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Economic and Stock Market Update (4th Quarter 2015)

This is a sample of the letter that I send to all of my management clients on a quarterly basis.

Economic and Stock Market Update

We continue to believe that the world economy will grow in 2016, led by solid gains in the US. Lower energy prices will act like a tax cut for all participants in the US economy for both the consumer and businesses. Business hiring will also continue to be strong, creating wage growth and allowing the consumer to step-up spending. We believe the US economy will break out of its slow growth and advance in the 3% to 3.5% range. I address some of the concerns market participants are focused on below:

-Rising interest rates: The Fed moved to raise rates, and bond prices actually rose (and rates fell). For now, the Fed moves will be small and virtually meaningless. We will see meaningful moves when inflation perks up and the bond markets respond. Until then, this is just noise.

-China: China’s growth is slowing, but should show a 4% growth rate, not a recession. Their stock market is overvalued, and the sell-off is healthy over the long run. But like our market, sell-offs create fear, and China needs to weather that storm.

-North Korea, Iran and Saudi Arabia, Russia and Syria: We have always had hot spots in the world. It seems we have a few more now, or at least more are boiling up at this time. If any of these turn into a shooting war, the markets will react. But over the long run, as long as we do not face nuclear annihilation, economic growth will trump world risks and we will move forward.

-Presidential election: The election has been interesting, and remains so. No matter what your political persuasion, keep in mind that America is strong enough to survive poor presidents. We have done so before, and will do so again.

-ISIS, terrorism: The attacks will continue. It is very difficult to stop people that are willing to kill themselves. That said, ISIS as a whole and the terrorist attacks have little impact on the world economy, and almost no impact on the US economy.

In the end, we believe that none of these concerns at their present level are enough to knock the US economy off its pegs. The US will show strong growth and allow the world to move forward economically.

Asset Allocation

We use this section to review the client’s target asset allocation and compare the actual allocation to the target.

Stock Portfolio Update

We needed a correction and got one. The stock market was overvalued, and the sell-off will bring stocks closer in line to their fundamentals. This will set up the next rally and help us avoid the really nasty sell-offs caused by a bubble. Unfortunately, one can never control a correction, and this one is taking a life of its own. There is some negative news, and maybe more than usual. But the overriding positives remain in place: the US economy will grow, driven higher by both low energy prices and a stronger consumer. The world economy will follow suit, and eventually stock prices will follow the economy higher.

The individual stock portfolios carry an overweight to energy. As you will see in the Performance section, this hurt our returns in 2015. However, energy stocks offer a compelling valuation and hefty dividend yield. The yield will buy us time to wait out the energy sell-off. As the economy grows, so will demand for energy, and eventually supply and demand will come in line. Until then, we will continue to build positions in our three oil companies and wait for prices to turn.

Our other major theme for the portfolio is technology. In most portfolios, we use a combination of individual tech stocks (Apple, Cisco, Micron and Seagate) and Ivy Science and Technology. The individual stocks are old line firms with earnings, while Ivy adds exposure to the new, faster growing firms. Our financial stocks are not the typical banks and insurance companies. Instead, we are currently invested in hedge fund managers (Blackstone, KKR and Och Ziff), credit card processor (Synchrony) and debt collection (PRA Group, the old Portfolio Recovery).

We have three major themes in the equity portfolios that do not use individual stocks: energy, technology and emerging markets. As will be seen in the next section, all three hurt our returns this year. Technology and EM offer the potential of faster growth rates, tech versus other industries and EM against other countries. These have always been higher risk investments, and we just need to be patient to see the higher growth rates translate into higher returns. Energy is a turnaround play. We will wait out the bounce in oil prices, and then reap the returns as this market normalizes.

News: Stock Portfolio

It was ruled that Caterpillar must pay roughly $75 million in damages in a lawsuit by a former supplier (Miller UK Ltd.). The supplier had accused Caterpillar of mishandling/stealing its trade secrets. The lawsuit was originally filed in 2010. The stock price was not affected by the news.

Corning announced that the company expects to raise their annual dividend by 10% a year through 2019. The company also plans to re-purchase $4 billion in shares. Combined, this is estimated to return more than $10 billion to shareholders. Corning ended its 72-year joint venture with Dow Chemical Co., and received $4.8 billion for its 50% stake. Along with this deal, Corning will receive a 40% stake in Hemlock Semiconductor group, which makes semiconductors for the solar panel industry. Corning also made headlines by entering the automotive industry. In December, Ford announced that the Ford GT supercar will be the first production vehicle to have a windshield which contains Gorilla Glass (Corning’s signature product).

During the quarter, Disney released “Star Wars: The Force Awakens.” The film is now the number one grossing film of all time in North America, surpassing Avatar. Star Wars accomplished this in 20 days, compared to the seven month time period for Avatar. The film has a chance to be the number one grossing film of all time (globally), with China yet to debut the film. The number to beat is $2.8 billion, and Star Wars currently sits at $1.54 billion just 20 days after the release.

Johnson & Johnson approved a $10 billion share repurchase program. JNJ did not specify a timeline for the share buybacks and will be funded by issuing debt. This buyback represents roughly 4% of the total shares outstanding.

Third-quarter orders for new freight cars fell 83% (to 7,374) from third-quarter 2014. This is the biggest decline since 1988, and the lowest total amount since 2010. The impact of this weighed in on our railcar makers, American Railcar (ARII) and Greenbrier (GBX). Greenbrier has felt more of this decline, as new freight car orders are a bigger part of their business.

We had four companies that raised their dividend during the quarter: Blackstone (to $0.49, up 11% year over), Emerson Electric (to $1.90, 1.1% increase), Greenbrier (to $0.80, 33% increase) and Seagate Technology (to $2.52, 17% increase). As noted in KKR’s description, the company has gone to a flat annual dividend payment of $0.64.

Bond Market Forecast and Update

The Federal Reserve moved to raise rates this quarter and bond prices actually rose (rates fell). For now, the Fed moves will be small and virtually meaningless. We will see meaningful moves when inflation perks up and the bond markets respond. We will have a significant move in interest rates when economic growth causes meaningful increases in commodity prices. Until then, we are stuck in this low interest rate environment.

We are trying to find attractive rates at various parts of the yield curve. For a while, we were able to get 3% YTM’s in the early 2020s, but those rates have now fallen below 3% (and are very close to 2%). I have no interest in locking money up for five to six years for 2%! We have been able to get relatively attractive yields on the short end, like a 1% yield for one year. This is basically sticking the money away for a year to see if rates are higher when the bond matures.

Once rates do rise, our ladder will provide cash flow that will allow us to participate in the higher rates without having to sell bonds at a loss. The longer-term bonds in the portfolio will lose money as rates rise, but these bonds are providing the return to the portfolio as we wait.

Performance

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.