May

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 23, 2016

on Tuesday, 24 May 2016. Posted in 2016, May

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 23,2016

Expect the Unexpected – A Contrarian View  

After surviving an earnings recession, a couple of definable market corrections, an energy crisis, global commodity deflation, potential China hard landing, US dollar appreciation, and of course the impending spiral down of the US economy into recession, equities, as measured by the S&P 500, as of last Friday were 4.1% below their all-time May 2015 highs.  Stocks have declined for four consecutive weeks, but the magnitude of selling pales (S&P 500 down 2.2%) in comparison to declines in August-September 2015 (-12.5%) and January-February 2016 (14.4%).  However, the stubborn permabears are no less enthusiastic on an ensuing debacle.  Reluctance to accept reality and the fact that almost all of these “dire circumstances” have reversed or lessened has not driven markets higher.  Oil prices have bottomed and stabilized, the US dollar is no longer in freefall, and multinational companies will show favorable earnings comparisons beginning with 2H2016.  Earnings should bottom in 2Q2016 and improve going forward into 2017.  Stocks should end the year above current levels.    

Moving Toward Normalization  

This improvement does not necessarily guarantee a renewal of a “full-fledged bull market.”  The most recent impediment to a market move above the 2015 record highs is the Fed policy of rate normalization overhanging financial markets since QE3 terminated the asset purchase program in October 2014.  The first step toward rate normalization was a 25 basis point increase in the Fed Funds rate in December 2015.  Recent Fed statements point to a second increase in rates either at the June or July Fed Open Market Committee (FOMC) meetings.  Our opinion is that speculation on Fed initiatives is of little value but listening to the Fed, particularly Chairmen Yellen and FOMC members has value.  Such is the case now.    
Immediately following a weak April employment data, Fed watchers discounted any rate increase until the fall.  After the release of the April minutes last week, the outlook changed.  Odds now favor a rate increase sooner rather than later.  According to the minutes:    


“Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen and inflation making progress toward the 2% objective, then it likely would be appropriate for the FOMC to increase the target range for the Federal Funds rate in June…Participants generally agreed that the risk to the economic outlook posed by global economic financial developments had receded over the intermeeting period.”    

Subsequently to the minutes, individual Fed officials publicly outlined their expectations for an increase in rates sooner than the market had expected.  To date, the reaction in the financial markets has been more talk than reaction, perhaps in recognition that the domestic economy is healthy and that the global outlook is improving.  As we have stated on these pages many times, the markets will react positively as the move to normalization moves forward.  Why then is this Fed policy taken by many as a negative in stocks?  

US economic growth is expected to improve during 2Q2016.  Forecasts for real GDP fall within the 2.0%-2.5% range of the past five years.  Many traders and investors assume that raising rates will negatively affect economic growth.  However, under current conditions rising rates gradually ensures
short rates will remain below the annual rate of inflation and therefore will not restrict growth.  A Fed Funds rate of 100 basis points lower than 2% inflation will not constrict economic growth.  In fact, slowly rising short rates is a positive for economic growth as savings increases, raising overall earnings.  Also, modest increases in mortgage rates will not impact housing as the current market problems are more restrictive mortgage qualifications, low inventory and rising home prices.  Retail prices are highly competitive as consumers continue to purchase more for less.  It is hard to believe a 25 basis point increase on a 17.5% credit card rate will defer purchasers.  Auto loan rates remain low and the extended term loans is more of an incentive than current loan interest payments.  Additionally, moving to a more realistic interest rate restocks the Fed arsenal to combat future economic disequilibrium.    

The impact of low rates has been widely documented.  The near-zero interest rates at most Central Banks has overvalued financial assets on historical basis.  The S&P 500 as a forward 4Q estimate of 16.6X and we would expect it to rise should earnings begin to increase above analysts’ expectations moving through 2017.  In an environment where the economy is growing at a subpar 2.0%-2.5% pace these higher earnings will more than offset wage push inflation and the accompanying slowly rising rates.  Those who are negative on equities going forward cite historically high valuations and foresee little earnings growth as rising rates slow the economy and ultimately bring about a cyclical downturn.  Our expectations are for modest increases in inflation and a slow ramp in interest rates.  As earnings accelerate, P/E multiples will expand.    

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 sharp 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

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 09, 2016

on Monday, 09 May 2016. Posted in 2016, May

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS May 09, 2016

Hard to be Patient.

“A man who is a master of patience is a master of everything else.”
George Savile

Yes, we are still in a bull market for stocks. Stocks, measured by the S&P 500, remain about 3% below the May 20, 2015 record high. After correcting in late summer – early fall 2015 and again in early 2016, stocks have challenged the record highs only to fall back to technical support levels. Through last week, the S&P 500 index was up 0.65% for the year and 2.79% below the year-ago level. Volatility, although not approaching the correction levels of August – September 2015 has remained historically elevated. The major negatives of last year and into early February have lessened but not disappeared. China has regained some traction in its transitional economy, oil is up 70% from its February 11th low, and the US dollar is down about 8% from its highs. Economic data on balance remains positive with little or no chance of a recession on the horizon. But the economy, measured by real GDP, continues to grow annually in a 2.0%-2.5% range, close to the 2.2% annual average since the end of the 2007-2008 recession.

While many short- term uncertainties remain, there has been progress on a number of fronts. Among these are:

Stability and Emerging Markets (EM) – Raw material prices have risen recently and for many EM countries this has been translated into higher equity prices. Even with the slowdown in China, many EM countries were in better financial condition to withstand a substantial decline in exports. In addition, the weakening of the US dollar has alleviated pressure from the dollar-dominated sovereign debt issued during the boom years. Stock markets have reflected this turn of events as the MSCI Emerging Market Index rose 6.1% year-to-date through April.

Oil Bottom – While it is impossible to determine the magnitude and short-term direction for crude oil, the February 11th rally off of the $26 a barrel crude price seems certain to hold. There is reason to question that at $45 this rise has been too much too fast. Inventories remain high and production is off only marginally. Demand continues to rise, but is nowhere near equilibrium. The fires in Alberta and the war in Libya may have temporarily kept prices elevated, but this has been more than offset by increased production in Iran.

China Improvement – Data are mixed but there are signs that the transition to a consumer economy is gaining momentum. Most recently the Chinese PPI bottomed. This indicator has historically shown a high correlation to Chinese GDP. Also, the increase in the Baltic Dry Freight Index from 300 to 700 indicates a movement of raw materials and most certainly including China.

Fed Policy – The most recent employment data will most likely push any interest rate increase back into early fall. Thus far current quarter economic data do not give any clear indication of acceleration in overall growth. Manufacturing remains positive, but only marginally, and one of the more robust sectors, Autos, looks to be topping.

Earnings
Earnings season is near completion and the results have not provided a catalyst to raise stocks above the record highs of 2015. According to FactSet, with 87% of the S&P 500 companies reporting results for 1Q2016, 71% had earnings above estimates. Revenues for these companies were only 53% above forecasts. At the sector level, Materials (84%), Consumer Staples (83%), Consumer Discretionary (82%), and Healthcare (81%) had the highest EPS beat rates. With the exception of Healthcare, companies in the other three sectors have outperformed the S&P 500 Index year-to-date through May 6th. The blended earnings decline for 1Q2016 is -7.1%, making it the first four consecutive quarterly year-over-year decline since 4Q2008-3Q2009. Also, the 7.1% decline is the largest since 3Q2009 of -15.8%. There is little reason for optimism in the current quarter. Analysts are forecasting a 4.7% drop in S&P 500 earnings for 2Q2016. Should oil prices and the dollar remain near current levels the 2Q numbers appear too low. FactSet reports that for 3Q2016 and 4Q2016 earnings are estimated to increase 1.4% and 7.5% respectively. Revenues are forecast to follow a similar trend, turning positive in 2H2016.

Housing
Disappointing data for New Home Sales and Starts have put in question the strength of the US housing recovery. New Home Sales have been lackluster, missing expectations in March by 1.7%. Single unit starts are up 22.2% in 1Q2016, maybe warmer weather, but most likely a reaction to low inventory. A shift back to a more balanced single unit/multiunit ratio may be evolving. The trend in rental housing over homeownership seems to be reversing as indicated by an increase in rental vacancy rates to 4.5% in March 2016 from the lows of 4.2% last summer. Housing demand is highly dependent on household formations. According to the most recent Housing Vacancy Survey, the average annual household formation increased from 450,000 in 4Q2015 to 540,000 in 1Q2016. As more millennials moved through their 20’s and into their 30’s, the demographic transition will drive household formation and homeownership. The slow but increasing trend in wages, 2.5% in 1Q2016 preliminary GDP Report, will support this transition from renter to owner.

Investment Policy
Our investment policy is less cautious and should move toward outright optimism as the economy and earnings reflect our outlook for 2H2016. 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