Economic and Stock Market Update (3rd 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. We will use this letter to discuss our economic forecast as well as our stock and bond strategies. We have also included the returns and the quarterly transactions that are found at the end of this letter.
Economic and Stock Market Update
We believe the U.S. economy can break out of its funk and grow in the 3.0% to 3.5% range. The growth will be spurred by the stronger consumer, but businesses will unleash their vast cash holdings and also contribute to the higher growth rate. The US growth will be enough to pull the rest of the world forward. The consumer has been helped by low interest rates and higher employment. If we could get meaningful wage increases into this mix, the economy would really take off.
Equity prices will stabilize after this correction. In a typical fashion, the news is blowing the negatives way out of proportion. We do not believe a recession is in store. The Chinese economy will grow close to 4% (down from 8%) and the Fed’s rate increase will be minimal. The markets will work through these worries and then, barring some huge unforeseen event, we should get the world’s stock markets back on track.
Interest rates will not rise meaningfully until petroleum prices rebound. This will occur once the world economy grows fast enough to increase demand. In the meantime, we are stuck in a very low interest rate environment.
We use this section to review the client’s target asset allocation and compare the actual allocation to the target.
Stock Portfolio Update
The correction caused the S&P 500 Index P/E to fall from 21.5 times (trailing earnings) to 20.5X. The forward P/E is fairly valued at 16.1X (down from 17.8X). We believe the sell-off will allow the stock market to grow at a 10% rate going forward, boosted by economic growth.
The correction has created a lot of stocks with tremendous valuations. We went from having difficulty finding stocks to buy, to wishing we had more money to buy these bargains. P/E’s and yields are extremely low on the hardest hit sectors of the market:
Stock P/E Yield
Greenbrier 6.6X 1.8%
Micron Tech 7.4 0.0
American Rail 7.4 4.3
Corning 8.75 2.8
Seagate 8.8 5.0
Stock P/E Yield
Hercules 12X 12.1%
KKR 12 9.6
Blackstone 13.5 9.4
Rio Tinto 22.4 6.0, high P/E due to falling earnings
CPSI 18 6.0
Conoco Phillips 25 5.8, high P/E due to falling earnings
We continue to overweight technology, energy and emerging markets. Energy and EM were extremely hard hit during the correction, but we still believe in their long-term growth potential. For energy, world demand needs to come in line with supply. This is happening as producers are shutting off wells, but will accelerate as the world’s economy accelerates and sops up the excess supply. Given that there was no innovation that eliminated the need for oil, we will eventually see a rebound in this indispensable commodity.
Technology continues to innovate and grow at a rapid pace. This will continue throughout the cycle and will lead to higher valuations for our tech holdings. The emerging markets have been battered, partly due to the sell-off in commodities, and partly for local reasons. Yet, nothing has changed for the long-term outlook for these developing countries. GDP growth will be fastest in the EM countries and this should translate to higher longer-term equity growth.
News: Stock Portfolio
During the quarter, Berkshire Hathaway (Warren Buffett) purchased Precision Castparts for $235 a share. This sales price represented a 21% premium on the day of the deal. The deal, including debt, was worth over $37 billion. Before the purchase, Berkshire already had a 3% stake in the company.
Blackstone (BX) spun-off its advisory services business and PJT Capital to form a publicly traded company (PJT Capital – Ticker: PJT). For every 40 shares held of Blackstone, we received one share of PJT. Fractional shares are being aggregated, then sold on the open market. The proceeds will then be paid back to shareholders in cash.
Micron and Intel announced a new technology called “3D Xpoint.” This technology is considered non-volatile memory, which has the opportunity to be a game changer in the memory/storage industry. This technology would surpass NAND flash, which is found in solid state drives, memory cards and USB storage. 3D Xpoint is reported to be 1,000 times faster and less volatile than current NAND storage. The technology is still in production and the companies have hinted that it may be available for sale in 2016.
Westport Innovations bought Fuel Energy Solutions (FSYS) in an all-stock transaction. The deal is valued at $136 million. Westport stockholders will own 65% of Fuel Energy Systems while the remaining 35% is held by FSYS holders. Fuel Systems manufacturers alternative fuel components that are used in transportation methods.
We had three companies that raised their dividend during the quarter: Blackstone (to $2.85, up 34% year over), ConocoPhillips (to $2.96, 1.5% increase) and Verizon (to $2.26, 3% increase).
Bond Market Forecast and Update
The Federal Reserve will raise rates by a very small amount. All the news about the Fed’s rate increase is just noise, and can be ignored. The larger rate increases that will affect the economy and stock market will not occur until the price of oil and other commodities begin to rise. In essence, we are going to see low interest rates for a while.
Once the rates begin to rise, they will most likely be in small doses and will not have a huge negative effect on the economy. Remember, historically we had rates in the 5% range and the economy did fine. Higher rates will hurt, but part of this will be offset by the increased income of our senior population. Rising rates will add volatility to both economic growth as well as the stock market, but they will not cause a recession.
Our bond portfolios continue to utilize a ladder strategy of high quality bonds. We define high quality as single A or better. Most of our A rated bonds are backed by credit enhancements like school bond guarantees. The longer-term bonds in the ladder will give the portfolio income, while the shorter-term maturities will provide cash flow. When rates rise, the short bonds will mature and give us cash to increase the portfolio’s yield. Long-term bonds will lose market value when rates rise, but we will look to hold these securities to maturity and recoup the market losses.
During the market sell-off, a lot of the bond maturities were used to add to the equity allocation. Bonds serve an excellent role in the portfolio, in this case providing a known amount of money (no matter what the markets are doing) that can be used to buy equities at lower levels.
This section is used to provide the client with account specific returns.
Transactions for the Quarter
Each client would have their transactions detailed in this section.