A Light in the Black

by Jason Norris, CFAExecutive Vice President of Research

A Light in the Black

What a week! With concerns about growth in China, continued deterioration of the Chinese equity market and U.S. investors rushed to the sidelines by redeeming over $17 billion in equity mutual funds and ETFs. This, coupled with concern over when the Fed will raise rates, led U.S. equities to experience a 12 percent correction from recent highs on Tuesday (see last week’s blog for more detail). This was long overdue as it had been almost four years since the S&P 500 had corrected by at least 10 percent, which was the third longest period in history. However, after six consecutive days of selling, on Wednesday the near-term bottom was reached on the S&P at 1867, down from its all-time high of 2130 which was reached on May 21, 2015.

Understandably, rapid downward moves in equities can be disconcerting. We don’t know if we’ve seen the bottom; however, we believe there is a light at the end of this tunnel in the form of domestic market fundamentals. For example, U.S. GDP was revised higher on Thursday from 2.3 percent q/q annualized to 3.7 percent. This was driven by several factors - primarily capital spending and consumer spending. Earlier this month we also saw retail sales numbers revised higher. When this data was originally reported, we did view it with some skepticism since our bottoms-up analysis did show better strength than the broad government reports.

After analysis of the earnings reports for the companies we own, it revealed annual growth in earnings of 2 percent; however, excluding Energy, growth was close to 13 percent. Even when looking at the broad market, earnings growth (excluding Energy) was around 5 percent. This growth was driven by the U.S. consumer and healthcare. These fundamentals signal to us that the U.S. economy is healthy and improving.

Earnings Growth for the 10 Economic Sectors of the S&P 500

	Q2 y-o-y growth	2015e
Consumer Discretionary	9.2%	11.3%
Consumer Staples	2.5%	1.7%
Financials	6.8%	15.9%
Healthcare	14.4%	12.7%
Industrials	-4.5%	-1.0%
Info Tech	4.5%	4.9%
Basic Materials	6.0%	-1.0%
Telecom	8.5%	8.3%
Utilities	6.5%	1.6%
Total (ex. Energy)	5.3%	7.0%
Energy	-55.7%	-56.3%
Total	-0.7%	1.0%

Source: FactSet

The table above highlights the underlying sectors of the U.S. market, showing both the actual growth rate for the second quarter and an estimate for 2015. The key to focus on is that commodity prices are bringing down Energy and Basic Materials, and the strong U.S. dollar and China is hurting Industrials. However, when you lift up the hood of the market, corporate America is still exhibiting solid growth.

Our Takeaways for the Week

• Corporate earnings remain healthy
• While volatility may remain until the Fed tightens, we still like equities long-term

Disclosures

Here Comes Santa Claus

by Ralph Cole, CFA Executive Vice President of Research

The Federal Reserve delivered some early Christmas cheer with a new policy statement on Wednesday, and by Thursday afternoon the Dow average had advanced 700 points. Please excuse us for being frustrated by the constant attention to the Fed and the parsing of every statement they utter. This tends to happen during any Fed tightening cycle. The chart below shows the average S&P 500 performance around the last five Fed tightening cycles. As you can see, about six months before the Fed starts raising rates the market goes through a correction of 5–7 percent and volatility rises.

The U.S. economy continues to hum along, and there is no lack of positive economic indicators. We believe that the Fed will be raising short-term interest rates in the middle of next year and they are doing their best to signal that move to the markets well in advance. The most recent examples last week were jobless claims, which dropped to a six-week low, consumer comfort climbing to a seven-year high, leading economic indicators rising an additional .6 percent and retail sales increasing by the most they have in eight months. In short, there is plenty of good economic news to go around, and enough momentum for the Fed to justify raising rates next year.

Wind of Change

While oil prices fell modestly this week, energy stocks began to rally. Since the peak in oil prices in June, the S&P energy sector fell 25 percent. This week oil prices are down another 2 percent, but oil stocks in the S&P were up 7 percent. We can’t say that we are surprised. Whenever you get such a dramatic drop in prices, it tends to produce bargains. Financial buyers aren’t necessarily brave enough to step into these situations, but strategic buyers are. This week Repsol, a Spanish oil company, made an offer to buy Talisman Energy for $12.9 billion. Talisman’s share price was as low as $3.96 on December 8, and now trades for just over $9.00 per share. We made the case last week that the sell-off in oil was overdone, and it appears others are coming to the same conclusion.

Our Takeaways from the Week

• The stock market will continue to experience increased volatility in the coming months as the Fed communicates its tightening plans
• The sell-off in oil stocks is overdone, and there is value in the sector
• Our warmest wishes for a happy holiday season!

Disclosures

A Pleasant Shade of Gray

by Jason Norris, CFA Executive Vice President of Research

Headline sales numbers from Black Friday looked disappointing with revenues falling 11 percent in 2014, which follows a negative year in 2013 as well. However, when we dig into the data, we see that sales have spread out over the entire week. Many stores have been starting their promotions earlier in the Thanksgiving week, meaning Black Friday is not the seminal event it once was. Coupled with an increasing amount of shoppers going online, the post-holiday shopathon is not the signal to the markets it once was.

Data from the entire weekend looked fine with sales rising approximately four percent, with a 15 percent clip coming from online sales. In forecasting the entire holiday season, industry analysts still expect low to mid-single digit growth. In light of gasoline prices down 35 percent from last year, we are comfortable with that growth forecast. In fact, this led us to increase our allocation to the consumer discretionary sector recently.

Quantitative Speaking

With the Fed wrapping up its quantitative easing last month, the European Central Bank has upped their rhetoric. This week, ECB president Mario Drahgi was more adamant that the ECB will be in the markets buying bonds. This put a small bid on the Euro; however, we are still waiting for the ECB to actually make meaningful purchases. Since 2012 when Drahgi stated the bank would do "whatever it takes" to prop up the Euro economy, there has been a lot of speaking, with little actual easing.

The economic data points coming out of Europe have been neutral at best. While the old adage of "don't fight the Fed" may be appropriate for the ECB and European equities, we would rather focus on large cap U.S. stocks due to a strong economy, falling commodity prices and low interest rates. One potential headwind for multinationals is going to be the strength of the U.S. dollar. The dollar has rallied 10 percent the past few months and this will start effecting overseas results this quarter. Due to this, recent portfolio additions have focused on the domestic economy, rather than the global economy.

Our Takeaways for the Week: 

• Falling gas prices and an improving U.S. economy keeps us bullish on U.S. stocks
• Continued dollar strengthening will benefit U.S. stocks and bonds, while pressuring commodity prices, thus keeping inflation low

Disclosures

Exit Stage Left

by Jason Norris, CFA Executive Vice President of Research

Exit Stage Left Wednesday’s release of The Federal Reserve’s meeting minutes raised more of a hawkish tone. On the surface, the minutes may be viewed as negative; however, due to an improving labor market and an indication of a better growth environment we would welcome an increase in the Federal funds rate next year. As expected, the Fed did formally end its quantitative easing (QE) program with its final active purchase of mortgage-backed securities and government bonds. This is a positive sign for the equity markets and the U.S. economy at large. Coincidentally, U.S. Gross Domestic Product (GDP) data was released this week showing a solid 3.5 percent growth rate, which was better than most expectations. Our forecast has been for the U.S. economy to pick up steam throughout the year, and this data has confirmed that call. This information has supported stocks, yet it has a minimal effect on the bond market with the 10-year treasury yielding 2.3 percent.

Signals Third quarter earnings reports have reinforced our belief of continued economic growth. Seventy percent of the companies in the S&P 500 index have reported earnings to date and the results have shown year-over-year earnings-per-share growth of nine percent and revenue growth of four percent. Healthcare and technology companies have led the way with higher reporting of 11 percent and nine percent top-line growth, respectively. These are two sectors we favor in our equity strategies. These positive earnings reports have enabled stocks to reclaim their footing in this bull market. From the recent all-time high in September, the S&P 500 fell 10 percent over the subsequent four weeks. However, in the last two weeks we have seen a nice snap back with equities sitting just below the record of 2020 set on September 19, 2014. At current valuations (the market is trading 15.5x forward earnings) and with the strong earnings we are witnessing, we continue to favor stocks over bonds.

Different Stages The quarter’s earnings season has not been friendly to the higher growth, momentum stocks. Last week Amazon “cautioned” investors that they are going to reinvest more money into “growth”. Historically, this wouldn’t have been viewed very negatively but it seems investors may be getting impatient for their return on investment as the stock declined by almost 10 percent. Over the last 10 years, Amazon’s profit margins have fallen from six percent to under one percent, while the stock has been a stellar performer. It looks like investors are shortening the leash. Twitter suffered a similar fate this week. Twitter’s growth metrics (advertising, users, etc.) were disappointing, resulting in a 20 percent decline this week. The overall growth of the company is still strong, but investors may be getting anxious when they are paying over 100x future earnings. While many of us are big users of both of these companies’ services that does not make the underlying stock a great investment. Investors need to make sure that the price they are going to pay for future cash flows allows them to earn a competitive return. We just don’t see that in these two names at this time.

Our Takeaways for the Week: 

• U.S. economic growth is improving which will lead to the Fed raising the funds rate earlier rather than later
• Third quarter earnings growth is healthy which supports a reasonably valued equity market

Disclosures

Slowdown?

by Jason Norris, CFA Executive Vice President of Research

The first couple weeks of trading in October have been volatile, primarily on the downside. While the U.S. economy continues to print positive data points, most other regions around the globe seem to be experiencing some headwinds. We continue to see deteriorating economic data coming out of the Eurozone. Germany had been stronger; however, recent data is pointing to the country possibly entering into recession. Industrial production and manufacturing orders came in weak, and this concern has pushed the yield on the 10-year German Bund to 0.84 percent.

China is a wildcard as well. Growth has been slowing moderately; however, Thursday evening technology investors were greeted with bad news from a key component supplier. Microchip Semiconductor, a supplier of chips that go into a broad array of consumer, household and industrial products, issued a warning citing weakness in China. The company believes this is a short-term issue, but demand just three months ago was strong. This resulted in a drubbing of the Philadelphia Semiconductor index and caused the industry to be down over 5 percent on Friday. Even though there may be some general hiccups in demand, we continue to play the semiconductor space through specific technologies and applications, primarily in the wireless space.

We don’t anticipate a slowdown here in the states. The U.S. economy should continue to exhibit solid growth and decouple itself from the rest of the globe. The most recent positive development has been the decline in energy prices over the last couple weeks, which will result in a nice increase of discretionary income for U.S. consumers.

When Doves Cry

The Fed released its meeting minutes earlier this week and the capital markets were pleasantly surprised. There had been some concern that the Fed may become more hawkish and looking to tighten. However, contents of the minutes showed the Fed to be focused on the data. They highlighted benign inflation, a strengthening U.S. dollar (which is positive for low inflation) as well as increased risks of a global slowdown due to Europe’s stalling growth. We still believe that the Fed will be looking to raise the funds rate in the second quarter of 2015. Even though inflation remains low, U.S. economic growth will support the beginning of a rate hike cycle.

European Central Bank President Mario Draghi also signaled his dovish intentions for the ECB earlier this week. At a speaking engagement in Washington D.C., he stated that the bank was willing and able to alter its current bond buying program which may eventually move from just asset-backed securities to actual sovereign debt. We believe the ECB will be active in the market and will attempt to push growth higher to fight any possibility of deflation.

Our Takeaways for the Week: 

• While the Eurozone looks to be slowing, U.S. economic growth remains healthy which is positive for both the U.S. dollar and equities
• The Fed will remain data dependent when determining when to increase rates, which probably won’t happen for another 6-9 months

Disclosures

The Last Days of Summer

by Ralph Cole, CFA Executive Vice President of Research

Stronger The U.S. economy was indeed stronger than first reported in the second quarter as estimates were revised higher this week when the commerce department reported that the U.S. economy grew 4.2 percent during the quarter. This pace fits with our narrative that the U.S. economy is truly getting healthier, particularly in the aftermath of a very harsh winter.

In fact, there was a lot to like about most of the economic reports this week. For example, durable goods orders grew 22 percent, led by airplanes; unemployment claims came in again under the 300,000 mark - yet another example of vitality in the labor markets; auto sales for the month of July were robust at over a 16 million annual rate of sales. In summary, current economic statistics suggest a sustainable expansion with moderate inflation.

Witchcraft Black magic may be the only explanation for ultra-low interest rates in the face of sound economic numbers. Our industry heuristic states that strong economic growth ultimately must translate into higher interest rates. Not so fast my friend. While the U.S. economy is growing quite nicely, Europe is suffering from falling growth rates, and plunging inflation which has contributed to record lows in interest rates throughout the Eurozone. For example, Germany’s 10-year bund fell to a .88 percent yield while 10-year debt yields touched 1.24 percent in France and hit a 2.22 percent in Italy. With European Central Bank chief Mario Draghi’s most recent speech in Jackson Hole last week, he essentially took perceived credit risk off the table for the Eurozone. With a compelling endorsement of U.S. style quantitative easing on the horizon, investors clearly are (for the time being) comfortable holding European debt.

Lower rates throughout the Eurozone have effectively put a bid under U.S. bonds. In the global market for debt, savers view U.S. debt as a good deal at these levels and continue to buy. Studies estimate that the downward pressure on U.S. rates from lower European rates is anywhere from 20–30 basis points. As you can see from the chart below, U.S. 10-year yields are at their outer-bounds relative to the yield on the 10-year German bund.

Our Takeaways for the Week

• The U.S. economic expansion has taken hold, and looks to be sustainable throughout the second half of 2014
• Lower interest rates around the world and continued quantitative easing by the Fed has kept a lid on interest rates … for now
• The end of summer brings the anticipation of football season, and the end to QE infinity

Disclosures