QUARTERLY INVESTMENT UPDATE
1st QUARTER 2017
Dear Clients & Friends,
March 9, 2009. Hard to believe, but it was eight years ago last month that the stock market touched its last major bottom. It was the depths of the global financial crisis. Unemployment was soaring. Investors feared an uncontrollable collapse of the world banking system. Yet, at seemingly the darkest hour, the Standard & Poor’s 500 Index scrapped its final low of an excruciating 17-month bear market. The index closed that day at 676.53. It has since more than tripled, to a recent high of 2,400.98 on March 1, 2017. From Election Day to March 1, the headline U.S. equity indexes climbed almost without interruption.
Eight years is a long time for the market to rise without a serious interruption such as a decline of 20% or more on a closing basis. The longest stretch that the Standard & Poor’s 500 Index and the Dow Jones Industrial Average have gone without at least one index experiencing such a drop is nine years and three months (October 1990 to January 2000). However, bull markets do not die of old age. In theory, this one could keep running several years more – if corporate profits continue to grow, interest rates remain well behaved and our leaders manage to avoid a political or geopolitical disaster. While nobody knows the day or the hour of the exact top, we want to be in an appropriately defensive posture when the turning point arrives. This does not mean selling all of our stocks and running to the hills.
One way of measuring the market’s overall valuation status is the price-to-peak earnings ratio, which is derived by dividing the current reading of the Standard & Poor’s 500 Index by the most recent 12 months of peak earnings, computed according to generally accepted accounting principles, for the constituent companies in the index. Currently, analysts estimate that the Standard & Poor’s 500 companies will achieve $120.57 of as-reported earnings by year-end 2017. Even if we assume that rosy forecast comes true, the index, at 20 times earnings, would trade at 2,411, less than 1% of its March top. For the market to climb significantly higher, and stay there, the current degree of investor exuberance would need to be sustained pretty much all year long. In short, we currently do not foresee more than a routine pullback of 5% or so, which would probably be healthy for the stock market.
During the quarter, we increased our current above-average cash levels to historic levels by selling over-valued investments. We increased our cash levels by selling our entire positions in Nuveen Floating Rate Income Fund (JFR), Oneok Partners L.P. (OKS), HSBC Holdings PLC (HSBC), The Walt Disney Company (DIS), and Eaton Vance Tax Managed (ETY). We used some of the cash to purchase undervalued equity stocks in the consumer staples sector, such as Colgate, Dollar General, Coke, The Kroger Co. and Kimberly Clark. We also added one more pharmaceutical position in Johnsons & Johnsons (JNJ).
On the Fixed Income side, while it is true that the Federal Reserve has embarked on a modest credit-snugging campaign, we feel that the central bank’s appetite for rate hikes will wane later in the year. Perhaps the economy will grow at a somewhat less torrid pace than Wall Street expects. Whatever the cause, the insiders of the bond market, such as dealers and other commercial interest who trade bonds for a living, do not seem to think yields are going much higher. They have been loading up on Treasury-bond futures. In fact, they have built up just about the largest net long position of the past six years. Accordingly, we established three additional bond positions on the fixed income portions of our portfolios for a trade. Our first position is the DoubleLine Total Return Bonds N (DLTNX) which features a portfolio of short duration bonds. Our second bond position is the iShares 20+ Year Treasury Bond ETF (TLT), which has a portfolio of long-dated bonds. Our third bond position is the Blackrock Muni Holdings Quality Fund, Inc. (MUE), which has a portfolio of municipal bonds with a current yield of 6%. When we say “for a trade”, it means that we can expect to hold the funds on a short-term basis as opposed to our holding of investments in companies that may take 3 to 5 years to achieve our target of fair value. In addition, we added a new position in SSE P/C (SSEZY), an electric-and-gas utility serving Scotland and portions of England. SSE has raised its dividend (in British pounds) each year since 1999, with a current dividend yield of 5.9%. We are also expecting SSE’s home currency to appreciate 5%-10% against the dollar over the next year or two. Thanks to the undervalued pound currency, a Big Mac in London costs the equivalent of only $3.70, tax included.
As far as our investment strategy is concerned, we continue to maintain our standard two-pronged strategy, which is to maintain a substantial exposure to common stocks (and mutual funds) as long as there is a reasonable prospect for double-digit returns. Furthermore, we will continue to take profits more frequently so that we could gradually increase our weighting in cash as well as the fixed income portion of our portfolios. During the quarter, we changed our average asset allocation mix of 45%-50% Equity, 45%-50% Fixed Income and 0%-10% cash to 40%-50% Equity, 40%-50% Fixed Income and 0%-20% cash for most of the portfolios.
We want to thank all of you for giving our firm the opportunity to serve you. We thank you very much for the trust and confidence you have placed in our firm as it is always appreciated. Please contact us should you have any questions or comments. Also, we want to invite you to visit our website at www.farmandinvestments.com for a quick Retirement calculator, our latest firm news, and Market Commentary archives.
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