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Quarterly Letter to Clients

July, 2017

Indices at quarter-end (June 30, 2017):

Dow Jones Industrials: 21,349.63 2Q'17 +3.32% YTD +8.03%

Standard & Poor's 500: 2,423.41 2Q'17 +2.57% YTD +8.24%

Someone told me that an optimist believes we live in the best possible world, while the pessimist is afraid that the optimist is right.

The quarter was rather uneventful, with stocks moving in a narrow band near the top of their recent range, edging to all-time highs. The Fed raised interest rates for a fourth time, but the credit markets refused to follow, as bonds continued to exhibit strength and yields moved lower. The ten-year Treasury note yields less today than it did before the Fed began its recent increases.

The economy is robust and things seem to be going swimmingly. Should we worry?

Perhaps we feel that prices have gone a little too far. By we I mean me.

Every dollar of net income from an investment costs you some multiple of that dollar. The multiple is basically tied to the prevailing level of interest rates, but is affected by psychology as well. We are human, we want to be in the game, but we don’t want to pay too much; we want good value for our money.

And value is the key. Different types of assets have different metrics. Residential real estate and commercial real estate, stocks, bonds, businesses, each have several methods of appraisal, and each method might well indicate a different price. So what is the right price?

Let’s say that the prevailing interest rate is around 4%. To get 4% on your money you would pay 25 times the net income of the asset (this is a simplified calculation, of course). We are at that level or less today. You can’t get 10% when the world is at 4%, that is an elementary truth.

Stocks and bonds, of course, go up and down daily, so pricing is dynamic. We price based on expectations, viewed over a longer term. We accept an average rate of return, which might include capital gains as well as cash flow, factoring in the occasional (and unavoidable) negative year.

We know that markets are cyclical. The cycles can be quite long in duration and are regularly punctuated by sharp reversals. So, buy at the bottom of the cycle and sell at the top, right?

It sounds easy, but there are inherent difficulties. For example, interest rates peaked around 1980-81 and have relentlessly trended downward since. Thirty-seven years is a very long cycle, and what are we to do in the interim? We cannot sit on our money, it must be invested, it has to be working for us at all times.

We have to invest in the market that exists today, and that means trying to pick our spots, trying to find relative value among today's offerings. Then we must give our choices adequate time to work out.

I have said this many times before: in all markets, time is the investor's greatest friend, and patience his greatest asset. The long-term trend, in equities at least, is always up. If you can’t buy at the bottom, holding on for long periods is almost as good.

One of the reasons that asset prices tend to appreciate over time is the effect of inflation. Our government budgets over a ten-year period and bases its ability to repay its debts upon the expected rate of inflation. The desired rate is in the area of 2% to 2.5%. Just like the homeowner who takes a 30-year mortgage, the government expects to repay with cheaper dollars.

Lately, they have had some trouble getting inflation up to that target. That won’t last forever; we can be pretty certain that inflation will eventually return to us. For investors, a basic target is 3% over inflation. If inflation is 1% and our accounts go up 4% though, we might feel a little bummed. We might feel like it was a forgettable year. We shouldn’t.

Many studies suggest that at current price levels future returns will be muted. Those studies are likely based upon our current very low inflation level. We may lately have gotten used to high single-digit returns in stocks and bonds, but 3% over inflation is not bad at all. And if that works out to 4% or 4.5% a year, we really have nothing to complain about, even though it still feels like not all that much. Of course, if we can do a little better, slip an extra $10 in the tray.

A very-long-term attitude, a conservative approach to balance sheets, and a focus on income will help us through any and all types of markets. I know that I will not be able to sell at the top; I hope that I can buy the dips well; and I pray that we all remain healthy enough to enjoy life and intelligent enough to recognize what is truly important and what is just noise.

Jim Pappas