Quarterly Newsletter January 4, 2017

So what do you think about this Trump rally? This is a question we are getting frequently. I have to admit we were a bit surprised by how strong the market has been since the election. Is the market getting expensive, should we raise some cash? The market is up 5% since the election so it is 5% more expensive than it was before the election. While we pay a lot of attention to valuation in our stock selections, valuation is not a great market timing tool. Quite frequently the market will trade up or down to extreme levels disregarding historical trading patterns.
spx

The graph above is a 35 year graph of the S&P 500. The green line is earnings/share, the red line is dividend/share and the jagged blue line is the price of the stock. If you had invested 35 years ago and put your stocks in your lock box, you would have experienced a lot of ups and downs (many quite severe) but I would guess you would be happy with your results today. You will notice there is a pretty good correlation between stock prices and earnings. The four gray areas are recessions. During recessions earnings drop and so do stock prices. If you were going to pick a time to not be in stocks recessions would be high on your list. You will also notice a pretty fair correlation between earnings and dividends. Over time companies have paid out between 30 and 60% of their earnings in dividends. Today the S&P 500 dividend/earnings percentage is 39%.

Earnings are down a little over the last couple years. Part of this is related to the depressed earnings of the oil industry. The market today is discounting better earnings ahead partly as a result of the dramatic changes in the White House.

The last recession ended in June 2009 so the economic recovery is now 7½ years old. The good news is the vast majority of the economic indicators we follow are predicting a continued upturn and no recession for the foreseeable future. Included in the Trump rally is the biggest increase in interest rates we have seen in a long time. As most of you know we keep a pretty close eye on the yield curve (short term interest rates vs long term interest rates). When short term interest rates exceed long term rates (2000 and 2006) the economy slows and a recession follows. While short rates have increased long rates have also increased, so the yield curve remains positive.

To wrap up I have 35 year charts on two of our core stocks—Johnson and Johnson and McDonalds and also a chart on American Electric Power (one of the nation’s largest electric utilities). The contrast between JNJ and MCD vs AEP in earnings and dividend increases is pretty obvious. Growth in earnings and dividends over time is very important to us. Not all of our core stocks have perfect earnings reports every quarter. Of the 28 stocks, 4 or 5 will typically have disappointing results. Our long term philosophy was severely tested during the early 2000s by McDonalds. Earnings were disappointing, the stock dropped and every article written about the company condemned them for foisting awful tasting, unhealthy food on its customers. We looked hard at their earnings and cash flow. While down a little, it wasn’t like they were losing money. As painful as it was, we bit the bullet and stayed with the company. The dividends kept coming in and eventually earnings turned up and the stock has responded nicely.

JNJ

MCD

AEP

I suspect 2017 will be an exciting year. We may be at war with Canada and Mexico or perhaps President Trump will negotiate the purchase of both countries. We have been through a relatively quiet period in the market. Quiet periods often are followed by periods of above average volatility so sit back and strap yourself in for a fun but sometimes punishing ride.

                                                                                                                                –David M. Meyer

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