“Waiting for Godot”
Play by Samuel Beckett

In many ways the absurdist play written by Samuel Beckett is a metaphor for the current discussion of future Fed policy. Overanalyzed with endless hyperbole, the Fed’s winding down of QE3 will most likely qualify as a non-event at its implementation. Chairman Bernanke has given no specific exit plan, only that it is data dependent. Economists and market strategists, wrong on their forecasts over the past few years, blame the Fed, giving rise to the assumption that they are incapable of a smooth policy adjustment. While there may be a short-term fallout for equities, when initiated, the economy will be stronger and the unemployment rate will be lower. Longer-term investors will want more exposure to equities, providing the catalyst, along with moderately rising interest rates, for the “Great Rotation” discussed in last week’s report. In the play Godot never came.

Chances are by year-end the Fed policy for exiting QE3 will have begun. Despite the negatives voiced by market strategists of the tapering or suspension of bond purchases, stocks, as measured by the S&P 500, have risen over 14% since the beginning of the year, and are now 150% off the fiscal crisis bottom in March 2009. The economy is forecast to accelerate in the latter part of 2013. Housing will continue to drive GDP growth with improvements in sentiment as house prices tick upward, and jobs are opened in construction and ancillary businesses. A lessening of the fiscal drag will add to growth. Even today the Sequester has not slowed down the economy as erroneously predicted the Administration and, in fact, the deficit is now 5% of GDP, compared to 10% only a short while ago. Core inflation, currently rising 1.7% year-over-year, presents no impediment to policy implementation.

Rates will rise, but not to the levels forecast by the perma-bears. With any slowdown in emerging countries’ growth, funds will shift to the more stable US markets rather than Europe, providing a floor for US equities and an additional inflow into fixed-income. Most adversely affected will be ETF and mutual fund bond investors, who will not comprehend the decline in principal until their statements, as rates move higher. According to well-respected authorities in housing research, mortgage rates will have to rise above 5% to present a meaningful deterrent to the current recovery. More stringent requirements for mortgages have already removed those borrowers affected by moderately rising rates.

Our investment strategy remains a full position in equities. The increased volatility is indicative of market uncertainty, not of a chaotic outcome of Fed policy. However, the run-up since the beginning of the year for equities and the recent rise in interest rates makes the possibility of a correction more likely. Longer term earnings growth should accelerate later in the year as private economy growth accelerates and the next leg of the bull market rises to new all-time highs and a return to the “Old Normal.”

Authors:                                                                                                
David Minor                                                                                                Rebecca Goyette

Editor:
William Hutchens

 “Rotation or Speculation?”

A head-fake earlier in the year sent many market strategists to prematurely predict the beginning of the “Great Rotation” from fixed income to equities (Compass 01-15-13).  Revisiting that proposition today shows just how premature it was.  No doubt, interest rates will be higher when the QE’s are ended; but the complexion of the investment landscape may take more time than is generally acknowledged to qualify as a rotation.  Last week as concerns over a Fed policy change drove stocks lower, the 10-Year Treasury bond rose above 2.10%, the highest level in 13 months.  This rate is nearly 60% above the lows of July 2012.  We suspect this increase is in anticipation to what investors believe will be a prolonged upward move in rates rather than supply/demand driven from an improving economy.  

As reported by Morgan Stanley (MS), for January through May equity mutual funds had a net inflow of $30 billion compared with an outflow of $17 billion for the same period last year.  Breaking down the data thus far for 2013, domestic equity net inflow was only $1 billion and foreign $29 billion.  However, this is a reversal of the $17 billion outflow for domestic equities in 2012.  For fixed-income, total mutual fund net inflows year-to-date were $45 billion, 28.6% lower than the $63 billion recorded for January – May 2012.  Net equity ETF inflows showed a dramatic increase since the beginning of 2013, $51 billion versus $25 billion in 2012.  Unfortunately, only total equity is reported for the ETF category and the foreign flow is included.  Similar to the mutual fund data, bond ETF’s flow declined year-to-date to $14 billion from $25 billion for the same period in 2012.  

Bond prices reached their highest levels last summer and have fallen to their lows today.   According to MS, bond mutual funds and ETF bond flows have been net positive in 88 of the past 91 weeks.  While money has moved into equities it is not yet readily apparent that this is a reversal rather than a drawdown of cash.  This is evidenced by a decline of $160 billion in money market funds over the same period.  Our research shows that Japan has been the recipient of strong inflows from both mutual funds and ETF equity investments.  New data should confirm our research as these investments have recently soured.  After rising 47.4% from January 1st, 2013 until the peak on May 22nd, since then the Nikkei has fallen 14.8%, but is still up 25.6% year-to-date.  We believe that ETF investing, aside from Japan, has been concentrated in emerging markets as well as developed country stocks.  There is a strong probability that the increase in ETF equity inflow is more speculative and unrelated to the rotation out of bonds.  With hedge funds underperforming the S&P 500 (5.6% vs. 14.1%) the pressure for outsized gains has sent them overseas and into more risk-oriented ETF’s.  

Our investment strategy remains a full position in equities.  The increased volatility is indicative of market uncertainty, not of a chaotic outcome of Fed policy.  However, the run-up since the beginning of the year for equities and the recent rise in interest rates makes the possibility of a correction more likely.  Longer term earnings growth should accelerate later in the year as private economy growth accelerates and the next leg of the bull market rises to new all-time highs and a return to the “Old Normal.”

Authors:                                                                                                
David Minor                                                                                                Rebecca Goyette

Editor:
William Hutchens

A Return of the “Old Normal”

As the investment world spends untold hours analyzing and modeling the potential outcome of a Federal Reserve policy change, the economic landscape trudges toward a natural rate. In actuality, the Fed will begin the tapering/unwinding of QE3 when the economy is capable of sustained unbridled economic growth. This seems far too logical and devoid of the chaos foretold by investment strategists. Interest rates, held artificially low since the inception of QE1 in December of 2008, and its subsequent follow-on’s, provide a safety net, fostering slow economic growth and outsized investment returns. Major averages recently surpassed their pre-crisis levels and bond investors have been rewarded with double-digit returns. This time spent under Fed monetization is referred to as the “New Normal.”

If you have not noticed, Fed policy is about to change and the consequences could be dire. This information comes from everywhere but the Federal Reserve. Chairman Bernanke has stated unequivocally the Fed will do what it believes necessary, but the when and how is unknown. As we discussed at length two weeks ago, the transition, when it occurs, may be far smoother than generally anticipated. Prior to implementation, key elements in place will be an economy with self-determining growth accompanied by lower unemployment. Should the Fed’s move prove premature, it stands ready to reintroduce palliative measures. All seems pretty simple to us.

The economy is well-positioned to move later in the year to fulfill Fed preconditions. While all eyes will be turned to the May employment release on Friday, these data are more of a lagging indicator heavily influenced by structural impediments (the margin of error is plus or minus 100,000 jobs). Currently, economic data are signaling a Spring soft spot, however, most negatives to economic growth are widely known and already in stock prices. These include the “fatal effects” of the Sequester, slow employment growth, deteriorating quarterly earnings, stagnating global growth, and more recently political scandal. On a brighter note, the housing recovery is broadening and despite the musings of the bubble crowd it is far from heating up. In fact, April home sales and starts are 67.3% and 52.6%, respectively, below their 2005 monthly highs. According to the March S&P/Case-Shiller data, the Home Price Composite Index, although up for all 20 cities year-over-year, is up only 10% off its lows and remains 28% below the pre-crisis highs.

Our investment strategy remains a full position in equities. The rise in market volatility in the past few weeks (+30.8%) is to many a confirmation of future market instability. To us, the increased volatility is indicative of market uncertainty, not of a chaotic outcome of Fed policy. However, the run-up since the beginning of the year for equities and the recent weakness in the economic data makes the possibility of a correction more likely. Longer term earnings growth should accelerate later in the year as private economy growth accelerates and the next leg of the bull market rises to new all-time highs and a return to the “Old Normal.”

Authors:                                                                                                
David Minor                                                                                                Rebecca Goyette

Editor:
William Hutchens

HUTCHENS INVESTMENT MANAGEMENT NAmeD BY LIPPER MARKETPLACE As Top FUND IN LARGE CAP EQUITY CATEGORY

Naples resident William Hutchens’ firm Hutchens Investment Management announced today that Lipper MarketPlace has recognized the Large Cap Equity product as a top performing fund in its category.

Lipper MarketPlace (formerly known as "Nelsons") maintains a database of information on over 2,000 investment managers and their investment products. The investment performance of the Hutchens Investment Management Large Cap Equity product ranks 34th out of 666 products (6% percentile) in this category for the 12-quarter period ending Sept. 30, 2012.

“We appreciate this honor and remain committed to providing the highest quality investment services to our institutional and high net worth clients. Our investment process, methodology and philosophy will continue to add value over the long term by controlling risk and focusing on fundamentals,” said William Hutchens, CFA, founder of Hutchens Investment Management. He lives in Naples and is a board member at Lorenzo Walker Institute of Technology.

About Hutchens Investment Management

Hutchens Investment Management’s team includes three senior professionals, two CFAs, and a client service staff dedicated to handling the most complex of issues. The firm has $85 million in assets under management for institutional investors, endowments and foundations, family offices and high net worth individuals. Hutchens Investment Management has outperformed benchmarks for 15 years on an absolute and risk-adjusted basis and has a track record of superior long term, risk-controlled returns.