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Quarterly Investing Newsletter

January 31, 2022

Our Three-Point Investment Philosophy


  • Proper allocation results from justifying the addition of risk, first.
  • Long-term results come from prudence and discretion in the short-term
  • The best allocation is governed, in part, by what is best for your plan.


NOTE: All information used in the production of this newsletter is current as of 12/31/21 and can be found by clicking here, unless otherwise noted.


Four-Point Near-Term Outlook


Since the bear market associated with the Great Depression, there have been four macro-economic conditions associated with bear markets:


  • Extreme Stock Valuations: Cautiously Negative
  • Recession: Cautiously Negative
  • Commodity Spike: Negative
  • Aggressive Federal Reserve: Cautious


Those are the four characteristics that we evaluate to gain perspective on the investing environment in the short-term.

A quick note before jumping into the data. It goes without saying that COVID-19, and the response to its presence, has largely shaped what the economic landscape looks like. You will find no mention of COVID-19 below, because we devoted an entire blog post to recent developments. Further, we also have an analogy to share with you that we think does the best job of putting investing in perspective.


Extreme Stock Valuations: Cautiously Negative


In terms of valuations, we remain very much in the same territory with US equities, as we have been for quite some time—S&P 500 valuations (21.8x) are still well above their 25-year average (16.83x). A redeeming bit of information, however, is that valuations have experienced somewhat of a normalization, with earnings growth (34.5%) outpacing the price return of the S&P 500 (26.9%) in 2021—this simply means that valuations have contracted, and that might mitigate some risk, especially considering that the contraction was due to earnings growth.


Conversely, a possible source of consternation is the fact that high valuations on the S&P 500 haven’t stopped or stunted the performance of the index, as a whole, as it produced a total return of 28.7% in 2021—the difference between the 28.7% return figure and the 26.9% return figure is that dividends are included in the former. Any consternation would potentially stem from performance exceeding conservative expectations brought on by current valuations and economic issues.—i.e., performance has been much better than one might expect.


As is typically the case, not all stocks are created equal, and that is certainly true with valuations in today’s market. To start with, the valuations of the top 10 stocks on the S&P 500 are 168% above their 25-year valuation average, as a group. The remaining 490 stocks are only 126% above their 25-year average, as a group—three percentage points behind the S&P 500 (129%), when comparing its current valuation, as an index, to its 25-year average. With the prices of the top 10 stocks rising to those heights, this has resulted in those same stocks accounting for 30.5% of the weighting of the overall index—translation: 2% of the stocks account for >30% of the index weighting. Further, considering the maturity of a company would be a good factor to add to the mix in evaluating stocks. As we have been saying, value stocks (typically, mature companies) seem poised to outperform growth (typically, immature companies), based on valuations across all market caps.


In terms of the 11 sectors represented by the S&P 500, three stand out for their relatively low valuations: energy (11.0x), utilities (11.8x), and financials (14.9x). Of those three, however, only energy has a substantial outlook for positive earnings growth—26.8%. Some other sectors, namely industrials and consumer discretionary, have projections for earnings growth in the same neighborhood as energy, but their valuations are significantly higher at 20.7x and 31.4x, respectively. The high valuations don’t necessarily render all stocks in each of those sectors unattractive, nor does it necessarily mean that the aggregate return of those sectors moving forward can’t be positive, but it does most likely make the argument that investment selection within those sectors needs to involve a highly discerning process.


Recently, the US markets have experienced a rather unprecedented run, relative to international markets. For about 15 years, US markets have outperformed international markets, and this is by far the longest period of out-performance by either market in the last 50 years. This is certainly not to say that the case is closed and international stocks are where we should turn our attention, while simultaneously eschewing US stocks—you just might expect that the potential for growth would be more easily found among the ranks of international stocks.


When we talk about valuations, we are talking about the number of times earnings per share (EPS—the E in the P/E ratio) can be divided into a stock’s price (the P in the P/E ratio)—this results in what is sometimes also referred to as the multiple. So, if the P/E ratio for a stock is high, this simply means that, relative to some previous period, the rest of the market, or some other grouping of stocks, EPS can be divided into a stock’s price more times than the particular benchmark being used. In order for valuations to return to more familiar territory, either the P (stock price) must decline or the E (EPS) must increase, and that is essentially where to start in evaluating a stock: what is its current valuation and what are the prospects for earnings to increase, which would justify the price also increasing? Reminder: investing is all about the future—what your investments be worth in the future, not now. So, just like Wayne Gretsky, we need to try to skate to where the puck is going (where future returns will come from), not where it’s already been.


Recession: Cautiously Negative


As we mentioned last time, the financial health of corporations appears to be fairly decent—generally, they have a substantial amount of cash on-hand. Further, while the percentage of corporate debt to GDP has only increased since 1951, the cost associated with servicing that debt is not currently at a high-water mark, and the duration of corporate debt has been expanding ever since the early 90s—this would seem to indicate a trend of firms locking in lower interest rates for longer. Based on this, we conclude that corporations are in a relatively good position to either take advantage of investment opportunities or to be able to weather poor economic conditions.


As mentioned above, earnings grew faster than stock prices during 2021, which lowered the P/E multiple for stocks over the course of 2021, and earnings are projected to continue grow pretty substantially over the course of 2022. Though labor costs have increased significantly as of late, profit margins have been strong. If earnings and profit margins are to continue their march forward, then consumption will be key, and that means that we need to take a close look at the consumer.


The American consumer accounts for just about 69% of our GDP. GDP growth quickly rebounded from the dip caused by the pandemic and has almost clawed completely back to the 2% growth trendline that we have been hugging for the past two decades. Most recently, GDP growth hit clocked in at an annualize rate of 6.9% in the 4th quarter of 2021—a substantial pace. The complete story of GDP growth is not captured in the aggregate figure, you might say. 4.9% of that growth came solely from companies restocking inventories (Source). More on this later, but supply, largely due to volatile demand, has experienced its own volatility and the restocking of inventory, alone, cannot support positive GDP growth for long—i.e., there must be demand so that inventories can be turned over, as is the case with normal business operations.


In terms of the financial resources that are on-hand, the consumer has substantially more assets than debt—$162.7tn vs $18tn. 25% of that, however, is tied up in homes and 19% in pension funds. The reason we bother to mention that is because pensions do not allow for withdrawals as needed and we already have experience with what substantially leveraging home equity can do—please refer to the Financial Crisis of 2008. Because of this, it might be more useful to compare the numbers without homes and pensions factored in—$91.1tn vs $18tn. Regardless, those numbers appear to indicate that the average consumer’s balance sheet reflects a fairly strong position.


If the consumer is to stay in a strong position, then the rate of spending cannot outpace the rate at which resources are acquired—i.e., income needs to be greater than expenses. The first key to this is to simply remain employed. As of 12/31/21, the unemployment rate dropped to 3.9% (Source). The rate of new hires slowed a bit in December, however, as 400,000 new hires were expected, but only 199,000 actually occurred (Source). In terms of wages, the average employee enjoyed a pay raise in the last quarter, but the pace slowed a bit from the third quarter—5% vs 6.5%, respectively (Source). One last stat to serve as a barometer for how the average worker is doing is productivity. In the third quarter of 2021, the Bureau of Labor Statistics figure for labor productivity declined at an annualized clip of 5.2% and is at its lowest point for at least a decade (Source). This is most likely reflective of the impact of the wave of infections related to the delta wave of the coronavirus and also the nonpharmaceutical interventions, such as being asked to work from home, which would serve to make attendance, alone, a matter of significant inconsistency.


As we will discuss momentarily, inflation has been quite strong as of late. In fact, it has advanced faster than the wage growth cited above, as indicated by the Consumer Price Index (CPI). Couple that with the average work environment being disrupted, as well as global political tensions, and you might be able to understand why consumer sentiment and consumer spending are waning. As of January 2020, consumer sentiment was at 99.8, the highest since March of 2018, and December 2003 before that. Most recently, the measure fell to 67.4 in November of 2021, the lowest point since 2011, with a slight rebound to 71.6 in December (Source). This lack of confidence was reflected in consumer spending, as personal consumption declined 0.6% (Source) and durable goods orders declined 0.9% (Source).


Commodity Spike: Negative


It’s no secret: inflation is here, having announced its arrival pretty forcefully. In December, the CPI advanced at an annualized rate of 6% (Source). The Personal Consumption Expenditures index (PCE), the preferred measure of the Federal Reserve, advanced at an annualized rate of 4.8% (Source). Essentially, the best way to understand the difference between these two indexes is that CPI represents prices, so what the average consumer has the potential to spend, whereas the PCE reflects a more realistic perspective of the consumer’s actual experience by looking at actual expenditures.


The factors that seem to be driving this growth in consumer costs: 1) plenty of easy money via stimulus coupled with low interest rates, 2) supply chain issues, and 3) depleted inventories. All of us are most likely familiar with the circumstances surrounding stimulus, and interest rates will be discussed next, but the story of the supply chain and inventories is essentially evolving. A major player in that story is China.


Currently, China is dealing with a spike in coronavirus cases, which has resulted in the Chinese government issuing stringent lockdowns. These lockdowns are impacting shipping, and workaround measures are having to be employed, which are most certainly not as efficient as the norm. Further, there are complications at ports around the world, but in the US particularly, and this has led to the number of ships with cargo waiting to dock to be greater than at any other point during the pandemic (Source). If you couple that with the trucker convoys that are being organized to protest nonpharmaceutical interventions around the world, including in Canada (Source), and the threat of a strike by 17,000 employees at BNSF railroad (Source), it’s hard to see from where or when relief might come. If only that was the end of the story, though. We could not discuss commodities and inflation without including tensions between Russia and Ukraine and a note or two on oil.


Why are tensions between Russian and Ukraine significant? The Nord Stream 2 pipeline, that’s why. The Nord Stream 2 pipeline will send natural gas from Russia to Europe via Ukraine (Source). The reason this is significant is because Russia supplies a third of the natural gas that other European nations need. Further, European countries rely on imports, like those from Russia, to fulfill 84% of the need for natural gas, which accounts for 25% of Europe’s energy consumption—all-in-all, this means that Russia, alone, fulfills 8.25% of Europe’s energy needs. Looking at things from Russia’s perspective, taxes derived from the export of natural gas account for 10% of the country’s federal budget. If Russia moves forward with invading Ukraine, EU nations have threatened to withhold approval of the completion of the pipeline (Source).


Oil prices, meanwhile, recently jumped to the highest they have been since 2014 (Source). It’s probably no mystery, but we depend on oil a great deal. It is literally impossible for a petroleum product to not be involved in the production or shipment of all other products. The bad news is that this obviously puts upward pressure on the makers of goods to raise prices to compensate for the additional cost. The good news is that it provides incentive for more rigs to come online—depending on the rig, the price of a barrel of oil might not be sufficient to even have the rig extract oil from the ground—and indeed, more rigs are coming online (Source).


Aggressive Federal Reserve: Cautious


For the longest time, it’s been hard to come up with something interest-ing (I had to) to say here, because circumstances have been pretty static. Since 2008-2009, we have had a 10-year Treasury rate below 5%, but now, as inflation has taken hold, we might begin to see a slow march upward for interest rates. Indeed, Jerome Powell, the chair of the Federal Reserve, recently stated that he “would say the committee is of a mind to raise the federal funds rate at the March meeting, assuming that conditions are appropriate for doing so” (Source).


Given that interest rates are the key means by which the Federal Reserve seeks to fulfill its charges related to inflation and employment, it would seem that inflation is doing its part to place upward pressure on interest rates, but wage growth is a factor that might modulate some of the more hawkish expectations for rate increases. Wage growth, as measured by the Employment Cost Index, slowed in the 4th quarter to 1% from 1.3% in the previous quarter (Source). Looking at the broader picture, however, shows that year-over-year growth from the third quarter of 2020 to 2021 was 3.7%, whereas year-over-year growth for the fourth quarters was 4% (Source). If a slowing trend continues, this might confirm that the calls for inflation being of a transitory nature are accurate and it might give the Fed reason to adopt a more cautious approach to raising rates.

The cautious outlook reflects the simple fact that when interest rates have risen in the past while at the levels they are now, stocks did well--i.e., that explains why the outlook is not more negative. The reality is, however, that the Fed is facing some real challenges, some of which are rather novel. In fact, Powell has said that "there is an element of uncertainty around the balance sheet" and that the "balance sheet is still a relatively new thing for the markets and for us, so we're less certain about that," referring to how the Federal Reserves balance sheet shows the results of all of its bond purchases as a tool to manage interest rates (Source). So, there is absolutely an element to this that is dependent on how well the Federal Reserve manages this novel situation. One factor that might render all of this completely irrelevant, however, is the simple fact that the low interest rate environment has led to the use of abnormally low discount rates to value stocks, and that has produced some risk misalignment (Source).


Closing Discussion


Suffice it to say, there’s a lot going on. There is certainly more that we could comment on: the semiconductor situation reaching a crisis point (Source), mortgage applications declining significantly (Source), the IMF lowering economic forecasts for the US and China (Source), a widening income gap revealing who has benefited the most during the pandemic (Source), a decline of auto prices (Source), a decline of pending home sales for the second month in a row (Source), and much more. Regardless, it’s probably fair to say that, at minimum, there’s a smoldering fire of uncertainty concerning economic and political conditions globally. Whether accelerant or water is thrown on that fire depends on how these issues are dealt with moving forward.

To speak frankly, the recent comments surrounding the tensions between Russia and Ukraine are an example of direction being virtually indiscernible. On one hand, you have members of the Biden administration stating that an invasion might be imminent (Source), whereas Ukraine disputes this claim outright (Source) and Russian leaders state that war with Ukraine would be “unthinkable” (Source). Like a lot of people these days, it seems like they need to get on the same page, and quick.