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Quarterly Letter to Clients

July, 2018

Indices at quarter-end (June 30, 2018):

Dow Jones Industrials: 24,271.41 2Q'18 +0.70% YTD -1.81%

Standard & Poor's 500: 2,718.37 2Q'18 +2.93% YTD +1.68%

Not too much in the way of news this quarter: the Fed raised rates again (we now expect a total of four rises for this year); and Washington continues to be intent on raising taxes, via tariffs on imported goods. Maybe they think the latter will help balance the budget, but it hasn’t helped our markets. The fingers on the triggers are very itchy. The three-month period just ended spent an equal amount of time on either side of zero before finishing with a very small gain.

In fact, the whole year to date has been difficult. Last year the market ran up on the premise of corporate tax cuts, which have helped the bottom line of many major companies. Now it is digesting and re-evaluating that rise.

We are also digesting the fact that tax cuts are not “growth.” Factor out the tax cuts and earnings have declined. While the tax-juiced higher earnings means that price-earnings ratios are down to more palatable levels, we are left (as always) trying to discern the future direction of our assets.

One thing making it a difficult market is that the disparity between the market “haves” and “have nots” has continued to grow. As the market gets “narrower,” fewer stocks are carrying the weight, and if you are not in those elite few, you are lagging the market. Investors chase those few companies higher, and the move feeds upon itself.

Even the indices change their composition to emphasize the stocks more in favor. This quarter, GE, having fallen on hard times, was eliminated from the Dow Jones Industrial Average after residing there for 110 years. The powers that be seem to think that Walgreen’s is more representative of today’s economy. We shall see, but at least they have eliminated the long drag of GE.

It is human nature to try to look forward, to evaluate what actions are most likely to gain. For me, making predictions has generally been a lesson in humility. The strategy that has always worked for me has been to buy good-quality securities and to hold them for long periods. But we don’t live in a vacuum. We have our opinions about the future, and we cannot ignore them. Today, for example, we are fairly confident that interest rates will continue to rise over the next year or two, and perhaps more. That means that the market price of all bonds (and in fact, all securities bought for their yield) will decline. Should we still be buyers, knowing that our account value will be lower in short order?

That is a very hard position to be in.

Rising rates also pressure stocks, and must be considered along with the usual myriad normal financial factors. When we look at earnings, growth prospects, the balance sheet, and so on, today we must also consider things like trade tariffs and “disruption” in various industries. We try to discern whether the market price of a particular business is reasonable relative to its earnings, debt and general outlook. We also want to know if Amazon is likely to crush them.

We make a value judgment; we take every factor that is available to us and weigh them. Do the plusses outweigh the minuses, or vice-versa? By enough to compensate for the risks? The markets are psychologically driven, so while we collect our evidence, all too often it is colored by confirmation bias, that unconscious mental process that leads us to look for data that support our preferred outcome.

I call this instinct. Right now, my instinct is to keep a bit of powder dry. When the market is directionless, as it has been for most of this year, it is difficult to find stocks with appeal.

There are times to be aggressive and times to be cautious. It is a valuation game, always the question of whether a security is attractively priced or not. And the only time a price is attractive is when it will be higher at some point in the future. How can we ever know?

So the cash levels in my accounts build. I must balance protecting our assets with growing them. If I am wrong (altogether possible) we will have lost the opportunity to gain from deploying our cash, while if I am right we will be able to deploy the cash at a better entry point.

The thinking is that if you can buy a security at a lower price you have gained that differential. If you are able to buy a stock at $40 that not long ago sold for $50, then, in effect, you have earned 20% on your money. Of course, technically you have saved, not earned. But if instead you bought at $50 and the stock now trades at $40 you might be less concerned with the semantics. When we calculate performance the difference can be stark.

We always search for the right price, whether buying, selling or simply holding. Sometimes the best choice is to simply wait.

Jim Pappas