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Quarterly Letter to Clients

January, 2019

Indices at quarter-end (December 31, 2018):

Dow Jones Industrials: 23,327.46 4Q'18 -11.83% YTD -5.63%

Standard & Poor's 500: 2,506.85 4Q'18 -13.97% YTD -6.23%

It was a difficult year, with the Dow and the S&P notching losses in the area of 6%.

Year-over-year not particularly remarkable, unless you measure the year-end figure against highs made during the course of the year. Versus those highs the markets slid into bear territory, down over 20% from the peak before rebounding at the finish.

Of course, if you measure against all-time highs, you probably also regret that you didn't sell your house in 2006.

Still, we were positive going into the fourth quarter, and to have slipped so much in the final twelve weeks of the year was disconcerting. Stocks fell around 12-14% in that final quarter. Bonds slid steadily through the year, before a small rebound near the end.

Remember, though, that markets are always in motion, and you cannot always be at the highs. It is what happens over the longer term that should occupy your thoughts and inform your strategies. Remember, too, that the market has been strong for 9 years now, so a bit of a breather is to be expected.

Cash was clearly the best place to be in 2018. Nothing else worked, not stocks, not bonds, not gold, not oil, not commodities. It was tough everywhere.

Investors have been worried that the economic expansion that began in 2009 might be waning. Bears point to tariffs and the related fact that we continue to run ever-larger trade deficits. Also always in mind is the debt that we as a nation have accumulated and continue to grow. Unsaid, but in the back of everyone's mind, floats the possibility of impeachment. While the president is certainly a polarizing figure, an impeachment would still roil markets.

We also have to consider that today, more than ever in history, we live in a global economy. It is no longer possible to see that China is slowing and to ignore that fact, or to think that it will not affect us. Goods and services are produced, distributed and consumed on a world stage.

Domestically, there are tangible signs of slowing, with interest rates rising, a trade war brewing, housing and autos slipping. We are a long way from a recession, with employment still full. But this year's earnings will be compared to 2018, when they were boosted by lower tax rates. Markets look forward, and P-Es are being adjusted to reflect the economy and rising interest rates.

Here on the ground, I have noticed many more retail vacancies than one would expect, given the robust employment figures. But here in Florida, at least, housing is still booming. If this is not the peak of the construction cycle, I cannot imagine what would be. One could say the same for employment. This mindset may well contribute to the recent market volatility: is the economy so high that the only path left is down?

In December the Fed raised rates, the fourth such action for 2018, and the ninth since the tightening began. The odds-makers who were once calling for 4 hikes in 2019 are now tending to think that one or two may be all that we see.

When the Fed stops hiking rates it means that growth has slowed significantly. They are looking for rates to be "neutral," which means that they are at a level that neither spurs the economy nor dampens it. That magical number is an unknown, a chimera, and is always variable. You want the pot to simmer, not boil over; you must constantly adjust the flame.

The Fed also raises rates in order to dampen inflation, which lately (thanks largely to oil prices) seems to be non-existent. And I am painfully aware that rising rates have hurt the bond market. Over the last thirty years this is only the fourth year that the Barclay's Aggregate Bond Index has shown a loss in bonds.

In my opinion, at the current level of around 2.25-2.50%, rates can hardly be said to be slowing economic activity. Other factors may come into play, but if things slow down, I don't think you can blame rates.

Bonds probably will continue to be soft going forward, as we can expect rates to continue to edge up. Still, I think that we are almost at a point where we can begin to buy shorter-term bonds again. Stocks will find their level each day, sometimes dramatically, as they have always done. While it may look a little scary at the moment, I do not think that stocks are particularly over-priced. So I am dusting off my buy list and looking for entry points.

I wish you a Happy and Healthy New Year.

Jim Pappas