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Annual Letter to Clients

January 7, 2016

An annual letter to clients is, I believe, a necessary part of investment management.  If you use an investment manager, they should send you one, and if you manage your own investments, you should prepare one for yourself.

I do not manage investments but prepared this letter to illustrate what should be in such a letter (and if you are a do-it-yourself-er) to provide a model you could follow.  Investing is a serious endeavor and the wrong choices can affect or, possibly, destroy your financial security.  These letters or annual reports or reckonings are an important part of managing, controlling and getting a better understanding of the big picture.  The investment portfolio referred to is consistent with the illustrations in my blogs.

Last year was sort of a time out.  The markets were flat and nothing much happened with interest rates.  Those with relatively well diversified stock portfolios saw a 2.2% and .7% drop in the Dow Jones Industrial Average (DJIA) and S&P 500 Index (S&P500) and almost equivalent 5.7% gains and losses in the NASDAQ and Russell 2000.  On balance, there was a small loss.  However, the dividends paid by the companies in the four indexes were about 7.5% (2.5%, 2.1%, 1.0% and 1.9% respectively) providing a 4.5% portfolio yield assuming equal portfolio allocations to all four index stocks.  Many brokerage accounts provide annual performance results and for exact amounts you should check your account.

Interest rates were basically unchanged irrespective of the Fed increasing rates 25 basis points at the end of the year.  FYI a basis point is money-speak and is 1/100th of a percent.  25 basis points is .25%.  I don’t believe that increase will have any appreciable effect on the markets other than to signal the Fed’s appraisal of a strengthening economy.  I wrote a blog about this on December 17, 2015 and refer this to you.  The flatness of interest rates indicates that bond values did not change noticeably in 2015 keeping portfolios stable.  Your 20-year laddered fixed income portfolio threw off 3.23% in interest

Since the Fed’s signal of a strengthening economy China halted stock trading on January 4, 2016 because of a precipitous reaction to a drop in manufacturing.  This caused the U.S. markets to also drop.  I believe this is a temporary blip and do not have a concern that this will have any effect on long term portfolio positions.  However I am pointing this out to indicate that the Fed’s five governors should have taken the China situation into account when agreeing among themselves about the economy.  We are really in a global economy and someone stubbing their toe halfway around the world would cause a ripple for us.

Our portfolio is comprised of the four major U.S. index funds.  We do not have any foreign or emerging market funds.  Our recommendations are contrary to that of many analysts who feel foreign investments is a must.  We agree that foreign exposure is important in a well-diversified portfolio. However, we believe we have that in our portfolio.  The sales’ revenues for the S&P500 companies in 2014 were almost 48% from sources outside the United States; and these operations were distributed throughout the globe.  That looks like foreign exposure to me.  I do not believe it is necessary to go out of your way to increase this exposure by buying foreign stocks or mutual funds.   Another point to consider is the amount of income taxes the S&P500 companies pay to Uncle Sam. It has been increasing with almost 62% of their taxes being paid to the U.S. leaving 38% to foreign governments.  Three years ago the split was 51% to Uncle Sam and 49% to foreign governments.  This indicates a trend of rising U.S. based profits and declining foreign profits.  Question: Why invest into a declining market?  Further, the dollar was flat this year vis-a-vis the Yen but strengthened against the Euro.  A stronger dollar hurts offshore investments since you get fewer dollars back when repatriating your money causing a loss on the currency conversion.  Even if you do very well in your foreign investments, a strong dollar will erode your profits.  This is very confusing and there are many moving parts.  I would rather let Coca-Cola, Johnson & Johnson and even Apple and IBM worry about this than deal with it separately in my portfolio.

Some people question whether foreign bonds that pay higher interest should be in their portfolio.  Well, the interest rates are partially a function of that country’s inflation rate and that results in a change in the exchange rate with the dollar.  If you took the time to do the math, it all balances out – there is no killing to be made this way.  Talking about killing, unless you are a distressed bond trader, you buy bonds to anchor your portfolio with definite interest payments and a return of your funds when the bonds mature.  If for any other reason, read someone else’s blogs.  Commodities are another story and since cash flow is an important factor in your asset allocation, we passed on this all together.  Gold and oil do not pay dividends. Also, both dropped significantly last year.

My last blog showed 10-year market performance and benchmark charts and graphs; but what are the charts really telling us?

The purpose of posting them is to indicate market trends over a reasonable period – such as ten years. From a birds-eye view, they show some macro trends. The markets, as defined by the four indexes illustrated, are trending upward, although it hasn’t been a smooth ride. There have been some huge dips and spike ups. The charts also show that the movement of these four indexes all follow the same direction, albeit with different amounts. Possibly, what this indicates is that to share in the growth of the market, it almost doesn’t matter what you invest in as long as you are in the market with diversified across-the-board stocks. The indexes I chose are the four most-quoted and largest indexes for their groups. We chose investing in funds that try to mimic these indexes.  I feel that accepting the market returns is the appropriate way to invest.  FYI, this type of investing is considered “passive” because the goal is to duplicate the market returns as reflected in the changes in the index and not beat the market as “actively” traded funds try to do. Over time, most of the actively managed mutual funds do not perform better than the index for that type of fund. In some years they might do much better, but over a long period, such as ten years they do not. However there are some funds that consistently do well, but they are in the minority.

What is not shown on the charts are the highs and lows within each year. Only the year-end amounts are shown.  For the purposes of indicating trends, this might be sufficient, but can also be misleading. For instance, the DJIA low point was around 6500 on March 9, 2009, yet this amount is not reflected at all in the charts since 2008 ended at 8776 and 2009 ended at 10428. However, this doesn’t change the long term trend.

Another thing the charts do not indicate are changes in the dollar amounts of dividends. The yields are provided in percentages. The year end 2008 DJIA yield was 3.58% and 2009 was 2.64%. This is a function of the dollar amount of dividends for that year divided by the market value of the index as of the end of the year. When the market tanked at Dec 31, 2008, the yield went up and when the market recovered, the yield dropped. Note that the 2008 dividends were $316.40 and the 2009 dividends were $277.38 which is a year to year dollar drop of about 12.3%. We live off of, spend or reinvest dollars, not the yield percent and to a great extent do not really do anything with the changing prices of stocks. This relatively small drop in dividends over that period in view of everything else that occurred doesn’t appear to be so devastating.

The Price/Earnings (P/E) trends are clear with some major deviations. Very high P/Es for the DJIA at 2007 and S&P500 at 2009 would need some examination and explanation of the aberrant activity in certain component members. However, the consistent P/Es before and after indicate stable earnings in relation to stock prices. In general, the market does not like surprises and erratic profits create instability. While employment dropped considerably in 2008/2009, corporate profits did not (possibly because of layoffs) and as profits increased stock prices rose. Also, there appears to be a trend now toward higher dividends even among the so called growth companies causing some stock prices to rise.

Similarly, not evident is each person’s starting point. If you started at the exact beginning of the period then the results are accurate for you. However, no one actually starts at the dates indicated, so results vary for each of us. Further adding or withdrawing funds during periods also skew results as do portfolio management and trading costs and taxes and the effects of having cash sit idle until invested.

There is more, but I think I made the point. The charts and indexes provide indications of trends and should be used as a guide along with all the other available data before you make a long term investing decision.

The above is an brief analysis of the investing situation based on how your portfolio is constituted.  If you have any comments or questions concerning the above, please do not hesitate to contact me.

Closing comment: I hope this is clear for you and it helps you evaluate your portfolio and its performance last year.  This is the type of update and explanation your investment manager should send to you.  Also, if you manage your investments yourself, I suggest preparing a similar analysis. This will help you get a firmer grasp on your investments, better understanding what you are doing, and why, and what alternatives are available.  Regardless of where you are with your investments, a new year has just begun and that is always a good time to reflect on what you are doing.  Good luck and best wishes for a Happy, Satisfying, Prosperous and Peaceful New Year.

Ed Mendlowitz

One Comment leave one →
  1. Ed Mendlowitz permalink
    January 11, 2016 3:02 pm

    Correction to blog: The portfolio yield should be the average of the yields of the four indexes or about 1.9%. This should be offset by the overall portfolio loss of -.7% indicating a net portfolio total return for the year of about 1.2% and not the 4.5% portfolio yield shown in the blog.

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