Lackluster returns for the popular Dow Jones Industrial Average and the S&P 500 masked what was a good second quarter and a good year so far for important segments of U.S. markets. Performance of those indexes is heavily influenced by huge multinational companies such as Boeing and Caterpillar. Feisty talk of tariffs from the White House does not bode well for global trade, and a strengthening dollar only serves to make U.S. goods more expensive abroad. On the positive side, tech stocks have continued to do well along with consumer discretionary stocks, especially “consumer tech” companies such as Netflix and Amazon. Energy stocks have also fared much better recently as share prices have finally begun to follow oil prices higher. Investors have been bidding up small cap stocks as those companies benefit from lower corporate taxes, high consumer confidence, and less dependence on foreign sales. The macroeconomic fundamentals that have been supporting the market for some time are still generally positive, but there are indications that the economic cycle may be maturing. Corporate earnings have been very strong, and the upcoming earnings season is expected to deliver another quarter of record growth. Yet, last quarter’s

stellar numbers failed to move the market much. It is possible the market may be anticipating peak earnings with future quarterly comparisons growing harder to beat. Also, after largely going missing while unemployment declined to historic lows, there is now evidence that compensation pressures, or wage inflation, are starting to flow through to costs of goods and services. That kind of durable cost increase can pressure profit margins. Consider the increasing cost of shipping by truck. A nationwide shortage of truck drivers is making logistics more complicated and expensive. Trucking companies are recruiting heavily, offering higher pay and hefty bonuses, and passing those costs on to their customers. The Federal Reserve, along with other central banks, has worked mightily over the past decade to stave off deflation and economic decline in the aftermath of the financial crisis. Zero interest rates and massive quantitative easing were the solution to restore the economy to sustainable growth and reach the Fed’s target goal of 2% inflation. Now that they believe they have succeeded, the Fed’s more hawkish policy seeks to “normalize” monetary policy by incrementally and steadily raising interest rates and reversing quantitative easing. The positive correlation between rising bond yields and stock prices has weakened this year, and the market may now be questioning if the Fed will get too far ahead of the curve by raising rates too much too soon. Global trade continues to be a major concern for the markets now. While the current administration seeks a “fairer deal” for the U.S., the figurative saber-rattling around threatened tariffs and retaliatory actions has sown doubt among investors as to how well the global economy could withstand the impact of a real trade war. Already, there are signs that the recent period of broad synchronized global growth may be ending as the U.S. economy thrives while Europe slows and emerging markets struggle with fallout from a strengthening U.S. dollar. Time will tell how things are going to play out, and our best approach is to listen to the markets. With the market stuck in a trading range, stocks may be telling us that what lies ahead may neither be as great as some expect nor as terrible as some fear.

www.dh .com JULY 2018

Dow, S&P 500 dri .

NASDAQ, small caps march higher.

Federal Reserve con nues “normaliza on” policy.

Global trade threatened by tariffs.

Also in This Issue  

Pages 2 & 4: Growth Stocks vs. Value Stocks. Page 2:  What Happened to Stock Splits? Page 3: Tech Sector Reorganiza on. 

 

Market Measures 2nd QTR

2018

S & P 500 (price)  2.9% 

Dow Jones Industrial Average   0.7% 

NASDAQ Composite   6.3% 

Russell 2000  7.4% 

MSCI EAFE   ‐2.3% 

Barclays Capital Inter Gov’t/Credit Bond Index  

  6/30/18  6/30/17 

10‐Year US Treasury Bond Yield    2.87%  2.30% 

Three‐month US Treasury Bill Yield    1.92%  1.02% 

0.0% 

YTD 2018

1.7%

-1.8%

8.8%

7.0%

-4.5%

-1.0%

I  O   

Second Quarter 2018 Review & Outlook by Whitney Brown

Page 2

Stock investing typically falls into two styles, Growth and Value. Investors buy stocks because they expect the price to rise or they are interested in collecting the dividend that the stock may pay, or

often a combination of both. Growth stocks are those companies that have potential for revenue and earnings growth in the near future. Growth stocks typically reinvest most of their profits into further business expansion. Most sectors of the market have at least some growth companies, but typically technology companies, biotechnology, consumer discretionary and alternative energy companies are more thought of as growth areas. Most growth stocks tend to be newer companies with dynamic products or services that could make a big impact in the market in the near future. Growth stocks can be more volatile than value stocks.

Value stocks are usually undervalued companies that often pay a dividend. A value stock trades at what appears to be a discounted price, based on its financial condition or other indicators. The definition of a good value may vary according to each investor’s valuation method. Value stocks that seem undervalued can stay undervalued for some time. The mid-to-late 1990’s was characterized by growth stocks really outpacing value. The dot-com era took growth investing to an extreme with “emerging” growth stocks that in a number of cases eventually went belly up. More typical growth names of today are companies that have demonstrated better than average gains in earnings in recent years and that are expected to deliver high levels of profit growth in the future. After the dot-com era, value stocks were the winners until 2006. Since 2006 growth stocks have, once again, beaten value

(Continued on page 4)

Growth Stocks vs. Value Stocks by Watt Dixon

What Happened to Stock Splits? by Jim Hall

If you have been investing in stocks longer than ten years, you probably have fond memories of receiving the occasional “stock split.” Many clients will relay stories of their relatives buying some small number of shares in some company back in the ‘40s or ‘50s and later bequeathing a significant

amount of money and shares to heirs. In general, a stock split has been a “feel good” maneuver that involves issuing additional shares to the investors who already own a company’s stock. As the company issued the new shares, the price would be adjusted so the market capitalization would stay the same. For instance, “XYZ” company might trade at $60/share “pre-split” and then trade at $30/share “post-split,” but you would own two shares rather than one. The investors didn’t have extra money but felt more positive about the company because they owned more shares. The company issuing the split shares did so hoping the price would continue to appreciate. Why would a company bother with this exercise? There was a widely held opinion that companies should be sensitive to the trading price of their stock and try to keep it affordable for the individual or “small” investor. This opinion was built on the belief those investors might avoid buying the more expensive stocks if they could only afford to buy a few shares. That opinion seems to be somewhat reinforced by the allure of “penny” stocks. Often you will hear of someone touting the fact they own 10,000 or 20,000 shares of a company and when you explore further, it might only be trading for 10 cents/share. Another more tangible reason for a stock split is to increase the number of shares available and therefore increase the number of shares trading on the market. Sometimes a company might have only a small number of shares outstanding. If so, any

sale or purchase of even a few of those shares might cause the price to move. Doubling or tripling the number of shares outstanding might allow more activity and create little to no price change when an individual decides to sell or buy. Since 1980, the S&P 500 has averaged about 45 splits per year; however, since 2008, the average has dropped to under 11. During 2017, there were only five and so far this year we’ve only seen two. The most likely explanation behind the dearth of stock splits seems to be tied to the emerging popularity of mutual funds and ETFs. These funds pool money from many individual investors and invest large sums in many different companies without consideration of the price level of an individual share. Their goal is to own dozens or even hundreds of different stocks and then have individual investors buy some number of units of their fund. Several years ago, before the advent of “discount brokers,” a stock trade may have added up to $200 in commissions or fees just to complete one transaction. Trying to buy 1 or 2 or 5 shares in a company became a very expensive proposition. The funds saw an opportunity and positioned themselves between the investors and the companies. They bought shares in many companies and packaged them in their funds. When you purchased a unit of their fund, you essentially owned a very small piece of all of the companies their fund had purchased. Since maintaining an affordable per share price level has become less interesting to companies and eliminated a reason for stock splits, successful companies now strive to create interest and excitement among their shareholders by “returning cash to investors” via “buybacks” or increasing their dividends. In the future, we probably will only see an occasional stock split.

   Page 3 

Tech Sector Reorganization by Stebbins Hubard

The tech sector is heading for a shakeup (with volatility possible) this September when the changes to the Global Industry Classification Standard (GICS) go into effect. We will see the formation of a new communication sector, replacing the telecom sector

which has shrunk to just four companies representing only 2% of the GICS’s market cap down from 9 % at its peak in 1999. This is the first change since the real estate sector was carved out of the financial sector in 2016. This new communication sector will be built largely out of stocks that currently occupy the telecom, technology and consumer discretionary sectors. This new sector is an attempt to better reflect the primary business of different companies, which often span multiple sector categories and don’t always reflect the industry they’re currently classified in. For example, Netflix, one of the most notable internet companies of the current era, is a consumer discretionary name, not a technology one. The shift in the creation of the new sector will impact some of the biggest stocks on the market. Walt Disney Co., Netflix Inc. and Comcast Corp. (three stocks that have a combined market capitalization of more than $450 billion) will all move from the consumer discretionary sector to the new communication sector, which will cover two primary subindustries of telecom services and media and entertainment. Facebook Inc. and Google parent Alphabet Inc. (combined market cap: $1.3 trillion) are among the technology stocks moving over. In other words, three of the five FAANG stocks

(Facebook, Amazon, Apple, Netflix and Google) will be switching sectors. These five large-capitalization internet and technology names have become trading favorites on Wall Street, having contributed a sizable portion of the overall market’s advance over the past year. The new communication sector, comprised of 60 stocks, will be the third-largest based on market cap, comprising 13.2% of the total (see chart below). Currently, tech amounts to nearly 26% of the market (dropping to 18% in Sept.), and has 167 stocks. The discretionary sector now represents 13.4% of the market (dropping to 9.9% in Sept.), making it the third-largest sector based on Jan. 31, 2018 data, and it has 163 stocks, the second-most. On a valuation basis the new communication sector will have a price/book ratio of 4.1, below both the revised technology group (5.8) and the revised consumer discretionary sector (6.4). It will also have the lowest dividend yield of the three, at 0.8%, compared with 1.6% for discretionary and 1.1% for technology. The forward P/E ratio will stand at 22.5 for the new sector, while it will be 19.7 for the revised tech group and 24 for the revised consumer sector. The S&P 500 overall has a price/book ratio of 2.8, a dividend yield of 1.8% and a P/E of 22.6. For investors, the implication of the change will principally be felt by those who seek exposure to specific industries through passive sector-tracking funds and exchange-traded funds (ETFs). Such products mimic the performance of a sector by holding the same components as the underlying sector’s index, in the same proportion. In order to accommodate the September changes, a tech ETF will have to sell its technology stocks that are moving sectors, while any

communication sector ETFs will have to buy them. It is estimated that the new communication sector could impact 26 ETFs with more than $60 billion in assets. Such trading activity could mean short-term volatility in the stocks, although MSCI and S&P will be releasing a full list of the largest impacted companies in August, which could mean that the impact is priced into the shares long before any changes occur.

Market Cap Weights of GICS Sectors with New Communication Sector

Page 4

Growth Stocks vs. Value Stocks (Continued)

stocks. With 12 years of Growth performing better than Value, many investors are wondering if value investing is dead. The U.S. has been experiencing improved economic growth lately, prompting the Federal Reserve to raise rates. The last time the Fed raised rates with regularity was the period of 2002-2006. During this period, as a defensive play, Value outperformed Growth for 15 straight quarters. Currently, with inflation trending up, the Fed could become more aggressive with rate hikes. In addition, with market volatility on the rise, investors may turn more to “safer” value stocks that pay steady dividends. Currently growth stocks are still outperforming value stocks despite conditions that would normally favor Value. Improving economic growth, stable commodity prices, and accelerating earnings typically give a nudge to value investors. Several factors may be in play causing an aberration in the norm. While the economy is solid

and we are near full employment, it is still is far from robust. Growth stocks generally do not need faster economic growth to produce earnings growth. Value has tended to outperform when economic growth has been fast enough to produce accelerating earnings growth in the cyclical sectors of the economy. If investors view 2018’s strong earnings growth as a one-time event or peak rather than a sustained trend, they may be looking toward upcoming earnings deceleration. Finally, defensive value sectors such as Real Estate, Utilities, Consumer Staples, and Telecom are the most interest rate sensitive sectors. With interest rates surging earlier in the year, these sectors have underperformed, further hurting Value vs. Growth. In most portfolios, a mix of value and growth names is usually warranted in order to seek total return from appreciation and income. However, growth stocks should be able to maintain their dominance unless the economy really kicks into high gear and earnings accelerate at a higher clip.

(Continued from page 2)