Back to Quarterly Letters

Back to Quarterly Letters || Previous Letter || Next Letter

Quarterly Letter to Clients

October, 2018

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

Dow Jones Industrials: 26,458.31 3Q'18 +9.01% YTD +7.04%

Standard & Poor's 500: 2,913.98 3Q'18 +7.220% YTD +9.00%

Experience is what you get when you make a mistake. Wisdom is the result of not making the same mistakes a second time. If you don't make too many mistakes, if your mistakes don't bankrupt you, and if you can avoid making the same mistakes for a long enough period of time, you have a chance of becoming very successful, perhaps even legendary in your industry. I'll settle for a modicum of success.

About now you probably want to know what could possibly go wrong? You would not be alone: the question I am constantly asked is how much longer the markets can run. There seems to be a universal unease with the level of the markets. Perhaps it is simply the length of time without a major correction.

We have difficulty thinking that good times can go on forever. We have been conditioned by experience to know that markets do not simply go up without interruption. We have a tendency to think that the party must end soon.

The bull is aging, true. But it will not die simply of old age.

When people ask me what worries me, or what might cause our economy to stumble, here is my answer: Roughly ten years ago, in crisis, we bailed out the banks and the brokers. We did this by flooding the economy with money, under various programs known as "quantitative easing." And we kept pumping money in until things turned around. It worked. That infusion financed the expansion that has been running since that time. Now we are looking at reversing that action, pulling cash back in. This shrinking of the Fed's balance sheet must be done with extreme care, with the objective of not damaging the economy or the banking system. The desired "soft landing" will be a difficult feat to pull off.

For many years--three-plus decades, actually--the total return, or performance, of corporate bonds has rivaled that of common stocks. This year, however, the race goes to stocks, by a wide margin. The reason, of course, is rising interest rates, which has driven bond prices down. That rise in rates, however, has not been fast enough or steep enough to interfere with corporate earnings. Yet.

Couple this with a reduction in corporate tax levels, meaning higher earnings even without growth, and the relative appeal of stocks jumps. If you assume that interest rates continue their march higher, you are hard pressed to justify buying bonds as opposed to stocks.

Many high-quality stocks are trading at relatively low valuations and are paying relatively high dividends. A conservative investor must be asking himself why he would buy a corporate bond when he can get very much the same income from the common stock.

There are reasons. Bonds are viewed as the "safe asset." We know that dividends are optional. We have seen long periods when stocks trended downward. And we have seen intense, short bursts when stocks cratered. Today, as stocks climb skyward, we may well have the ominous feeling that what goes up must come down. Often our fear of losing money, even if temporarily and "on paper," overcomes our knowledge that stocks have brushed aside their occasional falls and trended higher essentially forever.

It is my opinion that we are likely to see a long period of rising rates, and if the ascent is gradual, stocks will probably be our best investment option. I am not saying that stocks will hit new highs every year, or even that they will go up consistently; I am saying that between stocks and bonds over the next decade or two we are likely to be better off in equities.

Bonds still have a place in many portfolios that desire regular, steady income and minimum fluctuation. I am not advocating for a wholesale dumping of bond portfolios. I am simply saying that it is not likely that bonds will produce returns akin to what we have seen over the past 35 years.

I am also not saying that we should blindly jump into stocks. Care must be taken this late in the cycle, we must select high-quality issues and we must be mindful of relative valuations. Where I have added stocks, they tend to be solid, household-name companies with impressive financials. And we must be prepared for the higher volatility inherent in equities.

This is a very long-term viewpoint and strategy, but our financial health is a multi-generational effort. Our assets must take care of us through our entire lives, and with prudence, will take care of our children.

Jim Pappas