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Quarterly Letter to Clients

January, 2017

Indices at quarter-end (December 31, 2016):

Dow Jones Industrials: 19,762.60 4Q'16 +7.94% YTD +13.41%

Standard & Poor's 500: 2,238.83 4Q'16 +3.25% YTD +9.53%

Stocks have tripled over the last eight years, and the bull market seems long in the tooth. Until November, the markets looked like they would be only marginally higher for 2016. But following the election, stocks held a party. A strong advance carried the Dow Industrials to a new all-time record near 20,000. Bonds, under pressure due to another rate rise by the Fed, ceded some of their prior strong gains. Our bond holdings finished the year still nicely in the black, though well off the peak. The U. S. dollar continued it's run, and is at 14-year highs against most major currencies.

It is human nature to look for the reasons behind everything. So we ask: what has changed? Perhaps the stock market advance can be laid to promises by the president-elect to cut corporate taxes, which would mean more money at the bottom line, the "E" of the P-E ratio (price-earnings in case you just joined us). Or maybe promises of large increases in infrastructure spending is the cause. Or the potential re-patriation of the cash that American corporations hold abroad. Or a little of everything. In truth, the only change to date is the expectation of changes.

There are questions. For example, personally, I cannot come up with a rationalization as to why a corporation should pay a lower tax rate than you and I. It is you and I that will be picking up the slack left by those lower corporate taxes, as it is a certainty that spending will not abate. Political minds will have a rationale at the ready, but we individuals will still be pulling more of the weight.

We might also ask, if the trillion dollars proposed is actually spent on infrastructure (which we certainly need), won't that balloon the deficit and the national debt? How does that affect the dollar and by extension, international trade?

And another question: if the two trillion or so that corporations hold abroad is brought back to these shores, what might happen to all of those foreign banks in which the money now resides? And the American banks into which it might be dropped? There are so many more questions. For every action, as we were taught at an early age, there is a consequence, often unforeseen.

But let us leave conjecture and come back to reality. In December the Fed lifted short-term interest rates; the previous hike was a year earlier in December of 2015. The current target is for three more hikes in the new year. Each move has been a gentle one-quarter of one percent, stated as 25 basis points (written as "bps" and pronounced "bips"). These moves are made to either stimulate (by lowering rates) or temper (by raising rates) both the economy and inflation.

A dozen years ago, beginning in 2004, the Fed raised rates by 25 bps at 17 consecutive meetings, taking the short-term lending rate from 1% to 5.25% by 2006. The very next year, at the brink of chaos, they began cutting, until, by the end of 2008, the rate stood at zero to 0.25%. And there it sat for the next seven years.

Many of you know that I have predicted a turn in the bond market for the better part of a decade. I feel like the proverbial broken clock, that is right twice a day. Today the consensus is that the great bond bull market that has run for 35 years finally appears to have come to an end. We can expect it's reversal to be a protracted affair.

I anticipate that my bond holdings will suffer, but our maturities are short, averaging, across my holdings, around 6 to 7 years, and so the damage should be minimal. And if the upward slope in yields is as slight as I expect, we may not even feel it. I must caution that, going forward, we cannot expect bonds to produce gains matching those of prior years.

Rising rates should, in theory, mean shrinking P-E ratios and thus lower prices for stocks. Companies will have to pay more for the capital they need, as will home and auto buyers. The Fed is walking a tightrope trying to raise rates without damaging the economy. So far, the economy has been strong: auto sales, home sales, retail and restaurant sales, even airlines, have all been robust. So the Fed is probably right that the economy can absorb higher rates. Especially if they are gradual and expected. Maybe stocks will shrug off the rise if it is mild.

The president-elect promises certain changes in policy that would affect businesses in different ways. Financials and industrials are viewed to be beneficiaries of the incoming government. Healthcare, utilities and bond-surrogate consumer staples have been brought under pressure. Across my stock holdings I am overweight in the latter group, and thus my stock accounts have not matched the performance of the Dow.

I am stoic in the face of temporary underperformance. I am unperturbed by the rotation among industries. Be it stocks or bonds, I am a long-term, strategic player. I do not buy stocks or bonds because of temporary conditions. I have said it before: investment is not a sprint; rather, it is a life-long marathon. Pick quality companies and stay with them.

I wish you a Prosperous, Happy and Healthy New Year.

Jim Pappas