The year went out with a bang! The S&P’s 4th Quarter enjoyed a +6.6% return boosting the year’s total return to +21.8%. The rally was broad based; that is, most sectors within the S&P 500 were up around that +20% level with tech leading the way, up +37%. Interest rate sensitive sectors gained less. REITs (Real Estate Investment Trusts) and utilities were only up +7% and 8%, respectively due to rising short term rates.
Why the bang? The world is experiencing synchronized growth which profited companies both from here and from abroad. The US dollar declined making US companies more price competitive. In 2017, US corporate profits were up an estimated +10% which does not include any acceleration anticipated from recent tax cuts. Overseas central banks continued to add liquidity; global inflation was benign.
As usual, that leaves Gold Leaf to navigate the fine line between investing for the long term in good companies at attractive prices while balancing three key risks: 1). Valuation risk – are the markets too high and already reflect all the good news detailed in paragraph above? 2). Inflation risk – will inflation force higher interest rates? 3). Liquidity risk – is the era of QE “cheap money” coming to an end?
Gold Leaf portfolios are balanced to reduce risk. None appreciated as much as +21.8%, and yet we had our winners. Portola, a biotech firm, was up +115% for the year. Microchip Technology and Service Corp. both gained over +30%. Our laggards were all in the energy sector which is still working through the price see-saw engendered by shale drilling. Generally throughout the year, each time the market pegged a higher notch, we took that as an opportunity to take profits.
Our equity strategy merits comment. The market is currently rewarding high Price Earnings (PE) stocks (Amazon 310PE, GOOG 37PE, Facebook 35PE) hoping these companies will grow earnings fast enough to warrant the high price. Gold Leaf prefers to buy a stock when the price is lower, after the company has stumbled. The trick is to determine whether the flaw is fatal or fixable. For example, the equities we purchased in the recent past all had experienced some flaw. Several of our drug companies, e.g., had manufacturing problems; the drugs themselves are viable, we judged the manufacturing problems to be temporary, and bought at the lower price. Energy Transfer Partners (ETP), a pipeline operator, allowed drilling mud to enter Ohio creeks. The EPA shut them down; we thought it a time to buy. Over the longer haul, the margin of safety we obtain by waiting for price hiccups should prove profitable.
Fixed income investors (owners of bonds and other interest rate sensitive securities) should recall that we just finished an unprecedented 36 year bull market in bonds. The 30 yr. Treasury peaked at 14.8% in 1981. It now stands at 2.8%. As interest rates declined, bonds prices rose, and bond investors gained. The opposite will be true as rates rise. This has already begun to happen as the Fed raised short term rates three times in 2017 (with three more on tap for 2018). Short term maturities (like our VCSH, e.g.) declined in price in 2017. Fixed income investors who require income need to steel themselves a bit to ride out the price fluctuations realizing it is the income stream that is paramount; the price is much less important.
January 1, 2018 Paul F. Rodgers, CFA
Gold Leaf does not provide legal, accounting, or tax advice. Please consult your personal lawyer or accountant.