QUARTERLY LETTER

1st Quarter 2018 — Investment Strategy Review

“Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period – or even to look foolish – is also essential. ”
                                          — Warren E. Buffett


Volatility has returned in 2018 following an extended period when nothing seemed to deter the U.S. stock market’s steady advance. This long overdue correction attacked with shocking vengeance in early February and the market has struggled to regain its equilibrium. The S&P 500 index finished the first quarter with a loss of 1.2%, but no matter what happens during the remainder of the year, stocks have experienced an incredible winning streak. The bull cycle just celebrated its ninth anniversary, becoming the second longest in the post-World War II era. Needless to say, actuarial risk has increased.

2018’s stock market turbulence can be traced to the following key factors: the bipolar political scene in Washington DC, the growing threat of a trade war, the likelihood of additional rate hikes by the Federal Reserve, Facebook’s data sharing controversy, and historically high valuation. In addition, investor psychology had become dangerously euphoric. Buoyed by enthusiasm over tax reform and upward revisions of corporate earnings estimates, stocks raced upward in January, as did bullish sentiment. It is axiomatic in the investment game that excessive optimism kills rallies and this was the case early this year. Signs of exuberance were widespread. Surveys tracking the outlooks of investment strategists were registering high levels of bullishness not seen since the months prior to 1987’s debacle. Headlines such as “Retail Investors Jump Into Market” and “As Stocks Reach New Highs, Investors Abandon Defensive Positions” were on the front pages of financial periodicals. Comments from attendees at the World Economic Forum in Davos were glowing with confidence. Margin debt – the borrowings which use shareholdings as collateral – reached a record $642.8 billion. Not to get nerdy, but this number amounted to 1.31% of the total capitalization of NYSE listed issues, surpassing the peak achieved during the late 1990s tech bubble. In addition, January’s net inflow of cash into mutual and exchange-traded funds that invest in equities globally was the largest ever. As you can see, the stock market was set up for a stumble.

Another concern is the exponential growth of the exchange-traded fund business and the creation of new indices making it possible. This has exacerbated volatility, particularly during the bouts of recent selling. Today, speculators tend to jump in and out of exchange-traded sector funds and other index products, not stocks. During the biggest daily declines this year there has been zero differentiation between individual securities on a fundamental basis. Everything that is held in an exchange-traded fund suffers similar damage.

Take Warren Buffett’s Berkshire Hathaway, for example, which is renowned for its devoted shareholder base. During past market panics, the stock price at times would barely budge and was often boosted by a flight to safety. Not so as of late. Berkshire Hathaway has become a significant component of exchange-traded funds dedicated to the financial sector. The most actively traded of these is the Financial Select Sector SPDR, and the company has been assigned a huge 11.5% weighting of the assets. When investors are frightened out of this exchange-traded fund, Berkshire Hathaway shares must also be sold. This indiscriminate behavior has also impacted the short-term investment performance of other core positions held here.

Nevertheless, we remain confident about their long-term prospects as businesses. Remember, the quality and durability of the enterprise determines the ultimate outcome, not the manic nature of traders. Our investment philosophy which emphasizes independent thinking and a disciplined focus on value has treated us well over the years. In keeping with the advice from Buffett cited earlier, we have no problem looking unimaginative or foolish on occasion, especially if it enhances returns.

Thanks, as always, for your encouragement and support. Please call anytime.

3/31/18           Henry D. Mercer III

Index 1st Quarter Return   12/31/17 3/31/18
S&P 500 -1.2% Fed-funds Rate 1.25 - 1.50% 1.50 - 1.75%
    10 yr. T-note 2.41% 2.74%

* Please contact Mercer Capital Advisers, Inc. if there are any changes in your financial situation or your investment objectives or if you wish to add to or modify any restriction to the management of your account. Our current disclosure statement as set forth on Part II of our form ADV is available for your review upon request.

* Mercer Capital’s management fee is billed quarterly, in advance, based upon the market value of the assets on the last day of the previous quarter.

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