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Letter – 2016 Q3

The year got off to a tough start for us and most active managers, but we have held our own relative to the market since.  The market can be remarkably counter-intuitive.  Corporate earnings have actually retreated a bit.  Interest rates have moved slightly higher.  The quarter exhibited some nervousness around the presidential election.  Commodities remain in a deflationary cycle.  And yet the stock market continues to grind higher.

Is this irrational?  Not necessarily.  Ironically, an interesting take comes from economist Gary Shilling, who has offered more bearish than bullish commentary over the past few decades:  “If the dividend yields dropped to match the Treasury yield, the price/earnings ratio of the S&P would be closer to 63 than its current level of about 20. Following this logic, stocks are arguably undervalued by more than 60 percent.”  Over the past 30 years, the dividend yield has averaged nearly 3% lower than the 10 year Treasury yield, so Shilling’s viewpoint is not fanciful.  But rates may not be static.

There are indeed countervailing considerations, so we have not been overly aggressive, but we kept up with the market for the quarter.

It was a quarter that reversed internal trends of the first half of the year.  Investors have wanted it both ways – exposure to stocks but little risk.  People have wanted to be “in the market” but in “safe” stocks.  So many consumer staple stocks got bid up to levels where they weren’t so safe after all.  So just for example there were selloffs in defensive names such as Campbell Soup (-17.4%), Clorox (-9.0%), and Kimberly Clark (-7.6%).   The same is true of utilities and telecom stocks with their generous dividends; they were market leaders this year but were lower for the quarter as interest rates stopped moving lower and actually crept up slightly during the quarter.

The real question is not about short-term noise, but whether any long-term trends are changing – in interest rates and/or among industry groups.  The answer may be yes.  At some point, interest rates are likely to rise.  Intelligent commentators have been saying this for several years.  However, contrary to historic norms, despite inferior credit and liquidity the ten-year government yields in Spain and Italy are lower than those in the US.  Some feel those rates will be a magnet that forces US rates lower still, while others believe that European rates are unsustainably low.  The level and direction of interest rates has a major influence on the stock market; each industry group is impacted differently.

What about stocks that would benefit from higher interest rates?  In theory, banks should gain as interest rate spreads widen.  JP Morgan reflected this, gaining 7%.  But it is also true that banks are more heavily regulated than before 2008.  As such, they may be constrained from some of their historically most profitable activities – or they may be hit with huge fines.  That is a prospect facing Wells Fargo, which was also in a modest uptrend until the news broke about all of the fake accounts.  Banks may become the new utility stocks – decent yields, less fluctuation in earnings, and less upside.

The institution that we’ve added in the financial sector this quarter is in a bank that specializes in lending to tech companies – Silicon Valley Bank.  They are smart and entrepreneurial.  They are also less utility-like, and therefore higher risk.  That and the lack of a dividend means that we will limit our exposure.  But they are lending in the leading growth area of the economy.

Technology shares were the market leaders in the third quarter.  That strikes us as the resumption of a long-term trend that paused.  There may be more technical explanations for the rally as well.    It may be that part of the reason for the rebound in tech shares is that money has to go into existing shares, since the IPO market is dormant.  Normally a quiet IPO market is a sign of weakness in the economy or at least in a sector.  However, that is not the case at present.  Rather, interest rates are so low that tech entrepreneurs are opting to borrow rather than give away an interest in their company.

In a bull market, along with technology the other leaders have understandably been consumer and health care stocks.  These are the sectors with the best five and ten year gains.

What about health care now?  Will it resume its leadership or has something changed?  As in any sector, one cannot lump all parts of it together.  Biotechnology shares are the most volatile but have shown the most growth.  It is the home of so much blockbuster potential research.  The large pharmaceutical companies tend to grow more slowly and pay good dividends.  But even the majors can slip up.  Bristol Myers had some poor results on cancer efficacy and fell 26% for the quarter, but the market has likely overreacted given the company’s promising pipeline.

Monitoring sector performance depends in part upon the measure one uses.  It is interesting to me that different data sources show directional consistency but much variation when it comes to reporting sector returns.  Here is a quick quarter-end comparison of a few good sources:

Finviz Morningstar Fidelity
Tech 8.70 10.62 13.62
Financial 6.50 4.38 5.66
Health 0.50 0.95 1.48
Utility -4.80 -5.84 -4.67

It just depends on what stocks they have in their particular mix.

The one major sector we haven’t discussed is energy.  Oil stocks seem to be anticipating a reversion to higher prices for crude.  If this does not occur within some reasonable time frame, the stocks could weaken.  Natural gas stocks, which have been terrible for a long time, had a decent rally in the quarter.

The good news is that we made decent money this quarter, and so did the rest of America.  As reported in the Washington Post:  “Real median household income was $56,500 in 2015, the bureau reported, up from $53,700 in 2014. That 5.2 percent increase was the largest, in percentage terms, recorded by the bureau since it began tracking median income statistics in the 1960s.”  That should bode well for consumer stocks.  And hopefully for all of us.  Thank you again for your business and confidence.  We are available to help with broader financial planning issues at any time.

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