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January 2016 Market Update

As we write this, the S&P 500 is climbing again. Its price is within a couple points of an all-time high set on February 28, 2014 or almost two years ago.  Ultimately it rose to an all-time high of 2,130.8 on May
21, 2015 and has traded below that level since. We often see the market overshoot good news to the upside and overshoot bad news to the downside. The market, especially the US equity market, seems to be below true value now and here’s why.
First, it is important to evaluate what the market is telling us.  Let’s take a large blue chip company like McDonald’s (MCD).  It has 941 million shares outstanding.  Yesterday (1/20/2016) it closed at $115.78 with 11.8 million shares trading.  If you multiply the shares outstanding (941 million) times the closing price ($115.78) you get the market capitalization for the company of $108.2 billion.  The price dropped about $2 per share from the previous day closing price so, allowing for rounding, the market capitalization dropped by $2 billion!  But why didn’t the other 98.7% of the shares trade?  We suspect the reason is current owners thought one of two things: either the stock price was below the true value of McDonald’s and the company may grow in value in the future or they believed McDonald’s was going to send them a dividend check no matter what the share price. Market share price reflects the value of a minority interest which is not the true value of the total company. So when you hear about trillions of dollars of value being wiped off the face of the Earth, you know that is not an accurate number and arguably a false number.
Market distortions aside, is there something fundamentally wrong with publicly traded companies or the economy that is driving prices lower?  On the negative side there are two components. The world economy is growing slowly.  The US set a record for sub 3% GDP growth rate: 9 years as of 12/31/2014. If the economy grows at 2% and the stock market grows at 12%, then a disconnect occurs that must be corrected.  Some believe the current correction is bringing company values back in line with more realistic earnings growth. The second component on the negative side is energy.  Companies reliant on selling oil and ancillary services like oil rigs, drilling platforms, etc... are hurting and that hurts that sector of the economy.  On the positive side of the equation, lower oil prices benefit consumers, transportation companies, and utilities to name a few.  We have not seen this drive economic growth yet, but we will. Another positive is low inflation, also impacted by lower oil costs.  Lastly, despite a .25% rate hike by the Fed in December, interest rates are at historic lows. The dividend yield on stocks in the S&P 500 is still higher than the yield on the 10 year Treasury bond.  In our view, the positives outweigh the negatives for both the economy and equity investing.
There are risks to current GDP growth.  Let’s face it, 2% growth is a rounding error away from negative growth.  Regardless, your portfolio generates interest from bonds and dividends from stocks.  Coupled with the relative price stability of short and intermediate bonds, each portfolio has a significant safety net of income and liquidity at a reasonable price.
When we evaluate the landscape of our industry we see asset allocation between equities and fixed income with global diversification is still the norm.  Warren Buffett, in a recent SEC filing, revealed significant purchases of Phillips 66, an integrated oil company.  Like him, most stock owners are holding or buying additional shares. Selling is the exception rather than the rule for a successful portfolio. Wealth is built by buying and holding the stocks and bonds of profitable, growing, well managed companies.
As I close this, the S&P 500 has climbed to within a hair of the all-time high as of March 6, 2014.
McDonald’s has added back $2 billion of market capitalization. Nothing really changed.
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