September

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September, 27th 2016

on Tuesday, 27 September 2016. Posted in 2016, September

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 27, 2016

And in this Corner…
 
“Democracy is being allowed to vote for the candidate you dislike least.”               

                                                                                                                 Robert Byrne 

With the Fed meeting behind us and the Fedwatchers in semi-seclusion until mid-October, the focus shifted to the Monday night debate.  Objectivity when discussing politics is always difficult and our Reports have made a concerted effort to remain on the sidelines.  This election cycle, unlike most others, could have an impact on the securities markets in the short term.  Rarely are two candidates so markedly different, both personally and philosophically.  As the debate approached, stocks began to reflect the uncertainty of a possible Republican victory.  Up-to-date polling showed a tightening and momentum shift.  Fear of the unknown lifted volatility and equities retreated.   In actuality, the US securities markets are more comfortable with a known quantity.  This was illustrated after the Monday night debate, as overnight stock futures rose as Clinton proved the aggressor even though chances are high that the needle was not moved much in either candidate’s favor.  After all the hype given prior to the event, it was a letdown.  With two more debates scheduled, the polls should remain close right up until Election Day.  Only if the recent gains by Trump hold or improve will the market volatility increase as the impact of policy initiatives is assessed.  
 
Major policy changes in the immediate aftermath of the election are rare.  Three out of four election scenarios result in a divided government.  A Trump win and holding control of the Senate and House is more of a possibility than a Clinton victory and winning both Chambers of Congress.  Two of Trump’s policy initiatives, tax reform and trade policy, could move forward quickly with a sweep.  Tax reform would be welcomed in a Republican House.  In concert with Speaker Paul Ryan, prioritizing tax reform could fast track and give across the board tax cuts to individuals and reduce the corporate tax rate from 35% to 15%.  The problem remains the size of the federal deficit which will balloon from current levels (about $20 trillion) and increase an additional $10 trillion over ten years.  Of course with the Government there is always an alternative way to account for the deficit increases and bring it closer to “revenue neutral.”  Enter “dynamic scoring” which allows law makers to reduce the unfunded costs by assuming that the tax cut revenues from the growth in the economy would offset the deficit rather than using normal accounting.  Hence, Trump’s 4.5% real growth yields only a $3 trillion deficit over ten years. 
 
Trade reform, or protectionism, would carry a much greater risk.  Under the articles of NAFTA, the US could withdraw with six months’ notice.  One has to worry that Trump may try to leverage NAFTA to get Mexico to pay for the wall.  The President has broad powers to regulate trade if justified by economic or security reasons.  Add in the cost of immigration reform, defense spending, domestic initiatives such as childcare and education reform, and you create greater tail risk and Wall Street does not like big tail risk.  Clinton on the other hand, champions more of the same, big ideas with limited results.  A study by Morgan Stanley going back to 1933 shows that less than 25% of campaign promises are made into law if both Chambers are controlled by the other party.  The figure jumps to close to 50% if the parties are split in the House and the Senate.  Only with a sweep would Clinton be able to exact her tax increases.  The Morgan Stanley study also shows a less than 60% passage rate with a majority in Congress.  Given the hostility between both parties over the past 12 years even these figures seem too high.  
 
Earnings
 
Closing in on 3Q2016 earnings season the outlook opens the possibility of a much anticipated recovery after five consecutive quarters of year-over-year declines.  According to FactSet, S&P 500 earnings are estimated to decline 2.3%, this is below the estimated earnings growth of 0.3% at the beginning of the quarter (June 1).  Energy, once again shows the largest decline (66.4%).  Excluding Energy, the estimated total earnings growth rate improves to +0.9%

Investment Performance

Although not shown on the Table, Information Technology is the only sector to show an increase in earnings estimates since the end of 2Q2016.  Overall the lowered estimates reflect a smaller percentage decline when compared to the immediately preceding five quarters.  Analysts are looking to 4Q2016 for S&P earnings to be positive (5.7%), but given the historical precedent of forecasted earnings moving lower into the actual quarter, a decline of estimates into December 2016 would not be unusual.  Using S&P 500 stock performance there is evidence that earnings estimates are a key variable for stock prices.  Improving earnings in 4Q2016 and for 2017 are being discounted in recent sector stock prices.  The overall S&P 500 Index is up 5.9% year-to-date through September 23, 2016, with 3.3% coming since the end of June 30, 2016.  Sectors with declining prices in 1H2016, Financials, Healthcare and Information Technology are now all positive for the year.  All are estimated to have double-digit earnings increases next year (see Table).  
 
Meanwhile Back at the Fed
 
For now, Real GDP for 3Q2016 is tracking in the 2.5%-3.0% range.  Recent August data were mixed and the 3.5% GDP projection reduced.  Auto sales in August dropped 5.0% to 17.0 in SAAR million units.  A plateau in sales despite incentives is a headwind to GDP.  The disappointing Employment Report brings 2016 average monthly employment to a lower level than in the previous three years.  But it was the ISM Manufacturing Report and Retail Sales Report that drew the most attention.  In August, ISM Manufacturing Index published by the Institute for Supply Management, declined to 49.4, well-below the consensus estimate of 52.0 (a level below 50 signifies a decline in manufacturing).  All major components of the major index were lower.  As this is a survey it should not be interpreted as a leading indicator of a recession but, attention should be given going forward.  In mid-September, the Census Bureau reported August Retail Sales (ex. autos and gas stations) declined after being flat for July.  In addition, the University of Michigan’s Index of Consumer Sentiment was below estimates for September.  On September 27, 2016 the Conference Board reported that their Index of Consumer Confidence climbed to 104.1, up from 101.8 in August and the highest level since August 2007.  Housing remains erratic but clearly on an uptrend.   These data should keep Fedwatchers busy as the November meeting approaches.  We would welcome a 1/4 point rise by the Fed in December if for no other reason than to send the Fedwatchers and the Carry Trade packing.  
 
Investment Policy
 
Our investment policy remains optimistic.  Short-term volatility related to the election may happen, but should not interfere with long-term investment strategy.  The recent weakness in economic data confirms that we remain in a 2% growth cycle, but with better earnings on the horizon and a healthy and vibrant consumer.  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 domestic Large-Cap consumer, industrial and technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

Robert Byrne

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September, 13th 2016

on Tuesday, 13 September 2016. Posted in 2016, September

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 13, 2016

Here We Go Again

“Whenever you find yourself on the side of the majority, it is time to pause and reflect.”  
                                                                                                                      Mark Twain 

Stocks and bonds have once again succumbed to the uncertainty of Federal Reserve interest rate policy.  On cue, the Fed watchers have come out in force to question and criticize the unknown outcome of the Fed September FOMC Meeting scheduled for next week.  Prior to the meeting and the quiet period, which began on Tuesday 9/13, Fed FOMC members hit the road expressing their opinion on a potential 1/4 point rate increase.  As has been the case before, the opinions vary and in the end only add confusion to the potential outcome.  Enter the Traders.  With the stock market near all-time highs and bond yields at the low-end of the 2016 range, any prospect of a September rate rise results in increased volatility and a short-term selloff.  Last week the volatility index (VIX) was below 12 and has risen to over 18 in three trading sessions.  Over this period stocks, measured by the S&P 500, have fallen 2.3% and the 10-Year Treasury yield has risen from 1.53% to 1.73%.  Rising volatility is the preferred trading environment for hedge funds and algorithmic traders who comprise up to 80% of volume under these conditions.  

Three Card Monte is a card scam found in cities where the dealer challenges any passerby (the Mark) to choose the red suit card from two black suit cards.  The slight of hand of the dealer makes it virtually impossible to choose the red suit card.  This is a generalized description of the street game, but for most Fed watchers, the prospect of determining Fed interest rate policy yields a similar wrong choice.  This has been ongoing since the taper ended in October 2014.  Drawn by Fedspeak the Mark (the economists and strategists) have almost universally been wrong on future Fed policy.  But unlike the passerby in Three Card Monte, the Fed watcher refuses to walk away and with increasingly sophisticated models, double-down on their bets.  In financial markets, despite serial miscalculations, they continue to reset and trade on erroneous conclusions.  

Many Fed watchers believe that a benign 1/4 point increase is a policy mistake and highly risky, even at these near zero levels.  From late-October 2014 it took until December 2015 to start the tightening cycle with the first and so-far last 1/4 point Fed Fund rise.  Handicapping before and after the Fed meetings has become a full-time profession doomed to failure over this 18-month period.  The market verdict is that it will be very difficult for the Fed to embark on a policy of steadily rising rates.  Although the August employment number, at 151,000 was below the assumed Fed minimum number, it was strong enough to support a rate increase.  The 1.0% increase in 1H2016 Real GDP was less than the targeted minimum, however, 3Q2016 growth is tracking slightly over 3.0%.  Core inflation is rising slowly but still below the 2.0% level.  Wages have begun to move up but based on “data dependent” criteria, September seems to be a no-go.  But, there are no disruptions overseas, although implementation of Brexit is yet to happen, and both bond and currency markets remain stable.  While the outlook for the economy remains slow growth, a 1/4 point move may not be a policy mistake and definitely not precipitate dire consequences forecast by traders.  It might be time to tweak the data dependent criteria.

Longer term rates will increase, but as Ben Bernanke has stated, “The Fed cannot do it alone.”  The regulatory response to the financial crisis has limited financial intermediation by reducing risk-taking and leverage at the same time restricting economic growth.  Fiscal stimulus has been absent, the victim of partisan politics and now dependent on the outcome of the election.  Though hard to digest, we are still in the aftermath of the financial crisis.  Deleveraging of household debt (Compass 8/29/2016) is almost finished but credit demand and wage growth are below historical levels.  Housing is recovering but nationally prices remain about 10% lower than the pre-crisis peak.  Productivity, or output per hour, has been negative for four consecutive quarters (2Q2015-2Q2016).  This is a result of increasing labor costs and the effects of lower capital expenditures.  With the move to normalization will prove to be the tonic to rid the addiction to record-low interest rates.  A slow-but-steady increase in rates will increase the value of the dollar and may marginally impact the earnings recovery anticipated in 2017.  As employment costs rise and margins become squeezed, companies will shift away from stock buybacks and bring dividend increases in line with earnings, thereby freeing funds for investment in productive resources, i.e., increased capital spending.  

Investment Policy

Our investment policy remains optimistic and favors a strategy based on slow economic growth and improving 2017 quarterly earnings.  As long-term investors the repetition of these current conditions can be unnerving and result in second guessing a portfolio’s structure.  However, over the past year these selloffs, whether from Fed policy uncertainty, falling oil prices, China’s slowdown, a rising US dollar, and more recently Brexit, have all provided a buying opportunity.  During the downturns, our investment policy was cautious and to sit back and wait, turning optimistic after Brexit.  Many of the problems which surfaced in 2015 have lessened or are gone.  The S&P 500 as of this writing is 17.7% above its February 2016 lows.  Oil, which is drawing attention again, is still 70% above its bottom, also in February.  China’s economy has improved, along with many developing market economies and the US dollar has stabilized.  Only Brexit remains alive, as the withdrawal process from the EU has yet to be put in motion.  Additionally, after four quarters of lower earnings, a bottom appears to have been reached.  

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 and technology companies.  Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.  We would avoid companies deriving substantial revenues from Europe until the currency translation become favorable.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens