Back to Basics: News from Hutchens Investment Management

 
CONCORD, N.H. - May 6, 2014 - PRLog -- A Mule between Two Bales of Hay.

Recent stock market action reflects a growing uncertainty among investors on the prospects of future economic growth and in turn, earnings. The economy is showing signs of increased vigor as the post- winter data are released, a confirmation that the December 2013-February 2014 slowdown was weather related. Thus far, 1Q2014 earnings reports have been better than anticipated. Institutional investors, shaken by the sharp selloff in the high beta momentum stocks appear undecided about growth or value. This recent assault has forced investors to rethink their allocation and to reconsider the less risk lower alpha value stocks. Hedge funds, reeling from poor relative performance over the past few years, have targeted small cap growth, severely punishing high multiple stocks showing any signs of a slowdown in earnings. The absence of an uptick rule for short sales has exacerbated any selloff. Emerging markets have seen a return of the inflow as algorithmic traders using ETFs pile on. Meanwhile, the major averages flirt with new highs, and with stocks fairly valued and low interest rates, US equities are still the investment of choice. (Note: Further investigation shows the mule does not starve, but after some hesitation, chooses one of the piles of hay.)

Economic Runoff.

The latest economic data support the view of a winter-related economic slowdown beginning in December 2013. April nonfarm payrolls are up 288,000, well-above the 210,000 estimate and revisions for February/March added an additional 38,000 net jobs. The near record drop in the unemployment rate to 6.3% from 6.7% was attributable to reduced labor force participation as withdrawals increased as extended unemployment benefits expired. The April Manufacturing ISM increased to 54.9% from 53.7%, this was the 11th consecutive month of expansion (+50%). Solid gains in the ISM were reported for orders, production, and employment. According to the Commerce Department, consumer spending rebounded by 0.9% in March, another confirmation of a weather-related slowdown. However, existing home sales remain weak, as the March sales were flat against February and down 7.5% compared to March 2012.

Housing – Not Today!

In our April 25th Report, we discussed the recent slowdown in the housing sector and raised the possibility of an inflection point in the spring. Unfortunately, the problems which we discussed are more fundamental than just bad weather. This has been confirmed by weak housing data for March. Constraints on both the supply and demand sides will take additional time to readjust and move to a workable equilibrium. Housing, which was important to growth in 2012 and most of 2013, has declined to about 3% of GDP from 6%.

Of particular concern to homeownership is the first time buyer. Even with a 30% increase in mortgage rates to 4.40% for the 30-year fixed, rates remain historically low. The inventory of lower cost homes remains low after large investors swooped in and purchased not only distressed housing but existing homes for sale, discounted at 50-60% as potential buyers, stung by the financial crisis, were retrenching. Another constraining factor for many younger potential homebuyers not readily discussed is the burden of student loans. Prior to the financial crisis, student loan debt was viewed positively by banks and mortgage companies if payments were up to date. Due in part to new government mortgage regulations, this positive correlation is now viewed as a negative and the debt burden as an impediment to securing financing. Today this debt burden is seen as burdensome due to the fact that student debt increased 60.4% from 2005-2013 with a record 11.5% of the $1.08 trillion delinquent 90 days or in default. No doubt the high rate of unemployment has been a major contributor to this problem. The recent increase in monthly employment to a 2.5 million annual rate, should it continue, will be a benefit, but by no means an immediate solution. Also, the proposed controversial legislation in both the House and the Senate for an income-based repayment system for student loans will not be brought to the floor until after the mid-term elections.

Earnings – Changing Tides?

According to FactSet, with 371 of the S&P 500 companies reporting 1Q2014 earnings, 74% have reported EPS above the mean estimate and 52% for revenues. The current 12-month forward P/E is 15.3X, above the 5-year (13.2X) and 10-year (13.8X) average. In aggregate, 1Q2014 earnings are 5.4% above expectations, this is slightly below the 4-year average of 5.8%. Revenues on the other hand are 1.1% above estimates, but surprisingly this is above both the 1-year (0.3%) and the 4-year (0.6%) averages. For full-year the earnings growth rate estimate for the S&P is at 8.2%, below the 10.8% at year-end 2013. This brings total EPS to $18.50.

More interesting has been the shift in estimated earnings growth rates among the major S&P 500 sectors. Of particular note is the estimated increase in Healthcare and the small reduction for Technology. The two sectors comprise 32% of the S&P market cap while Telecom, Utilities and Materials are less than 9% of the total weighting. Federal Government healthcare expenditures are a direct influence on these revisions. The increase in Obamacare spending was at a 9.9% annual rate in 1Q2014 this follows a 5.6% annual increase in 4Q2013. Prior to the start of Obamacare, government expenditures averaged 2.5% over the prior four years. For Technolgy, the increase can be tied to capital spending as corporate upgrades are centered on enhancing productivity. More recently, it has been access to the cloud, a paradigm shift with long-term cost advantages.

More troubling are the sharp declines forecast for Consumer Discretionary and Staples which are about 22% of the S&P weightings. Given the full-year earnings downward adjustments for these two sectors and the high current multiples (19X), consumer-oriented stocks are, in our opinion, vulnerable on value alone. Interestingly, despite the downward revisions, the Consumer Discretionary sector consensus earnings are estimated for 2Q2014 at +12.3% as of last week. This is remarkable in light of the fact that for those 34 companies giving guidance, 33 were negative. Recent economic data show increases in personal consumption expenditures. It is too early to conclude whether these lowered estimates reflect consumer retrenchment or a return to earth for analysts.

Our investment policy remains long-term optimistic on corporate equities. Contrary to most strategists, we believe that continued economic growth, accompanied by rising real interest rates, will result in a multiple expansion for equities.

Authors:

David Minor
Rebecca Goyette

Editor:
William Hutchens

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Hutchens Investment Management
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