June 2020 Quarterly Update

July 9, 2019

Memo to Clients and Friends:

Re: Q2 Review

The first quarter of the year outdid itself to the downside with the market returning a negative 19.6%. But it made up for it since by increasing over 20% to end June with a year to date return of -3.1%, at least according to the S&P 500. Other measures of equity performance did not rebound as strongly.

A new index we have been watching more closely for several years is the S&P 500 Dividend Aristocrats, a collection of blue-chip dividend paying stocks that are more in line with our own yield favored approach. Over the past ten years, the records of the S&P 500 and its Dividend Aristocrats have been virtually identical but performance along the way has varied significantly and is more in line with our own performance configuration. As you will see from the benchmarks below, we have added it to the list of comparisons as a matter of perspective and ongoing interest.

Bond performance in Q2 leveled off after a very strong first quarter and money market yields are at alltime lows of close to zero. In fact, the return from the Bloomberg Barclays 1-3-month T-Bill Index was slightly negative in the second quarter due to anomalous swings in rates.

Benchmark Index Returns	3 Months Ending 06/30/2020	YTD Ending 06/30/2020
Lipper Balanced Fund Index	13.3%	-2.5%
S&P Dividend Aristocrats	17.7%	-9.7%
S&P 500 Stock Index	20.5%	-3.1%
Russell 1000 Value Index	14.3%	-16.3%
Bloomberg Barclays 1-3 Month T-Bill Index	-0.1%	0.1%
S&P-7-10-Year-US Treas. Bond Index	0.8%	11.1%
S&P U.S. Gov & Corporate 20+ Year Bond Index	5.4%	15.2%

 

As noted above, money market yields are now close to zero. This partly explains the strength of the stock market in spite of ongoing concerns about the Covid virus and economic recovery. The money fund yields have been pushed to historic lows by ongoing efforts from the Federal Reserve Bank to be sure that a liquidity shortage is no barrier to growth. High interest rates to defend the value of the dollar were at least part of the cause of the Great Depression in the 1930’s.

Current policy was started ten years ago by then Fed Chair Bernanke following the financial crises. But despite the huge growth in GDP generated since then, it has been continued, a policy we think has been less and less productive in recent years.

Then, along came the coronavirus resulting in the virtual shutdown in the U.S. (and global) economy. It is estimated that unemployment at its peak reached close to 15% of the workforce. To offset the individual pain caused by layoffs related to government COVID policy, huge stimulus packages were passed costing $7 trillion (note a trillion is a 1 followed by 12 zeros. It is a huge amount of money) so far and another is now being discussed. Because the money to pay for the programs does not just magically appear, the Fed was forced to effectively create money to fund the debt needed to pay for the stimulus. This has forced even more money into the economy. This was a necessary step to promote economic recovery but is a prime reason interest rates today are so low.

While all of this money was added to the system, not all of it was spent immediately, despite government efforts. In fact, saving rates among individuals have recently moved up sharply due to the virus. If the real economy does not need it, money ends up in the financial economy.

With interest rates near zero, it is not surprising that many consider common stocks the only game left where you can hopefully earn something. That is a big part of what produced the large and rapid turnaround in the market.

Another factor in recent equity returns has been psychological in nature. There was no question that if the virus caused the economy to fall off a cliff, the stock market would go down and it did. It reached its low near the end of March. However, the stock market looks ahead, not necessarily at what is happening today. As soon as it became clear that the apocalypse would not be as bad as initially thought, the market started going up again. The latest news on the economy, while not great, is vastly improved over what was originally anticipated, and statistics like unemployment have recently been much better and also well ahead of expectations. With lots of uninvested money lying around, this is what the market is now seeing. No wonder it went up.

Now back near or at all-time highs in terms of price, what comes next? We think not much that is sustainable and it would not be a surprise if the stock market ended the year about where it is today.

Given zero short-term rates and an improving economy, it is not difficult to justify the stock market selling at 20 to 25 times trend line earnings. Historically the market has sold at 15-16 times earnings, but that was when interest rates were considerably higher. Today the market sells at about 22 times projected next 12-month earnings, or pretty much in line with “fair value” under today’s conditions and expectations.

Finally, technology stocks continue their drive upward and, as the largest sector in the stock market, their positive performance has a substantial influence on the reported aggregate returns within the S&P 500. This is what largely accounts for the unusual performance disparity between the S&P 500 and other measures of market returns. The Dividend Aristocrats Index, for instance, calculates performance as though each security has equal weight. That approach is much closer to how most portfolios are actually managed and is one of the reasons we have added it to our benchmarks.

But what about risk with the S&P back near its February all time high? There is some evidence that the market is becoming more speculative. This is shown in the NASDAQ index that, unlike most other indexes has been regularly hitting new all-time highs. And the performance spread between the bluechip Dividend Aristocrats and the tech heavy S&P 500 is also a warning sign. This is what often happens at market tops. Opportunity stocks get stretched away from the rest of the market. Of course, there is also the risk that the recovery begins to lag what the market now seems to have in mind or the Covid virus takes off again.

Any of the above could cause a correction similar to what we saw in the first quarter and the odds are not insignificant that this could happen. Starting today we would say the there is a 35% probability that we could see another sharp decline. We would put similar odds on a relatively flat market between now and the end of the year and slightly lower odds on a continued rise. This is not a time to place big bets.

Top 20 Stocks

3M Company	Illinois Tool Works Inc.
AbbVie Inc.	Intel Corporation
Ameriprise Financial	Lowes Companies Inc.
Amgen Inc.	Microsoft Corporation
Archer Daniels Midland	Pfizer, Inc.
AT&T Inc.	Polaris Industries Inc.
Cardinal Health	Qualcomm Inc.
Emerson Electric Company	Cisco Systems, Inc.
Enterprise Products Partners L.P.	Starbucks Corporation
Fastenal Company	Technology Sector SPDR Fund

This quarter we saw some turnover in our top twenty list as Aflac, PepsiCo, and VF Corp came off the list while Cardinal Health, Polaris, and the Technology Sector SPDR ETF entered our top 20. We have spent some time in our recent letters on VF Corp (as a possible sell which we have recently been trimming where appropriate), Pepsi (a good stock to hold in difficult times), and Polaris (as one we would consider adding to once the worst had passed. In fact, we did add a few shares of Polaris at lower prices).

Looking at the new names, the Technology Sector Fund, is the one that joins the list as a new kind of purchase for us. For the last several years we have occasionally used low cost exchange traded funds (or ETFs) to make purchases in which buying and holding individual stocks has been difficult or where we preferred broader market exposure. Technology is a sector we would like to hold more of in theory, but for practical purposes (low or no income yield and very high valuations) it has been difficult to find enough individual stocks that meet our criteria for purchase today. The stocks in the sector we already own were mostly acquired many years ago when they did meet our minimum yield and growth requirements.

The technology sector is currently weighted at over 27% of the S&P, and this is after the sectors were reformatted so that companies like Amazon, Google, and Facebook are no longer considered technology (Amazon is now classified as consumer discretionary while Facebook and Google are communication services). Clearly technology is here to stay, and it has also been a general “winner” in the current recession. Enter the Technology Sector Fund. The Fund allows us to purchase a broad list of tech companies with just one purchase. We began purchasing it in the second quarter particularly in accounts that were very low in technology, and we plan to expand its use where appropriate.

While we do not plan any great changes in our strategy, there are some advantages to using sector funds. The one advantage that is particularly attractive for us today is that the technology sector fund is well diversified and therefore much less volatile than any of the individual securities it holds. In a time when the market can often seem fickle and an individual stock may rise or fall 5% or more on what seems like almost no news, the sector fund provides some level of comfort while allowing us the opportunity to participate in companies we might not otherwise own. From time to time you will probably see other sector funds being added to portfolios though they will never be a dominant part of our approach.

Drug distributor Cardinal Health is a long-time holding that we have trimmed or sold in the past (when the opioid crises was running hot), but more recently we have been buyers of the stock as we believe that they were one of the better actors during that whole crises. For instance, they were one of the first to move toward settling the many law suits that all distributors faced several years ago and while earnings took a hit, they never wavered on dividend payments and continued to raise them year after year. Cardinal Health distributes pharmaceuticals and medical products to over 90% of hospitals in the U.S. It serves over 29,000 pharmacies, 10,000 clinics, and 6,500 labs, and its home healthcare business reaches over 3 million individuals. In addition, Cardinal operates in an industry with high demand that is much more recession-proof than the typical company. After falling well off its highs earlier in the year the stock met all our criteria for purchase, and it remains on our buy list with a dividend yield of 3.75% that is well above its historical average. Cardinal Health is a stock we look forward to owning for some time.

Insurer Aflac fell off our list based on poor performance as the financial sector was the second worst performing in the S&P 500 year to date (behind energy). Along with other financials, Aflac stock has failed to gain back much ground in this recovery compared with the rest of the market. The rest of 2020 is likely to be difficult as the Corona virus began to have a direct impact on claims beginning in April. But Aflac is a financially strong company, and the current difficulties are likely to translate to earnings that are relatively flat rather than down substantially when compared to 2019. The depressed stock price already reflects much of the bad news, and our hunch is that the stock has overreacted to the downside. Meanwhile Aflac remains a financially strong dividend aristocrat (with 37 years of consecutive dividend increases), there does not appear to be any risk of a dividend cut, and we are paid over 3% while we wait for better days. For the time being we remain generally neutral on Aflac stock and rate it a “hold”.

Conclusion

Back near its all-time high, there do not seem to be any great bargains left in the stock market. So, while we will continue to look for opportunities to swap between stocks (to improve either valuation, income yield, or quality), it appears unlikely that any new initiatives will be undertaken this quarter. But of course, this is all dependent on price.

We do believe that the odds of another correction some time between now and the end of the year are pretty good. Should this occur, activity will pick up. But we are reasonably happy with the current structure of our portfolios.

Of course, if your long-range objectives change, so should the structure of your portfolio. If anyone believes this to be the case, please call us so we can discuss the implications for your account.

Sincerely,

Loudon Investment Management, LLC

DML/EJS/JJS/LO