Economic Resiliency

Time to buy, sell, or wait? Among war, inflation, interest rate hikes, congressional gridlock, and everything else, what do we do as investors? Short answer – buy or wait. The fear gauge, VIX, is at levels not seen since the early days of the pandemic and the “taper tantrum” of 2018 before that (when the Fed started tightening the last time). In those instances, over the following 6 months the markets rallied around 40% and 16%, respectively.

The biggest losers in this current drawdown have been high growth tech companies and recent IPOs. Software companies are down about 25%, stocks that came to market in the last 2-3 years (IPOs) are down 38%, and ultra-high growth/new technology companies are down over 50%. In this segment of the market, this is more than a market correction, this is a market crash. Granted many of these stocks did not deserve the valuation they were trading at, so crashing from their dizzying heights was justified – an unprofitable exercise bike company worth more than Ford? But, just as always happens the baby gets thrown out with the bathwater. Quality companies booking solid profits like Salesforce, Netflix, Zoom, Twitter, Shopify, and Facebook have seen their stock prices cut in half despite onboarding millions more users, increasing revenues, and in many cases increasing their brands and market dominance.

An investor with long-term growth goals should be looking at buying companies and sectors that are solidly growing earnings and will be leaders of the future economy. Over the past few months, the only trades that seem to have worked have been in the energy sector (as oil and gas prices have risen – most likely from inflation and geopolitics). However, over the next year or two, or beyond, who do you think will grow earnings and innovation faster, a company like Chevron or one like Apple? I think the answer is obvious, yet Chevron is up over 36% since December and Apple is down 10%. Sector rotations and choppiness are normal in the short term, but macro trends persist and typically win-out over longer timescales.

Fear is very high right now, but the economy remains strong and resilient. And as economies and companies grow so do their share prices in general. Consumers make up 70% of US GDP and the most recent reports showed spending increased at its fastest pace in ten months. This comes at a time when inflation was at 40-year highs with fuel prices soaring, wages stagnated, investment portfolios were declining, and war was looming. It’s going to take more than fears of Fed rate hikes and geopolitical maneuvering to drive this economy into a recession. The recent choppiness in the market looks at the very least like a “wait and see” moment, if not a buying opportunity.

A Look Back and Look Ahead

It was another strong year for equities in 2021 with the S&P and Nasdaq each advancing around 27% and the Dow 19%. Much of the rise came as a result of a very accommodative Fed that continued to pump record amounts of cash into the economy and investor optimism over vaccine and therapeutic developments to combat COVID. But not all was rosy in the economy as consumers experienced the highest levels of inflation since 1982 and global trade bottlenecks crimped supply of goods the world over.

In 2020, consumers were stuck at home and not spending. Their savings accounts rose as did their appetites for new entertaining consumer goods and desires to upgrade current gadgets. Yet at the same time factories and ports were shutting down operations in major trade hubs as governments and employers tried their best to contain COVID outbreaks. The result was inflation.

Supply was limited just as demand for goods skyrocketed. Prices for container space jumped, increasing costs on everything from paper products and electronics to oil and gas. However, the worst may be over. Inflation most likely already peaked and will be returning to a normal range by year end 2022. Goods are presently flowing much smoother than just a few months ago and we’ve seen commodity prices recede from their highs earlier this year - a major driver of inflation. And as inflation abates, the Fed most likely won’t be so swift to raise rates as they previously stated was their intention for the coming year.

Twenty twenty-two is poised to be another tricky year as businesses try to navigate pandemic disruptions, but it should bring with it continued economic expansion with investment returns moderating relative to the last two years, but growing nonetheless.

Taxes and Stock Market

Stocks are ending the week roughly flat after seesawing and selling off on capital gains tax fears on Thursday. For those worried that they will be paying higher taxes, rest assured only the very wealthy will be doing so. According to Bloomberg, a top rate of 39.6% would only apply to those with more than $1 million in annual income. Some investors may fear that with higher taxes there will be less investment in the stock market and thus create a market sell-off. Historically, this has not been the case. Reuters notes the following:

Consider that in 1981 the capital gains rate was cut significantly—from 28% to 20%. The S&P 500 fell 22% over the 12 months after the law was enacted. Then in 1987, the rates were changed, back up to 28%. The S&P rose significantly, but then dropped in the 1987 crash. In 1997, the rate was again cut down to 20%. The S&P 500 continued the bull market run it was already in. Then in 2003, the rate was cut again, down to 15%. Stocks dropped sharply in reaction to the announcement, but when the rate cut was actually enacted, stocks had begun a bull run.

At best it is indiscernible what effect capital gains tax has on the stock market. The most important factor remains staying invested for the long-haul and trying to look beyond the noise.

Market Volatility

Markets have been experiencing increased volatility since mid-February when interest rates began moving sharply higher. Stock investors are concerned that increased borrowing costs will put downward pressure on growth and threaten the solvency of some companies. Even if true, keep in mind that interest rates are still very, very low so the main concern is the uncertainty. How much higher will yields go and will added inflation force the Fed to raise rates driving yields ever higher? It is our contention that rate volatility will subside soon, and calm will return to the markets. The growth story for stocks is still in tack with rising GDP, economies reopening, and more fiscal stimulus on the way. We see further pull-backs as buying opportunities.

2021 Outlook

The story of 2020 and 2021 is (obviously) the virus. Simply speaking, the markets trade lower when the virus looks less contained and higher when it looks more contained. For this reason, and others stated below we are optimistic on stocks for 2021.

• The vaccines currently available have about a 95% protection rate and their rollout has been going relatively smoothly. The government hopes to have the majority of the population vaccinated by summer.

• Business and manufacturing sentiment are strong, and data suggests we are on a new cyclical upturn (as measured by corporate profits and cash flow). We should be at pre-Covid levels by late spring.

• Job confidence is rising with food service and leisure jobs projected to return robustly in the second half of 2021.

• Trade tensions will most likely ease, keeping a lid on inflation and enhancing consumer confidence.

• US growth in GDP is projected to be between 4 and 6%.

• Fiscal and monetary policy will remain loose, meaning there will be a large supply of cheap money, and treasury checks will be going out soon as a result of the latest stimulus package.

Conclusion:
For the stock market, we believe the risks to the economy in the form of evictions, restaurant and store closures, virus spikes, et cetera will be more than offset by the largest stimulus program in modern history (between Federal Reserve actions and congressional legislation). Even after this great run for stocks, valuations are still reasonable due to record low interest rates. Investments in bonds and cash simply don’t currently offer meaningful returns as they once did. Stocks have room to run.

Pandemic, Protest, and Profit

The S&P is down just 4% year to date and the Nasdaq is nearing record highs while the nation is grappling with a pandemic, protests, and unemployment not seen since the 1930s. The market “feels” divorced from reality, but that feeling might not be as accurate as your gut tells you. Let us explore the factors at play.

When the markets were at their lowest in late March that represented the height of uncertainty. Cities, counties, and states were locking down in what seemed to be random fashion. The federal government had not yet solidified any fiscal plan to tackle the oncoming economic tsunami resulting from industry shutdowns and mass layoffs. Reporting on the virus was varying widely. Death rates were soaring. And all of this was happening at lightning speed. Then things began to change – both materially and psychologically. First, the CARES Act was passed. This let people know they would be covered with unemployment insurance regardless of the type of job they lost, gave them an additional $600 per week, and promised checks of $1,200, in addition to support for small and medium sized businesses. Then the Federal Reserve stepped up and stated that they would supply unlimited liquidity (cash money) to keep the gears of the financial markets turning, including buying corporate bonds – essentially breaking the law to support the markets. The Fed has two mandates by law: maximize employment and stabilize inflation. They can do this through interest rate actions with member banks. They are not permitted to buy stocks or bonds (other than US Treasury bills). When the Fed stated it would intervene in the corporate bond market it had the effect of boosting asset prices in the high yield bond space immediately and without them even making any purchases yet. It also sent a very powerful signal to the market that the Fed will do whatever it takes to boost asset prices. With a sort of wink and nod investors took this to mean that the Fed would buy stocks if prices got too low. Since these actions, the stock market has not looked back. So, does the stock market not care that nearly 40 million people are out of work? The short answer is no, not really.

We have to remember what the stock market tracks. It tracks the value of the largest, best capitalized companies (often tech), and the amount of cash demand chasing after them. If there were an index of “all companies in America” it would probably be trading down some 70-80%. Who wants to invest in restaurants and hair salons with the nation on the couch? The service industry (food, lodging, etc) is getting crushed right now but Facebook, Google, Amazon, and Netflix are seeing solid profits. The problem is those kinds of companies employ a tiny fraction compared to the service and related industries. So even as Wall Street (Silicon Valley) hires and profits, Main Street can still struggle. And with added dollars in Americans’ pockets from the fiscal stimulus there is more than enough to make it back into the coffers of the tech giants.

But where do we go from here? As investors, we must always be looking forward. The April and May run-up in stocks were certainly looking to brighter days after the dark ones of February and March. Earnings estimates for 2021 are roughly 3% lower than 2019 (they are -30% for 2020, but who’s counting). Meaning that if the recovery goes about as expected, then companies should be earning roughly the same amount a year from now as they did a year ago. With interest rates near zero, this should bode pretty well for stocks. If things do stabilize this way, we would anticipate a rotation into some of the companies investors have shied away from recently, and expect smaller gains from the winners of the previous two months. There are some other considerations that cannot be ignored, however. For one, there is massive political unrest with protests in every major city. The cultural divide is at widths not seen since the 1960s and faith in institutions is waning. Additionally, these actions could set off a new wave of infection putting increased strain on the healthcare system and blow even larger holes in state budgets. There are also the rising US-China trade tensions and China’s recent national security actions aimed at taking more control over Hong Kong. Given how far we have come from the bottom and the tremendous uncertainty that still lies ahead (it is an election year after all) it would be prudent to temper expectations for gains like we have seen these past few weeks and remain invested in companies with solid cash flow and strong balance sheets. Keep in mind though, if we get a breakthrough vaccine sooner rather than later, we could party like it’s 1999.

A note on markets in the time of COVID

Markets are trying to price in corporate earnings during a time when most businesses are shuttered, and people are both restricted and afraid to interact socially and commercially – a nearly impossible task. This is why we see violent moves to the upside and downside in the stock market. These are not driven by fundamentals, but by speculation that things are either getting better or getting worse on a day to day basis. So, let’s look at bull and bear case scenarios:

Bull: People are able to meet current obligations, stay in their homes/apartments, and return to their old jobs within the next 2 months. The economy returns to growth in the next quarter and the $2T stimulus package (and possibly another package) combined with infinite liquidity provided by the Fed and 0% interest rates lead to strong market returns.

Bear: Quarantine drags on for many months and re-opening businesses lead to spike in cases and re-quarantining. Unemployment goes beyond 20-30%, businesses are forced to close for good and people are unable to meet mortgage and rent obligations. There is a huge demand shock as people are unable and unwilling to spend they way they used to leading to significant recession and depression.

As an investor one must keep in mind that not everyone will lose their jobs and not all businesses will go under. The stock market may see much darker days ahead but there will be a recovery in time. Panic selling can decimate portfolio returns. You will never be able to catch the exact bottom, but buying at lower levels is a great way to boost returns for long-term investors.

Fourth Quarter, Plenty of Game to Play

·         Short term stock pullbacks provide buying opportunity

·         Fed lowering interest rates and providing liquidity for asset purchases

·         Cyclical industries and international stocks look undervalued

·         Historically low bond yields are pushing income investors into dividend paying stocks

We are entering the fourth quarter of 2019, and we assume we are also entering the fourth quarter of the current bull market - but how much time is left is anyone’s guess. There are many reasons to predict the current expansion will continue, and conversely reasons to predict its end. Let’s start with the headwinds.

 Political risk is distorting markets in the short term. We see daily stock market changes happening as a result of tweets and trade policy leaks. This is not helpful for businesses trying to make long term investment decisions. We have seen growth slow globally and domestic GDP estimates are hovering around 1.8-2.1% for 2019. This is coming off 2.8% in 2017 and 2.5% last year. Regarding policy, the effect of corporate tax cuts are accounted for in current growth estimates and stock prices. Secondly, most of the money saved in taxes went to share buybacks rather than production or efficiency upgrades. Additionally, the stock market is trading at about 16x earnings at the current tax rate. If taxes return to 35% that jumps to about 24x earnings and suddenly the market looks very expensive. On the jobs front, hiring looks like it might be peaking, and unemployment is about as low as it can go. However, the Fed is feeling pressured to cut rates further to keep inflation up around 2% and to stabilize the banking industry by providing liquidity amidst slowing growth. This Fed action may have the unintended consequence of actually slowing the economy this late in the economic cycle. Cutting rates to boost purchases doesn’t do as much in this current environment because borrowing costs are already extremely low. For example, due to asset inflation in the housing prices right now, the down payment cost and creditworthiness are the major hindrances, not rates; where down payment and creditworthiness is not much an issue like with medium sized purchases such as cars, TVs, furniture, etc., people are willing to wait for financing rates to get even cheaper if they see rates falling; those with savings accounts as their main or only nest egg are seeing their returns dwindle under lower rates; and lastly, the psychological impact of lowering rates will signal to people that the economy is not doing well and that in and of itself can become self-fulfilling.

Now let’s examine market tailwinds.

Just because the bull market is old does not mean it has an expiration date. Unemployment is at a 50-year low, the economy is still in expansion territory, and inflation is low and fairly steady. Monetary policy around the globe is in easing mode. This is providing ample cash for asset purchases including continued share buybacks on a massive scale ($940B for S&P 500 companies alone in 2019). Earnings are steadily growing, albeit slower than in previous years, but are not showing signs of retreating into negative territory (especially with share buybacks reducing the number of shares in the market, goosing up earnings per share numbers). Cyclical industries like financials and energy look to be undervalued and could provide outsized market returns if investors flock back in. Lots of cash rotated into defensive stocks too soon fearing a major industrial slowdown. An example of this can be seen in the utilities sector. Cash has poured into utilities over the last two years due to their traditionally “safe haven” position in tough markets providing high dividend yields. But now the utilities sector is about 60% overvalued relative to the rest of the market on a price to earnings comparison. International equities also look cheap on a historic basis and provide good dividends. Investors have been shying away from there for years. Another boon to dividend paying stocks is the dearth of income generated by bonds. With 10-year treasuries paying around 1.7%, investors are looking to quality equity names for their fixed income needs. Even 30-year corporate bonds are hovering around 3% interest, not to mention the explosion of negative interest-bearing bonds overseas. Do you want to lock up your money for 30 years and earn 1% above inflation at best or even lend $100 to get back $99, or do you want to take your chances in the stock or real-estate markets over that same time frame?

Bottom line: The Federal Reserve and its kind around the world are begging other governments, and investors big and small to borrow money and buy stuff.

We don’t know when the expansion will end or how deep the pull backs will be along the way, but this bull market looks like is has a bit more game to play before it’s over.

Q2 Update: Stock and Bond Tug of War

Stocks have surged since their December lows and continue to ride an upward trajectory into the second quarter indicating investor optimism about economic growth. At the same time however, investors have demanded shorter-term bonds and shunned longer dated maturities pushing the yield curve to flatten and even invert – usually a good predictor of recession. So, do investors think the economy is poised for growth or contraction? The truth is probably somewhere in the middle. Earnings estimates for the current quarter are pretty low and many equity investors are betting that the bad news is already baked into the current price. Better earnings or positive guidance could compel stocks to jump higher. More cautious investors are pointing towards the age of the current bull market, international trade disputes (especially US-China and Europe-Great Britain), and Fed tightening actions as reasons to decrease risk. We see further economic expansion but with volatility along the way.

On a diversification note, the world’s stock markets are moving less in sync with each other than at any time in the last 20 years – meaning that owing a diversified portfolio across the globe makes sense again. The low correlation can increase risk adjusted returns and any pull back could be a good time to add to international positions for long-term investors.

Good Start After Bad Finish

After closing out the year on a negative note with markets selling off aggressively in October and December, January brought the rebound we were looking for. Market uncertainty and unease began to take hold in autumn with ongoing tariff disputes with major trading partners (namely China) and an inversion of the yield curve. As traders flocked for the safety of cash we looked to both capture profits and find cheaper entry points for quality stocks and funds in client portfolios. In December we aggressively bought on big sell-offs and continue to look for opportunities as they arise.

Stocks prices change based on both current facts and future expectations. Towards the end of last year prices were sharply dropping based on the expectations that trade wars, currency fluctuations, higher interest rates, and many other factors were conspiring to drag on earnings. Then in January the hard facts of earnings started coming in painting a much different picture. Most companies are still reporting record profits despite all the noise. The markets remain volatile (as to be expected at this point in the economic cycle) but we still see economic expansion over the next few quarters at least.