To Our Shareholders:
CGM Mutual Fund increased 11.7% during the fourth quarter of 2016, compared to the Standard and Poor’s 500 Index ("S&P 500 Index") which increased 3.8% and the BofA Merrill Lynch U.S. Corporate, Government and Mortgage Bond Index which returned -3.1% over the same period. For the twelve months ended December 31, 2016, CGM Mutual Fund returned 7.6%, the S&P 500 Index returned 12.0% and the BofA Merrill Lynch U.S. Corporate, Government and Mortgage Bond Index returned 2.6%.
The Year in Review and Economic Outlook
U.S. stocks got off to a rough start in 2016, falling 6% in the opening week of the year as prices generally tracked falling oil prices. By mid-January, the price of oil hit a 12 year low of $26.55 per barrel as global consumption decreased and supply expanded further with the addition of Iranian oil after sanctions were lifted. The continued drop in oil and global commodity prices that began in 2015, along with weakened global economies, especially in emerging markets, curtailed demand for U.S. goods. Nevertheless, the U.S. economy continued its slow and steady growth, driven largely by U.S. consumer spending. In January, the Consumer Price Index rose at the fastest annual clip since October 2014, climbing 1.4% from the previous year. Strong retail sales, low unemployment and gradually rising wages demonstrated that the U.S. economy was poised to continue to expand and not slip back into a recession. By the end of the first quarter, the price of oil began to recover on the news that some oil producing nations would consider production cuts and U.S. shale producers began to curb output. Stocks continued to move with the price of oil and finished the end of the first quarter in positive territory.
Early second quarter reports showed a pullback in U.S. retail sales, anemic U.S. business investment and continued weak global demand which was underscored by the Commerce Department’s disappointing report of 1.1% GDP for the first quarter. These factors influenced the decision of the Federal Reserve Board ("the Fed") to continue to leave interest rates unchanged in April which further weakened the dollar and sustained rising oil prices. However, low interest rates also contributed to a recovery in the U.S. housing market. In May the Commerce Department reported that April housing starts jumped 6.6% and purchases of new single-family homes increased by an annual rate of 16.6%, the fastest growth since January 2008. Stock prices in June were heavily influenced by market speculation on Brexit. On June 24 Great Britain announced that voters had chosen to leave the European Union sending investors to the relative safety of government bonds, currencies and gold. In response, U.S. bank stocks were hit particularly hard as the S&P 500 Index lost 3.6%. After two days of declines in response to the Brexit vote the market rebounded with a strong three day rally at the end of the quarter.
Third quarter growth in stock prices was significantly influenced by positive employment and income reports along with historically low bond yields. A July Labor Department report showed wages increasing at the fastest annual pace since 2009, with a 2.6% surge in June 2016 from a year earlier. Later in the quarter, the Census Bureau provided evidence of the first significant rise in annual household income in several years with median household incomes increasing 5.2% from a year earlier, after adjusting for inflation. Increased household income boosts consumer spending which accounts for approximately two-thirds of U.S. economic output and has been the primary driver of U.S. economic growth since the end of the recession. Late in the third quarter, stocks reacted negatively to the European Central Bank’s decision to maintain and not expand its bond buying and interest rate policy which was later countered by a favorable response to the announcement of the Bank of Japan’s pro-inflation policies. Overall, global central bank stimulus policies made U.S. Treasuries more attractive and on July 5 the yield on the 10 year U.S. Treasury briefly hit an all-time low of 1.37%. Stocks continued to rise through the end of the quarter, helped in part, by the recovering banking sector.
The dollar strengthened early in the fourth quarter, improving U.S. consumers’ purchasing power and business investment. In addition, government bond yields began to rise, driven in part by higher U.S. wages and rising oil and commodities prices. The election of Donald Trump as the next U.S. President sent stocks and bond yields higher as the market viewed the potential for the new administration’s increased fiscal spending and tax cuts along with the paring of regulations as factors that will invigorate the U.S. economy and increase inflation. In mid-December, the Fed cited rising inflation and a strong labor market when it raised its target interest rate by 0.25%. The Fed’s action slowed down the surge in stock prices that began with the election. The Labor Department reported third quarter GDP grew at a seasonally adjusted rate of 3.5%, the strongest increase in two years, and rising oil prices spurred by impending production cuts, pushed stocks higher as the year came to a close. The yield on the 10 year U.S. Treasury ended the year at 2.45%.
Portfolio Strategy
CGM Mutual Fund was fully invested throughout 2016 in anticipation of strengthening economic growth which, we believed, would support higher interest rates. Growth remained moderate throughout the year, but prospects for stronger growth and higher interest rates were augmented after the election.
Homebuilders and commercial banks were the largest Fund concentration during the year. The homebuilders underperformed and were sold during the third quarter. The commercial banks appreciated sharply after the election and were significant contributors to the Fund’s performance. We established a significant position in semiconductor stocks in the second half of the year which enhanced performance.
The fixed income section of the Fund fluctuated between 25% and 28% of the portfolio during the year. The fixed income portfolio was invested in U.S. Treasury notes with less than a two-year maturity in anticipation of higher interest rates.
The Fund portfolio at year end was concentrated in securities which we believe will benefit from stronger growth and higher interest rates.
On December 31, 2016, CGM Mutual Fund was
27.2% invested in U.S. Treasury securities. The three largest industry positions in the equity portion of the portfolio were in commercial banks, electronic components and broker/dealers. The Fund’s three largest equity holdings were Bank of America Corporation (BAC, Financial) (commercial banks), Morgan Stanley (MS, Financial) (broker/dealers) and Citigroup Inc. (C, Financial) (commercial banks).
David C. Fietze
President
G. Kenneth Heebner
Portfolio Manager
January 3, 2017
