September

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 25, 2017

on Monday, 25 September 2017. Posted in 2017, September

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 25, 2017

Back to the Future…Again
“It takes considerable knowledge just to realize the extent of your own ignorance.”
                                                   Thomas Sowell

As equity markets flirt with new record highs many market analysts again turn bearish as overvaluation, the Fed, and perception of a slowing economy with a flattening yield curve signal a market top. The September to mid-October period is historically weak as managers review portfolios and tax considerations are implemented. The lower 3Q2017 earnings estimates are fortifying the bearish convictions. The so-called “Wall of Worry” grows higher but as has happened many times in the not-toodistant past, forecasting the death of the secular bull market will prove premature.

The bears began the attack in 2013 after the resurrection of a weakened Europe and slowing economies of China and Japan threatened global recession. US markets ignored the dire predictions and the S&P 500 Index rose 29.6% on the back of rising earnings (+11.5%) and a 2% economy. In 2014, oil prices fell 46%, and along with a rising dollar, the end of Fed tapering, the S&P 500 Index rose 11.4%. Our view throughout these two years was for slow but continued growth (averaging about 2%), led by a transition to a healthier consumer supplemented by falling energy prices. The 9.8% market selloff during the September 19, 2014-October 15, 2014 quickly reversed, and by December 5, 2014 the S&P 500 was 14.2% above its October lows. The Compass Reports during that time stated our optimism that the Fed was employing the correct policy, oil sector weakness would not bring down the 2% economy, and the financially healthy consumer would anchor the next phase of growth moving forward.

Throughout the 2013-2014 period, the bears overreached in their analysis of the record levels of margin debt, China and Japan economic weakness, and once again, overvaluation. The real experts, Permabears, believe they added to their credibility by including the views of “some of the brightest minds in finance sounding the alarm about a stock market bubble,” (CNN Money, 8/19/14). Joining the chorus was Noble Prize winning economist, Robert Shiller’s valuations at “worrisome levels,” hedge fund king Carl Ichan’s belief that “we are in an asset bubble,” and former Treasury Secretary Robert Rubin’s comment that the “excesses caused by artificial interest rates could create another financial crisis.” A centerpiece of the bearish argument was the ineffective policy advocated by the Fed which was proven wrong and discussed in the Compass entitled “Market Listens as Chicken Little Speaks” on August 4th 2014:

“Underlying the bearish argument is the assumption that after tapering concludes, any Fed policy actions will fail as inflation will rise well-above expectations and interest rates are forced higher than anticipated. The prospect of tightening would create broad selloffs in both stocks and bonds and may even result in a bear market depending on the extent of economic weakness. As investors it makes little difference whether the Fed raises interest rates in early-2015, mid-2015 or late-2015. Last week the Fed stated that it will be a “considerable” time before rates are raised. Even if the Fed begins to raise rates 25 basis points at every other meeting, it would take 2 years to reach 2%. Traders are obsessing when
the Fed will begin to increase rates, but to investors it is a sign the economy is normalizing and not an unintended consequence, but Chicken Little Lives.”

Going forward into 2015, earnings were dominated by losses in the Energy sector. By mid-July the S&P was up only 2.4%, but had reached its highs for the year. A correction of 12.5% from July highs resulted in a double-bottom in August and September, stocks then rallied to close the year with the S&P 500 down 0.3%. All major indices fell with the exception of the NASDAQ Composite (+5.7%) led by Technology and Biotech. Needless to say, Fed interest rate policy, the weakness in oil, contagion from a possible Greek default, and China’s deteriorating economy put the bears in charge. Technicians were claiming a wild assortment of negative formations, the Permabear elite (Roubini, Faber, and Rosenberg) were all over the media predicting the next global recession. Our Investment Policy became cautious in lateMarch 2015 based on the slowing economy and the outlook for earnings. Markets were dominated by high volatility as evidenced by caution in our October 19, 2015 Report written after stocks had rallied. High volatility exacerbated the market weakness as traders dominated. At that time we stated:

“Traders participate in both up and down markets without any regard for fundamental economic value placed on individual stocks or indices. Computer programs react to specific trading patterns which offer the best chances for success. These algorithms are limited by a finite number of profitable trades. Volatility is the key to profit and the more the algorithmic traders, the higher the volatility. In periods like those experienced in the last few weeks, markets become casinos increasing the possibility of flash crashes and mass losses of investment funds.”

Stocks began 2016 with selling dominated by high volatility that once again resulted in a double-bottom in January and February. The S&P 500 declined 14.5% from its highs in early-November. Sentiment deteriorated to levels not seen since 2009. Oil fell from $37 a barrel at year-end 2015 to $26 a barrel on February 11, 2016. Traders were still shorting at these ridiculously low levels as rationality in the pits was non-existent. Stocks became closely correlated to oil as the downward spiral accelerated, indicating to bears that the global recession was now on the horizon. US corporate earnings were forecasted to decline through mid-year and the economy was slowing, and deflation would soon follow.

With oil and stocks joined at the hip our strategy “To Sit Back and Wait” in early January was reaffirmed. Our cautious outlook continued through most of 1Q2016 however, as we stated repeatedly throughout the chaos, long-term investors should consider any corrections as buying opportunities. Skies began to clear and by late-April the markets regained nearly all losses and as markets began to discount the improving economic and earnings outlook. Since February 2016 the S&P 500 is up 38.5%, oil has doubled, earnings turned positive in 3Q2016 reaching double-digit growth in 2Q2017. Interest rates remain low and inflation remains below 2%. Global growth is estimated by UBS at 3.7% for 2017. For these reasons and document in the Compass, our strategy moved to outright optimism in early-May 2016.

The purpose of this exercise is to focus on the inability of bearish analysts to go beyond the short-term and put forth a rational long-term strategy. Some, like Marc Faber and Jim Rogers, have been bearish for decades, others (Roubini, Shiller and Rosenberg) have not been right since calling the bear market prior to the financial crisis, with substantial lead-time. Should the current weakness in technology stocks spread to the broad market and continue for more than a week, bears, as well as the reconstructed Fed naysayers, will once again dominate financial media harping on overvaluation. In isolated instances bears have correctly called small corrections, but tend to remain focused on the cause even when the effect is minimal. Tunnel vision has limited their ability to see only short-term negatives, extrapolating them into a bear market often accompanied by an economic recession. Permabears will be right at some point, but most likely after they turn bullish.

Energy Redux

Markets have been at or near record highs for much of 2017. Year-to-date the S&P 500 has risen 11.8% and the NASDAQ Composite is up 19.4%. Large-Cap Technology stocks (XLK), although volatile recently, have risen 19.3%, followed by Healthcare (XLV) +18.0%, Materials (XLB) +13.8%, and Industrials (XLI) +13.6%. Energy (XLE) is the biggest loser, down 9.4%. However, over the past two weeks, the XLE has been the biggest winner, up 5.5% despite a sharp reduction in 3Q2017 earnings forecasts. Caution is advised for investors when looking at the Energy sector because of its international geopolitical exposure and rapidly improving technology in fracking, which has dropped break-even prices per barrel on average below $45. Inventories are still high and there is an abundance supply “on the high seas.” With crude prices over $50 and holding for about two weeks, money has flowed into these stocks as if the supply/demand equation will soon balance, but future prices will be determined by innovation. With more oil and gas between the rocks than under the sand prices will depend on free market principles, rather than OPEC. Why else would Saudi Aramco be planning an IPO for 2018?

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap Consumer Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 12, 2017

on Tuesday, 12 September 2017. Posted in 2017, September

HUTCHENS INVESTMENT MANAGEMENT WEEKLY COMPASS September 12, 2017

US Equities – Hurricane Edition 
“It’s difficult to make predictions, especially about the future.”
                                                   Yogi Berra – Philosopher

Looking beyond the short-term considerations for US equities has become lost in geopolitical problems (North Korea) and Washington dysfunction, however, peeking into 2018 the outlook for stocks decidedly outweighs the alternatives, i.e. fixed income and cash. The most recent economic data, published prior to hurricanes Harvey and Irma, put the economy closer to “normal” growth than any period since the financial crisis. Equities have reacted positively to these improvements. Stocks, measured by the major averages, are all within striking distance of new highs. The short-term consequences of the two major hurricanes will no doubt have mixed effects on the data through year-end empowering the permabears to once again yell “impending recession.” The economy will eventually fall into recession, but with current underlying strength accompanied by low interest rates and minimal inflation, it will not be for a while. Additionally, the economic world is experiencing synchronous global growth.

Before moving beyond 2017, investors should carefully assess the impact of the short-term effect of the recent hurricanes. With such external events, overall economic growth initially may show a slight decline as the non-productive aspects of the hurricanes (business closures, cleanup, hours worked and aggregate weekly earnings) moves through the recovery process. The total costs from the two hurricanes vary, but well-over $120 billion is reasonable. Most of the funds will go to the recovery. There will be a positive boost in GDP beginning some time in 4Q2017 extending into 2018. This lagged stimulus will come from restocking, rebuilding, and replacement (homes and autos). After Katrina (2005), there was about nine months of recovery in replacement and overbuild of housing before a return to trend. Following Sandy (2012) auto sales reached new highs and used car prices rose. Non-residential construction, home improvement and building material companies should benefit. Residential flood losses, mostly uninsured, will far outdistance wind losses, putting more costs to the consumers and government.

The economy entering 2018 will benefit from the tailwinds of the hurricanes, craftsmen along with anyone who can handle a hammer, will earn excess income, boosting consumer spending as part of the tailwind. No doubt 3Q2017 and 4Q2017 earnings will be affected for many of the S&P 500 companies. The impact will vary in magnitude and duration. The oil sector, already lowering estimates prior to hurricane Harvey, will show the most earnings volatility. Quantifying lost sales is subjective in the refinery business but precise in the damage and totaled autos. Companies have perennially used weather as an excuse for lower earnings. Over the past few years it has been with winter storms. Expect more confusion during 3Q2017 earnings season centered among retailers, restaurant chains, and travel and leisure. According to FactSet, the estimated S&P 500 earnings growth rate for 3Q2017 is now 4.9%, below the 7.5% at the end of June. Many of the negative adjustments to earnings will improve demand beyond the near-term. Company specific fundamental analysis will provide more focused estimates of storm-affected earnings than ETF sectors.

Stock Market Estimates

The stock market is a discounting mechanism. The Table below illustrates the potential S&P 500 Index with an expanding domestic economy, low interest rates, increasing corporate earnings, and moderately rising P/E rates. Also, the current consensus earnings estimates do not reflect tax reform.

Wealth Management

According to the Ogden September 2017 Monthly Strategy, relative to the past decade’s normal relationship, stocks are fairly valued, versus 10-year US Treasury Bonds. At this time there is no reason for a reallocation to bonds. Only at yields above 3.5% for the10-year Treasury would bonds be more attractive than stocks.

Investment Policy

Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap Consumer Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens