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High-quality equities remain appropriate for long-term investors

By Staff | Apr 10, 2019

Craig Holston

After a dramatic sell off in the equity markets to end 2018, the S&P 500 rallied 13.65 percent in the first quarter of 2019. Investors looked past ongoing trade negotiations and focused instead on the continued strength of the U.S. economy and the companies that would most benefit from long-term growth. The industrial and energy sectors (which benefited from a 28 percent increase in crude oil) were big winners in the quarter along with information technology.

Investors also seemingly took advantage of temporarily cheaper prices to bid stocks back up toward their autumn 2018 highs. Indeed, we commented at the beginning of January that stock prices seemed sufficiently cheap to us that the S&P 500 could rally 10 percent or more in 2019 just to get back to “fair value.” Since then, the price to earnings ratio (P/E) of the S&P 500 has moved back up to its historical average. Once a market reverts to fair value, stocks tend to appreciate at the rate of future earnings growth, holding interest rates constant.

The move by the Federal Reserve Board to pause its campaign of steadily hiking interest rates also played a big factor in the equity rally. The yield on 10-Year Treasury bonds fell sharply below 2.5 percent in late March from 2.8 percent at the end of 2018, and 3.2 percent in October. After underperforming in 2018, real estate companies, utilities, and other high dividend payers rose in price as these companies benefited from the relative value of the income they provide versus traditional bonds.

Corporate earnings grew more than 20 percent in 2018, as the reduction in the corporate tax rate to 21 percent led to a quantum, one-time leap in profits. We would, however, expect both earnings and equity market returns to be more muted for the balance of 2019, as recent data points to a continued slowdown in Europe and Asia, as well as pockets of the U.S. economy. In addition, the decision by the U.S. government to initiate tariffs on some of its trading partners, and keep those tariffs in place, has sowed growing concern that U.S. companies will pay more for their input costs and see their sales slow overseas. We are watching closely how our portfolio companies are affected by, and try to fly around, a trade-induced slowdown.

Despite this more cautious tone, we still feel that high-quality equities remain appropriate for long-term investors depending on their overall risk tolerance and income needs. For clients who may benefit from the volatility reducing properties of traditional fixed income, we have been building individual bond portfolios. We are careful to emphasize shorter maturities, however. Because the yield curve is nearly flat (meaning yields on short-term and long-term bonds are essentially the same) we can protect our clients from future interest-rate moves to the upside by avoiding longer maturities.

Although most clients own both elements of growth and income in their portfolios, there are some who rely on larger distributions from their portfolios to help fund living expenses. For this group of investors, we continue to recommend higher dividend-paying equities that have a long history of increasing dividend payouts over time. In periods of higher market volatility, the consistency of the income stream of dividends has allowed investors to “weather the storm” better than those owning pure growth investments.

Craig Holston is the chief operating officer and senior portfolio manager with the Sanibel Captiva Trust Company.