January 2019 Client Letter
Last year ended on a sour note for stock-only investors, with the S&P 500 losing more than 9% in December and more than 13% for the quarter. December’s performance was the second-worst December on record for the index. While we weren’t surprised by the correction, the magnitude of the decline looked excessive given the lack of any meaningful negative surprises. Fed policy and trade rhetoric took the brunt of the initial blame for the sell-off; but Wall Street quickly decided the sell-off was a warning sign of recession. Demands for the Fed to back off its interest-rate-hiking cycle soon followed.
After initially resisting the Street’s appeals for support, steeper losses caused the Fed to capitulate. Just six weeks prior the Fed indicated interest rates would continue to increase in 2019 and there were no planned changes in the balance sheet unwind. Then, in its first meeting of 2019, the central bankers did a complete 180 on their policy outlook. As of now, no further interest rate increases are penciled in for 2019, and the balance sheet unwinding is likely to end sooner than originally anticipated. The selling pressure in the stock market seems to have subsided since.
Is the Stock-Market Correction a Signal of Recession?
Recessions are often accompanied by falling stock prices, but falling prices don’t guarantee economic contraction. There have been plenty of false positives throughout history. While the Fed made the predictable decision to cave to Wall Street’s demands to halt interest-rate increases, there aren’t yet many signs a recession is on the way.
The coincident economic data points toward continued economic strength. GDP is growing close to 3%, according to the Atlanta Fed GDPNow forecast; industrial production is up close to 4% over the last year despite trade skirmishes; the unemployment rate is under 4%; consumers appear to be in good financial shape.
The leading indicators look less solid, with two out of the last three months down; but financial markets have played a big role in those downticks. We are also encouraged that the railroad sector, a good leading economic indicator, continues to show signs of strength.
As the WSJ reported recently, the CEOs of two of the biggest rail firms in the U.S. are signaling that the U.S. economy remains on solid footing:
CSX CEO Jim Foote said customers plan to ship more goods and are also moving ahead on long-term capital projects, including expanding facilities. “When you talk to the business people, they’ve always indicated that the economy was still in good shape,” Mr. Foote said in an interview last week…
“There are a number of overhangs that you could point to and worry about whether that could trigger a slowdown,” including trade effects and consumer sentiment shifting due to the government shutdown, Union Pacific CEO Lance Fritz said last week. But the railroad’s customers expect strong demand and shipments across a number of sectors, including construction materials, steel, and plastics.
A Key Takeaway from Last Quarter’s Volatility
A key takeaway from the fourth-quarter volatility is how quickly things can unravel. Investors have apparently grown so accustomed to a decade of easy money and low interest rates that small changes in the amount of stimulus and in interest rates can have a large impact.
A phrase on Wall Street says that old age does not kill a bull market. While true, we are many years into the current cycle. The economy and stock market are cyclical beasts, and eventually, this cycle will end. Some believe the end of the current stock-market cycle is already here.
Are We at the End of the Cycle?
Jeremy Grantham’s firm, GMO, says the bubble in U.S. stocks is busting. Grantham is an expert in financial bubbles and widely known for identifying in advance the dangers of the dotcom and housing bubbles. Grantham’s associate, Martin Tarlie, wrote recently that a new model of bubbles suggests we may be at the beginning of the end of inflated U.S. stock valuations.
Tarlie suggests the size and duration of the move0 in stock prices in the last quarter of 2018 is similar to the moves that preceded the tech bubble burst and the crash of 1929. Tarlie and his fellow analysts found five major bubbles over the last 200-plus years, including the 1910s, 1929, the early 1980s, the tech boom, and today. Grantham wrote this in a more recent letter to investors:
As a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market…. When most have talking heads yammering about Amazon, Tencent and bitcoin and not Patriot replays—just as late 1999 featured the latest in Pets.com—we are probably down to the last few months.
If Grantham and Tarlie are correct, what should you do with your portfolio? Risk assessment is always paramount, but it is especially important toward the end of a growth cycle. Through the years, my dad has been relentless in his efforts to alert investors of the dangers of taking on too much risk. In August 2014, he explained a strategy for risk avoidance:
One of the most important investment steps you can take is to look at the big picture—that is, get high above street level so you can actually see the parade. Big risks are always big ideas, loaded with complexity and controversy. In most cases, the media is geared to work against you, and it’s difficult to break through and get at the truth. To frame risk parameters, I use inference reading—what I call outcome analysis—and on-the-ground anecdotal evidence. Whether you are currently in retirement or saving for a secure retirement within the next decade or so, retirement investing leads directly to risk analysis. I exert minimal effort worrying about what I am going to make on my investments. I concentrate on interest, dividends, portfolio balance, diversification, and compound interest. I know what I am being paid up front. And I know that a well-diversified portfolio of equities, fixed income, precious metals, and foreign currencies has historically provided consistent, positive, prudent returns.”
We pursue the same approach at Richard C. Young & Co., Ltd. We concentrate on diversification, income, compound interest, portfolio balance, and dividends.
The Humble Dividend
Dividends are central to our equity investment strategy. If a company doesn’t pay a dividend, we don’t invest. Over the last few years, dividend investing has fallen out of favor with many in the investing public. High-growth sectors where dividends are scant have captured investor attention and dollars.
In our view, it’s folly to eschew dividends today for the promise of capital appreciation from speculative sectors tomorrow. Dividends have always formed an essential part of the stock investing equation. In fact, over the last three decades, dividends and the reinvestment of dividends have generated over half of the stock market’s total return.
So why don’t more investors demand dividends? A hang-up for many is that dividend-paying companies are often boring businesses. They make things like soap and bleach, or they transmit electricity. The growth opportunities of many dividend payers pale in comparison to those available to firms in emerging industries. Nobody is getting rich quickly by investing in dividend-paying stocks. Creating wealth through the power of compounding is a slow and predictable process. But slow and predictable still beats speculative, unlikely, and uncertain as a strategy for building wealth.
Dividends a Soothing Tonic
What else is there to like about dividends? When markets fluctuate violently, as they did in December, the knowledge you are investing in businesses paying reliable dividends today with the promise of higher dividends tomorrow can act as a soothing tonic during uncertain times.
The Secular Health Care Wave
Our affinity for dividends is why we recently decided to close our positions in the Fidelity and Vanguard Health Care funds and to instead purchase individual health care stocks. We continue to favor the long-term outlook for the health care sector. By purchasing individual stocks, we have been able to nearly double the dividend yield of the health care ETFs while maintaining exposure to the sector’s powerful secular tailwind.
By the year 2030, the Baby Boomers will all be 65 or older. The Boomer generation represents such a large part of America’s population that one of every five American residents will be at retirement age. Reaching 65 and retiring creates obvious demands on your portfolio, but there are also major health impacts. Americans 65 and older use twice the number of prescription drugs compared to the under-65 population. Increased utilization, combined with growth in specialty medications, is expected to fuel a 6% rise in annual prescription spending over the next decade.
In 2010, Americans over 65 spent three times more than the average working-age person on health care and, even though they represented 13% of the population, America’s elderly citizens generated 34% of all health care spending. As Americans age beyond 65, the costs accelerate, with health expenses doubling between ages 70 and 90.
More Than Half of Americans Are on Two Prescription Drugs
In 2008, 88.4% of Americans over age 60 were using prescription drugs, and 36.7% of Americans 60 and over were regularly using five or more prescription drugs. Another 27.3% were using three or four drugs regularly. A 2013 Mayo Clinic study found that “nearly 70 percent of Americans are on at least one prescription drug, and more than half take two.” What does this all mean for the future? Health care spending is projected to increase to $5 trillion by 2022.
The stocks we are purchasing today to participate in the health care sector include Johnson & Johnson, CVS, Pfizer, Merck, Medtronic, Novartis, Novo Nordisk, and Sanofi Aventis. Most of you are familiar with JNJ and CVS, as both are long-time holdings. New names you may not be as familiar with are profiled below.
Pfizer is a global pharmaceutical company with strong portfolios of branded consumer drugs and prescription medications. Among Pfizer’s best-known consumer health care products are Advil, Robitussin, Centrum, and Nexium. The drug maker’s prescription portfolio is headlined by well-known names like Celebrex, Chantix, Enbrel, EpiPen, Lipitor, Prevnar, Viagra, Xanax, and Zoloft. Pfizer has been paying a dividend since 1901.
Merck is another major pharmaceutical producer. Merck spends billions on R&D each year to produce a pipeline of innovative and proprietary drugs. Merck’s portfolio of drugs includes well-known names like Clarinex, Fosamax, Gardasil (a vaccine for the human papillomavirus), Keytruda, the MMR II vaccine, Propecia, Singulair, and Zocor. Merck has been working on ways to treat and prevent illness since 1891 and has paid a dividend to shareholders since 1935.
In 1949, Earl Bakken and Palmer Hermundslie founded a medical equipment repair shop called Medtronic. The two men were asked to modify and create custom medical equipment solutions for their customers, and they became known for their ability to get the job done. When a blackout hit the Minneapolis area where Medtronic was based, Dr. C. Walton Lillehei, who often came to Bakken and Hermundslie for help with medical devices, asked the men to invent a battery-operated pacemaker. The invention would put Medtronic on the map. Today Medtronic operates from over 370 locations in 160 countries. The company now employs over 9,600 scientists and engineers and has amassed a portfolio of over 46,000 patents.
Novartis is made up of three main segments. The first is innovative medicines, which is again broken into two pieces: Novartis Oncology and Novartis Pharmaceuticals. The Oncology division focuses on treatments for cancer and rare diseases. Pharmaceuticals focus on a wider range of treatment and research areas, including ophthalmology, immunology, hepatology and dermatology, neuroscience, respiratory, and cardio-metabolic. Novartis’s portfolio of drugs includes well-known names like Cipro, Cosentyx, Ilaris, Lamisil, and Ritalin, among others. Novartis’s other businesses are Sandoz, which produces generic and biosimilar drugs, and Alcon, which produces the world’s widest selection of eye care devices.
In Denmark in the mid-1920s, two separate companies were founded to produce and sell insulin, which had recently been discovered. The companies, Nordisk Insulin Laboratorium and Novo Terapeutisk Laboratorium founded in 1923 and 1925, respectively, would later merge, becoming Novo Nordisk. Since that time, the company’s focus has been on care for diabetes. Today 81% of Novo Nordisk’s sales are related to diabetes care, for which it supplies nearly half the world’s insulin. Novo Nordisk does have smaller divisions focused on treatments for hemophilia, growth disorders, obesity, and other serious chronic diseases.
Sanofi is a global healthcare leader focused on human vaccines, rare diseases, multiple sclerosis, oncology, immunology, infectious diseases, diabetes and cardiovascular solutions, consumer healthcare, established prescription products and generics. Sanofi’s consumer healthcare portfolio is loaded with brand name over the counter drugs and products including Allegra, Gold Bond, Nasacort, Unisom and many more. The company’s prescription portfolio is also full of strong brands, including Ambien, Flomax, Plavix, and more.
Have a good month. As always, please call us at (888) 456-5444 if your financial situation has changed or if you have questions about your investment portfolio.
Matthew A. Young
President and Chief Executive Officer
P.S. We view gold as an insurance policy for your portfolio. Gold tends to perform well during periods of uncertainty and stress. In the fourth quarter, gold performed as one would expect. The SPDR GoldShares ETF was up 7.5% compared to a 13.5% loss in the S&P 500.
P.P.S. One of the more disappointing developments beginning in the fourth quarter was the decline of the bellwether 10-year treasury yield. After climbing to a near-seven-year high, the yield declined back down to 2.75% in late January. As the yield environment in general improved for much of 2018, we saw a significant increase in the yield on new purchases for corporate bonds. For new individual corporate bond purchases, we still anticipate being able to tie down yields north of 3%.
P.P.S. Several clients have rightfully expressed concern to me about the amount of debt owed by the U.S. federal government. While certainly a concern, the more pressing risk could be the debt and budgetary issues facing many states in the U.S., especially during the next recession. Many states have cash reserves of only 1% to 2% of their budgets. Many are also funded almost entirely by their income taxes. Income taxes take a major hit during recessions, and the states most reliant on them will be hit hard. Perhaps what’s worst about state finances are the many underfunded pension programs across the country. States have been underfunding their pensions for years, robbing Peter to pay Paul. At some point, perhaps during the next recession, those states will be forced to choose between keeping the promises they have made to their retired employees and maintaining their current spending. The extra taxation and debt necessary to deal with any shortfalls could negatively impact economic growth and soak up financing, leaving businesses paying higher rates, eroding earnings and ultimately costing shareholders.