March

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS March 23, 2015

on Monday, 23 March 2015. Posted in 2015, March

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS March 23, 2015

Climbing a "Wall of Worry"

“Knowledge is an unending adventure at the edge of uncertainty.”
                                                                                Jacob Bronkowski – Scientist

 

Volatility returned to the oil and currency markets, and in turn to equities. Many have claimed the March market volatility compares favorably with January. The recent brief uptick in volatility reflects increased uncertainty of future Fed interest rate policy, deteriorating 2015 earnings estimates, a stronger-than-expected dollar, and falling commodity prices. Most of these are the same worries that surfaced last January. Meanwhile, stock markets, measured by the S&P 500 and the NASDAQ, are within striking distance of all-time highs. Although the S&P 500 Volatility Index approached the 17 level prior to the March Fed meeting, it has fallen back to the 13 level since. In January, the Index was above 20 for the first half of the month and reached intra-day highs above 23. Despite what most analysts are saying about market volatility in March, it is more in-line with markets prior to the October 2014 selloff, rather than January 2015. This more normal level of volatility is often present during rising markets.

Among the issues creating the “Wall of Worry” are Fed policy and 2015 earnings.

  • Federal Reserve Interest Rate Policy – Our position on Fed speak has long been to listen, not overanalyze. Strategists have spent undue time and effort in playing up the dire consequences of anticipated Fed policy. It began in 2009, ramped up through three rounds of QE’s, and has continued through the taper. The Fed will raise rates, but it will not be until they feel their duel mandate can be accomplished. The recent removal of the word “patient,” not unlike the prior elimination of “considerable time,” was interpreted as a clear signal of an imminent increase in rates. Traders, not learning from their prior lesson in semantics, bet heavily before the statement that markets would react negatively to removal of this single word, tipping the odds in favor of a rate increase in June.

The Fed did as traders and Fed-watchers predicted and removed “patient.” But the Fed added that the US economy had lost momentum between meetings, and that recent US dollar strength was slowing inflation and negatively impacting US exports. Currency and bond traders rushed to cover short positions and stocks rallied. The Fed statement reflected interpretation of current data, most of which was available to traders and analysts. The Fed has long-stated before the tapering began, that it is “data dependent,” and Chairman Yellen only reaffirmed this policy, but not before traders were spooked again. A further confirmation came as the bond market lowered the probability of a June rate hike to 10% immediately after the statement was released.

According to the “watcher experts” another worrisome aspect of the Fed interest rate policy is the Federal Reserve has painted itself into a corner. The premise is the Fed wants to increase rates but because of economic conditions, both domestic and international, risks a further slowing. While money has been created, it is not being spent. The consumer is back-loaded and in the best
financial shape since the 1990’s. Spending will eventually come on, but uncertainty keeps traditional spending habits on ice. Gas and other energy costs have been falling since last June, but the savings are barely noticeable in the spending data. The recent increases in gas prices only confirms the uncertainty that these price declines are short-term and better off saved than spent.

Those claiming the Fed is behind the curve for not raising rates last year would today be demonizing them for raising rates in a slowing economy. The current confluence of economic events: QE’s in Japan and Europe; a slowing domestic economy; the deflationary aspects of a 50% decline in crude oil; and the inability of wages increasing would have the “watchers” focusing on premature increases and potential inverted yield curve accompanied by declining corporate earnings. With the equities markets near all-time highs and stocks fairly valued, the economy will pick up later in the year, and despite the potential for a correction, there will be no recession, neither economic or earnings.

  • 1Q2015 Earnings – The earnings results in 1Q2015 can be summed up in two words: oil & dollars. Without beating a dead horse, the 50% decline in the price of crude and its widespread impact on the energy sector is well-known, but the overall earnings shortfall from the strengthening dollar is more difficult to quantify. Already, bears have concluded we are approaching an earnings recession with equities overvalued. Any perceived further weakness in the economy will empower the bearish argument of overvaluation of stocks, with biotech and technology bubbles. In the forthcoming earnings season, not unlike last quarter, misses in revenues and on the bottom line will be severely punished. Sectors that derive more than 40% of earnings abroad will be targeted. Overall, about 46% of S&P 500 earnings are non-US, with Materials and Information Technology above 50%, and Healthcare, Consumer Staples and Industrials more than 40%.

The nominal trade-weighted value of the US dollar has appreciated nearly 22% since mid-2014. It is the rate of increase (averaging 2.3% month-to-month) that has precipitated recent downward revisions in 1Q2015 earnings. According to Reuters, 1Q2015 S&P500 earnings are estimated to decline 3.1%, the first decline since 3Q2012 (-1.0%), and the largest since 3Q2009 (-15.5%). As shown in the Table below, five sectors are projected to show year-over-year earnings growth and five showing declines.

3 20 2015

Interestingly, the Energy sector has a 43.3% higher weighting in the S&P 500 earnings than in the S&P 500 market cap Index. This means the effect of the 63.4% decline in earnings is not equally reflected in the cap-weighted S&P 500 Index. The earnings drag of the 11.2% earnings weight in the S&P 500 is -6.5%, thereby giving an adjusted S&P 500 earnings, ex-Energy, an increase of 3.4% in Q12015.

The dollar shock will be more quantifiable after 1Q2015 earnings are reported. For the remainder of 2015, earnings estimates will increase or decrease depending on the effect of non-US earnings in the first quarter. But similar circumstances of dollar strength and earnings weakness are not without historical precedence. During the 1990’s stocks rose despite Fed rate increases and a strengthening dollar. From year-end 1991 to December 31, 1996, S&P 500 earnings rose 111%. However, earnings only rose 17.7% from January 1997 through December 2000. An earnings recession in 1997-1998 saw earnings rise 1.0% in 1997 and fall 7.0% in 1998. There was no economic recession and stocks, measured by the S&P 500, climbed 33% in 1997 and 28% in 1998. Currency fluctuations can have a measurable effect on short-term earnings, but longer-term stock valuations are the present value of discounted future cash flow and earnings surprise.

Markets may become vulnerable through earnings season as investors and traders assess the effects of declining earnings amid fluctuating oil prices, a strong dollar, and below consensus economic data. We would avoid companies highly dependent on overseas earnings, and until stability returns to the commodities markets, energy and raw material producers. In the short-term, there is potential for a definable correction which will offer a tactical buying opportunity. Once the Fed raises rates, stocks should perform well during a rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and limited multiple expansion with continued upside for equities. Our investment policy remains optimistic on Large-Cap domestic corporate equities.


Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS March 9, 2015

on Thursday, 12 March 2015. Posted in 2015, March

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS March 9, 2015

Is Perception Reality?

“If everybody is thinking the same, then somebody isn’t thinking.”
                                                                            General George S. Patton, Jr.

 

In our last Report we discussed the possibility of a stock market correction during 1H2015. The probability of a selloff is based on a temporary slowdown in economic growth and an earnings recession giving the perception of a lack of aggregate earnings support.  Data released for January and February, with the exception of the employment reports, remain “bumpy” and will be reflected in weak first quarter GDP.  Combined with the lowered S&P 500 earnings estimates, these data may trigger a change in the perception of the stage of the current business cycle.  The added misunderstanding of the Fed’s move towards normalized rates will fuel bearish arguments.  These perceived negatives do not extend to our longer term outlook or, in turn, our optimism on the economy.  Yes, the Fed will raise rates, and in retrospect, the timing will be of minimal consequence.  Remember rate normalization is not tightening, but rather the Fed stepping aside.  Traders, addicted to low rates that artificially raise asset values, fear withdrawal and normalization. 

Employment and Inflation

Another good month for non-farm employment led to a sharp selloff in equities as the perspective meeting date for a Fed rate increase moved from late-2015 – early-2016 to mid-year 2015.  Stocks fell nearly 300 points and the 10-year Treasury down to the 2-year Treasury saw yields rise 10-12 basis points.  The 295,000 jobs added in February obviously caught the markets, i.e. traders, off guard.  But, employment has been averaging 275,000 net new jobs for the past 12-months.  The anticipation of a sooner-than-expected rate rise is happening in a non-inflationary environment with slow-but-stable economic growth.  In fact, GDP estimates have come down from above 3% to about 2% since the beginning of February.  Inflation hovers around 1% and consumers rather save than spend.  Average hourly earnings rose a meager 0.1%, disappointing given the increases in two of the past three months - - no wage inflation on the radar screen.  As the data dependent Fed assesses the current situation, the preemptive rise in interest rates across the board may prove a head fake. 

1H2015 Earnings Recession

Over the next few weeks into the beginning of 1Q2015 earnings season there will be widespread discussions on the “earnings recession” and its negative impact on stocks.  (Earnings recessions are defined as two or more consecutive quarterly declines in S&P 500 EPS.)  This will be overblown in the media, exaggerated by bears, and taken completely out of context by retail investors.  Under normal conditions, S&P 500 earnings recessions and an associated stock market decline are a function of a business cycle downturn.  According to JK Investment Consulting, “Of the major stock market declines that are associated with earnings recessions, it turns out the 8 out of 10 cases a business recession was the underlying cause.”  Furthermore “17 out of 27 major stock market declines (10% or more) since 1960 have not involved earnings recessions at all.”   As mentioned in a previous Compass, the major contributor to the lowered forecast of 1H2015 earnings is the sharp price decline in crude oil and its effect on the Energy sector. The Table below summarizes this impact on earnings. 

SP500 March

Even under more “normal” conditions, earnings recessions cannot be considered a lead indicator of definable stock market corrections.  The above estimates are highly influenced by lower crude prices, which historically are a net-plus for economic growth.

Bond/Stock Reversal

As the reckoning day for Fed rate normalization approaches, bond yields are ticking higher.  The effect of moderate increases in short-term interest rates on the long end of the curve is unclear.  A leveling of the yield curve is anticipated as economic growth remains slow and inflation remains below 2%.  Wage-push inflation is virtually nonexistent.  The reversal from bonds to stocks, particularly those held in Mutual Funds is further out than was thought after the April 2013 Fed policy change. The down move on Friday in both stocks and bonds was triggered by stronger job data, not by the Fed.  From the beginning of the year through March 3, 2015, total Mutual Fund bond net inflows were $38 billion compared with only $12 billion through the same period a year ago.  This latest data marks 11 straight weeks of inflow and inflows in 57 of the past 61 weeks.  No sign of wavering in the face of the inevitable Fed rate adjustment.  Year-to-date, Equity Fund net outflows were $18 billion, compared with net inflows of $11 billion in 2014.  We will be following any reaction in Mutual Fund flows to Fed policy, but do not expect “The Great Reversal” of prior periods of rate increases. 

Our investment policy remains optimistic on Large-Cap domestic corporate equities.  As the US dollar strengthens we would avoid companies highly dependent on overseas earnings, and until stability returns to the commodities markets, energy and raw material producers.  In the short-term, there is potential for a definable correction which will offer a tactical buying opportunity.  Once the Fed raises rates, stocks should perform well during a rate normalization process.  Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and limited multiple expansion with continued upside for equities.  

 

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens