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Quarterly Letter to Clients

January, 2020

Indices at quarter-end (December 31, 2019):

Dow Jones Industrials: 28,538.44 4Q'19 +6.02% YTD +22.34%

Standard & Poor's 500: 3,230.78 4Q'19 +8.53% YTD +28.88%

It was a “rip-snortin’” year, with the S&P gaining almost 29%, the Dow up by over 22%, and bond indices posting advances ranging from 9% to 15%. It is so easy to forget that at this time last year we were marking the end of a negative year.

We had a good year. My stock accounts were closer to the Dow's numbers than to the S&P, while our fixed-income holdings were within the range of the bond averages. Most of my accounts contain both types of securities, and thus gained proportionately.

A blend of stocks and bonds is considered a conservative investment strategy. Indeed, conservative investment selection has proven to be beneficial to my accounts over the longer run, yielding us gains that beat the market, not in a particular year, perhaps, but over rolling 5- and 10- year periods stretching back to the inception of my business in 1988.

Recently my nephew called, asking my opinion about buying a house. During the discussion he said, “…but a year ago the house would have sold for ($35,000 less)….” To which I replied, “but you aren’t buying it a year ago.”

He, of course, was worried that a year from now the price might be lower. This is my constant dilemma: buying at the right price. A house certainly differs from buying investments, where we track price changes daily (or even multiple times daily). But no matter what you are buying—and a house is a major investment—you want to know that you paid a fair price. And you hope that it will be worth more in the future. We are all just like my nephew, we don’t want to buy only to see a lower valuation a year from now.

At the year-end the stocks that make up the Dow and S&P averages sold for around 19 times their estimated earnings for the new year. The stocks that you hear about, the ones that make the nightly news, that account for the biggest weighting in the indices, are typically selling in the 25-35 times area, sometimes more. This is rich, but the Street justifies the prices, due to their potential growth and today’s interest rates. I resist paying high multiples, which keeps me out of the stocks that make the daily headlines. I also like to hold higher cash levels when the market is this high.

There is a theory that says that at any given moment all the information about a company is known and factored into that moment’s price. This is a rational view, and is the basis for investing for the long term. As a long-term investor, what we really want to know is, will that company’s earnings continue to grow and is the dividend stable? We can be well assured that if those factors are met we will see positive returns over time, and that today’s price will look cheap years from now.

This may hold true for stocks; it is not necessarily true when it comes to bonds.

Today, investment-grade corporate bonds trade at a level roughly equivalent to 30 times earnings (figuring their yield as the “earnings”). Government bonds are even higher, near 50 times. This is a rich price, a price at which we would only buy for the relative safety offered by bonds. There is almost no potential for capital gains in bonds. Institutions may be buyers of bonds to offset future liabilities; retail bond buyers today (you and me) are buying for safety, not for investment returns.

My position today is that the perception of safety in bonds may prove to be illusory. Rates will go up (eventually) and inflation is a given, with the trillion-dollar annual deficits we are running. It is simply a matter of when. (I could say much more about our budgetary woes, and the threat to our currency, but we will certainly have that discussion at a later date.)

The majority of my clients are at a point in life where they need income from their accounts, and do not want to see their values decline. Historically we have solved that problem by mixing stocks, for their growth potential, and bonds, for their stability and cash flow. Today, though, we are being nudged toward replacing that bond segment with high-quality, dividend-paying stocks, which are paying more in dividends than those same companies bonds might yield. Along with competitive yields, their stocks also offer the possibility of gains, as compared to bonds, which today all but guarantee losses.

So we will make the shift, gradually, carefully, prudently.

There is one upside to low rates: my nephew got a 30-year mortgage at about 3.5%. Good luck with your new house Tommy.

I wish you all a very happy, healthy, prosperous New Year.

Jim Pappas