December 29, 2017

Stocks rose modestly yesterday in very light trading. Perhaps the most notable mover yesterday was the dollar, which fell to within 2% of its 12-month low set in September. One would think with the combination of a strengthening economy, a less active Fed, and broad tax cuts to take effect next week, the dollar would be gathering strength. But that doesn’t seem to be the case. Maybe the U.S. economy won’t be quite the worldwide standout some expect next year. Time will tell.

At this time of year, you often hear discussion of a trading concept called “Dogs of the Dow”. You all know that the Dow Jones Industrial Average contains 30 stocks. The “dogs” are considered to be those stocks that provide the highest dividend yield, the logic being that high yields are needed to compensate for lower-than-average expected earnings and dividend growth. The “Dogs of the Dow” are the 10 stocks that sport the highest dividend yield at year end. Last year, the Dogs just about matched the Dow’s overall performance. But looks can be a bit deceiving. Two of the dogs, Boeing and Caterpillar, had stellar years. Boeing has risen nearly 90%, while CAT has gone up close to 70%. In fact, if I simply looked at the other eight, collectively they rose just 4%. While I can always do that sort of exercise retrospectively, this year two stocks so outperformed the rest that the difference was striking. At the start of last year, few would have said these two names would be up close to 80% on average. Boeing’s stock had flatlined the previous two years despite a very strong backlog. The old saw on Boeing had been that the stock price reflected order trends. While its backlog has been huge for a number of years, there had been no real acceleration in orders, and therefore, not much action in its stock price. Caterpillar is a bit different. The producer of heavy machinery for the construction and mining industries, it is the classic well-run cyclical company. When times are good, they can be very good. But when there is excess capacity and orders are slim, CAT has a tough time. Its shares were serial underperformers in recent years, but started to turn in early 2016 as construction spending began to rise and energy and mining showed signs of bottoming.

Looking ahead, neither is in the 2017 class any longer, having been replaced by Procter & Gamble# and GE#. Procter has done reasonably well lately, but soap and disposable diapers are hardly rapidly growing businesses. New Internet startups have eaten into its market share for shaving products. But PG is still one of the stellar companies in America, and has the longest streak of annual dividend increases, at over 60 years. GE, on the other hand, is a company in transition. That is a polite way to say that 2017 was a really bad year. Its stock fell over 40%, it slashed its dividend more than in half, and set a new 52-week low as recently as yesterday. While its aerospace and health businesses are solid, its largest division, power generation, suffers from too much inventory and not enough orders. Growth in alternative energy solutions won’t make life any easier. GE has new top management and they have stated that 2018 is a reset year. If that’s the bottom, then maybe GE will see some sunshine before year end. But there is a significant chance that its problems are too big to solve in 2018. We will see. Other members of the Dogs similarly have a few scars and a lot of uncertainties. Merck# has a wonderful new cancer drug, but it also has an aging portfolio of drugs coming off patent. To be polite, its pipeline of new drugs is uncertain. Verizon# has gone through a tough price war. 5G, the pending successor to 4G, gives it opportunities. But history shows that improved technology doesn’t always translate into faster growth or profits in the telco industry. Exxon# and Chevron# have been doing much better as oil prices have recovered, but their futures are closely tied to the price of oil. If oil is $70 or higher a year from now, these companies should do quite well. But if prices are below $50, holding steady will be a good accomplishment. Pfizer, like Merck, has pipeline issues. Cisco# should benefit from a growth in technology spending but it isn’t the growth stock it once was. Mid-single digit revenue growth would be a big accomplishment. Coca-Cola# also has new management. It is trying a new approach, selling most of its bottling assets to franchisees. Its key brands, Coke and Diet Coke are struggling. They aren’t exactly millennial favorites. But as far as I can tell, millennials still have to drink something (they don’t seem to like free tap water all that much), and Coke might yet prosper if it can find the right formula. Finally, there is IBM#. 2018 should be the year when IBM finally returns to revenue growth. It has staked out a few niches in attractive areas like data analytics and blockchain. But it still has a shrinking legacy business to deal with.

So there you have it, a rag-tag bunch of rather solid companies at the core, with somewhat muted growth expectations and a few warts on the side. That probably is a fair description of the Dogs of the Dow every year. But I am sure of one thing. Just as Boeing and Caterpillar came alive in 2017, at least one or two of these companies will surprise on the upside. The fact that they are priced as they are today suggests expectations aren’t very high. That is what provides opportunity and makes investing in the Dogs of the Dow successful over a number of years. The past several years, and that includes 2017 in particular, growth stocks have dramatically outperformed value stocks. That trend started to change in the fourth quarter of this year, but one quarter’s performance is hardly a trend. Nonetheless, the timing to think about this group may be pretty good. At least you can sift through the 10 and decide on one or two that seem most attractive to you.

I can’t end without telling, as Paul Harvey used to say, the rest of the story. The eight stocks in the Dow in 2017 with the lowest dividend yields at the start of the year rose by more than 30%. That doesn’t happen all that often, but in a year when growth trounces value as an investment theme, that’s the result. Will 2018 replicate 2017? It could. But history would suggest otherwise. The relative disparity in price between growth and value is at about a two-standard deviation differential today. One can never time exactly when that will reverse, but I will leave you with one little morsel to chew on. Right now the economic picture looks about as good as it gets. Real growth around the world is near 3% and even rising a bit. Unemployment in this country is at a decade low. Confidence is near record highs. Personal wealth is also at record levels and, as Christmas season just showed, Americans today are willing spenders for the first time in a decade. On top of all that, Washington just passed the biggest tax cut in over 30 years. And still there are no signs of inflation.

But how often have you woken up to a clear blue sky only to see rain before sunset? It doesn’t happen all that often, but it happens. Maybe too much of a good thing will bring with it some inflation or higher interest rates. Maybe the political landscape will worsen in front of mid-term elections. There are lots of maybes. Life may stay great for another year or two, but it is hard to see how prospects get a lot better than what we see today. When blue skies shine, it’s time to get outside and enjoy it. But blue skies don’t last forever. Don’t chase what’s working, simply betting on momentum. Be disciplined and look for value. Eventually, you will be rewarded.

Today, Jude Law is 45. Ted Danson is 70. Jon Voight turns 79. Happy New Year!

James M. Meyer, CFA 610-260-2220

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# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

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