Economic and Stock Market Update (1st Quarter 2015)
This is a sample of the letter that I send to all of my management clients on a quarterly basis.
This letter will serve as our quarterly review of your accounts. The letter outlines our thoughts on the economy as well as our stock and bond strategies. Your quarterly returns are found in the Performance Section and the quarterly transactions are found at the end of this letter.
Economic and Stock Market Update
The faster economic growth that we expected did not come last quarter. This may be due to the extremely cold weather, but we continue to find excuses as the US economy muddles along. We believe that the huge drop in oil prices and other commodities will act like a tax cut for both corporate America and its consumers. This should be the impetus that leads to accelerating growth in the 3.5% to 4% range. The winter weather hurt economic activity, but maybe even more important was the fact that consumers saved their energy savings. This held back economic growth but will be a positive factor in the future.
We remain very positive on the economy. We are waiting for two huge factors to juice the economy going forward: the aforementioned consumer and business capital spending. Businesses are also saving, but at some point will look to spend their huge cash hoard to take advantage of the growing economy. We will continue to muddle along until these two forces spend, and then the US economy can grow at a rate over 4%.
The growing economy will be a positive for stocks, but stock prices are now getting into over-bought territory. A correction would be healthy for the stock market in the long-term. We have lowered our growth estimate to 8%. The large increase in interest rates has been delayed due to the drop in energy prices. The Fed will raise rates, but this will be very small and very slow. The real rate increases will come in reaction to the growing economy and rising inflation.
We use this section to review the client’s target asset allocation and compare the actual allocation to the target.
Stock Portfolio Update
As the stock market continues to advance, it is getting a little pricy. The S&P 500 Index P/E is now at 20.25 times trailing earnings. Even the forward P/E is ahead of itself at 17.4X. This is especially evident when we look at specific slow growth stocks:
Company P/E Growth
Coke 25X 5%
MMM 22X 9%
McDonald’s 20X 6%
Proctor Gamble 25X 7%
Pfizer 24X 2%
We could use a correction to let the fundamentals catch up with the Market. A sell-off now will allow the market to advance for a longer period going forward. Based on our projections for acceleration in economic growth, we still predict the long-term growth of the market from these levels to be in the 8% range. International and EM should show higher returns over the remainder of the cycle.
We continue to reduce or eliminate the small bank holdings as we find better opportunities elsewhere. Most portfolios have eliminated these issues, but a few holdings remain until we find a suitable replacement. The portfolio’s financials will be made up of the private equity managers (Blackstone, KKR, and Och Ziff) and the credit card processor (Synchrony) going forward. I do not see us adding large banks or insurance companies to the portfolios unless the valuations become much more attractive.
The portfolio is weighted towards cyclicals based on our economic forecast. The growing economy will eventually lead to higher oil prices (our overweight in oil stocks which includes Conoco, Royal Dutch and Occidental) and commodities (Rio Tinto). Our other cyclical holdings will see increased revenues and earnings: Caterpillar, Norfolk Southern and railroad suppliers American Rail and Greenbrier.
Another major holding is technology. Some accounts supplement the individual holdings with Ivy Science and Technology fund. Our tech holdings include Apple, Cisco, Computer Programs, Corning and Hercules. Our other positions are held for specific growth targets or for diversification.
News: Stock Portfolio
Apple had an outstanding earnings release during quarter one. The company sold 75 million iPhones during quarter four, which was up from 51 million from the previous year. Apple had released its new line of iPhones (iPhone 6 models), which helped spike demand. Apple’s stock price was up 13% for the quarter.
Blackstone has agreed to purchases the Willis Tower (formerly known as the Sears Tower) for $1.3 billion. Blackstone is betting on future growth in the city of Chicago.
The Willis Tower is the second-tallest building in the United States.
Disney announced that they will be opening a Shanghai resort in 2016, which was pushed back from a potential opening in late 2015. The resort will open in the spring of 2016, and the total estimated cost is $5.5 billion. The project is a joint venture with different entities within the Shanghai government.
Hercules announced a new stock offering during the quarter. The offering was for 6.6 million shares, which were priced at $13.64 a share. The stock fell 7% for the quarter.
We saw four companies increase their dividend this quarter: Cisco (to $0.84, 11%), Computer Programs & Systems (to $0.64, 14%) Ford (to 0.60, 20%), and Rio Tinto (to $1.20, 10%).
Stocks Nearing Their Target Sales Price:
Bond Market Forecast and Update
The Federal Reserve will raise rates by a very small amount. The larger rate increases that will matter to investors will not occur until the price of oil and other commodities begin to rise. We are stuck in this low interest rate environment for a while.
The growing economy will eventually lead to a turnaround in oil prices and later rising inflation. This will be the major driver for rising interest rates. We still believe rates can rise to normal levels (3% for money funds, 5% for short/intermediate bonds and 6% for long bonds). Because rates are so low, it is prohibitively expensive to hold a money fund waiting to invest at the higher yields. A short ladder works, especially for investors that have been buying a laddered portfolio all along. But those trying to establish a ladder now face yields under 1% out to 2019. The other alternative, which we employ for those that can handle the additional risk, is to add longer bonds to our existing maturity ladder. The ladder shortens as time passes and gives us a higher return than investing in short-term bonds. But when rates do rise, all of the bonds in the portfolio will sell off. The longer bonds will show more of a loss and may cause some participants to question this strategy. Our intention is to hold for maturity, thus recouping all of the losses and allowing the ladder to produce cash flow to invest in the future higher rates.
Our bond portfolios continue to utilize a ladder strategy of high quality bonds. We define high quality as single A or better. In some portfolios we do buy non-rated bonds, but these bonds carry a single-A or better underlying rating. Most of our A rated bonds are backed by credit enhancements like school bond guarantees.
The stock portfolio lost to the S&P 500 this quarter, which was held back by our oil positions and the higher yielding stocks. Our oil holdings showed larger loses (Conoco was down 9%, Occidental lost 8% and Royal Dutch fell 9%). Energy prices will remain volatile and may lose more until oil prices stabilize. In the meantime, these issues pay dividends above 4%, which will pay us to be patient for the turnaround. Other dividend payers that lost value included Rio Tinto (-10%), CPSI (-10%) and Hercules (-7%). Our winners helped to bring the total return close to breakeven: Black Stone (16%), Disney (13%), Apple (13%) and Tupperware (11%). Our client’s quarterly returns would be shown below.
The chart below is an example of some of the managers/ETFs we use.
|Fund Name||Total Return 3 Mo||Index Return 3 Mo||Total Return 12 Mo||Index Return 12 Mo||Total Return 3 Yr||Index Return 3 Yr||
|Dodge & Cox International Stock||4.20||3.89||1.48||-2.90||12.25||9.03||MSCI EAFE Value NR|
|Harbor International Instl||5.77||4.88||-2.43||-0.92||6.76||9.02||MSCI EAFE NR USD|
|Homestead Value||1.46||-0.69||12.96||9.12||17.19||15.34||S & P 500/Value|
|Homestead Growth||5.39||2.47||14.23||16.11||17.23||16.85||S & P 500/Growth|
|Lazard Emerging Markets||-1.98||2.24||-5.90||0.44||-1.20||0.31||MSCI EM NR|
|Schwab Fund US Large Index||-0.07||0.95||9.94||12.73||16.30||16.11||S & P 500|
|iShares Russell 3000 Index||1.76||1.80||12.18||12.37||16.22||16.43||Russell 3000 TR|
|iShares S&P 500 Value Index||-0.72||-0.69||8.93||9.12||15.12||15.34||S & P 500/Value|
|Vanguard S&P 500 ETF||0.94||0.95||12.68||12.73||16.07||16.11||S & P 500|
|Ivy Science & Technology I||5.10||1.52||8.79||16.96||21.10||13.65||MSCI US INFO TECH 25/50|
|Harding Loevner International Instl||5.18||5.85||4.36||1.05||8.29||8.96||MSCI EAFE Growth NR|
|Harding Loevner Emerging Markets||1.42||2.24||-0.97||0.44||3.24||0.31||MSCI EM NR|
|Matthews Asia Dividend Investor||8.64||7.49||10.50||6.31||9.53||7.68||S&P ASIA PACIFIC BMI TR USD|
|Matthews Pacific Tiger Investor||7.53||8.02||17.47||5.70||10.76||7.70||Vanguard Pacific Stock Index|
|Oppenheimer Developing Markets A||-1.35||2.24||-4.38||0.44||2.31||0.31||MSCI EM NR|
|Vanguard Energy ETF||-2.20||-2.38||-13.22||-13.66||3.17||2.65||MSCI US IMI/Energy 25-50 NR|
|William Blair International Growth N||5.59||5.85||3.08||1.05||9.49||8.96||MSCI EAFE Growth NR|
|Vanguard Energy Inv||-1.58||-1.51||-17.67||-13.47||-0.66||0.50||S & P NA Natl Res|
|Brandes Emerging Markets A||-5.94||2.24||-14.17||0.44||-3.13||0.31||MSCI EM NR|
Mutual Funds: Our fund’s portfolio showed gains due to the positive returns in our international growth segment. Matthews Pacific led with a gain of 7.5%. Other winners included William Blair (5.8%), Harbor (5.5%) and Harding (5%). Two of our US holdings also showed solid returns with Homestead Growth and Ivy Science and Technology gaining 5%. Offsetting the positive returns were our emerging markets holdings. Especially hard hit was our newly added EM manager, Brandes, which fell 6%. Oppenheimer and Lazard showed small losses. Our oil holding, Vanguard Energy, also lost value, dropping 2%.
Transactions for the Quarter
Each client would have their transactions detailed in this section.
Please call me if you have any questions on this letter.
Donald R. Gross, Jr., CFA