Winter 2015 Investor Letter: Narrow Leadership And Heightened Volatility

In our recently published Winter 2015 Investor Letter we discuss the challenging year faced by investors in 2015. A number of notable events occurred in 2015, the market succumbed to a 10% correction after going nearly four years without one, the Federal Reserve raised interest rates for the first time in over nine years, and 2015 equity market returns were concentrated in a handful of names, those names have been referred to as the FANG stocks, Facebook, Amazon, Netflix and Google (now called Alphabet.) Our Investor Letter contains our thoughts on the coming year. These thoughts include commentary on oil, the US Dollar and recent economic activity.

From The Blog of HORAN Capital Advisors

For additional insight into our views for the market and economy, see our Investor Letter accessible at the below link.

• Winter 2015 Investor Letter

Ed Hyman: Halfway Through Current Expansion Cycle

Ed Hyman, Chairman of Evercore ISI, and rated the number one economist for 35 consecutive years by Institutional Investor, recently sat for Part One of a two part interview with Conseulo Mack of WealthTrack, which was aired a few days ago. Also participating in the interview was Dennis Stattman, the Portfolio Manager of Blackrock Global Allocation Fund.

Hyman pointed out many positives he has witnessed in his travels around the country and gleaned from Evercore ISI's business surveys. In short, Ed Hyman believes the U.S. economy is only halfway through its current expansion. He believes the consumer, employment and now broadly rising wages are some factors that continue to support slow but steady U.S. economic growth. The interview does point out his concerns as well.

Dennis Stattman on the other hand, believes greater opportunities for investors can be found in non-U.S. markets. His concern is the U.S. economy and market growth have been largely supported by the Fed's quantitative easing programs. The U.S. market began to stumble last year once the Fed pulled back on its QE endeavors. Additionally, Dennis Stattman believes U.S. firms will find it difficult to grow profits in an environment where corporate profits as a percentage of GDP are at historically high levels. Dennis did not say this, but if one believes QE inflated U.S. equity prices, the European Central Bank and Bank of Japan continue to implement QE strategies.

The interview runs about 30 minutes and is a worthwhile viewing for readers. I will post Part Two when available, likely next weekend.

A Difficult Beginning For The Market To Start The New Year And What Investors Might Now Expect

For stock investors, the poor market performance to start the new year was not what market participants expected. Most readers have seen the statistic that the 5.96% decline in the S&P 500 Index so far this year is the worst market performance to begin a year on record. In an effort to keep things somewhat in perspective,

• since 1928 there have been 421 worse 5-day periods for the S&P 500 Index. (h/t @RyanDetrick)

• in August, the 5-day market decline was -11%.

Influencing investor perceptions is the fact not many asset class categories performed well last year. Except for the FANG stocks (Facebook, Amazon, Netflix and Google (now called Alphabet)) diversifying one's investments across asset classes did not generate expected results and we commented on this in our last post of 2015. Coincident to the narrow market leadership has been the fact the S&P 500 Index has moved higher since the end of the financial crisis in a nearly uninterrupted climb. Until mid-year last year, the S&P 500 had gone nearly four years without a greater than 10% market correction.

From The Blog of HORAN Capital Advisors

Prior to the last correction in August, two back to back sizable declines occurred in 2010 and 2011. One factor evident subsequent to 2011 was the lower volatility exhibited by the market, i.e., lower daily price swings in the market. This is seen in the chart below. The two circles on the chart mark  the period around the time of the 2010 and 2011 corrections.

From The Blog of HORAN Capital Advisors

One theme we believe will play out over the course of this year is a market that has a more normal, that is, higher level of volatility on a daily basis. The start of this year is proving this to be the case.

There are several factors at play that are likely to be a catalyst for the higher level of market swings. The first and probably most significant one is the late stage of this economic expansion with our belief the economy is in the early last third of the cycle. This raises the question of how late in the cycle is the economy. At issue is the divergence in the ISM manufacturing and non-manufacturing indexes.

From The Blog of HORAN Capital Advisors

The ISM Manufacturing Index has fallen below 50 and is evidence of contraction in the manufacturing segment of the economy. According to the report, "contraction in new orders, production, employment and raw materials inventories accounted for the overall softness in December." In reviewing some of the respondents comments in the report, many of them referenced weakness in energy and commodities as an issue.

With respect to the ISM Non-Manufacturing Index, Charles Schwab notes, "With the service sector making up roughly 88% of the U.S. economy according to HFE Research, the easy answer is that the manufacturing sector (the other 12%) will be dragged along. But the cautionary tale is that the manufacturing side of the economy in the past has been a leading indicator; so we do not have blinders on to the risk of a recession if services were to falter. But the consumer-oriented services sector does generally benefit from lower energy prices; while the hit to the energy sector would lessen if oil prices were to stabilize." We also believe the consumer is in good financial shape and will benefit from their improved balance sheets and the benefit derived from lower energy costs.

The second factor is the Fed. In December the Fed increased the Fed Funds rate by .25% or 25 basis points. Historically, when the Fed embarks on a tightening cycle, the market stumbles at the first rate hike. A rate increase from this low of an interest rate level historically does not hinder economic growth. The uncertainty with this rate tightening cycle is the fact economic growth since the financial crisis has been highly supported by quantitative easing activities. Subsequent to the Fed rate increase, the yield curve has actually begun to flatten with longer term rates declining in spite of an increase in short term rates.

From The Blog of HORAN Capital Advisors

So where does this lead us with respect to the equity markets? As a backdrop,

• 240 stocks in the S&P 500 Index are down more than 20% from their 52 week high

• another 160 stocks are down between 10-20% from their 52 week high

• in other words 80% of S&P 500 stocks are down greater than 10% from their 52 week high

• the market is down 9.6% compared to the high reached in May 2015

• if the market falls just 2.8% it will reach the low of August 25th (1,867)

From a technical and sentiment perspective the market is certainly approaching, if not near, oversold levels. With Friday's market close, the VIX futures curve went into backwardation. This occurred near the market bottom on August 22, 2015. VIX backwardation is an indication traders expect volatility in the future to be lower than it is now. Historically, when this occurs, short term market rallies tend to result from this technical event.

From The Blog of HORAN Capital Advisors

The American Association of Individual Investors' report last week showed, in addition to a decline in bullish sentiment to a level last reached in July 2015, the bull/bear spread came in at -16.1% versus the prior week's level of +1.5%. This week's reading is the most bearish the spread has been since July of 2015 as well.

From The Blog of HORAN Capital Advisors

Source: AAII

The equity put/call ratio spiked higher to .93 on Friday. This ratio measures the sentiment of investors by dividing put volume by call volume. At the extremes, this particular measure is a contrarian one; hence, P/C ratios above 1.0 signal overly bearish sentiment by investors. Levels above 1.0 are most associated with an oversold equity market.

From The Blog of HORAN Capital Advisors

The next two charts show the percentage of S&P 500 stocks trading above their 50 and 200 day moving averages. Both charts show the low percentages occur near market levels which have historically been indicative of market bottoms.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

Lastly, a look at the market itself. In addition to the above noted technical and sentiment indicators, the below chart shows the market is nearing an oversold level. The technical money flow index (MFI) is nearing the oversold level, less than 20. The caveat is strong market downtrends can result in the MFI remaining below 20 for an extended period of time. The current MFI level is near the level reached at the August market low. On the other hand, both the MACD and On Balance Volume indicators are not indicating a market ready to bounce. For a number of other reasons also, but these two indicators may indicate the market retests the low reached in August, i.e., S&P 500 Index level 1,867. As noted at the outset of this post, to reach the August low, the market would need to decline only 55 points or 2.8% from Friday's close.

From The Blog of HORAN Capital Advisors

In summary, Burt White, Chief Investment Officer at LPL Research, provided good commentary for investors as they navigate this market environment.

"Risks remain, however, as continued declines in energy prices have delayed vital capital investment by a major segment of the U.S. economy, corporate earnings remain muted, and manufacturing remains weighed down by tepid global demand and a stronger dollar. Although the turmoil in the oil markets remains a top concern, the lower prices should help speed up the painful supply adjustment process and may bring about greater stability as the year unfolds. Should the supply-demand imbalance in energy stabilize as we expect, this could be a potential catalyst for additional capital spending and accelerated profit growth as 2016 progresses." 

"Volatility has always been a part of investing and always will be. In fact, over the last 15 years, every calendar year has seen at least one pullback of at least 6% and a median correction of 14%. So while volatility is normal (and even expected), it is always nerve-wracking. These short-term market flare-ups are often quick and severe, but fueled by feelings of fear and concern over perceived risks that may not be actual threats. We expect volatility to remain heightened for the remainder of 2016, which is common as the business cycle ages, and in turn, makes sticking to your long-term investment plans even more important to avoid locking in losses and missing out on opportunities. This current pullback...could continue over the short term as fear and concern trump much of the good news coming from the U.S. economy. What remains as the key to weathering these short-term bouts of volatility is a commitment to a well-formulated plan, a long-term focus, and good headphones to tune out the noise of short-term negativity."

Tobin's Q Below 1.0 In Q3 2015

As of the third quarter the Tobin's Q ratio declined below 1.0. The Tobin Q ratio was originally formulated by Yale University professor James Tobin. James Tobin is a Nobel laureate in economics. The theory behind the ratio is the combined market value of companies on the stock market should be equal to the replacement cost of company assets. The Q ratio is defined as the ratio of the market value of a firm to the replacement cost of its assets. When the stock market trades at a ‘discount’ to the replacement cost of its assets, the market is inexpensive. This discount is when the ratio is below 1.0. When the ratio is above 1.0, the market trades at a premium to its replacement cost. As the below chart shows, this reading below 1.0 is the first since the Q ratio equaled .986 at the end of Q2 2013.

From The Blog of HORAN Capital Advisors

Since 1990 the average Q ratio level is .94, but certainly skewed by the high Q reached at the height of the technology bubble in 2000. Going back to 1950, the long run average Q ratio is approximately .70. The Tobin Q ratio is not a short term timing indicator; however, it does allow one to evaluate over and undervaluation of the market. In terms of expected returns, the below chart shows future 10-year forward returns at various Q levels. Evident from the chart is lower Q levels are associated with better forward returns.

From The Blog of HORAN Capital Advisors

What are the implications with "Q" values greater than or less than 1.0,? According to the website, Money Terms,

"A Tobin's Q of more than one means that the market value of assets (as reflected in share prices) is greater than their replacement cost. This means it is likely that capex will create wealth for shareholders. This means companies should increase capex, raising more money to do so if necessary, but should not make acquisitions. This should reduce share prices and increase asset prices, pushing Q towards one." 

"A Tobin's Q of less than one suggests that the market value of the assets is less than replacement cost, making acquisitions cheaper than capex; buying cheaper than setting up from scratch. This should increase share prices and reduce asset prices, again pushing Q towards one."

2015 Was A Year For Growth Stocks And Only A Handful Were Needed

The Dow Jones Industrial Average declined 2.2% in 2015, its first negative return year since 2008. The S&P 500 Index fell .7% and the Nasdaq posted a positive 5.7 return for the year. Several interesting phenomenon occurred in 2015: narrow market breadth, strong outperformance of growth stocks versus value stocks and strong performance of the FANGs (Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Alphabet or Google (GOOG)).

• For the year the average return of the FANGs equaled 77.2%. 

• Looking at returns a little more broadly, yet highlighting the narrow market leadership, the average return for the top 10 stocks in the S&P 500 Index by market capitalization were up 25.9%, while the average return of the remaining 490+ were down 1.1%.

As noted at the beginning of the post, there was a large difference in return of large cap growth and large cap value stocks. The S&P 500 Growth Index was up 3.76% while the S&P 500 Value Index declined 5.59%. The growth and value indices do have overlap in the holdings that comprise each of the index. Some key highlights though:

S&P 500 Growth Index (310 names)

• Average return = 9.1%
• Average all positive returns 20.2% (212 companies)
• Average all negative returns -15.0% (97 companies)

S&P 500 Value Index (367 names)

• Average Return = -8.5%
• Average all positive returns 12.1% (136 names)
• Average all negative returns -20.5% (231 names)

Below is a chart noting the 2015 return (not average return) for each respective index.

From The Blog of HORAN Capital Advisors

S&P Dow Jones Indices does use data to construct indexes for "pure" value and "pure" growth parameters.  S&P constructs these indexes with the following parameters in mind:

• Style Index Series: This series divides the complete market capitalization of each parent index approximately equally into growth and value indices, while limiting the number of stocks that overlap between them. This series is exhaustive (i.e., covering all stocks in the parent index universe) and uses the conventional, cost-efficient, market capitalization-weighting scheme.

• Pure Style Index Series: This series is based on identifying approximately one quarter (1/4) of the market capitalization of the index as pure growth, and one quarter (1/4) as pure value. There are no overlapping stocks and stocks are weighted by their style attractiveness.

As can be seen in the below chart, the S&P 500 Pure Value Index is down nearly double the S&P 500 Value Index for 2015. The complimentary pure growth index has generated half the return as the S&P 500 Growth Index; however, the absolute magnitude of the difference is not large.

From The Blog of HORAN Capital Advisors

Lastly, the two charts below show the average sector returns for the growth/value and pure growth/pure value styles. Again, because the pure growth and pure value styles eliminate any overlap between the two indexes, the differing sector returns is clearly visible. For the S&P 500 Pure Value sectors, not one sector has an average return that is positive for 2015. This simply speaks to the significant outperformance of growth versus value in 2015.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

As 2016 gets under way, the significant disparity in growth versus value will be one factor investors will want to evaluate. Value type equities certainly look attractive from a valuation perspective; however, the slow pace of economic growth, both in the U.S. and abroad, have weighed significantly on value stocks. Additionally, energy oriented equities account for three times as many names in the value index and the weak returns in this space have been well written about this year. In the coming week we will have more perspective on our views for 2016.

Individual Investors Still Liking Apple

The below list details the most active stocks reported by Better Investing members. Better Investing members continue to show buying interest in Apple (AAPL). Since my last update of this list in November, General Electric (GE) and Kinder Morgan (KMI) are new additions while Netflix (NFLX) and Johnson & Johnson (JNJ) have fallen from the top 10.

From The Blog of HORAN Capital Advisors

Full View

Disclosure: Firm long AAPL, QCOM. Family Long AAPL, SWKS, GE

Midstream MLPs Potential Funding Hurdles

Stocks in Energy Master Limited Partnerships (MLPs) have experienced some of the worst declines of any sector this year. The below chart of the Credit Suisse X-Links Cushings MLP Infrastructure ETN (MLPN) is a clear example of the magnitude of the decline. From the ETN's high to its low this year, the ETN fell over 52%. In less than a month, and mostly the past week, MLPN has rebounded 19% yet remains 43% below its 52-week high.

From The Blog of HORAN Capital Advisors

Given the magnitude of the decline in MLPs investors are evaluating whether this is an opportunity to begin building positions in the asset class. One decision point revolves around technicals while the other is centered in evaluating the fundamentals of many MLPs themselves. Technically, the recent bounce in some MLPs is placing them near short term overbought levels. In my view it will be the fundamentals that drive the future long term returns of the asset class and it is here where the waters become a little murky.

The growth of shale fracking has been a game changer for the natural gas and overall energy market in the U.S. The over supplied levels for both gas and oil has been written about ad nauseum this year, but suffice it to say the U.S. has abundant supplies of energy resources in the near term.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

The consequence for exploration and production (E&P) MLPs is the increased supply is resulting in lower prices for their product, thus pressuring margins. Historically, the safe plays in MLPs were the midstream companies that essentially transported the product from the well head and then paid a toll based on the volume of oil/gas transported through their pipelines. Therein lies one question, if the E&P companies produce less, will less be transported by midstream MLPs, thus negatively impacting the revenue of the midstream MLPs?

Two additional issues are facing MLPs broadly that are related. As noted above a part of MLP growth has come from the booming natural gas segment, largely a result of shale fracking. In order to handle the growth, MLPs have increased their capital expenditure budgets and financed the expenditures via both equity and debt funding sources. This has occurred at the same time MLPs have strived to grow their distributions to shareholders.

Given the challenges facing many of the E&P MLPs, a few have cut distributions in order to funnel cash flow to capital expenditures due to the inability to access the credit markets without facing potential credit rating downgrades. Additionally, some of these MLPs have resisted issuing equity at these lower stock price levels due to the increased dilutive impact to existing shareholders. Also, the E&P companies will be facing an increasing need to roll over maturing debt.

From The Blog of HORAN Capital Advisors

Source: Ned Davis Research via Twitter
In reviewing the fundamentals then, one common measure used to evaluate MLPs is the debt to EBITDA ratio. In a 2013 Barron's article, Ned Davis Research opined,

“the debt-to-EBITDA ratio of the Alerian MLP Index goes a long way towards explaining returns. When the median stock in the index trades above 2.6 debt-to-EBITDA, MLPs have lost 10% on average. When it’s been below 2.6, they’ve gained 20%...” 

One midstream oriented MLP index is the Cushing MLP Infrastructure Index and all but one MLP in that index has a debt to EBITDA ratio greater than 2.6. Half of the MLPs have debt/EBITDA ratios greater than 5.0 and several are double digits.

From The Blog of HORAN Capital Advisors

Detailed Data File

The next question is what level of financing will be needed going forward to fund growth? The above file contains detail on cash flow from operations versus capital expenditures. In total, the gap that needed to be funded in 2015 with debt or equity is in excess of $11 billion. I also included a more detailed quarterly cash flow report for Energy Transfer Partners (ETP) in order to provide readers with insight into the funding sources and uses of cash by the company. A number of midstream MLP's have similar funding source breakdowns between equity and debt issuance.

As noted earlier in this post, debt is likely to be a more restrictive funding source, so equity is the alternative. With MLP prices depressed, MLP’s are less likely to issue equity due to the level of dilution. The alternative is to cut cap ex, cut the dividend or a combination of the two. Given the market’s negative reaction to recent distribution cuts by several MLPs, managements at MLP companies are likely to take a harder look before cutting distributions and more likely focus on cap ex first. Cutting capital expenditures has the potential negative impact of constraining future growth; however, this is likely what is needed given the U.S. energy glut.

Our Most Read Blog Articles In 2015

Below are links to some of the most read articles on our blog in 2015. Several of the articles written early in 2015 may continue to have relevance as we approach 2016,

• the first article below on how to profit from a rise in oil prices.
• article #10, which highlights issues surrounding a strong U.S. Dollar
• article #5 on the list detailed issues we believed the market needed to resolve in order to generate strong returns this year. Some of the issues we outlined then, like weakness in high yield bonds, have risen to the top of investors minds as the year is coming to a close.
• the last article in the list evaluated the significance of the death cross and how the trigger might be most useful in one's decision making process.

Over the course of the next several weeks we will provide a more comprehensive review of 2015, and more importantly, our outlook for 2016 which will also be included in our Winter Investor Letter.

1. How To Profit From An Increase In Oil Prices When It Occurs (1/29/2015)
   
   
2. A Rising Bearish Wedge Pattern Is Developing In the S&P 500 Index (2/10/2015)
   
   
3. Dividend Paying Stocks Struggling Mightily (5/6/2015)
   
   
4. Additional P/E Multiple Expansion Possible Until The First Fed Rate Hike (3/8/2015)
   
   
5. A Market Needing To Resolve Divergences In 2015 (1/2/2015)
   
   
6. Ed Hyman: Bull Market In Early Stage (1/11/2015)
   
   
7. Bullish Sentiment Declines To Level Last Seen In Early 2013 (3/19/2015)
   
   
8. Mega Cap Stocks Driving Market Returns (12/5/2015)
   
   
9. Shale Oil And Gas Production Projected To Increase In February (1/17/2015)
   
   
10. Dollar Strength Continuing Headwind For Emerging Market Equities (10/6/2015)
    
    
11. Anemic Economic Growth Since The Great Recession And Some Causes (5/11/2015)
    
    
12. Market Advance Not Extraordinary In Terms Of Magnitude And Duration (2/27/2015)
    
    
13. Death Cross More Of A Buy Signal? (9/2/2015)
    

Retailers Poised To Offer Significant Discounts In The New Year

The business inventory to sales ratio and retail inventory to sales ratio are above or near levels last seen prior to the last recession. In an article in the Wall Street Journal ($) this morning it was noted, "Sales at physical stores fell 6.7% over the most recent weekend, while traffic declined 10.4%, according to RetailNext, which collects data through analytics software it provides to retailers. That is worse than the 5.8% decline in sales and the 8% drop in traffic recorded from Nov. 1 through Dec. 14." This build up in inventory at the retail level as well as in the pipeline, likely results in brick and mortar retailers offering significant discounts after Christmas.

From The Blog of HORAN Capital Advisors

The major challenge for brick and mortar retailers is the consumer's desire to shop online. Data through the third quarter reflects the growth in online purchases.

From The Blog of HORAN Capital Advisors

The continued popularity of online shopping is a challenge brick and mortar retailers will not easily resolve.

Buybacks And Dividends Exceeded Reported Earnings In Third Quarter

For the third quarter, S&P Dow Jones Indices is reporting that on a quarter over quarter basis buybacks for S&P 500 companies increased 14.5% and increased 3.7% on a year over year basis. The dividend plus buyback yield for the index is 5.53% and is at the highest level since the fourth quarter of 2011. The third quarter total of buybacks and dividends of $245.65 billion exceeded reported earnings of $205.90 billion. This is the fourth consecutive quarter that buybacks and dividends exceeded reported earnings. Highlights from S&P's buyback releases:

• For the seventh consecutive quarter, over 20% of the S&P 500 issues reduced their year-over-year diluted share count by at least 4%, therefore boosting their earnings-per-share (EPS) by at least 4%.

• Total shareholder return, dividends plus buybacks, set a 12-month record, at $934.8 billion.

• “...14.6% of the S&P 500 issues have a current share count level at least 4% lower than their Q4 2014 level, meaning that those issues have already front-loaded at least a 4% tail wind to their Q4 2015 EPS,” according to Howard Silverblatt, Senior index Analyst at S&P Dow Jones Indices.

From The Blog of HORAN Capital Advisors

As detailed in the below table, the industrials sector has the highest combined dividend plus buyback yield of all the S&P 500 Index sectors at 6.72%.

From The Blog of HORAN Capital Advisors

It seems apparent that companies took advantage of the third quarter market weakness in the third quarter to reduce their share count. Historically, this has not always been the case as I noted in an article a few years ago; however, Q3 seems to be the exception.

From The Blog of HORAN Capital Advisors

One key to continued strength in buybacks and dividend growth will be the ability of companies to grow earnings and cash flow. Silverblatt noted in the report, 

• Silverblatt stated that cash reserves declined 1.4% during the third quarter as S&P 500 Industrial (Old) available cash and equivalent decreased to $1.30 trillion, from the second quarter’s $1.32 trillion, and was 2.1% below the record $1.33 trillion set at the end of 2014.

• “High levels of shareholder return are now part of norm, with dividend increases almost assumed for non-commodity issues, and buybacks, while receiving bad-press, are expected to continue. Companies continue to have the resources to support these expenditures via cash-flow and still low financing rates. However, given that the Fed has now started to increase interest rates, debt financing will become more expensive, albeit slowly, putting pressure on buybacks. Cutting or limiting buybacks may not be a welcome move for investors, but scaling back dividends is typically a road that management avoids at high costs.”

Source:

S&P 500 Q3 Buybacks Increases 14.5% Over Q2 2015, Up 3.7% Year-Over-Year
S&P Dow Jones Indices
By: Howard Silverblatt, Senior index Analyst
December 21, 2015

Industrial Production Turns Negative

This afternoon the Fed raised interest rates by 25 basis points, i.e., .25%. Certainly a quarter point hike in rates should not have a significant impact overall. However, the economy does seem to be shifting into a lower gear. One note of caution is the industrial production report this morning. The report shows the first year over year decline since the end of the last recession. As the below chart shows, a negative reading on industrial production nearly always occurs around recessionary periods.

From The Blog of HORAN Capital Advisors

Econoday's report on the release contained a couple of highlights.

• November was another weak month for the industrial economy, in part reflecting unusually warm temperatures that are driving down utility output. Industrial production came in down a very sharp 0.6% in November. This is the biggest drop in 3-1/2 years. Utility output fell a monthly 4.3% after falling 2.8% in October. Mining, reflecting low commodity prices and contraction in energy extraction, has also been week, down 1.1% for a third straight decline.

• This brings us to the most important component, manufacturing, where October's 0.3 percent bounce higher (revised downward from 0.4 percent) now unfortunately looks like an outlier. Manufacturing production came in unchanged in November reflecting weakness in motor vehicles, down 1.0 percent in the month, and also a dip back for construction supplies which fell 0.2% after a weather-related surge of 2.3% in October. One positive is a slight snapback for business equipment which, after declines in the two prior months, rose 0.2%.

• All the weakness is pulling down capacity utilization, to 77.0% in November for a heavy 5 tenths dip. Utilization is running more than 3 percentage points below its long-term average. Mining utilization is now under 80%, down 1.1 points in the month to 79.4%. Utility utilization fell 3.4 points in the month to 74.5% with manufacturing utilization down 1 tenth to 76.2%. Excess capacity, though not cited as a major factor behind the lack of inflation in the economy, does hold down the cost of goods.

This poor reading on industrial production is occurring in an environment where the U.S. economy is growing at a below trend pace. The weak industrial production number could be an indication of slower economic growth ahead. The industrial production and related capacity utilization figures are considered coincident indicators, meaning that changes in the levels of these indicators usually reflect similar changes in overall economic activity, and therefore gross domestic product (GDP). The release will shed light on short-term rates of change and business cycle growth. As the below chart notes, economic growth since the end of the financial crisis has been running  nearly 50% below the average growth rate of the economy since 1950.

From The Blog of HORAN Capital Advisors

Junk Bond Risk Leading To A Potential 'Blood In The Streets' Environment

Investor attention at the end of last week's trading was focused on the sharp sell off in high yield bonds, better know as junk bonds. This sell off was precipitated by the firm, Third Avenue, restricting redemptions on its Focused Credit Fund. Subsequent to Third Avenue's announcement, Stone Lion Capital Partners L.P. said it suspended redemptions in its credit hedge funds due to the high level of redemption requests it has received. Many stories have been written about the events impacting the high yield bond market, here and here. 

In reality, a better classification for the Third Avenue Focused Credit Fund is probably a distressed debt fund or special situation fund. The fund's "focused credit" reference means just that, the fund is highly concentrated with nearly 30% of the fund's assets invested in its top 10 bond holdings. In other words, the fund is not a diversified bond fund. Our clients know we eliminated our high yield bond exposure in July of 2014. One reason we sold the high yield exposure last year was due to the narrow spreads on high yield broadly as reflected by the red dot in the below chart. This tight spread characteristic is an indication of the rich valuation of the high yield asset class at that time.

From The Blog of HORAN Capital Advisors

The issues surrounding high yield are being felt in the equity market as high yield bonds and stocks are highly correlated. Last week the Nasdaq declined 4.1% with the S&P 500 Index and the Dow Jones Industrial Average both declining 3.8% and 3.3%, respectively. For the year both the Dow and S&P 500 Index are essentially flat for the year on a total return basis while the Nasdaq remains up a little over 4.0% year to date. On a price only basis the S&P 500 Index is down 5.6% from its high in May.

The pullback last week has resulted in the CBOE Equity Put Call Ratio spiking higher to .92 as can be seen in the chart below. As I have noted in earlier posts, P/C ratios over 1.0 are representative of an oversold market. The second chart shows the VIX index and this fear measure has also jumped higher to 24.4. Readers can track these fear measures here.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

One near term concern we discussed in a mid-November post was the fact the On Balance Volume indicator (OBV) continued to show more trading volume on down days than on up days. This has been the case all year and has resulted in a downward sloping trend for the OBV a noted by the second white line in the below chart. From a positive perspective some technical indicators are beginning to look more favorable (CBOE P/C ratio noted earlier), but also indicators like the Full Stochastic Indicator below.

From The Blog of HORAN Capital Advisors

The risk developing in the junk bond market is a consequence of the Fed's extended near zero interest rate policy and investors feeling the need to reach for yield. Similar challenges have developed in the energy Master Limited Partnership (MLP) space. The belief is the Fed desires to begin removing the proverbial bunch bowl and raise interest rates at the conclusion of next week's Fed meeting. I suppose it is possible the recent issues facing the bond market could result in the rate increase being pushed into early next year.

Many of the headlines over the weekend were bearish ones with valid concerns about the high yield bond issues spreading into other areas of the market. On the other hand, this week's Barron's cover story highlighted 2016 forecast by ten strategists and all ten predicted higher equity returns for next year, with the average equaling 10%. With the issues facing the high yield bond market and a potential Fed rate hike around the corner, higher volatility in equities could face investors as the year nears its end. If this volatility is on the downside, Baron Rothschild, a member of the Rothschild banking family, is created with saying, "Buy when there’s blood in the streets, even if the blood is your own."

The Facts Behind A Disappearing Middle Class

Today, a number of media outlets have been discussing the disappearing middle class. The report was released by the Pew Research Center and notes, in 2015 21% of households comprise the top two income tiers, with Pew defining as more than twice the nation’s median income or at least $126,000 a year for a three-person household, which is up from 14% in 1971. For the bottom two income tiers, a three-person household earning $42,000 a year or less, in 1971 25% of households were in the lower two earning tiers versus 29% in 2015. The media outlets failed to provide detail around the cause behind this change.

Below is select commentary from the website Political Calculations and the author's article, Solving the Mystery of the Disappearing U.S. Middle Class, which provides detail behind this shrinkage in the middle class. With the ranks of both the lowest and highest income earning American households simultaneously increasing as the ranks of middle income earning Americans have become depleted. But who were the biggest winners and losers?"

• "The biggest winners since 1971 are people 65 and older. This age group was the only one that had a smaller share in the lower-income tier in 2015 than in 1971. Not coincidentally, the poverty rate among people 65 and older fell from 24.6% in 1970 to 10% in 2014. Evidence shows that rising Social Security benefits have played a key role in improving the economic status of older adults. The youngest adults, ages 18 to 29, are among the notable losers with a significant rise in their share in the lower-income tiers."

"What the Pew Research Center's analysts were seeing in the 'hollowing out' of the U.S. middle class wasn't the result of some nefarious cause, but rather the inevitable result of the changing age demographics of the U.S. population. More specifically, the differences in the size of the living population of the U.S. by generation. The chart below shows the number of Americans born, whose births were registered, in each year from 1909 through 2004, while also indicating their generational grouping."

From The Blog of HORAN Capital Advisors

Source: Political Calculations

The next chart below provided by Political Calculations shows the income distribution by the last three generational groups.

From The Blog of HORAN Capital Advisors

Source: Political Calculations

The article notes,

• "What we see is that Baby Boomers, who would be Age 51 to Age 69 in 2015, occupy the ranks of the highest income earners in the U.S., while Millennials, who would be Age 16 to 33 in 2015, occupy the ranks of the low end of the income earning spectrum."

• "Meanwhile, we see that the much smaller Generation X finds itself sandwiched between these two larger generations in the ranks of the middle class."

• "Is it really any wonder then that the number of middle class households has shrunk as it has while the apparent income inequality among U.S. households has increased?"

"The mystery of the disappearing U.S. middle class is solved - the apparent movement of Americans toward the "economic extremes" is primarily the result of the changing age demographics of the U.S. income earning population (emphasis added)! Now, if we could just get a better class of journalists to dial down their overly excited and poorly considered emotional hyperbole...."

Additional detail can be found by reading the entire Political Calculations article.

A Fed Rate Increase May Be Larger Headwind For Short Maturity Bonds

Whether the Fed raises rates in December or early in 2016, many market strategists believe higher interest rates will be a reality very soon. A few of our recent articles mentioned our belief that the Fed missed the opportunity to raise rates twelve or eighteen months ago and a rate rise now will be implemented simply in order to provide the Fed with a cushion in the event additional stimulus were needed. Certainly the Fed has used other extraordinary means in an effort to stimulate the economy other than rate adjustments over the last few years.

Nonetheless, the anticipated change in Fed policy to one where rates begin to move higher can have short term negative consequences for bond investors as we have written recently. All bonds will not react the same as rates are increased though. Logically if would seem the largest negative impact will be felt at the long end of the yield curve; however, the below chart compares the yield curve shifts over the last several years. What is occurring is longer rates are actually declining with rates on the short end, under five years, increasing. In other words, the curve is flattening with the twist occurring around the five year maturity range resulting in poorer total return for shorter maturity bonds than longer ones.

From The Blog of HORAN Capital Advisors

Certainly rising rates can have an impact on long rates; however, another key variable is the level of inflation. What the economy has not seen during this recovery is a move to higher inflation. On the contrary, with the contraction in energy and commodity prices, along with a stronger U.S. Dollar, inflation has remained near zero as can be seen with the red line in the below chart.

From The Blog of HORAN Capital Advisors

A potential catalyst to increased inflation is the fact consumer wage growth has been accelerating over the past three years despite what gets reported in the media. Since the consumer accounts for about 70% of economic activity in the U.S., higher wages can result in more buying pressure and thus the potential for higher selling prices on goods and services. Additionally, consumers are getting an indirect boost in their income as a result of the contraction in energy prices. Consumers are paying less for gasoline and utilities, leaving more income available to be spent on discretionary purchases. In addition to a strong U.S. Dollar, the increased efficiency being created by the internet and cloud via growth in e-commerce seems to be keeping a lid on price inflation. The end result near term is the worst performing segment of the bond market in terms of maturity may be on short term bonds versus the long term ones.

Mega Cap Stocks Driving Market Returns

One aspect of the market recovery since the August/September lows has been the narrow market breadth. The Russell 1000 Index return has been held up by the large mega cap stocks within the index. This has been the case for the S&P 500 Index as well. As the below chart shows, the yellow line representing the year to date return for the Guggenheim Russell Top 50 Index (XLG) has outpaced both the iShares Russell 1000 Index (IWB) return and the Guggenheim S&P 500 Equal Weight Index (RSP) return.

From The Blog of HORAN Capital Advisors

The other phenomenon occurring this year is the wide disparity in performance of growth and value stocks. The below chart shows growth stocks within the S&P 500 Index are outpeforming the value stocks within the index by nearly ten percentage points. The value index is being weighed down by several of its top weighted sectors like energy and industrials. Additionally, both Exxon Mobil (XOM) and Chevron (CVX) are represented in the top 10 holdings in the iShares S&P 500 Value Index (IVE) and energy broadly has been one of the weakest market sectors.

From The Blog of HORAN Capital Advisors

It seems one can not give away some of the industrial and energy companies. Recent headwinds of a strong U.S. Dollar and low energy prices have negatively impacted many industrial and energy stocks. With the Fed seemingly near liftoff for interest rates, further Dollar strength is likely and will continue to pressure multinational companies like industrial and energy firms. A silver lining is the fact year over year comparison for energy prices and the Dollar begin to get easier starting in the first quarter of 2016. This would put less negative pressure on earnings growth for some of these companies through 2016, all else being equal.

Gold And The Equity Markets

Gold prices have not been immune to the broader issues facing the overall commodity market. Year to date, the price of gold is down 10.8% while the broader CRB Commodity Index is down 20.3%. A part of the issue negatively impacting the price of gold is output is outpacing demand. With the decline in the price of gold the cost to extract gold exceeds the market price in many cases.

From The Blog of HORAN Capital Advisors

More importantly though, gold is mostly transacted in US Dollars and the strength in the Dollar is a headwind for the price of the metal. The light blue line in the below chart represents the trade weighted Dollar Index compared with gold prices (yellow line). The lines show gold price weakness as the Dollar strengthens. Gold has a negative .65 correlation to the trade weighted Dollar index. With the Federal Reserve nearing lift off for U.S. rates, additional Dollar strength will likely be an outcome into 2016.

From The Blog of HORAN Capital Advisors

Additionally, the red line in the above chart shows the ratio of the S&P 500 Index to the price of gold. This ratio has a positive correlation to the trade weighted dollar and is partly a result of weaker gold prices as the Dollar rises. Another important factor that contributes to the upward sloping red ratio line is a rising S&P 500 Index. The obvious factor that contributes to higher equity prices is the growth in earnings and therein lies the issue for equity prices. As the below chart shows, earnings growth for the S&P 500 Index will be negative for two successive quarters if earnings are negative for the fourth quarter. This would be the first back to back quarterly earnings decline since 2009. The second chart below shows 12-month forward earnings estimates for the S&P 500 Index and the negative growth expectations are weighing negatively on recent S&P 500 returns.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

A large part of the earnings weakness is being attributed to the stronger Dollar and its negative impact on multi national companies as they convert foreign earnings back to the Dollar and the negative earnings issues impacting much of the energy sector. As the calendar rolls into 2016, both the currency and energy comparisons should be less of a headwind on a year over year basis.

Absent some type of shock or fear event, gold prices, like many commodities, are likely to remain pressured due to a stronger Dollar and an excess gold supply. For the S&P 500 Index, and equities broadly, a resumption of earnings growth going into 2016 will be necessary for equities to move higher. 

Replacing Federal Reserve Rate Decisions With A Mathematical Formula?

Natixis Global Asset Management recently published a white paper, Can the Federal Reserve Be Replaced by a Mathematical Formula?, highlighting the Fed Oversight Reform and Modernization act approved by the Financial Services Committee of the House of Representatives. This Act would require the Fed to establish a mathematical formula in setting interest rate policy. Not surprisingly, the Fed is not in favor of this type of proposal.

Several highlights in the Natixis paper:

• The positive side is that it could force the Federal Reserve to monitor developments that it has completely overlooked in the past: credit, asset prices, liquidity, external deficit; it would then need a more complex formula than a Taylor rule;

• One negative side is obviously that a mathematical formula cannot take into account the complexity of an economic situation: dozens of variables would have to be included (real growth, labour costs, longterm interest rates, savings rate, detailed situation of the labour and real estate markets, etc.);

• Another negative side is that in contemporary economies, central banks have - and will probably increasingly have - instruments other than the short-term interest rate: purchases and sales of financial assets (bonds, ABS), quantitative easing when interest rates become zero, banks’ prudential ratios, etc. Should each instrument be determined by a mathematical formula?

• This plan will in all likelihood be abandoned. However, we should not forget that the Federal Reserve’s choices, not guided by a mathematical formula, have quite often been catastrophic over the past 20 years (by accepting asset price bubbles, external deficits, excessive debt levels, etc.). Automating these choices would not have only drawbacks.

The Taylor Rule is one mathematical formula that gets attention and is used by some to determine what the Fed Funds rate should be. The Taylor Rule looks at inflation and employment levels, which today suggests the Fed Funds rate should be near 3%.

From The Blog of HORAN Capital Advisors

The paper notes that today the Fed uses other monetary tools other than adjustments to short term interest rates:

"purchases or sales of financial assets, generally as part of a quantitative easing programme; in the future, increasingly, banks’ prudential ratios (capital ratios, required reserves, etc.). This makes it possible to markedly increase the effectiveness of monetary policy compared with a situation where only the short-term interest rate is controlled, especially by also controlling long-term interest rates"

By not using a formula and,

"By freely setting monetary policy over the past 20 years without being constrained by the use of a mathematical formula, the Federal Reserve has let the following appear:

• A huge US external deficit from 2002 to 2008;
• Recurrently, excessive private-sector debt levels;
• Asset price bubbles;
• Useless excess liquidity.

"A more complex mathematical formula than a Taylor rule could have forced the Federal Reserve to react to these developments and to not let excessive indebtedness and asset price bubbles develop, which led to the subsequent financial and banking crises."

One conclusion from the white paper notes a formula alone may not serve as the only solution; however,

"But we should not forget that a complex formula that takes into account credit, asset prices, external deficits, etc. would prevent the errors of judgement and monetary policy choices that for the last 20 years have led to - particularly in the United States - crises linked to excessive indebtedness and bursting asset price bubbles."

Source:

Can the Federal Reserve be replaced by a mathematical formula?
Natixis Global Asset Management
By: Patrick Artus
November 27, 2015

E-Commerce Sales Growth Challenging Traditional Retailers

Brick and mortar retailers continue to face the challenge brought about by the continued growth in e-commerce sales. As the below chart shows, e-commerce sales as a percentage of total retail sales has grown to 7.4% from just under 3% at the beginning of 2006. From a growth perspective, year over year growth in e-commerce sales remains steady at over 15%. 

From The Blog of HORAN Capital Advisors

Thankful For The Market Action So Far In 2015

In the spirit of Thanksgiving, investors and readers can be thankful the market has weathered the news headlines headwinds coming out of Europe and the Middle East. Looking at the positives and not sweating the small stuff can certainly make for a happier investor. A recent opinion article in the New York Times, Choose to Be Grateful. It Will Make You Happier, touches on this issue.

The S&P 500 Index ended the pre-Thanksgiving Holiday trading day essentially unchanged, closing at 2,088.87. This unchanged outcome is what the market has delivered to investors for most of the eleven months of the year. As the below chart shows, the S&P 500 Index has been stuck in a 6% trading range (maroon box) except for the decline between August and September. This August and September period resulted in the market contracting 12.3% from its May high to the August low. The quick recovery from the double bottom reached in September has simply taken the market back into its year long trading range. On a price only basis, the S&P 500 Index is up just under 2% so far in 2015.

From The Blog of HORAN Capital Advisors

As investors return to the market following the Thanksgiving Holiday, they will face the uncertainty surrounding the Fed's rate decision in mid December. Until then though, the market's trading range may persist until the rate uncertainty is resolved.