November

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 30, 2015

on Monday, 30 November 2015. Posted in November, 2015

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 30, 2015

Is the Real Santa Claus on the Internet?

“There are three stages of man’s life: He believes in Santa Claus, he doesn’t believe in Santa Claus, he is Santa Claus.”                                        Author Unknown

The major equity indices remain near all-time highs set earlier in the year. Technicians and market strategists assert that a close above these record levels is a necessary precondition for the continuation of the bull market. These are the same analysts who during the August and September correction, were touting “death cross” and global recession. Today, many of the conditions present when the S&P 500 was down 12.5% from its high of 2,134.72 on May 20th, still exist. China and Emerging Markets are faced with excess capacity and deflationary pressures, oversupply plagues the Energy and Materials markets, the US dollar remains strong, US economic growth in 3Q was 2.1%, and 4Q2015 year-over-year earnings forecast is negative for the third consecutive quarter. Our investment strategy prior and through selloff was “In the short-term, there is potential for a selloff which will offer a tactical buying opportunity.” (Compass 7/20/15) Whether or not Santa brings a rally in December, or did we already have it in October, has no bearing on the fact the US economy is not going into recession and the shift to more consumer-oriented spending will keep real GDP in the 2.0%-2.5% range. It is a stock selection market as this transition unfolds.

Back to the Consumer

The shift to a more dominant consumer comes at a cost to corporate earnings. Shackled by energy and a strong US dollar corporate quarterly earnings will remain below historical growth levels at least through 1Q2016 and maybe beyond. In 2Q2016, the energy weakness will have lapped the sharp declines of 2015. However, the US dollar has strengthened again to 1.05 euros after touching 1.16 euros in late-August. Over this same period the 30-year Treasury Bond yield rose from 2.75% to 3.00%, while the 30-year German Bund has fallen from 1.55% to 1.30%. With our two major trading partners, Canada and Mexico, the dollar strength is muted. The weakness in the euro and to a lesser extent, the Japanese yen, is the result of the respective Central Bank’s easy monetary policy. Combined with the impending increase in US rates, the unintended consequence of this easing policy will be the increased flow of foreign exchange into US dollar dominated securities. Foreign investors will have the opportunity of potential dollar appreciation and capital gains with US equity investments.

With unemployment at 5% we expect wages to accelerate above real GDP growth, and when combined with lower gas and heating costs consumers, already brandishing healthy balance sheets, will zero in on high inventory induced retail discounts. The obvious transition from in-store purchases to online will accelerate. In fact, Thanksgiving and Black Friday online sales reported by Adobe were $4.47 billion, up 18% over 2014. (The data are based on 4,500 retail websites, including 80% of all online transactions of the 100 largest retailers.) Preliminary data indicate online surpassed in-store for the first time. As labor markets tighten and with 5.5 million unfilled job openings, wages and disposable incomes will increase. Rising wages will put additional pressure on corporate profit margins, while the Internet enables consumers to become more productive by getting more for their dollar. Middle class consumer purchases will increase in nominal terms (inflation) as wages continue rising. Corporate revenues will reflect this increased spending but lower margins will affect the bottom line. Results will vary company-tocompany with Mega-Caps optimizing combined retail and technology being the major beneficiaries.  Among these companies are Amazon, Apple, Facebook, Google, Microsoft and Netflix.

Earnings

Earnings and revenues have been weak for the past two years. A combination of dramatically low energy and other commodity prices have turned the Energy and Materials sectors negative by almost any matrix.  The continued strength of the dollar has affected earnings and revenues of most companies doing business overseas. But this is changing. Crude oil prices, while not expected to rise much in the next few years,
look like they have bottomed and are finding a base near $40 a barrel. The dollar remains strong and may strengthen further when rates are normalized. More favorable quarterly comparisons for both earnings and revenues will begin to show in the first half of 2016. Corporations, ex-Financial, have $1.7 trillion in cash, with Technology (35%) and Healthcare (18%) with the largest amount. A tax solution could bring the bulk of these funds held abroad back to the US. It may happen if Congress gets around to tax reform.

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The Fed will shortly be raising interest rates. The most thoroughly discussed policy change in monetary history will have a beneficial effect on stock multiples if the past is repeated. The Table above shows the effect of rising real Long-Term Treasury yields and earnings multiples and an estimate for the S&P 500 Index. According to Morgan Stanley, in a study going back to 1930 multiples are positively impacted as real rates rise up to 4%, beyond that level real rates have a negative or minimal impact. Given the current slow growth environment, it will be at least a couple of years before real rates go above the historic 4% benchmark. Even with rates where they are today, a 4% real rate would require a 5.8% nominal rate. Our studies show it is at the 3.5%-4% level of inflation that equities historically react negatively. This would imply a nominal rate for Long-Term Treasuries of 7.50%-8%, an extraordinary increase in inflation given the domestic and international outlook.

Investment Policy

The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. Expect volatility as corporations shift to satisfy increased consumer demand in an environment of global uncertainty and a strong dollar. The transition to a more consumer-oriented economy is in its early stages.  Once the Fed raises rates, stocks should perform well during the 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 multiple expansion with continued upside for select Large-Cap Consumer Discretionary and Technology companies.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 16, 2015 (Copy)

on Monday, 16 November 2015. Posted in November, 2015

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 16, 2015

Painting with a Broad Brush - - Trends for 2016 and Beyond.

The recent correction in August-September was attributable to the modest slowdown in China, deflationary impact of sharply lower commodity prices, and anticipation of the first Federal Reserve interest rate increase. The market, after a near-record monthly performance for October, is once again revisiting these “nagging” problems. Oil is near its cyclical lows and industrial commodity prices are still falling. The terrorist attacks in France have added a new dimension to ISIS. However, as worrisome is the potential for major European and US cities this may be, rarely do external incidences similar to this have a long-term effect on world financial markets. The most recent selloff is reflective of a slowdown in corporate profits and the transition to a more consumer-oriented spending.

US Economy – a business cycle with no recession in sight.

Finally, rate normalization is about to happen. As we look ahead commodity prices will have bottomed, Asia will stabilize, rising wages will increase disposable income, and the Fed has begun rate normalization at a very modest pace. The economy will continue to grow at a 2.0%-3.0% real rate as low energy prices and technological innovation keep inflation at low levels. Some wage push will be evident as the labor market tightens putting pressure on corporate profit margins. Since the financial crisis, corporations have had near record profit margins and cash flow. But that is about to change. Real disposable income is rising as technological advances and lower costs offset rising rents and healthcare increases.

Consumers, for the foreseeable future, are the driving force as spending holds steady above the levels of the prior five years. Housing is benefitting from a more normal cycle as the market is cleared of distressed sales and foreclosures. Economists complain that a high of 3.0% real GDP growth is too low, while investors remember that equities rose throughout a six year period with 2.1% real GDP growth. Auto sales continue to surprise and are running at an 18 million rate during August and September. The high level of light truck sales indicates small businesses are doing well.

Most consumers have adapted to life on the Internet. Services which were paid for are now free. Smart phones are the lynchpin to daily living. Television, as we know, it is history as media costs are down. Unlimited movies are always available for a monthly fee for less than two movies from cable. Houses and cars are all but purchased utilizing real estate and car dealer websites, no more driving around needlessly deciding your preference. These increases in productivity include banking, bill paying, shopping, food services, and even healthcare advice. However, these services are deflationary by virtue of lower costs to consumers and loss of business in many service companies. All this makes us more productive, but does not show up in a conventional measurement of productivity.

Today the housing market is growing, but erratically. New Home Sales in September at 468,000 (SAR) are still 50% below the 2000-2006 levels and back to levels not seen since the early-1980’s. First-time homeowners are about 30%, well-below the historical average of 40%. Existing Home Sales can be expected to grow as more homeowners’ equity rises from increasing home prices. In September 2015 sales were 5.55 million (SAR), the second highest rate since February 2007, when sales were declining.
Pent up sellers are trading up or buying smaller homes as retirement age approaches.  Similar to the New Home data, first-time buyers are below historical levels. The low sales rate for first-time buyers is more a function of demographics and supply/demand, rather than secular.

We believe over the next few years these sales will rise as household formations continue and the scarcity of new homes is solved. While many housing analysts blame the change in living preference of Millennial’s as a major reason for low sales, surveys by the Federal Reserve tell a different story. Over 70% of Millennial’s want to own their own home, but at this time, low income and student debt are a constraint. Rising prices and limited inventory at the low end further complicate homeownership. This
will change as the new home market becomes more in-line with potential purchasers, remember, Millennial’s finish college later, start careers late, and marry older and have children well-beyond past generations. For these reasons the new housing market seems back loaded.

Investment Policy

The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. In the short-term, there is potential for a further selloff offering a tactical buying opportunity. Markets remain vulnerable as investors and traders continue to assess China and Emerging Market economies, a stronger dollar, and mediocre earnings. Earnings should begin more favorable comparisons in 2016. Once the Fed
raises rates, stocks should perform well during the 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 multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 2, 2015

on Monday, 02 November 2015. Posted in November, 2015

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS November 2, 2015

Media Meddling

The dire predictions for stocks just three weeks ago were met head on by the sixth best October in market history. The major averages are back near their all-time highs. Bears are unfazed, citing weak breadth as a major reason for a reversal and further declines. Many are looking for the levels of late-August to be retested, but this seems unlikely as the rationale behind the selloff was based on questionable extrap-olation of international and domestic data. With the full participation of the financial media, the slowdown in China was spread across global economies and impending deflation would bring not only Emerging Markets, but also Developed Countries, to their knees. To us, it had characteristics of a “bear raid.” Changes in the marketplace brought about by ETF’s and an increased presence of Algorithmic Traders set the stage for sharp fluctuations in stock prices.

The growth of liquidity in passive ETF’s gives traders the ability to buy and sell (including short sales) major sectors without trading individual stocks. Other examples are; Emerging Market ETFs, Commodity ETF’s, and country ETF’s. One of the first sectors sellers gravitated to was Biotech. When drug pricing was questioned, the run on the Biotech and Health Service sectors forced many investors of individual ETF participating companies to sell, if for no other reason than the stocks continued to fall. This has happened to a lesser extent with MLP’s as oil prices declined. With media support, misguided research explaining that a China slowdown would dramatically reduce earnings for any tech business even marginally involved in Asia. For individual companies like Apple, it was a combination of a peaking in momentum for smartphone sales and its exposure to China, which would drive the stock price lower. Any company supplying Apple was also degraded. A Report by Goldman Sachs, listing US companies and their percentage of revenues from China, sent their stock prices down 30%-50%. Even after company CEO’s refuted these data, widely published by Forbes, USA Today and most national newspapers, there has been no retraction by the analyst or the media outlets.

We mention Apple because it was immediately following the release of their 3Q2015 earnings that, despite Conference Call assurance in July, momentum in smartphone sales was continuing and China was growing better-than-anticipated, the stock plunged. From its high of $132 prior to earnings, the stock sold down to the low $90’s. The point here is that somehow fundamentals were no longer a deciding factor for Apple and for many other tech stocks. Apple is a company with about $200 billion in cash and cash equivalents, or about $35 in value per share. While unknown sources convinced media that Apple was wholly dependent on smartphones and China and it was time to sell. To hell with the fact Apple is a cash machine and good fundamental analysts know the value of the company is the present value of future cash flow. Apple’s recently released 4Q2015 was more in line with the Conference Call and the stock rallied to about $120, where it is today. Apple’s December 2015 quarter guidance implies continued revenue growth in China and Emerging Markets. Also, 69% of Apple users have yet to upgrade to a larger screen. We did not sell any of our Apple in our managed accounts.

3Q 2015 Earnings

According to Thomson-Reuters, S&P 500 earnings, ex-Energy, are expected to grow 6.3% in 3Q2015. FactSet in its latest Earnings Insight shows that of the 340 S&P 500 companies reported, 76% have beaten the mean estimate and 47% have reported sales above the mean estimate. For companies with higher earnings than estimated, the aggregate beat is 5.9%. As would be expected, Energy and Materials are reporting the largest year-over-year decreases of all major sectors.

performance summery

The Table shows that only Healthcare, Infotech, Consumer Staples and Consumer Discretionary are up since the beginning of the year, although all Sectors rose for the month of October. While difficult to draw a direct correlation of the impact of earnings on October ETF prices, the companies beating estimates rose 2.2% for the four day period around earnings, double the historic 1.1% rate. Healthcare and Infotech have been showing better-than-anticipated earnings and revenues on an individual company basis. Both sectors are leaders in the rally. According to Bespoke Investment Group, the Healthcare sector is up 6.3% since 10/23/15, while the S&P 500 is up only 1.5%. On an equal-weighted basis, the rise is 7.3% with only two stocks in the sector showing declines, Stryker (-2.7%) and CR Bard (-0.2%). For this sector, this is contradiction to the weak breadth mentioned earlier in the Report.

Money Flows into Stocks

One of the indicators that we follow is Mutual fund and ETF’s net purchasers and net sellers of Mutual fund shares. Mutual fund investors have been net sellers of US equity funds going back to January 2010. Only during 2013 and into 1Q2014 were there any consistent purchases. There have been net sales of US domestic equity fund shares in 75 of the latest 80 weeks and for the past 15 straight weeks. Thus far in 2015 the outflow is $114 billion against a total inflow of $46 billion for full-year 2014. International flows are small by comparison with net flows into foreign funds of $28 billion year-to-date, compared with $11 billion for all of 2014. These data continue to confirm the absence of the individual investor, outside of money managers and company sponsored pension plans. Both domestic and international fund flows were negative for the four weeks ending 10/21/15 and therefore Mutual funds were probably not a positive during the rally. The net flows into ETF’s are more volatile. Unfortunately, the data do not break out domestic and international, but do show a $9.5 billion net inflow into equity ETF’s for the four weeks ended 10/21/15. For the last two week period, that inflow was $7.2 billion. For the year to late-October the flow into equity ETF’s was $81 billion, compared to $60 billion for all of 2014. Inflows were positive for 65 of the past 89 weeks. ETF flows are more indicative of institutional purchases and sales and given the volatility they appear more trading oriented, with individual weeks reaching $20 billion in either direction.

The US Economy

Real GDP for 3Q2015 at a 1.5% increase was inline and cannot be expected to change anyone’s investment strategy. For the market, it was priced in and has no implication for Fed action. Housing, though the recent data are mixed, is more a supply/demand problem with insufficient inventory resulting in rising prices as potential purchasers back away. Although New Home Sales were down in September, prices are up 13% year-over-year. This week will see economic data for manufacturing and retail sales. These data are not market movers but Friday’s employment report may disappoint as there has been a rise in layoffs and many skilled jobs go unanswered. Short-term, after the great October, anything can happen. Biotech research and technology improving productivity will not go away. Companies on the leading edge of medical innovation will not be regulated out of the market. The recent earnings of Apple, Google, Amazon and Microsoft affirm our belief in large cap technology companies. As 2016 approaches, dollar comparisons will become more favorable. During the recent rally, companies with more than 50% in international revenue showed better relative performance. This indicates investors are already discounting better earnings in the coming year.

Investment Policy

The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. In the short-term, there is potential for a further selloff offering a tactical buying opportunity. Markets remain vulnerable as investors and traders continue to assess China and Emerging Market economies, a stronger dollar, and mediocre earnings. Earnings should begin more favorable comparisons in 2016 and stocks, currently 16.7x estimated forward 12-month earnings are fairly valued. Once the Fed raises rates, stocks should perform well during the 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 multiple expansion with continued upside for equities. Our investment policy remains optimistic on selective large-cap domestic corporate equities.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens