March Quarter Investor Letter

We continue to believe that equities are reasonably valued and will likely provide worthwhile returns in 2019, but the near-term outlook calls for a healthy dose of caution.  After a 14% decline in the S&P 500 during the fourth quarter of 2018 left stocks deeply oversold, the 12% rally in the first quarter has rendered equities somewhat overbought.  Consequently, a consolidation/correction within the bull market should not surprise any investor.

Several factors are at play here.  First, there is no doubt that GDP growth in the March quarter was sharply below the 2.2% gain at the end of last year.  The abrupt slowdown in the quarter reflects the government shutdown, severe winter weather, weakness among most of our trading partners in Europe and Asia, the roughly 7% year over year increase in the exchange value of the Dollar, as well as some typical quirks in first quarter seasonal adjustments.  As a result, corporate earnings are likely to be disappointing at best.  Moreover, palpable fear that the economy is headed for a recession has resulted from the recent inversion, albeit modest, in the 3-year/10-year Treasury yield curve.  Historically, inversions, with short-term rates rising above longer-dated yields, have presaged recessions, often with very long lags, but not always.  More important, however, it is a credit crunch, not a curve inversion per se, that brings on a recession.  There is no sign of one, now or on the horizon.  It is our view that, while growth will slow, no recession is likely this year and probably not even in 2020.  Long-term bond yields are under pressure because there has been a flight to safety as yields abroad, particularly in Germany and Japan are negative, and inflation is "missing in action." Also, the Federal Reserve has indicated that there will be no increase in the Federal Funds rate this year, and perhaps not even in 2020.  The futures markets are actually predicting there will be at least one rate reduction this year.

Regardless of these factors, in the past couple of weeks there has been an injection of fear in the minds of investors, who see sluggish retail sales, flat to lower industrial production, soft commodity prices (ex-oil) and an overall decline in interest rates.  They are moving to realize some profits from the strong March quarter rally.  Price moves in individual stocks are volatile and exaggerated because of the thin trading markets as well as the activities of algorithmic traders and ETFs, about which we have written frequently in the past.  Layered on top of the various fundamental factors are concerns regarding the slow progress of a trade deal with China, the chaos emanating from the Brexit efforts, and the often absurd and outrageous policies of taxation, regulation and spending put forth by various candidates for the Democratic presidential nomination.

Nevertheless, there are now a growing number of data points that suggest economic growth will pick up beginning in the June quarter.  We still believe that overall S&P 500 profits can reach $170, which suggests a forward price/earnings multiple of 16 and an earnings yield of more than 6% compared with roughly 4.8% for current BBB bonds.  As long as there are no serious, cycle-ending imbalances in the economy, and as long as the labor force continues modest growth without triggering wage-push inflation, and there is some improvement in productivity, a modest rise in corporate earnings should support higher equity prices.  In short, the next couple of months may be volatile and difficult, but for the year as a whole, we expect worthwhile returns from equities.

February Letter

Over the past few months, it has become abundantly clear that the U.S. economy is slowing down.  It took much too long for Fed Chairman Powell and most of his fellow FOMC members to see the contemporaneous data that most of us on Wall Street had been observing for weeks.  GDP growth this year is likely to be about 2% (+/-), whereas growth last year came in at about 3%.  The second half of this year is likely to be stronger than the first.  Inflation remains at less than 2%, even as employment and wages continue to rise at a modest pace.  The benefits of globalization, technological advances and many intensely competitive on line retail markets are all keeping a lid on pricing power.  Moreover, money supply growth and bank lending are proceeding at non-inflationary rates.  Corporate profits rose about 20% last year, benefiting significantly from the reduction in the corporate tax rate.  In the context of a 2% growth rate economy, profits this year are likely to advance at less than a double digit pace.  Nevertheless, we continue to expect that S&P 500 earnings will reach $170 this year.  At 2800, the Index is valuing this outcome at 16.5 times, for an earnings yield of 6.1%, still significantly above corporate bond yields.

At this writing, the S&P 500 has advanced 11.1% since the beginning of the year.  While this is outwardly a very large number, bear in mind that stock prices declined by 14% in the fourth quarter of 2018, before the FOMC came to its senses and reversed its policy of monetary tightening.  As we noted last month, market volatility is likely to remain high.  We expect to take advantage of price corrections to initiate or add to positions in well situated companies.

As always, there are risks to any forecast.  We believe there is little chance that the US economy will overheat any time soon, which would bring forth a tighter monetary policy.  On the contrary, the risks to growth stem largely from international and geopolitical factors, all of which are well known.  We do keep an eye on the strength of the US Dollar, as it affects both our exports and the translation of foreign-source earnings.  Growth in Europe has slowed to a crawl.  Growth in China also continues to come down.  China is now using both fiscal and monetary stimulus to increase its growth rate.  The ECB continues to pursue an accomodative monetary policy, as does the Bank of Japan.  If a trade deal with China is not soon forthcoming, and if the Administration raises tariffs sharply against not only Chinese imports but also those from the European Union, then all bets are off, and our forecast and our investment strategy will change dramatically to a maximum defensive posture.