January 08, 2019

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Cutler Investment Group 2018 and Fourth Quarter Review

Market Commentary

Don’t panic. It is not 2008.

After a decade of nearly uninterrupted bull markets we faced some obstacles in 2018. Nearly every asset class entered a bear market at some point this past year (defined as a 20% drop in price from the recent high). The S&P 500 was officially spared, with the bell ringing on December 24^th with the index down 19.8%. “The Worst Christmas Eve Since the Great Depression!” screamed headlines and “It is all the Fed’s fault” screamed President Trump!

January is a terrific time to look forward. Forward to how much weight we are going to lose. Forward to how much exercise we are going to get. Forward to Cutler’s market themes for 2019. Investors need to be proactive and not reactive, so we need to think about what 2019 looks like as much as we need to worry about 2018. So, 2019 themes for investors to consider are:

• Valuations. After the pullback in stocks, at year-end the S&P 500 traded at 14.5x forward earnings, which is below long-term averages. (source: JP Morgan)
• Economic growth. The US economy continued to grow at a 2%+ pace, albeit this has decelerated from the post-tax-cut feeding frenzy.
• Interest rates. The Federal Open Markets Committee raised rates to 2.5%. This remains well below long-term averages, but the market reaction has likely hastened a dovish Fed outlook.
• Currency. US growth has supported the dollar vis-à-vis foreign currencies. A softer interest rate path may reverse last year’s dollar strength.

Broadly speaking, the themes highlighted above are positive for stocks. Cutler’s outlook, given the factors above, is that investors should be comfortable owning equities at today’s levels. While many investors continue to look back on the Great Recession with trepidation, that economy was a historical anomaly. Today, there are few candidates for bubbles or “irrational exuberance” hallmarked by previous crashes. In Cutler’s view, market corrections occur, and this is a healthy part of the ebb and flow of stocks. For long-term investors, today may represent a nice entry point.

Portfolio Positioning

While markets were weak in the Fourth Quarter, there was a flight to quality which highlighted the defensive nature of our portfolio. It is this defensive nature that is a core tenant of Cutler’s Equity Income strategy, and the Fourth Quarter performance was consistent with our portfolio expectation. Cutler’s Equity Income strategy returned -8.78% (net of fees) versus the S&P 500 Total Return performance of -13.52% and the Russell 1000 Value Total Return of -11.72%.
Looking closely at sector performance, one can see a theme of growth and risk underperforming during the quarter. The most significant drops were seen in the Technology, Consumer Discretionary, and newly constituted Communication Services sectors, with significant companies like Apple, Amazon and Facebook each dropping 20% to 30% in the fourth quarter.  Apple’s issues may be company-centric, however, as they struggle to justify their $1 Trillion market capitalization based upon a dependency on iPhone sales that has had a less than enthusiastic product replacement cycle. As 2019 unfolded, Apple’s pre-announcement that tensions with China had impacted sales also negatively impacted the stock’s performance.

The Equity Income holding’s highest return positions mirror the risk-off trade at the end of the year. Procter & Gamble led the portfolio with 11.43% return. This was followed by Merck, McDonald’s, Verizon, and Dominion Energy rounding out the top 5 positions. Schlumberger, which began the quarter as the strategy’s smallest position, was down 40% in the period.  Fortunately, the minuscule size of Schlumberger in the portfolio limited the negative impact from this return, not making the top five in worst performing contributors. On the opposite side of the return spectrum, Microsoft had grown to our size limitations, where it became necessary to reduce the position. Microsoft has been a very strong holding for Cutler, supported by the growth of their cloud business. While still a top position in our strategy, we reduced the exposure in order to stay within our desired weightings.  The chart below provides a breakdown of the contributions to the portfolio performance.
 

TOP 5 AND BOTTOM 5 HOLDINGS BY PERFORMANCE BY CONTRIBUTION - AS OF 12.31.18
Best Performing Securities	Average Weight (%)	Security Contribution to Portfolio Return (%)
McDonald’s Corp	4.33	0.27
Procter & Gamble Co	2.49	0.26
Merck & Co	3.08	0.24
Verizon Communications	2.83	0.17
Dominion Energy	2.40	0.06
Worst Performing Securities	Average Weight (%)	Security Contribution to Portfolio Return (%)
The Home Depot	4.26	-0.76
United Technologies	2.70	-0.67
Caterpillar Inc	3.74	-0.66
BlackRock Inc	3.81	-0.64
Becton, Dickinson and Co	4.48	-0.62

 
Looking forward, an interesting development is the broadening of the strategy’s investable universe. A hallmark of our philosophy is a 10-year dividend history without a reduction. Given that we are now 10-years from the depths of the bear market, there are numerous securities which are now becoming eligible for purchase. This is especially notable in the Financials sector. Given the sell-off in the markets, and the valuations available, we will look to take advantage of this growing opportunity set, as appropriate.

Thank you for your continued trust in Cutler. Please reach out to us if you have questions or concerns about the markets and how they can impact your portfolio.

Net performance is pre-tax, net of advisory fees and transaction costs and includes the reinvestment of dividends. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be profitable or suitable for a particular investor's financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses. Source: Morningstar
 
All opinions and data included in this commentary are as of January 8, 2019 and are subject to change.  The opinions and views expressed herein are of Cutler Investment Counsel, LLC and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This report is provided for informational purposes only and should not be considered a recommendation or solicitation to purchase securities. This information should not be used as the sole basis to make any investment decision.  The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed.  Neither Cutler Investment Counsel, LLC nor its information providers are responsible for any damages or losses arising from any use of this information

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