Stocks posted their worst quarter in nearly four years. At one point, stocks were 13% off their highs, finishing the third quarter down -8%. 90% of all mutual funds, including index and exchange-traded funds (ETFs) lost money during the quarter.
It was about time. Stocks had not experienced a 10% or more decline since 2011, it was starting to get almost eerie. We needed to shake out the weak hands, get rid of the excess euphoria and the unrealistic expectation that the only direction stocks fluctuate is up. When we opened our monthly statements during the first week of October, we saw September 30th-based account values that were lower than we expected. As tempting as it may have been to react, the correct move was simply patience. During the first two weeks of October, stocks gained back almost all of the previous quarter’s decline. As of this writing, October 28, 2015, stocks have now recovered nearly all of the third quarter decline, and are now up slightly for the year. What happened to the late August /early September correction? It was followed by a powerful rally that has served to put this historic bull market back on track. When we open our monthly statements during the first week of November, we should see October 31-based account values that are much more pleasant to look at. Concerns about slowing growth in China not only sparked the correction, but also provided the Fed a reason to delay raising interest rates for at least another meeting. The correction was long overdue, much needed and just the kind we like to see. The best corrections are temporary and based on reasons that are not material to most U.S. companies. A China slow down, for instance, does not have a huge impact on our portfolio or most domestic companies. America imports approximately 4 times more goods than it exports to China. While companies like Caterpillar and Boeing get a lot of attention when China slows down, most of the companies that we own, benefit from a stronger dollar and cheaper Chinese imports. The significant positives that remain in place for the U.S. economy make a sustained economic recession highly unlikely. Our economy continues to be the strongest in the world. Energy prices are low, interest rates are low and unemployment is low. Simply put, this means people have jobs and extra money to spend. As a result, consumers are paying down debt, buying cars and remodeling their homes. This is driving consumption in our economy, including record auto sales. Yet, all this has been accomplished with relatively low housing starts. Strong housing starts are usually a huge driver in most recoveries. Housing starts are still down significantly from 20062007 levels. If housing starts were to return to more normal levels, we think this economy could begin a nice second leg up. Even without help from housing, the latest, final GDP (gross domestic product) reading from the 2nd quarter showed 3.9% growth, which is excellent.
GDP, unemployment levels, interest rates and gas prices are all facts that can’t be argued with. They bode well for higher stock prices down the road. However, we like companies that stand to benefit if energy prices and interest rates start going back up. For example, companies like Occidental Petroleum (OXY, $70.20) and Umpqua Bancorp (UMPQ, $16.40). These companies pay dividends of 4% and 3.75% respectively, and they make sense to hold while we wait for higher energy prices and higher interest rates. If these stocks return to their previous highs over time, they could also produce 55% and 83% gains respectively, not including dividends.
We also like special situation stocks like DollarTree (DLTR, $63.02) and Yum Brands (YUM, $73.17) which owns KFC, PizzaHut and Taco Bell, because of their strong, long term growth records and their current low stock prices due to temporarily weak quarterly earnings. DollarTree’s purchase of Family Dollar will take some time to digest as will the slowdown in China for KFC. But these are not long term issues. DollarTree is a fantastic franchise and the growing Chinese population absolutely craves KFC. Neither of these characteristics are likely to change any time soon. We also continue to like and own healthcare stocks in general, and specifically AbbVie Inc. (ABBV – a spin-off of Abbot Labs, $52.94) and Invivo Therapeutics (NVIV, $7.40). Most large, diversified drug companies such as Pfizer and Bristol Myers are trading near all-time highs, while AbbVie is down over 25% and pays a healthy 4% dividend. While Invivo is down significantly in price from its mention in this newsletter last quarter, we continue to like their prospects. While the company may be small and extremely speculative, their spinal cord repair tests on humans and approval process with the FDA continue to progress nicely.
Our job is to stay focused on finding the companies that provide the best values and that stand to benefit from trends in our society. Our job is not to time the market, but to time our ownership of undervalued companies, so as to maximize returns for our clients and shareholders. We hope our clients and shareholders stay focused on the long term, and ideally find ways to make additional investments when stocks are down. That’s it. No market timing or panicking required. Remember last quarter’s newsletter about our most successful clients over the past two decades? They were the buy and hold investors, who never panicked, who simply rode out every market downturn, and have made 4 to 5 times their original investment over the past two decades. You can’t argue with success.
We anticipate more volatility this fall as the markets gyrate around any Fed action, guidance or lack of action, yet we anticipate higher stock prices over the next 6 months as the strong U.S. consumer continues to drive corporate profits higher and the economy continues to expand. In short, stocks appear poised to appreciate. In particular, the weakness in energy, financial, retail and healthcare stocks has provided some of the best bargains we’ve seen in years.
We sincerely thank you for your interest, patience and loyalty as we continue building wealth wisely.