Year End Letter

December 14, 2018

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Dear Clients and Friends,

What a year it's been! In the first half of 2018, the stock market generated healthy returns driven by tax cuts for corporations, strong economic results, robust corporate earnings and stock buybacks. The S&P 500 was up approximately 10% through Sept. 20, 2018.

Around the middle of this year, the wheels began to wobble. Optimism waned and was replaced by fear that the factors that drove the markets higher in early 2018 would fade in 2019. Investors realized that trade sanctions, tariffs, and tough diplomatic talk have consequences in the form of tariff retaliation, higher material costs, and supply chain disruptions. Going into 2019, we face an environment of moderate corporate earnings growth and uncertainty in Federal Reserve policy in a slower economic environment. As of the writing of this letter, the markets have mostly given up any gains for the year.

Divergence was also evident in the international landscape. With modest growth in the US and expectations of the Fed finally raising interest rates, the dollar continues to climb vs. other currencies. This actually hurts the earnings of large, multinational companies that sell a lot of products abroad – the type of company that we historically have owned, like Proctor & Gamble, Ford, or Coca-Cola. We still feel that the benefits of international diversification outweigh these fluctuations, but it is simplistic to think that foreign or emerging markets are an automatic key to better investment performance. Other than Europe, most foreign stock markets fared much worse than the US markets this year.

As conservative investors, we watched our client accounts grow over the last two years, but not as much as the broader markets as measured by the S&P 500 or the Dow. This was for two reasons. First, much of the market's performance was driven by the so-called FANG tech stocks – Facebook, Amazon, Netflix, Google – and the like. While these are large and influential companies, our investment philosophy does not lead us to buy these stocks. The stocks are very volatile and the valuations are incredibly high. Being underrepresented in high growth momentum stocks hurt our relative performance until mid-year. But in the market's subsequent weakness, many of these same stocks have fallen faster and harder than other stocks. As a group, the FANG stocks have lost a trillion dollars in value since their peak.

Secondly, a portfolio balanced between stocks and bonds will likely not keep up with a booming stock market. The bonds are a steady source of income, safety of principal, and lower volatility. The good news for investors is that rising interest rates translate into more attractive bond yields. And when financial fears return and stocks fall, bonds tend to retain their value – especially very high quality bonds with relatively short maturities.

While we might not own stocks in the fastest growing companies, our portfolios represent the broader global economy. We own companies in growing categories like semiconductor chips for data centers, cloud computing infrastructure and digital entertainment content. Our portfolio also consists of more stable businesses like razor blades, sticky pads, and underwear. Interestingly, while all of these companies are American, close to 50% of their sales and earnings come from overseas.

The future is, as always, uncertain. Storm clouds of political uncertainty seem to be growing, especially in regards to our relationship with China. But recent history has taught us that things can change in the space of a tweet.

Our faith is holding a reasonably valued, balanced, and diversified portfolio remains strong.

Wishing you Happy Holidays and Prosperous New Year.
Stewart & Patten Co. LLC


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