June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 20, 2016

on Monday, 20 June 2016. Posted in 2016, June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 20, 2016

Brexit – What Happens in Europe Stays in Europe

With the Brexit referendum coming on Thursday, any changes in momentum in either direction will result in market overreaction. The vote will alleviate the uncertainty of “Remain or Leave” the EU by Britain. Markets should react in accordance with the vote with only the aftershock affecting US securities. Not unlike the sovereign debt crises of 2010-2012, the dire consequences for Britain and Europe are predicted to spread across the global economy. This time consequences include financial chaos, a UK recession, loss of freedom of residency across the EU countries, and a breakdown of cross border trading between Britain and remaining EU countries. For now any disruption will be short-term and mainly centered in Britain. The UK financial sector appears vulnerable, but this should be only temporary as employment and regulatory matters settle out. For the US economy the affect should be negligible, as only 2.9% of total S&P 500 revenue is from the UK. Last week the Volatility Index (VIX) rose above 20 for the first time since February as traders have taken sides on the outcome. This is reminiscent of only a few years ago when a Greek default was going to bring the world banking system to its knees.
Over the weekend polls showed a shift to staying in the EU. This has resulted in short-term covering today as traders around the globe unwind or hedge their positions, but with two full days before the vote, uncertainty remains. No doubt the confusion from last week’s Fed meeting has added to the market’s volatility and there always exists the potential for a violent reaction to Brexit. In our opinion, this would create a significant buying opportunity for US equities similar to what followed the last EU crisis. Immediately following the October 2011 announcement of QE by Draghi, the S&P 500 rallied and was up 32.3% six months later.

Fed Up

Even as the Fed FOMC meeting left rates unchanged as expected, it was the implied lack of future rate increases that shook the financial markets. It is hard to believe the weak jobs data is the major contributor to this abrupt shift in rate trajectory. Most likely it was the decline in bond yields signaling a drop in inflationary expectations. Unfortunately, central bankers still believe that low interest rates or even negative rates stimulate economic activity. There is scant evidence to support this policy as a long-term accelerator. More plausible is the rapid decline in yields. Many believe that as Europe and Japan rates fall negative, foreign investors turn to the US for yield, but more likely it has been hedge funds and algorithmic traders taking advantage of uncertainty.
At the last meeting the Fed completely reversed its policy implementation plan intimating that monetary stimulation has run its course and it cannot do anymore to stimulate GDP growth beyond 2% or increase inflation above 2% annually. Historically, fiscal policy, limited by high debt levels following a financial crisis, results in a long period of stagnation with normal growth not returning for as long as a decade. For equities this is not all negative. An economy growing at 2% and inflation approaching 2% and 2% from
dividends give stocks a total return of 6%. The unknown is earnings, P/E and margins, all of which should improve in the second half of 2016.

Amazon vs. Walmart

The growth of online shopping has disrupted retail sales beyond comprehension only a few short years ago. Established retailers, led by Walmart, are attempting to reinvent themselves as e-commerce competitors are accommodating the traditional brick-and-mortar consumer. Walmart, the champion of the “Big Box” stores is circling the wagons and attempting to upend its traditional model to compete with this new retail paradigm. The long-term success of Walmart has been its unrivaled scale resulting in “everyday low prices.” The Walmart culture has been unchallenged and its low prices and broad range of products sustained its leadership until the e-commerce disruptor Amazon challenged.

Amazon

According to a recent report by Morgan Stanley for all US retailers, online sales in the US grew 15% in 2015 against 14% in 2014. Amazon sales increased sales increased 29% in 2015 compared with 25% in 2014. Over the same period, traditional retail fell across all major categories; Specialty Apparel 10%-7%, Department Stores 19%-14%, Broadlines (Big Box) 29%-23%, and Hardlines 26%-21%. Many reasons can be cited for the decline but the competition from Amazon and other e-commerce retailers has accelerated the shift. Amazon’s low prices, broad product offering, and Prime membership limit potential growth of “old retail.” In addition, Amazon can withstand razor thin core GAAP EBIT margins (0.5% in 2015). The 84 million millennials, not particularly selective over apparel, are channel agnostic, with a preference for speed and convenience. Only off-price retail stores, catering to an entirely difference consumer, seem to be insulated from the shift to e-commerce.
Amazon not only competes on price and range of products, but also on accessibility. Walmart offers a broad range of products at reduced prices under many roofs. Amazon offers the same, but saves time. The free two-day shipping on almost anything for $99 annually gives buyers an easy decision to max out with Amazon. Surprisingly, Amazon is the second largest seller of clothes. Cowen & Company expects Amazon to overtake the leader Macy’s in 2017. A recent spinoff of Prime, Amazon Dash competes with Walgreens and CVS for common household products. To better compete for lower average income shoppers, Amazon is offering a $10.99 monthly payment for Prime. The challenge for retailers in the e-commerce era is to protect sales and profits. Because of the pressure to offer free shipping and competitive prices these retailers must continue to be profitable at the higher margin existing stores. Expanding sales online increases technology spending, and in the end the retailer may end up selling to the same customer online for a lower price. Both technology spending and online sales squeeze margins further.

Walmart

For decades, Walmart was the undisputed disruptor of American retailing. But Amazon is the new disruptor. In 2015 Walmart’s $485 billion in revenues was 3.5x Amazon’s. A pretty healthy margin but this year Walmart’s revenue will be flat while the consensus forecast for Amazon is an increase of over 25%. Walmart is attempting to disrupt its own model in additional to making current operations more efficient. Walmart is spending over $1 billion this year to improve its e-commerce technology. This follows $10.5 billion last year spent on information technology. According to the company the goal is to merge physical and online retail. Closing smaller stores and opening more supercenters does not qualify as self-disruption and sounds like doing more of what it always did.
Amazon and Walmart are examples of a retail disruptor creating a new paradigm and the largest “Big Box” store which must disrupt its own current model to compete. However, the cost for Walmart may be too high to go head-to-head with e-commerce Amazon, which may in part, explain the reluctance to self-disrupt and rely upon more conventional adjustments that have worked for decades. No doubt consolidation will continue in the retail space forced by increasing e-commerce shopping. Millennials, a generation bent on convenience, will continue to do everything possible over the internet. The costs for many conventional retailers will be prohibitive and many will close, sell only online, or channel the products through large broadline e-commerce retailers. Consumers are the ultimate beneficiary, as they continue to get more value for less cost, a trend likely to accelerate even during slow overall economic growth.

Investment Policy

Our investment policy is cautiously optimistic as the economy and earnings reflect our outlook for 2H2016 and into 2017. 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. 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 June 6, 2016

on Monday, 06 June 2016. Posted in 2016, June

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS June 6, 2016

Is That a Light at the End of the Tunnel?  

The equities markets, measured by the S&P 500, continue to trade in a narrow range since the recent April high of 2,111.  While the 2,100 level receives much media attention it is meaningless from anything other than a psychological benchmark.  The S&P 500 is only about 1% below the 2,134.72 all-time high of May 20, 2015.  The Index has failed on numerous attempts to surpass this high, leading bears to forecast a push to new lows.  Our assessment is that the market will set new highs rather than selloff to levels of midFebruary.  Many of the problems cited for the February lows have lessened, or in some cases, turned positive.  Among these were the elevated US dollar, low crude oil prices, and the prospect of a hard landing in China.  Of course the “Wall of Worry” is replete with headline risks and always enough to make a bearish case for the market to roll over.  When there is nothing else there is the potential market reaction to Fed interest rate policy.  In our last Compass, we discussed the Fed move toward normalization and its effect on stocks.  The conclusion is that zero interest rates do more harm than good and even despite the low jobs number, the sooner the move toward normalization the better.  It is highly unlikely that a data dependent quarter point move will disrupt the economy.  In fact, the increases will recreate an arsenal for potential Fed action should growth falter.    

Short term the potential of Brexit will be resolved by a vote on June 23, 2016.  The vote appears too close to call, but no matter what the result, the impact of Britain withdrawing from the EU will be largely confined to Europe, with little likelihood of this being a game changer for the US economy or the stock market.  Any negative reaction in US markets should be viewed as a buying opportunity.  Another negative being mentioned is the Presidential election.  It is far too early with too much uncertainty surrounding both candidates to rationally affect equities.  No matter who wins, from a regulatory perspective things could not get much worse and Congress has the lowest approval rating in history, but stocks are challenging all-time highs.  We will wait until after the summer conventions to assess potential impact of the candidates.  

The May employment report showed a net increase of only 38,000 new jobs in May and the employment rate fell to 4.7% as 400,000 left the workforce.  Needless to say the results are confusing.  The ADP Report seems more realistic at 173,000 net new jobs.  The BLS report does not reconcile with job openings (JOLTS) at eight month highs and the lowest layoff rate in five years.  Another explanation is the low jobs number suggests employers are adjusting to the slowdown, giving credibility to the BLS report as a lagging indicator.   Adding to the confusion is the BLS explanation that the margin of error for the data is plus or minus 100,000.  Either way, the data bear watching and was pivotal in Chairman Yellen’s speech today in Philadelphia.  It is highly likely the next increase in rates will happen in the fall.  A reset of the timing of the increase will not affect the longer term trend in stock prices.    

The most recent economic data indicate a slight acceleration in 2Q2016 growth.  The GDPNow Model (FRB Atlanta) forecasts real GDP at 2.5% and the NowCasting Model (FRB New York) and a close 2.4% in 2Q2016.  These forecasts are as of June 3 after the employment report.  The ISM Manufacturing Index rose to 51.3 in May, a 0.5% increase.  This was above expectations and marked the third consecutive month of expansion.  Consumer spending in April rose at the fastest rate in seven years, posting a 1% month-over-month increase.  Personal income rose 0.4%, indicating a drawdown of savings to finance current expenditures.  May auto sales for US manufacturers were below forecasts however, combined

domestic and foreign manufacturers reported 17.45 million SAAR total sales, stronger than the 17.3 million estimated. The May University of Michigan Consumer Sentiment Index increased 5.7 points compared to the April report.  Highlighted was the optimism toward auto and housing sales due to low interest rates.  As more and more purchases are made online, consumers get more for less and will continue to expand e-commerce sales.  Consumers are being fiscally responsible even as consumer credit outstanding rises to record levels.  Debt payments as a percent of disposable income are below the low levels of the 1980’s, and at 10.1% of disposable income in 4Q2015, substantially lower than the 16.4% record rate in 1Q2004.    

It is generally conceded that stock gains are limited by valuation.  With a 4Q2016 forward P/E for the S&P 500 of 17x, well-above historic levels, analysts seem reluctant to raise estimates.  Most recently Energy and Materials have had subtle upward revisions in earnings estimates for 2016.  Also, the US dollar remains below levels of last year and should show up in increased earnings of multinational corporations as 2016 progresses.  Because of these factors, earnings may result in an upward surprise sooner than analysts forecast.  The trailing 12 month S&P 500 P/E is 24.3x, a dangerous level according to the bears and a limiting factor for stock prices.  Often missing from this conversation is that the historical long-term average over the past 35 years is 24x, leaving room for a multiple expansion should earnings surprise to the upside.  Once again the question becomes what, if anything will boost corporate earnings to a sustainable level in a 2%-2.5% GDP environment?  Our answer is consumer spending and productivity gains.  Combined with increased household formations a fiscally sound consumer will be the lynchpin to sustainable GDP growth and in turn rising quarterly earnings.     
 
Investment Policy  

Our investment policy is cautiously optimistic as the economy and earnings reflect our outlook for 2H2016 and into 2017.  As the seasonal light volume of summer approaches and 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.  Longer term we believe that consumerled 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