TRENDS NEWSLETTER QUARTERLY MARKET REVIEW & OUTLOOK

Year-to-Date 2017 Stock Market Performance: Dow Jones 9.34% / S&P 500 Index 9.34% / NASQAQ Composite 14.14% / MSCI World 10.65%

“As an investor my job is to figure out what will happen rather than what should happen.”

- David Einhorn

Trends is written by Ryan J. Stewart, Chief Investment Officer, Passumpsic Financial Advisors

Second Quarter 2017

It Was Not a Good Time to Sell in May

Aside from the gloomy skies and wet weather here in the North-

east, the summer trading season has delivered some solid returns

over the past three months. For the second quarter, the S&P 500

Index rose 3.09% giving the Index a year-to-date return of 9.34%.

At this point, the “sell in May and go away” theory has been a bit

of a bust as stock markets extend their gains into the start of the

third quarter.

S&P 500 Index

Source: Bloomberg

Moving forward, and aside from the usual hiccups, stocks could

continue their upward trend pushing the S&P 500 Index even

higher in the coming months. Corporate tax cuts—citing the repat-

riation of corporate cash from overseas—along with deregulation

in sectors such as energy and financials, would be major catalysts

to push stock prices even higher. Corporate stock buybacks are

also at high levels reducing the float of available shares in the mar-

ket which in turn lowers valuations making stocks more attractive

on a price basis (i.e. price-to-earnings).

The disclaimer to this upward trend in stocks is that 5% to 10%

corrections will occur—markets never move “straight up” for long

periods of time—so any correction should not be feared; instead

investors should be optimistic. Downturns in stock prices allow

investors to add to current positions or buy attractive stocks at

much better entry points.

Partying Like it’s 1999!

The banter around town is that technology stocks, namely the

FANGs—Facebook, Apple, Netflix, and Google—are getting

long in the tooth (pun intended) based on valuations like price-to

-earnings ratios. The “tech bubble” theory suggests that technol-

ogy stocks are headed back to the wreckage of 2000 and that

indices like the S&P 500 will fall precipitously as a result.

NASDAQ Composite

Source: Bloomberg

A major difference between 1999-2000 from today is that tech-

nology stocks make up approximately 18% of the S&P 500’s

sector weighting compared to a 35% weighting at the height of

the technology bubble. This is not an attempt to dispel John

Templeton’s quote “The four most expensive words in the Eng-

lish language are, this time it’s different.” but technology stocks

like the FANGs have an impressive history of earnings growth.

This earnings history is unlike the tech bubble when many tech-

nology stocks—like Pets.com and Webvan—had no earnings

and traded at astronomical valuations.

That is not to say some technology stocks trade at valuations

reminiscent of the tech bubble but many investors seem to be

less willing to fall for a pipedream. Coupled with greater inves-

tor education, the stock analyst community has greater oversight

than it did in 2000 allowing for more scrutiny of company finan-

cials and earnings guidance. Overall the environment has

changed greatly since Webvan folded but there will always be

the risk of “this time it’s different” undermining reality.

TRENDS NEWSLETTER: QUARTERLY MARKET REVIEW & OUTLOOK

To the Charts: A Few Technology Stocks

Apple (AAPL) Sector: Technology Hardware

With the new Mac, iPad Professional and the new iPhone 8 ex-

pected to arrive in the fall, Apple has become the consumers go-

to-place for gadgets and services. Apple has a history of innova-

tion and that history continues as the company introduces features

like wireless charging and facial recognition for security.

Concerns over slowing iPhone sales, a rather tepid embrace of the

company’s Apple Watch—in comparison to other company prod-

ucts—have some analysts questioning Apple’s ability to grow at

a double-digit rate. New innovative products are the key to Ap-

ple’s success and the company continues to fire on all cylinders

when it comes to new product lines.

Apple (AAPL)

Source: Bloomberg

Facebook (FB) Sector: Internet Software & Services

Facebook completed its initial public offering (IPO) in 2012 and

has grown to be one of the world’s largest Internet companies.

Facebook currently has around $33 billion in cash and short-term

investments, which will allow for acquisitions and expansion in

global markets.

Facebook’s monthly user count is around 1.9 billion and growing.

Expectations are for revenue growth of 35% in 2017 and near 30%

in 2018 based on increases in advertising revenues. Shares of Fa-

cebook trade at a forward price-to-earnings of 29x based on 2017

estimated earnings of $5.33 per share.

Facebook (FB)

Source: Bloomberg

Netflix (NFLX) Sector: Internet & Direct Marketing Retail

Netflix is the place to binge watch your favorite TV shows, mov-

ies, and Netflix Original shows like the highly successful

“Stranger Things”. As with Facebook, revenues for Netflix are

expected to grow by 28% and 22% for 2017 and 2018, respective-

ly.

Slowing subscriber growth in the U.S. is expected to be offset by

strong growth in the company’s global markets offering its

streaming service in 190 countries. Netflix is a highly volatile

stock based on quarter-over-quarter subscriber results.

Netflix (NFLX)

Source: Bloomberg

TRENDS NEWSLETTER: QUARTERLY MARKET REVIEW & OUTLOOK

Portfolio Management Strategies

Finding “Value” in a Bull Market with the P/E Ratio

Equity markets continue to extend their gains with the S&P 500

Index up 18% on an annualized basis since the November presi-

dential election. As indices like the S&P 500, NASDAQ, and

Dow Jones Industrial Average continue to reach new highs, con-

cerns over stock valuations have many investors not only wor-

ried about a possible near-term correction but also in their abil-

ity to find new stocks to buy.

Finding “value” in a market that has risen 18% and continues to

hit new highs can be a tedious task as many “big name” stocks

trade at prices well above their fair value. As an example, online

titan Amazon (AMZN) trades at a price-to-earnings of 187.49x,

which means that investors are paying $187.49 for every dollar

of earnings that Amazon produces. This compares to Ford Mo-

tor’s (F) shares that are trading at a price-to-earnings of only 12x

and yielding 5.10%. Amazon does not pay a dividend.

So why are investors willing to pay $187 on a price-to-earnings

basis (price multiple) for shares of Amazon but are not willing

to pay a meager $12 on a price multiple basis for shares of Ford?

The answer boils down to “growth” - new industry versus old

industry. Amazon has been and continues to be a highly profita-

ble company and is now a leader in ecommerce and retail. Given

Amazon’s prospects, investors are willing to pay more for Ama-

zon’s earnings because Amazon is growing faster than Ford (and

many other companies). Investors gauge the potential profitabil-

ity of a company on a forward looking basis. If the potential for

strong growth looks favorable, investors will pay a “premium”

for stocks that grow profits faster than their overall sector or

index average.

As stock markets move higher, finding stocks that are selling at

“value” multiples compared to their sector peers and/or their index

becomes more difficult. Investors may find themselves buying into

“value traps” - stocks that are selling at a price-to-earnings ratio

well below that of other stocks in their sector. This may seem like

a deal so an investor takes a long position but as the investor will

find out, the stock is selling at a discount multiple to its peers or

the index because the buy-side interest for the stock is weaker than

the sell-side volume. This drives the price per share lower along

with the price-to-earnings ratio.

The key driver for stock performance is quarterly earnings. As

with Amazon, companies with strong forward earnings guidance

that can report earnings that beat Wall Street analysts earnings

estimates typically outperform their sector and index. Analyzing a

company’s future prospects is a way to find value in a rising mar-

ket. When utilizing the price-to-earnings ratio in analyzing stocks,

the historical trailing twelve month (TTM) price-to-earnings dif-

fers from the forward looking price-to-earnings ratio.

The TTM price-to-earnings ratio is what a company has already

reported on a quarter-over-quarter and annual basis and is histori-

cal data. The forward looking price-to-earnings ratio is based upon

the stock analyst communities average earnings estimates on a

quarter-over-quarter and annual basis. The one caveat to this meth-

od of price-to-earnings ratio analysis is the analysts’ earnings esti-

mates can be wrong. When a company misses their earnings report

shares typically will trade lower. The price-to-earnings ratio is one

ratio of many to use for stock analysis in an effort to find value

stocks even in a bull market. No one valuation metric on its own is

flawless so as always it’s important that investors do their home-

work as it relates to stock analysis.

Standard & Poor’s 500 Index

Source: Bloomberg

CBOE Volatility Index (VIX)

Amazon (AMZN)

Source: Bloomberg

Ford Motor Company (F)

Source: Bloomberg

Third Quarter 2017 Outlook

As usual earnings season kicks off in July, which always creates a

bit more volatility early in the earnings season. Volatility, as

measured by the Volatility Index (VIX), is actually at a multi-year

low signaling that stocks could move even higher. The VIX has

been trending lower for the past two years and is trading at a level

not seen since the mid-1990s.

Washington politics and the Fed will be key drivers for stocks

moving into the third quarter. If gridlock in Washington is the

new norm then stocks may correct as investor optimism over the

Trump Administration’s ability to deliver on its campaign promis-

es wanes. The Fed may turn a bit more dovish than it was just a

month ago. U.S. economic growth (measured through the gross

domestic product) is still struggling while the Fed’s rate hike in-

flation target of 2% seems to be a difficult bogey to hit. Bloom-

berg Professional’s Fed Funds Implied Probability—as measured

by the Fed Funds futures contract—does not place any meaningful

rate hike probabilities until January 2018 at a 40.8% probability

for a 25-basis point hike.

The third quarter may provide continued upside in stocks while

interest rates hover at the low end of historical levels. This sets the

stage for cash to continue to be pushed into stocks as investors

search for yield and capital appreciation. This flow of cash from

low risk assets into stocks will continue until a corrective catalyst

rears its head pressuring stocks. Even a correction in stocks may

be short lived. Based on the VIX, investors are clamoring to buy

stocks, especially those in high growth sectors like technology. As

in 2016, dividend stocks—like those in the utility sector—may

also experience some strength as dividends regain their allure.

Gold spot has traded in a narrow range for most of 2017 after

breaking out of a December 22nd low of $1,128. Gold began the

second quarter at $1,253 and ended little changed at the end of

June at $1,241. Even a falling dollar could not push gold spot

higher. Concerns about the Fed and interest rate hikes overshad-

owed the falling dollar because rising U.S. interest rates would

eventually place downside pressure on gold spot. Gold will contin-

ue to trade in a narrow range as stock markets around the world

see increased money flows as investors search for yield.

Oil prices continue to be volatile with no material catalyst to

move prices higher as OPEC continues to struggle with output

agreements. Crude prices hit an April high of $54.31 for the sec-

ond quarter and ended the quarter at $46.04. This downturn in oil

prices could bode well for consumers and business owners as the

winter heating season is around the corner (sorry!). Low oil prices

would be beneficial to the Christmas shopping season as consum-

ers pay less at the gas station and on home heating oil bills.

Moving into the third quarter, earnings season will be on the

front burner allowing investors to gauge, based on valuation met-

rics like price-to-earnings, if stocks can continue to run higher or if

valuations are becoming too rich to keep the rally going. Global

tensions will continue to make headlines as North Korea continues

to evolve its nuclear arms program. The war of words will only get

tougher as the U.S. and South Korea deal with the North’s leader

Kim Jong-Un. Tougher words and increased war games and tests

in the region could move markets lower if investors feel a confron-

tation is the only way to resolve the issue. South Korea is open to

talks so this may in fact reduce tensions over the next few months.

TRENDS NEWSLETTER: QUARTERLY MARKET REVIEW & OUTLOOK

Disclaimer: Stocks and other investments discussed in the Trends newsletter are not FDIC insured or backed by Passumpsic Savings Bank and loss

of principal is possible. Past performance is not indicative of future results. Nothing contained in the Trends Newsletter shall be construed as an

offer to buy, sell, or hold any stock, bond, or commodity. Trends is intended for informational use only.

VIX CBOE Volatility Index (VIX)

Source: Bloomberg

Crude Oil

Source: Bloomberg