Market Commentary

2016 Election Thoughts

Many people were likely surprised by Tuesday’s presidential election results. There is no doubt that the markets were certainly confused on how to interpret the outcome.  As election results on Tuesday night began hinting of a Trump victory, Dow Jones Industrial Average futures plummeted, indicating that Wednesday’s market results were likely to be ugly.  Yet when the U.S. markets opened on Wednesday, they were flat.  Even more surprising was the fact that Wednesday ended with the Dow Jones Industrial Average being up 257 points, or 1.4%!  A big day in the market, and definitely a roller-coaster ride.

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Newsletter – Quarter 3, 2016

It has been said that corporate earnings are the lifeblood of the stock market. When earnings are flowing properly, the market typically thrives. However, when that flow becomes stagnant, the market tends to struggle. In fact, earnings growth has proven to be the single strongest driver of stock prices over the long term, as evidenced by the roughly 90% correlation between the S&P 500 and the earnings of its component companies over time. However, there has been a breakdown in this relationship recently as the market continues to hover near all-time highs even as earnings in the just completed quarter are expected to have declined for the sixth quarter in a row.

The main reason the market has remained strong in the midst of weak overall earnings is that it has been supported by the historically low interest rate environment that has been fostered by the Federal Reserve and other central banks around the world in their effort to boost economic growth. Ultralow rates have suppressed yields on fixed-income securities, making equities more attractive on a relative basis and driving the stock market steadily higher. However, given that central banks are already about as accommodative as they can be, it is unlikely that stocks will receive a significant lift from further monetary stimulus. In fact, the Fed is likely to begin removing a little bit of the punch from the monetary punchbowl by raising rates in the coming months. And while we fully expect that this process will be extremely gradual and that an equity-friendly low-rate environment will remain in place for some time to come, the market is not likely to react well to any rate hikes unless accompanied by a pickup in earnings growth.

Another big boost to the market in recent years has come from a sharp rise in the amount of corporate stock buybacks. In fact, buybacks have served as the largest source of demand for stocks in recent years, including well over $1 trillion of purchases made over the past two years alone. Buybacks serve to drive up share prices and prop up the per-share earnings of companies by reducing the number of shares outstanding. The rise in buybacks is in part a function of the low-rate environment, which has allowed many companies to finance a considerable portion of their buybacks through debt issuance. And though corporate balance sheets are still generally in pretty decent shape, debt levels have risen considerably over the past few years. As a result, the recent pace of buybacks financed through debt is not likely to be sustainable over the long term, particularly if interest rates begin to creep up.

Given that stock valuations have already received a significant lift from low interest rates and an elevated level of stock buybacks, the next major boost to the market is likely to have to come from good old-fashioned earnings growth. While corporate earnings as a whole have been mired in a recession for several quarters, there is cause for optimism as two of the main factors that have pressured overall earnings have eased in recent months. The collapse in the price of oil has weighed heavily on the profits of energy firms over the past couple of years, while the substantial rise in the U.S. dollar has served to reduce the profits of U.S. multinational companies. However, with the price of both oil and the dollar now more stable, these significant headwinds to overall corporate profitability are likely to fade, and the earnings recession should soon come to an end. Even so, with the economy continuing to push forward at a steady but uninspiring pace, we think that earnings growth as a whole is likely to be just moderate for the foreseeable future.

With stock gains outpacing overall corporate earnings growth in recent years, the forward price-to earnings ratio of the S&P 500 has steadily risen to around 17, a level that is now above its historical average of 15. Given our expectations for moderate earnings growth, we think that the valuation of the stock market as a whole is a bit stretched, even in the context of a low interest rate environment. Even so, while fewer in number than in recent years, there are still some quality individual companies that are growing earnings at a healthy clip and trading at reasonable valuations. With market volatility likely to increase as we approach both the election and a potential rate hike from the Fed later in the year, we think there will be additional long-term investment opportunities to take advantage of in the months to come.

Sincerely,

Alison J. Gamble, President

Newsletter – Quarter 2, 2016

As we celebrate Gamble Jones’ 60th anniversary, we thought it would be appropriate to review our investment philosophy. We have used this approach from the beginning to help clients reach their financial goals. Although the world has changed significantly, these investment tenets are as true today as they were when Jim Gamble opened the doors in 1956.

We are long-term investors rather than short-term traders. Investors look at a company’s long-term prospects, whereas traders try to capitalize on short-term price fluctuations. In today’s world of internet and 24-hour cable news, short-term price movements are frequent, random, and impossible to predict. However, the short-term prices are generally tethered to a company’s intrinsic value, which is far more stable. As investors, we focus on a company’s long-term business fundamentals and generally disregard short-term price fluctuations. In short, we focus on high-quality companies and let them create value for clients over time.

Cutting through short-term noise, a company’s fundamental value is determined by its ability to grow and generate cash flow for owners. Strong balance sheets and attractive returns on capital are good indicators of a well-run business. Return on capital measures the cash flow that each dollar invested in the business generates. An attractive return on capital signifies that a business generates excess cash that can be returned to shareholders. Strong balance sheets are also preferred as they provide support in difficult economic times.

At its core, investing is a value proposition comparing what you pay to what you get. The price you pay is clear. It is set by the market. Getting your money’s worth is the hard part. The art lies in determining what a company is worth. We use a company’s business fundamentals to make this determination. Once you decide what a company is worth, comparing it to the market price is simple. If the current price is unattractive, either wait for a lower price or look for a better alternative.

Although the above discussion was written with equities in mind, we use the same approach for fixed income. We prefer to hold fixed-income securities to maturity because trading costs are high. As with equities, we stick with high-quality, investment-grade issues. We also use low-cost mutual funds to add diversity and exposure to less-liquid areas of the bond market.

Portfolio construction is the final piece of our investment philosophy. The balance between equity and fixed income is determined on a case-by-case basis. Clients who are less risk tolerant own more fixed income. The number of securities in a portfolio is large enough to provide diversification, but small enough so that each investment makes a contribution. The size of the cash position is a function of both a client’s investment objective and the by-product of the current investment environment.

This investment philosophy has served us well over the past 60 years, and we continue to use it as we embark on the next 60. Although we currently believe the market as a whole is fairly fully valued, we do find individual stocks that appear attractive. Market volatility can understandably be unnerving for investors, so it is important to keep a long-term perspective. Once the short-term noise dies down, the substance of a company is what truly matters. We stand ready to take advantage of long-term investment opportunities created by short-term price movements.

As required by law, we have included the cover page of our ADV II, disclosing the creation of Gamble Jones Capital Management. (See PDF version for cover page.)

Sincerely,

Gamble Jones Investment Counsel

Brexit Referendum

In the world of investing, the stock market loves good news, dislikes bad news, and absolutely hates uncertainty. Last week, when the results of the Brexit referendum became known to the world, financial markets were completely caught off guard by the “leave the EU” victory.

Investors face a number of uncertainties following the vote, including whether this is the beginning of a European movement to delink from the European Union and whether Scotland and Northern Ireland will seek independence from Britain. In addition, uncertainty remains over how Britain’s future relationship with the EU will take shape and the economic impact that Brexit will all have on the U.K., the EU, and the rest of the world. It is likely that we won’t have the answers to these issues for some time to come. It is also important to note that the referendum is technically non-binding. And while it is highly unlikely that the government will ignore the vote, there is currently an online petition with Parliament calling for a second vote that gathered over three million signatures in the first 48 hours after the results were announced. In the probable event that Brexit comes to fruition, the U.K. government will have two years to unwind its involvement with the EU, a process that will not likely even begin until a new prime minister is elected in the months to come.

One initial impact from the vote has been an increase in the dollar relative to the euro and pound. A sustained appreciation of the dollar would serve as a drag on the earnings of U.S. multinational companies. In addition, given the uncertainty of how the referendum will affect the global economy, it is unlikely that the Federal Reserve will increase interest rates anytime soon.

The many uncertainties surrounding the Brexit referendum will likely have a negative economic impact in Europe in the short term as business confidence and investment in Europe will likely suffer. However, we feel the long-term impact on the global economy will be minimal as the current uncertainties will gradually be sorted out. We expect the U.S. economy to remain resilient, pushing forward at a moderate pace as it has continually done in the face of many headwinds over the past few years. However, during the next few months, the uncertainty of the Brexit decision will likely cause a higher level of volatility in the stock market as investors try to digest what it all means. During this time, we will sort through all of the noise in search for long-term investment opportunities presented by the short-term volatility.

Sincerely,

Alison J. Gamble, President
Gamble Jones Investment Counsel

Newsletter – Quarter 1, 2016

Oil – black gold, Texas tea, major contributor to stock market volatility. After an unusually long stretch of relative calm over the past few years, the stock market has been a bit jumpy in recent months. Large swings in the price of oil have certainly played a major role in this heightened market volatility. The market followed oil sharply lower in the first half of the quarter with each reaching its lows for the year on February 11th. As oil rallied off its lows, stocks too reversed course, leading the Dow Jones Industrial Average to its biggest comeback from a deficit during a quarter since 1933.

While oil and stock prices have not historically been highly correlated, they have certainly traded in tandem lately. Chief among the many reasons for this is that the price of oil has increasingly been looked upon in recent months as an indicator of economic health. There has been a growing concern among investors that the driving force behind oil’s price plunge has been a reduction in demand that could be signaling a rapidly slowing global economy that could ultimately drag the U.S. into recession. Some have also feared that the collapse in oil could force so many of the weaker energy companies to default on their loans that it would overwhelm the banking industry and result in a financial contagion similar to the one which occurred in 2008. As oil has risen off its lows, these concerns have eased, and stocks have followed suit.

Our view is that the market has overreacted to the oil price swings. We continue to believe that the primary cause of the weakness in oil has been a supply glut resulting largely from the surge in U.S. shale production in recent years. The strengthening of the dollar over the past couple of years has also played a role in oil’s decline as it has made the dollar-denominated commodity more expensive in other currencies. So while a softening in demand for oil has likely played a secondary role in oil’s price drop, we don’t think it is an indicator of a looming global recession. Though China’s economy has cooled and global economic growth has slowed, we don’t view the slowdown as being significant enough to derail the U.S. economy. With a strengthening labor market and a housing market that remains in solid shape, the U.S. economy should remain resilient, continuing to plug along at a moderate but steady pace as it has for the past few years.

We also think that the banking industry as a whole is well equipped to absorb the spike in energy loan defaults that is sure to come. Energy loans make up just a fraction of the dollar amount that residential mortgage loans did in 2007. In addition, U.S. banks are in far better shape than they were a decade ago, as they have been forced to build their capital cushions by the stringent regulations that have been put in place since the time of the financial crisis.

The 50% rally in the price of oil off of its 12-year low of $26 per barrel has certainly been impressive. And while we think there is a good chance that oil has put in a bottom, we do not expect it to continue to head straight up from here. Significant production cuts still need to be made to bring supply in balance with demand, and these cuts are likely to occur very gradually over the course of the next several months or longer as weaker U.S. shale companies are forced out of business. Much of the recent oil rally has been built on hopes that a mid-April meeting of OPEC members and other major oil producers such as Russia will result in an agreement to limit production that could help to jumpstart the process of reducing supply. However, reaching and enforcing such an agreement among rival oil exporters has historically proven to be a difficult task. Another reason for the jump in the price of oil has been the weakening of the dollar over the past couple of months following its extended run-up. However, the dollar could easily begin to strengthen again, particularly if it is anticipated that the Federal Reserve is moving closer to raising interest rates. As a result, our expectation is that the price of oil will continue to bounce around in the coming months and that the stock market could very well continue to follow its lead.

While the stock market has calmed down quite a bit over the past few weeks, it would come as no surprise if volatility were to pick up again in the coming months given all of the uncertainty surrounding the price of oil, the global economy, the timing of interest rate hikes, and the upcoming elections. And though we continue to find individual stocks that we believe are attractively valued, we think the market as a whole is trading at a pretty full valuation, which could also contribute to volatility. Though market volatility can understandably be unnerving for investors, it is important during such times to maintain a long-term perspective. Legendary investor Benjamin Graham once said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Once all the noise dies down, what truly matters is the substance of a company. Over the long run, a stock’s value will be determined by the underlying company’s actual business performance, not by the price swings resulting from the fickle nature of markets. For this reason, our focus remains centered on owning attractively valued, financially strong companies that are built to withstand the many different economic and market cycles that are sure to occur along the way. We stand prepared to take advantage of any such long-term investment opportunities created by the short-term effects of market volatility.

Sincerely,

Alison Gamble, President

Oil- Current State of the Market

A comment on the current state of our stock market:

When we invest in stocks for clients, we are essentially paying for a future stream of earnings of companies discounted to today’s dollars. We want to have as much confidence in the stability and growth of the future earnings of those companies as possible. Any global trends which have the potential to negatively impact earnings flow on a broad scale will disrupt the market price of common stocks. The approximately 70% decline in the price of oil over the past year is one of those global trends that is currently affecting common stock prices.

The drop in the value of oil is a double-edged sword. On the positive side, many of our oil-based consumer items as well as gasoline will be much cheaper for the consumer. However, on the negative side, oil is now at a price where many smaller producers cannot make money and are forced to make layoffs or shut down completely.

Sixty years of investing on behalf of clients has taught us that while markets are cyclical and global trends affect market behavior, it is ultimately earnings growth that drives long term stock prices. After a strong six-year bull market from 2009 through 2014, the equity markets have experienced downward pressure since May of 2015. Whether this decline in equity prices is a much needed market correction or the beginning of a bear market is not yet apparent.

What is apparent is that the drop in oil prices has been one of the main catalysts for the market decline. We also know that this will pass in time and that stocks will once again get back to reflecting their future earnings, until we face the next major global trend.

Sincerely,

Alison J. Gamble, President
Gamble Jones Investment Counsel

Thoughts on Market Timing

When we were grinding out our financial education, each of us had professors that explained how market timing was rarely successful. The problem is that the trader has to make two correct decisions: when to get out of the market and when to get back into the market. The truth is that on average we would be better off being invested during bear and bull markets. Part of this statement comes from the simple fact that it is difficult to time the end of a correction and the beginning of a bull market. Or vice versa. William Sharpe found that market timers must be right 82% of the time just to match the returns realized by buy-and-hold investors.

Think back to March of 2009. In the midst of financial meltdown and pundits’ warnings of imminent doom, who knew the market would turn on March 9th, running up over 20% in 15 days and initiating one of the greatest and prolonged bull markets in the history of the U.S. stock market?

A study by SEI Investments reviewed all the bear markets since World War II. According to the study, stocks rose an average of 32.5% in the 12 months following the bear-market bottom. Yet, if the bottom was missed by seven days, that return fell to 24.3%. How much would we miss out on if an investor has been stung by the previous drop and has not reinvested for two months? Three months?

Even though the markets have been gyrating over interest rates, China, and even presidential candidate bandwagons, keep in mind that we have invested in quality companies. These companies create value by earning a cash return on equity capital that exceeds their cost of equity capital. This excess return translates into bigger dividends and a higher stock price. We feel these companies can weather the storm of market uncertainty and provide growth in a variety of economic environments.

We do thank you for the trust you have placed with us in managing your assets.

Sincerely,

Alison J. Gamble, President
Gamble Jones Investment Counsel