Favorable Fundamentals Remain in Place

© 2018 Bastiat Capital 1 www.bastiatfunds.com

Favorable Fundamentals Remain in Place

Bastiat Capital Q4 2017 Commentary

The headline to our fourth quarter 2016 commentary was “Now it’s time to make money.” That is exactly

how 2017 played out, much to the disappointment of the dissenters trafficking in doom and gloom. As we

noted then, there is never “a shortage of pundits, hungry for media attention, stirring panic and angst.

Nothing sells investment newsletters more swiftly than fear mongering.”

The S&P 500 posted a remarkable return of 19.42% on the year. Our composite portfolio (all client

portfolios combined) outperformed, with a gain of 22.36%, despite being as much as 15% in cash at

times due to the inflow of new money and a reluctance on our part to waiver from our standard practice of

allocating capital slowly but deliberately to mitigate risk. To illustrate the point, our largest legacy accounts,

representing more than 60% of total assets under management and more or less fully invested

throughout the year, returned 24.24% on a composite basis.

We were hoping for a correction of sorts to more efficiently deploy the new capital, but unlike most years

in the last decade, the dip never came. Indeed, in 2017, the S&P 500 notched a record 12 straight months

without a loss. This was accompanied by extremely low volatility as illustrated by the CBOE Volatility Index

(VIX). The average daily closing reading on the VIX in 2017 was 11.10, the lowest of any year by some

margin since the index’s inception in 1986. The average yearly average is more than 20.0.

Also, the S&P 500 has now posted nine straight years of gains. The same phenomenon occurred from

1991 to 1999, during which the aggregate increase was 450%, while the current winning streak adds up

to 261%. Since 1923, the index was up more than 20% in a single year on 32 occasions. Surprisingly,

there have only been 24 down years. So, what happens after a big move like we saw in 2017? On average,

the index posted a gain of 10.46% (median: 12.80%) after a year that registered a 20%-plus gain, with



positive returns more than two-thirds of the time. In other words, history tells us that there is a 66%

probability the market will again be positive at the end of 2018 and that the gain could be more than

10%. It gets better because historical returns of the S&P 500 show that on five different occasions when

the index returned 20%, it was followed by another 20% year, and for one of the five, the 20% returns

lasted another four years. This is the risk that market-timers face; if their timing is wrong, the

consequences are harsh.

On October 16, 2008, Warren Buffett wrote, in a New York Times op-ed that, “I can’t predict the short-

term movements of the stock market… I haven’t the faintest idea as to whether stocks will be higher or

lower a month—or a year—from now. What is likely, however, is that the market will move higher, perhaps

substantially so, well before either sentiment or the economy turns up. So, if you wait for the robins, spring

will be over.”

We do expect a weak January as investors take profits following last year’s super-sized returns. Once the

selling stops and indicators confirm continued economic growth, the market should once again, as it

usually does, reach new record highs. Recall, the S&P 500 kicked off in 2016 by falling 8% over its first 10

trading days, its worst opening period in history. After 28 trading days, the index was down a little over -

10%, again marking its worst start in history. This pattern could repeat itself. But long-term investors

ought not to be phased by the volatility. Volatility is not a risk; it is the source of future returns.

Also, keep in mind that most sell-offs are brief. Since 1923, the S&P 500 has experienced 47 corrections

of between 5% and 9.9%. Measured from peak to trough, they lasted on average one month, and the

market fully recovered after two months. We have seen 17 pullbacks that exceeded 10% but were limited

to 19.9%. In these instances, the decline lasted on average five months, and it took another four months

to fully recover. A severe but not catastrophic drop of between 20% and 40% occurred six times and took

on average 10 months to bottom, with another 12 months to recover fully. We have seen three so-called

mega-meltdowns of more than 40%. These are the ones that require extraordinary nerve and patience.

They last on average 23 months, and the market takes close to five years for a full recovery, at which point,

if history is any indication, investors can expect the S&P 500 to double before another substantial

pullback.



Four market strategists tracked by Bloomberg project that the S&P 500 will finish above 3,000, even as

high as 3,100, which calls for a 16% gain on the year. On the other hand, Bloomberg polled their regular

cohort of Wall Street analysts who appear less bullish. Their consensus S&P 500 price target for the end

of 2018 stands at 2,854, which would mean a gain of roughly 6%. Over the past nine years, these analysts

have underestimated actual returns seven times.

A Year Ago

In last year’s commentary, we quoted, Raymond James Financial Chief Investment Strategist Jeffrey Saut,

who argued that a cut in the corporate tax rate to 15% “could prove to be difficult,” but even at a tax rate

of 25%, the S&P 500 earnings estimate for 2017 would be approximately $144. A 17 P/E would give a

price target for the S&P 500 of roughly 2,450 by the end of 2017, nearly a 10% increase.

As Saut’s bullishness was vindicated, and with the final corporate tax cut coming in at 21% in the bill

passed by Congress at the end of the year, it is worth finding out what he thinks now. "I would expect

2018 to be an almost repeat of 2017, Saud recently told an interviewer. “People are still way

underinvested. Earnings are starting to come in better than expected. And with the tax reform, and

especially the corporate tax cuts, I think earnings are going to continue to surprise on the upside.”

The Tax Bill

A sorehead television host told viewers that their taxes are going up to give major corporations an

“embarrassing amount of money.” The unpalatable fact is that four out of every five taxpayers will see their

taxes go down. Several major corporations embraced the tax cuts with announcements of increased wages

and bonuses, which most rational people would consider good news, but which our host offered as proof

that the tax bill is a disaster. As soon as an issue is politicized, common sense is the victim.

The smart folk at Bloomberg News, a more

reliable source, examined the impact of the new

tax code on eight families:

“As soon as an issue is politicized,

common sense is the victim.”



(1) The Multimillionaires in New York: Under the current law their effective tax rate is 30.51%. They

will now pay 31.19%. Oops, the rich are paying more, not a whole lot more, but it contradicts the

propaganda filling our email inboxes and what we hear on television;

(2) The Second-Home Scenario in California with a primary residence in Malibu and a second home in

Lake Tahoe. Oops, another example that undermines the media’s disinformation campaign. Their

effective tax rate goes up from 26.77% to 27.24%, but again, small potatoes in the overall

context of their income and wealth;

(3) Small Business Owner in Pittsburgh: Wowzers, do we have a happy bunch of people in Pittsburg

today!? Their effective tax rate goes down from 18.69% to 11.58%;

(4) The Suburban Family in Westchester (could be neighbors to the Clintons, although this family’s

gross income is “only” $275,000). Their effective rate goes down from 17.43% to 15.10%, a mere

$6,000 “savings,” which a TV pundit will no doubt characterize as a tax break for the super-rich;

(5) Single in Manhattan and earning $130,000 will now be paying tax at an effective rate of 16.90%,

down from the current 18.57%;

(6) Married in Austin and earning $100,000: Here’s a big break for the “poor,” but don’t tell the media.

Their effective tax rate comes down from 11.28% to 8.74%;

(7) Median Income Family in Oregon earning $58,000 will see their effective tax rate come down from

8.01% to 6.38%, but still contributes $3,699 a year toward our bloated defense budget. Cut the

defense budget and give these wage-earners all a tax holiday is what we say; and

(8) Renting in Milwaukee: A couple with one child earning $40,000 pay $515 under the current tax

code will now receive a tax refund (an enhanced child tax credit) of $400.

An Inconvenient Truth

Now, to divulge a secret the media entirely misses. Take the couple in Milwaukee, who earn $40,000 and

ostensibly pay no taxes. In fact, properly analyzed, they pay 15.3% ($6,120) in stealth taxes, in the form of

payroll taxes (these are technically paid 50/50 by the employee and the employer, but it’s reasonable to

view the employer contribution as coming out of the employee’s pocket). For someone barely scraping by,

$6,120 is a ton of money! Our family in Milwaukee earning $40,000 is responsible for adding $6,120 to

the Treasury in return for a $400 child tax credit!



For those who argue that the payroll tax is not a tax because

the money is “set aside” for retirement purposes, we have a

bridge in Brooklyn on offer at a bargain price. If today's retirees

had paid their social security contributions and those of their

employer in the S&P 500 over the past 40 years, they would

have had at least $1.0 million to $1.5 million in their retirement

accounts today, depending on their salary levels. The average

monthly social security check is $1,350.

The families in Milwaukee and Oregon should be allowed to deposit their payroll taxes in two or three

designated ETFs, to remain untouched until they reach the age of, say, 67, and then only in annual

withdrawals of, say, 5% of capital on hand. A small part of the monthly contribution could go to an

insurance company that would provide them virtually unlimited healthcare, more than matching what

Medicare has to offer, on retirement. Now that would be real tax reform for the not-so-well-off, or poor

Take this all one step further. There are some dire predictions about massive budget deficits awaiting us in

coming years as a result of “all these irresponsible tax breaks for the rich.” Does that concern our

“honorable members of parliament?” Not in the least. They have a card up their sleeve. Don’t call us

Nostradamus if this all pans out. It seems a logical progression from the way they wheel-and-deal in

Washington. Within the next three years (unless tax revenues balloon), payroll taxes will go up by about

3%, perhaps not equally split between employers and employees. We suspect employers will have to

contribute, say, 2.45% and employees 0.55%. In addition, a means test will be applied and taxpayers with

a net worth in excess of, say, $5 million, will not be entitled to any benefits, or perhaps only to Medicare.

As Margaret Thatcher always argued: “Socialists eventually run out of other people’s money.”

Bastiat on the Beeb

On November 23, in an interview with BBC World Service, I pointed out that Apple was paying all the

taxes it was legally obligated to pay. This was the quote that the BBC chose to use following an hour-long

interview recorded a week earlier.

“For those who argue that the

payroll tax is not a tax because

the money is “set aside” for

retirement purposes, we have

a bridge in Brooklyn on offer

at a bargain price.”



For the record, what I told the BBC did not fit

their narrative, namely, that corporations should

be milked for all they are worth. My first and

most important point was that though the so-

called “rich” own Apple stock, so do tens of

millions of government workers (firefighter and

teachers, for example) at federal, state and local levels. Hence, when governments tax Apple’s profits, they

harm the retirement prospects of these workers. This fact is easy to prove.

Apple’s effective tax rate, based on actual cash taxes paid, was 18.1% in the company’s fiscal year ended

Sept. 30. The company’s current market cap is close to $900 billion. What would have happened to Apple’s

market cap if it paid the full 35% statutory rate? Based on fiscal 2017’s pre-tax earnings, it would have

lowered net income by another $11 billion. Apple’s current P/E ratio is 20. If Apple were forced to send an

additional $11 billion to Washington, its market cap would have taken a $220 billion hit (20 times $11

billion), and with that the retirement ambitions of many of its shareholders.

Taxing corporations destroys capital.

I proposed a more sensible tax regime, but the BBC preferred the comments of a Nobel Laureate who

claimed to be working on normalizing the tax regimes of nations – good luck with that. I recommended a

tax on the worldwide revenues of corporations of 1% to 2%, with such revenues being distributed to the

governments of the countries where the revenues were generated. Tax capital gains and dividends at 15%

at source, again distributing such taxes in line with the revenue tax distributions. Tax all dividends and

capital gains, regardless of the entity owning the stocks or residence status. For example, university

endowments would not be exempt. Only allow 50% of short-term capital losses as tax deductions against

capital gains within three years of incurring the losses. This tax regime would rid corporations of the cost

of employing an army of professionals to prepare their tax returns and eliminate a bureaucracy dedicated

to examining corporate tax returns, levying taxes on agreed upon profits and filing lawsuits when such

agreement cannot be reached. More importantly, countries would have to compete for capital and

resources not based on a favorable tax regime, but on their business climate.

“…though the so-called “rich” own

Apple stock, so do tens of millions of

government workers…at the federal,

state and local levels.”



We favor companies where management works hard to manage all costs, including the tax expense. In the

current political climate, corporate taxes are a hot topic. Because of the media’s penchant for presenting a

misleading picture as to the taxes paid by US corporations, we offered an alternative perspective based on

reality.

Tax Reform

Intuitively—some might argue simplistically—we believe

that lower taxes alone, without compensatory cuts in

government spending, cannot create sustainable organic

economic growth. This seems logical, but we hope we are

wrong. All the experts were convinced that Ben Bernanke’s massive expansion of the Fed’s balance sheet

was bound to fuel hyperinflation and cause the dollar to tank. It did not happen.

Instead of jumping to conclusions, let’s wait five years and then reassess the wisdom of today’s tax cuts. It

would defy our skepticism if, at the end of 2022, GDP stands at $23 trillion and government expenditures

at $4.5 trillion. Under such a scenario, the ratio of government expenditures as a percent of GDP would

have dropped from the current 22% to a more respectable 19.5%. This is another way of saying that if

growth in government expenditures (i.e. no budget cuts) lags significantly behind GDP growth over the

next five years.

In this context, consider that the economies of China, India, Philippines, Vietnam, and Indonesia are

growing at twice the rate of the developed world. In the aggregate, the populations of these countries

amount to 3.2 billion people. We could boost our GDP by 1% in 2018 if we increase our per capita

revenues from these countries by an additional six pennies. In other words, if these economies continue to

grow gangbuster and US corporations can increase the revenues they generate from these countries in a

meaningful way, the debate about tax rates and fiscal deficits may prove to be moot.

“We believe that lower taxes

alone, without compensatory

cuts in government spending,

cannot create sustainable

organic economic growth.”



Recession Watch

In the US, the risk of an economic recession in 2018 remains

minimal, supported by the consensus expectation for the

global economy to continue the current growth trajectory.

Both the Fed and the European Central Bank are aligned to

raise interest rates in sympathy with economic growth to

normalize rates and trim their balance sheets. The European stock markets are expected to post strong

returns on the back of earnings growth, attractive valuations and restrained political volatility.

Growth in Europe continues at an above-trend pace as the economic recovery remains on track.

Accommodative policy, meaningful increases in corporate earnings, attractive relative valuations, and

subdued political volatility provide a confluence of tailwinds for asset prices. Economic growth in China will

benefit other Asian countries, which augers well for 2018.

Economic Models

Economic theory often fails to enhance econometric models. There are just too many variables to fit into

one economic model. Experts diminish their ability to forecast future economic trends the more models

and variables they add to their toolbox. In short, a market economy is bafflingly complex. Don’t expect

journalists to peddle predictions and interpretations of any significance. If they get one component in the

complex scenario correct, that would be a small miracle, and they would soon be trading the habit of

publishing click-bait material on the internet for more lofty aspirations.

• Janet L. Yellen, summed up the uncertainty as follows: “You will note that I am casting my

statements about the stance of policy and the outlook in very conditional terms. I do this because

of the great uncertainty that surrounds these issues. Frankly, all approaches to assessing the

stance of policy are inherently imprecise.”

• Fed Governor, Donald L. Kohn, once put it more bluntly, “I think a third lesson is humility – we

should always keep in mind how little we know about the economy. Monetary policy operates in an

environment of pervasive uncertainty.”

“In the US, the risk of an

economic recession in 2018

remains minimal…”



• Former Fed Chairman Alan Greenspan once compared making monetary policy to driving a car

guided only by a cracked rearview mirror.

• Finally, James Grant, publisher of Grant’s Interest Rate Observer, wrote that “Both [economists

and scientists] use quantitative methods to build predictive models, but physics deals with matter;

economics confronts human beings…economists can never match the predictive success of the

scientists who wear lab coats.”

All this is to say, that continued growth in Asia,

with some pick up in Europe’s stagnant economies,

and the future might just be much brighter than

the prophets of doom would want us to believe.

Scrap the sanctions on Russia (all sanctions for

that matter), and we have another $1.3 trillion

economy, with 150 million people that could

become a vehicle for economic growth in the US; or to quote Frédéric Bastiat: “When goods cross borders

armies won’t.” We have a choice to waste resources on military spending or apply our skills, resources and

capital to enhance and improve trade relations with all. Seems like a no-brainer.

GDP

Growth in the US is accelerating from an unusually low base, with coincident economic indicators currently

showing strength, and should post further gains during the first quarter.

Under the new tax code, companies will be allowed to fully expense all capital expenditures in the year of

purchase, which should spur strong demand for capital equipment. This, in turn, will give manufacturers

the confidence to build inventories in anticipation of meeting increased demand. Consequently, we expect a

major uptick in economic activity in the first half of the year.

Goldman Sachs revised its GDP growth forecast upwards for 2018 to 2.6%, with a lesser 1.7% in 2019.

This seems like political expediency, similar to Professor Krugman’s prediction published in The New York

Times on November 9, 2016, “… if the question is when markets will recover, a first-pass answer is never…

under any circumstances, putting an irresponsible, ignorant man who takes his advice from all the wrong

“All this is to say, that continued

growth in Asia, with some pick up

in Europe’s stagnant economies,

and the future might just be much

brighter than the prophets of doom

would want us to believe.”



people in charge of the nation with the world’s most important economy would be very bad news. What

makes it especially bad right now, however, is the fundamentally fragile state much of the world is still in,

eight years after the great financial crisis.”

We do not care who sits in the Oval Office. Economic fundamentals, the level of public confidence and a

string of economic indicators add up to GDP growth of at least 3.0% in 2018. A good question for

Goldman would be, “How do you square your

lowball growth estimates with your

unemployment rate projections of 3.5% in 2018

and 3.3% in 2019?”

Real or inflation-adjusted GDP growth rose to

1.5% in Q3 2016 and to 1.8% in Q4 2016. This

was followed in 2017, with growth rates of2.0%,

2.2% and 2.3% in Q1, Q2 and Q3, respectively. A rate of 2.5% is expected for Q4 2017.

The transportation sector is a good indicator of the state of the economy. Truck tonnage surged almost

8% in the year ending November, proof of a marked improvement in economic activity over the past 12

months.

Yield Curve

A yield curve goes flat when the premium, or spread, between short- and long-term bonds drops to zero.

An inverted yield curve occurs when the spread turns negative.

The yield curve acts as an indicator of the strength of the economy, as well the market’s expectation about

inflation. Inflation usually coincides with strong economic growth, which in turn increases the demand for

higher yields to offset the impact of inflation on interest income. Higher long-term yields have been a good

indicator that a recession is not around the corner. On the other hand, the spread between three-month

bills and 10-year Treasuries has inverted before each of the past seven recessions. Over the past month or

so, economists have noted that the spread between two-year and 10-year notes is now 56 basis points.

This is down from 125 at the beginning of the year, while the gap between five-year and 30-year bonds,

came down from 140 basis points at the start of the year, to the current 63.

“A good question for Goldman

would be, “How do you square your

lowball growth estimates with your

unemployment rate projections of

3.5% in 2018 and 3.3% in 2019?”



One reason for this phenomenon is not so much a deterioration in economic expectations, as the action of

the Fed to increase short-term rates. The lack of inflation has kept long-term interest rates in check. The

surplus of capital theory also applies here. The demand for long-term, high-quality bonds emanating from

insurers and pension funds, as well as large long-term bond purchases by central banks in Europe and

Japan also add to downward pressure on long-term yields.

The Dollar

The dollar is down more than 7% versus the world’s

major currencies this year, the most in more than a

decade. For multinationals, like the large-cap

companies we own, this is not all bad news, as they

make a decent chunk of their money abroad. In the

preparation of their financial statements, they

convert foreign profits into dollars, regardless of whether they repatriate those profits or not. A weaker

dollar, year-over-year, results in an increase in foreign earnings on currency translation, even if actual

profits as accounted for in foreign currencies were flat. If a company’s foreign earnings made up, say, half

of net income in 2016, regardless of growth in those profits, there will be an approximate 3.5% year-over-

year increase in 2017 as a result of the 7% decline in the value of the dollar. Add to that the restatement

of deferred tax liabilities (see below), and large companies in the US will all report earnings increases of

more than 10%, unrelated to operations per se. We admit that this is not, in fact, organic growth, but the

media will headline the double-digit earnings gains without qualification.

A note on deferred tax liabilities/assets: Up until the change in the corporate tax rate, companies provided

for deferred taxes using the 35% tax rate. For example, timing difference (an accounting abstraction) of

$100 million would give rise to a deferred tax liability of $35 million. This liability would now have to be

restated at a 21% tax rate, namely, written down to $21 million, resulting in the recognition of a $14

million gain in the fourth quarter of 2017 (think of it as debt forgiveness). Deferred tax assets would also

have to be restated with the opposite effect, but most companies carry much larger deferred tax liabilities

than assets.

“The dollar is down more than

7%...for multinationals, like the

large-cap companies we own, this

is not all bad news.”



Tax cuts, imaginary and real, combined with a tighter

monetary policy, as signaled by the Fed’s intentions to

raise interest rates further in 2018, could mean a

stronger dollar next year. Experts point to the Reagan-

Volker period in the early 1980s and the post-German

unification period in the early 1990s as a precedent.

The euro was the strongest major currency in 2017, following the favorable outcomes of the Dutch and

French election and failure of Congress to get anything of consequence done on the legislative front.

Repatriation of corporate profits will not have much of a positive impact on the dollar, as most of these

untaxed profits already are invested in US Treasuries or other dollar-based securities. On the other hand,

the proposed change in the manner in which foreign profits are to be taxed could mean a speedier

repatriation of foreign profits. Such repatriations would narrow the current account deficit, relatively

speaking, which in turn could favor the dollar.

As always, there is no consensus when making predictions about the direction of interest rates, exchange

rates, inflation, GDP growth and the like. Daniel Katzive, head of Foreign Exchange strategy in North

America at BNP Paribas contradicts the above arguments, when he told Bloomberg that, “Most of the

people that we talk to wouldn’t be terribly surprised if, by the end of next year, the dollar was substantially

weaker, especially against the euro. In the futures market, hedge funds and money managers have piled

into bullish bets on the euro, pushing them close to a six-year high on a net basis.”

Global Economy

Recent economic data suggests that the

synchronized economic expansion in the US, Europe,

and Japan is improving noticeably, following years of

lethargy.

The preliminary December PMI for the eurozone implies a broadening in the expansion trend with regional

stragglers like France and Italy starting to enjoy some meaningful economic activity. With Washington

“…the synchronized economic

expansion in the US, Europe and

Japan is improving noticeably…”

“Tax cuts, imaginary and

real, combined with a tighter

monetary policy...could mean

a stronger dollar next year.”



cutting the corporate tax rate to 21%, Japan is following suit with a proposed statutory rate of 20%,

down from the current 29.7%.

Inflation

The Bureau of Labor Statistics, reported that the November Consumer Price Index increased year-over-

year (Y/Y) by 2.20%, up from 2.04% the previous month. Y/Y Core CPI (ex. Food and Energy) came in at

1.71%, down from the previous month's 1.77%. The energy index rose 3.9% and accounted for about

three-fourths of the all items increase. The gasoline index increased 7.3%. The shelter index continued to

rise, and the indexes for motor vehicle insurance, used cars and trucks, and new vehicles also increased.

The indexes for apparel, airline fares, and household furnishings and operations all declined in November.

Home Builders

Confidence is important, and folks at the

National Association of Home Builders

(NAHB) have it in spades. Their monthly

sentiment index, a decent leading indicator of

home sales, surged five points to 74 in

December, the highest reading since 1999. The component that tracks current conditions rose four points

to 81, the future sales gauge rose three points to 79, while the sub index that tracks buyer traffic jumped

eight points to 58, its highest since 1998.

Groundbreaking on single-family homes proceeded in November at the strongest pace in a decade.

Residential starts rose 3.3% to a 1.3 million annualized rate after registering 1.26 million in October.

Single-family starts jumped 5.3% to 930,000, highest since September 2007. Housing units authorized

but not yet started reached 155,000, the most since June 2008, and homes under construction increased

to 1.11 million, the most since August 2007.

The euphoria at NAHB is understandable considering that US home sales in November exceeded

expectations by registering their highest level in nearly 11 years. The NAHB reported that existing home

sales surged 5.6% percent to a seasonally adjusted annual rate of 5.81 million units. Despite the recent

gains, existing home sales remain constrained by a chronic shortage of houses at the lower end of the

“Confidence is important, and folks

at the National Association of Home

Builders have it in spades.”



market and elevated prices that are discouraging rookie house hunters, with the number of first-time

buyers accounting for a measly 29% of November’s transactions. Realtors say a 40% share of first-time

buyers is needed for a robust housing market. Housing inventory has fallen for 30 straight months on a

year-on-year basis. With supply constraints, the median house price increased 5.8% from a year ago to

$248,000 in November. That was the 69th consecutive month of year-on-year price gains.

Residential construction spending should make a meaningful contribution to fourth quarter GDP.

Housing’s combined contribution to GDP averages 15% to 18%. The contribution from residential

investment, which includes construction of new single-family and multifamily structures, residential

remodeling, production of manufactured homes, and brokers’ fees averages roughly 3% to 5% of GDP.

Jobs

The small business index of future hiring plans in

November posted its strongest reading in the 44-

year history of the survey. This suggests that the

reduction in regulatory burdens, coupled with a

strong expectation of reduced future tax burdens,

have already produced positive results.

A reminder: US GDP advanced by more than 3% in 15 straight quarters from Q2 1996 through Q4 1999,

averaging a remarkable 4.7% during this period. Since then we have almost forgotten what a healthy

economy looks like.

From 1993 through 1999, payrolls gained, on average, 2.6% per year, which makes for a good standard of

measurement during times of strong economic growth. In theory, a 3.7 million gain in payrolls in 2017

would qualify as commensurate with the 1993 to 1999 years. Through the end of 2017, the economy only

added 1.9 million jobs, which is less than two-thirds of what we experienced in the ’90s. By any reasonable

logic, however good the job numbers may look, and they certainly do, compared to what we have seen over

the past 15 years, they are not robust. Let’s remind ourselves that 16.3 million workers have left the labor

market since the November 2007 peak. If they suddenly decide to return, the unemployment rate will not

be showing 4.1%; more like 14%. The potential labor force is 147 million workers, with the 16.3 million

“…the reduction in regulatory

burdens, coupled with a strong

expectation of reduced future tax

burdens, have already produced

positive results.”



comprising 11%. The labor participation rate has been approximately 62% since 2014, down from 66% in

2007. It was 67.5% in 1999, which economists view as the true full employment rate. The average weekly

earnings of production and non-supervisory employees rose by just 2.6% Y/Y in November. These gains

were 2.2%, 2.6% and 2.7% in October, September, and August, respectively.

Wages

Based on the most recent numbers published by the Bureau of Labor Statistics, real (inflation-adjusted)

annual earnings of the middle class are at $37,474, down 13.0% from 44 years ago. Measured in nominal

terms the chart reflects a smooth upward trend, although it is misleading because it does not take account

of the average hours per week and inflation.

The average hours per week declined from around 39 hours per week in the mid-1960s to a low of 33

hours at the end of the last recession. The post-recession recovery has seen a meaningless increase of 0.7

hours or 42 minutes.

Adjusting for the purchasing power of today’s dollar gives us an average weekly wage of $749 (gross

amount with no adjustment for withholding taxes and other deductions), which is well below its $846 peak

back in the early 1970s. A 50-week year translates into an average wage of $37,474. Peak inflation-

adjusted earnings of $43,074 were clocked in October 1972.

Market Crash

It should not surprise us that as the market makes new highs, the number of people predicting a crash

grows exponentially. They all have one hope, that is, to be able to boast: “I told you so.” With no recession

in sight, the 1987 crash is the flavor of the day, as this cathartic episode occurred in the absence of any

economic distress.

The cause of the ’87 crash was a deadly combination of program trading and portfolio insurance. Program

trading exploited the computerized arbitrage between cash and the futures markets. The insurance

strategy of shorting S&P 500 futures to hedge against equity losses failed miserably. Those in the know at

the time explain that too many investors tried to obtain "insurance" by selling index futures at the same

time. This crowded trade pushed S&P futures to a large discount against the spot market, which triggered



an avalanche of selling and a concurrent purchase of futures by program trading operations. The added

pressure on spot prices prompted more selling. It all became a self-fulfilling prophecy. Since Black Monday

in October 1987, circuit breakers have been put in place that would halt trading if the market sells off at

intervals of 7%, 13% and 20%.

Experts tell us that there are currently numerous new systematic strategies in place that can replicate

1987’s mischief. High-frequency trading that entails a significantly large number of shares or ETFs, in

conjunction with derivatives and leverage is a recipe for history to repeat itself. A decline in money supply

and a rate hike campaign by the Fed, both factors present today, were contributing factors in 1987. We

would retort that the Fed’s tightening is being done from ultra-low interest rate levels and, as to money

supply, the world is awash in cash.

Investing for the Long-Haul

It is easy to conclude that if anyone had bought Apple shares 37 years ago, when the company launched

its IPO, they would show an annualized return of 16.5% p.a., beating out Berkshire Hathaway’s 12.4% p.a.

over the same period. This would be more attributable to dumb luck than a vindication of the buy-and-

hold strategy that we and Warren Buffet embrace.

How many investors would have held onto the stock during the turbulent years of the mid-‘80s? Not us.

When Steve Jobs was fired, he sold out, which would have been enough incentive for most to follow suit.

Add to that, internal divisions, three unremarkable CEOs (John Sculley, Michael Spindler, and Gil Amelio),

only one product (the Macintosh computer) and a stock price that slid back to its IPO levels. Jobs returned

in 1997. Initially, the market was unimpressed, and Apple hit a 12-year low. Jobs defied his skeptics,

however, and transformed Apple from a computer company to a consumer electronics juggernaut, and the

rest is history.

We side with those who lost patience and bailed out. We did not manage money in 2001 when Jobs

launched the iPod. Even in 2006, we were put off by insiders selling stock and a bloated stock option

overhang. However, in 2012, when the company stopped the practice of granting stock options, we

interpreted that as a step in the right direction. There was no doubt that the company’s business model

was being transformed for the better and we backed up the truck; some might have argued a bit late in the



day. Not really. We now show a 24% p.a. return on that

first buy, back in 2012. It was and is a buy-and-hold

investment for us, but we are not oblivious to the fact

that unless we monitor the company’s progress very

closely (quarter-by-quarter), the “hold” component of

our strategy could come unstuck. Hold quality stocks, hold them for the long-haul, but keep a very close

eye on them.

Conclusion

Last year, we wrapped up our commentary as follows: “we look forward to 2017 with unusual optimism…

Regardless [of political developments], we stick to our strategy. We hold the world’s best highly profitable

companies with resilient business models and, yes, when the markets sell-off, our stocks also trade down,

but they recover very quickly once the panic selling stops.” We repeat this sentiment for the new year.

We celebrated our 11th anniversary at the end of April 2017. During this time, the stock market

experienced unprecedented turmoil. We thank our clients not only for their loyalty but also for their kind

words and support that comes in many forms, such as adding capital to their portfolios and recommending

us to family and friends. We do not spend a lot of time chasing new business. We prefer to keep our focus

on research and rely almost exclusively on word-of-mouth, the best form of publicity, to grow our asset

base.

“Hold quality stock, hold them

for the long-haul, but keep a

very close eye on them.”

Favorable Fundamentals Remain in Place

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