overall economic well-being of the consumer.  This has spurred auto sales to historic levels and served as underpinning for the uptrend in the housing market.  Unfortunately the corporate side of the ledger has been plagued by low productivity and a higher dollar.  Oversupply of oil and other industrial raw materials resulted in recession levels for revenues and profits for their respective sectors.  Despite continued negative forecasts, the economy kept its 2% real growth and stocks corrected by trading in a long-term narrow range.  Our optimism is based on the belief that the mislabeled “Trump Rally” largely is a response to economic gains.  Overall real growth has improved, employment remains strong, Fed policy is on track, inflation and wages are rising, and a vibrant consumer is spending.  The prospects of enhanced growth from aggressive fiscal policies are welcome, but the consumer is the lynchpin to sustainable economic growth and in turn, a rising stock market.   
 
A Healthy Consumer
 
A short-sighted market ignores the potential that the current economic foundation holds for growth.  While waiting on Washington, better demographics and technology continue to drive the economy.  For the consumer, spending is a combination of ability and willingness.  Ability is determined by change in disposable personal income and willingness is chiefly affected by confidence.  Today consumer spending on necessities as a percent of disposable income is at levels not seen since the early-1980’s.  Any boost from tax cuts will go directly into spendable income.  Consumer Confidence, measured by both the Conference Board and the University of Michigan, is near record levels for Expectation Indices, while not directly correlated to spending, the improving financial state of consumers gives weight to spending expectations.   
 
Another gauge of a healthy consumer is credit quality.  At tops of the business cycle, consumer spending is restricted by debt and increasing delinquencies.  The ratio of household debt to disposable income was at 1.35 in 2008, today it has fallen nearly 30 percentage points and is now at levels not seen since 2002.   The debt service coverage ratio (percentage of before tax earnings spent on paying off loans, including
auto, student and revolving credit) is about 10%, a record low going back to 1980 when the series began.  Although there are early indications of increases in auto delinquencies to sub-prime consumers (below 660 credit rating), overall credit delinquencies (90-day plus) are down from 9% in 2010 to below 4% in 2016.  Mortgages represent about 75% of household debt with 90% at a record low 3.8% average fixed rate.  Even with a rising interest rate with less than 10% of consumer loans exposed to rate increases, consumers are protected from higher payments.   
 
Data from the Census Bureau shows that for the first time 2007 real median income for middle-income households increased 5.2% in 2015, the latest data available.  Housing formations have been increasing at a 1 million units annual rate over the past two years and this rate is expected to continue.  These data are part of the tailwind in housing that we have discussed in previous reports.  With home inventories low, rental rates rising, and erratic new home starts, the housing market should benefit from rising wages and negative equity (10%).  Additionally, foreclosures are moving out of the 7-year restriction creating an additional source of potential demand which will continue over the next several years.  In summary, the financial health of consumers continues to improve and even given the frustrations of Congress, tax reform and deregulation will augment consumer spending.
 
Investment Policy
 
Washington moves slowly and with repeal and replace of ObamaCare as the stated first order of business, problems will arise with a replacement plan and accompanying timeline.  Repeal is easy, replacement will be difficult and frustration, especially by the Administration, will be magnified in the media.  Offsetting the long procedural delays for a new healthcare bill could come from reversing Obama’s executive orders.   From an investor perspective, the choice of tax reform is far more beneficial than assuming ownership of contentious TrumpCare.  However, tax reform too will require legislation and Trump already has issue with the House revenue offset, “Border Adjustment” (Compass 1/03/17).  The question facing markets will the delays create frustration turning to impatience and result in a sell off in equities.     
 
Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors see limited visibility for economic improvement from new 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, portfolio’s should include value companies exhibiting sustainable earnings growth and dividends.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS January 3, 2017

on Tuesday, 03 January 2017. Posted in 2017, January

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS January 3, 2017

Trudging Through the Swamp
 “Concealment makes the soul a swamp.  Confession is how you drain it.”        
                                                                                                    Charles M. Blow

There is no doubt that 2016 finished on much better footing than it started.  January was the worst start of any year on record.   By early February when the market hit bottom, oil had fallen into the mid-20’s and rumors abounded of a repeat of the 2008 banking crisis.  The bull market was over and the permabears chorused “As January goes, so does the rest of 2016.”  Markets remained range-bound into mid-year but the economy showed signs of improvement.  By July stocks were well-above their early 2016 lows as oil prices increased, earnings showed signs of turning positive and China’s growth stabilized.   
 
In August, Brexit was a non-event, and markets rallied.  The earnings recession did not pre-stage an economic recession and by 3Q2016 earnings had recovered and economic data were turning consistently more positive.  Going into the election the S&P was up 4.5%, NASDAQ +4.9% and the broader-based Russell 2000 +5.2%.  These gains reflected the improvement in the economy and optimism on corporate sales and earnings.  The possibility of a Trump victory was not even an afterthought as most forecasters saw no real change in a Clinton White House.  All this changed dramatically in the early hours of November 9th.  Almost immediately the naysayers found growth in a Trump presidency.  Markets reacted and by year-end the S&P 500 closed up 9.5% and the Russell 2000 was up 19.5%.  The leading sectors reflected economic optimism as Energy (+27%), Financials (+22%) and Technology (+20%) provided leadership in the market.   
 
Many market observers believe the recent Trump rally will die under its own weight early this year.  In fact, Morgan Stanley advises clients to “buy the election and sell the inauguration.”  Upon reflection, there is no doubt that the potential of lower taxes, reduced regulation and fiscal stimulus, if enacted, will be a boost to economic growth.  But these policies are not without risk, much of which is political - - the market has not had much experience in navigating the swamp.   
 
US Dollar – The dollar index (DX) has risen 3.6% this year and is up over 7% in the past three months.  The rising dollar has negatively affected US corporations’ earnings over the past few years.  With the Fed raising rates and much of the rest of the Developed World holding to low interest rates, the US dollar has an upward bias.  However, there is an upside to dollar strength as foreigners seek out appreciating assets, US common stock can offer a double bang for the invested buck.  Stocks are denominated in dollars and an appreciating dollar compounds in a rising stock market.  Under such circumstances, the benefits from holding dollar-denominated stocks could outweigh the risk of lower earnings.   
 
There is a House Republican proposal to “border adjust” the corporate income tax.  This blueprint proposes converting the corporate income tax into a destination-based cash flow system by not taxing revenues from exports and disallowing deductions for the cost of imports, effectively an export subsidy combined with an import tariff of equal size.  If this policy is trade neutral the dollar would appreciate.  At a 20% tax rate the US dollar could appreciate 10-15% on a trade-weighted basis.  The potential for disruption has resulted in corporate pushback but the dollar may appreciate as more of this plan is revealed.   
 
Congress – There is no guarantee that Congress will approve all or most of the Trump Administration proposals.  Even Republicans can’t unite.  This is particularly true on tax reform, where Congressional Republicans are for lower rates but split on how to get there.  Some want revenue neutral and for others cost is not an object.  Given priority will be “repeal and replace” Obamacare with Trumpcare.  The problems are obvious, but there is no plan for replacement and whatever it is, Trump and the Republicans will own it.  Already Senator Schumer has targeted Trump’s cabinet for extended confirmation hearings by requesting two days of hearings for eight of the nominees.  On the other hand, there are 25 Democratic Senators and two Independents who caucus with Democrats, up for reelection in 2018.  Of these, ten represent states Trump won.  They are vulnerable, making them more amenable to support many of the new Administration’s populist initiatives.  This could provide a path to passage.  President-elect Trump has shown he is impulsive, rude, impatient, and easily frustrated.  None of these qualities make a good politician.  During the first 100 days the country will find out what to expect for the next four years.    Reality Check
 
In our last Compass we discussed the fact that the Trump rally did not begin in a vacuum, but in an increasingly healthy economic environment that supported many of the growth plans.  Since that Report the economy has shown additional strength in manufacturing and construction, including housing.  The December ISM Manufacturing Index, reported by the Institute for Supply Management, rose to 56.2 from 54.7 in November.  The consensus forecast was for a slight decline to 53.6.  The gain reflects a 4.3 point increase in the Production Index and a 7.2 point jump in New Orders.  The US Department of Commerce said US Construction Spending rose 0.9% in November to a seasonally adjusted annual rate of $1.2 trillion, the highest level since April 2006.  Also, Homebuilder Sentiment published by the National Association of Home Builders, rose to an 11 year high as current conditions and expectations both reached levels not seen since July 2005.   
 
Investment Policy
 
Our investment policy remains optimistic. Realistically the positives from expansionary policies will take more time than generally expected.  A more dominant consumer-oriented economy is evolving, 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 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