2021 Q4

I hope everyone has had a good start to the year. Mine started with a bout of Omicron. I was patient zero in our household and then we went 6 for 6. Nothing serious but it did put me on my back foot to start the year…thus you are receiving this a few weeks later than we’d like. We appreciate your patience.

2021 was an interesting year for the stock market. The major stock indexes logged yet another double-digit year of growth. There were reasons for the markets to be optimistic. Corporate earnings were good, consumer demand was up, unemployment was low, money was loose, and the economy posted strong enough GDP numbers to bring us back to the long-term trendline of economic growth. These factors are all tailwinds for stocks and 2021 proved to be a good year for many companies.

A good year for many but not a good year for all

For some time now though, we have noticed disparity in different parts of the market. In some places, like traditional growth, valuations are high but not obscenely so. In other places, valuations appear to be reasonable. There are also areas of the market that have been downright speculative. In our 2021 Q2 commentary, we pointed to the speculative behavior occurring in certain areas of the market: SPAC’s, meme stocks, crypto-currency, FinTech, innovative tech, and non-profitable tech. These areas of the markets had received huge inflows of capital since the pandemic which had driven the price of many companies to lofty levels. About halfway through 2021 though, the gains started to reverse. By the end of the year, roughly 40% of the companies in the Nasdaq index had a share price that was 50% lower than their 52-week high.

The chart below has some notable names that experienced heavy losses in 2021. If I had continued this chart into 2022, it looks worse, but need something to talk about next quarter.

At the surface level of the market, this was barely noticeable. In fact, the Nasdaq 100 continued a steady upward climb through the end of the year. That begs the question, how is it possible that almost half the companies in an index can drop by 50% and yet that index still goes up in price?

The answer: Big Tech. With their earnings perceived to be destined to grow forever, capitalism and passive fund flows have rewarded the Big Tech companies handsomely. Google, Facebook, Microsoft, Amazon, Apple and Tesla have now grown to the point where they make up 45% of the total value of the Nasdaq 100. 6 companies = almost 50% of the market. They are so big that their combined market capitalization is twice the Gross Domestic Product of every country in the world, excluding the US and China. They’re big. Really, really big. Historically big. Andre the Giant big. The performance of these 6 stocks heavily influences the direction of the index, nearly to the point of domination. If they are performing well, a lot of other securities in the index can be performing poorly and you won’t notice it on the surface.  That is exactly what happened in the latter half of 2021. Big Tech was stable, other areas…not so much.

The chart below shows % drop-off from the highest price of several Ark Invest Funds. Ark managers focus on investing in what they believe to be life transforming innovations. Their funds are a good proxy for the types of companies who had their share price drop in 2021. They performed excellently the last few years and, arguably, for good reason. Many of these companies have extraordinary ideas and extraordinary products. They may very well may change the way we interact with the world. Areas such as FinTech, robotics, genome science, biotechnology, and the metaverse to name a few, all have the potential to deeply affect the way we live and interact with one another.

The world has seen several life altering innovations in the past couple of centuries: the automobile, trains, oil, electricity, and the internet, to name a few. In his book, Engines that Move Markets, Alasdair Nairn examines market behavior during these cycles of innovation. In each cycle, speculative market bubbles developed when innovation was coupled with what he calls a rare combination of coincident conditions. Let’s look through this list of coincident conditions and make some very brief notes (in parenthesis) on whether each of these conditions exist today:

  • The emergence of a new and potentially transforming technology about which extravagant claims can be made with apparent justification (Yep…quite a bit of it out there)
  • A climate of relatively easy money and credit conditions (let’s see here…lowest interest rates ever, multiple stimulus checks directly deposited into consumers accounts, and the largest increase of M2 money supply on record. I think this one is covered too)
  • General investor and consumer optimism (I’m feeling pretty good)
  • A wave of new publications promoting the merits of the new technology (um…yes. Also, Reddit)
  • An efficient and productive supply machine, capable of creating a host of new companies to meet investor demand (SPAC’s; ETF’s, Coinbase, Robinhood. There is nothing bad about any of them but it does illustrate that the finance supply chain is alive and well)
  • Suspension of normal valuation and other assessment criteria (I could go on about this one for a long time)

It looks like all the conditions that marked prior market bubbles are present today. While I would stop short of calling what has developed a bubble, the price of many securities did get expensive, very expensive. Fueled by government stimulus, time on their hands, new ways to speculate, and encouraged by the promise of a changing world, the market drove the price of these securities higher and higher. Eventually people woke up to the fact that, for instance, there are a limited number of people who will spend $1,500 on a stationary bike from Peloton. As always happens, the market then reversed many of the gains that had been realized over the last three years. As it is often said, trees do not grow to the sky.

While these speculative movements only happened in relatively small corners of the investing world, they are important to note for a couple of reasons:

First, it may mean that investors are turning a more discerning eye to where they invest their capital. The investing world has been seemingly oblivious to fundamentals for some time, focused on investments of promise rather than investments of profits.  If people are growing concerned about the truly speculative corners of the market, they also may start turning a more discerning eye to the price of the rest of the market. In the last few weeks of the year, it looked like even Big Tech was susceptible to some price reconsideration.

Second, it is a reminder that “the market” is a diverse place. We think this is a really important point as we look to the years ahead. The stock market certainly faces mounting challenges: inflation, rising interest rates, geopolitical tensions, a slowing economy, etc. There is also a lot of talk of the US market being over-valued. I could quote any number of investors, many of whom we have great respect for, that say the market is over-priced and due for a correction.  There is certainly an argument to be made there. But 2021 was a good reminder that “the market” is more diverse than we often give it credit. It may look expensive, there may be speculative areas, but there are also reasonably priced opportunities with the potential for good long-term growth. From our vantage point, there is more diversity in the price of securities today than we’ve seen for a decade. As such, we will continue to look for opportunities to invest capital at an acceptable level of risk.


2021 Q3

Happy fall to everyone. It’s my favorite time year. It always has been, even before pumpkin spiced lattes and all things flannel came in vogue. As the cool weather sets in, we hope that you have a great fall and holiday season.

The third quarter gave us no shortage of things to consider: market volatility, rising interest rates, a good ol’ fashioned government debt ceiling showdown, a floundering infrastructure package, defaulting developers, haywire supply chains…lots of stuff to ponder, far too much to get to here. We will give a market update and some thoughts on a couple of these issues. As always, if you have questions feel free to reach out.

The S&P 500 eked out a small gain for the quarter of 0.2%. During July and August, the market continued its upward climb with the S&P hitting a new high at the beginning of September. It was not to last though. Rising treasury rates and the specter of inflation spooked investors and the market quickly dropped 5%. Elsewhere in the world, rising energy costs and aggressive regulatory measures implemented by China pressured global markets. The foreign traded Chinese stock market, and other major markets suffered corrections, with many of their indices falling more than 10%.

It was good to see the market take at least another breather. It’s basically been on a non-stop upward climb since the Federal Reserve announced in March 2020 their intention to purchase $120 billion in US debt every month. The economic recovery from the initial COVID lockdowns has been robust, but many argue the main driver behind the continued market gains is the Federal Reserve’s asset purchases. The liquidity those purchases provide appear to have been necessary to avoid an economic collapse during the height of the lockdowns but at this point we might be getting too much of a good thing. The famed economist/professor, Mohamed El-Erian, recently remarked in a Financial Times article:

For their part, investors should recognize that the enormous beneficial impact on asset prices of prolonged central bank yield repression comes with a consequential possibility of collateral damage and unintended consequences. Indeed, they need only look at how hard it has become to find the type of reliable diversifiers that help underpin the old portfolio mix of return potential and risk mitigation[i]. 

One impact of additional liquidity and low interest rates has been consistently rising asset prices, such as we have witnessed in the stock market, bond market, real estate market, and just about almost every financial instrument. Many of these markets have hit all-time highs recently and, as we remarked in our last commentary, stock valuations are high on a historical basis by almost every metric. When the Federal Reserve tapers their asset purchases, which they will likely do in the near future, a part of the support for high asset prices will be removed and the market will be forced to stand on its own.

The unintended consequences of the Federal Reserve’s actions may play out over a long period of time. For instance, pushing asset prices to historical highs may mean we have to endure a subsequent long period of low returns. If you want to know what this might look like, Bank of America’s (BofA) research arm releases a chart forecasting 10-year returns (see right). One nice feature of this graph is they include their track-record since 1990 and, importantly, they’ve been in the ballpark of actual returns most of the time. As of now, they have the market, as defined by the S&P 500, pegged at an annualized negative rate of return over the next 10 years. GMO, an institutional investor, publishes a similar analysis, estimating forward returns for the next 7 years[ii]. Theirs, shown below, presents an even less rosy picture (an important side note…they present it in “real return” meaning, return minus inflation).


These estimates are not prophetic, but they are informative. The process BofA and GMO use for these estimates examines forward economic growth potential and assumes a reversion to the mean of investment returns, earnings per share growth, profit margins, and valuations. In simpler terms, if the US market is to repeat the performance of the last decade, it will have to buck historical trends or tap into some new channel of economic growth. Possible? Yes. Probable? No.

Looking back at the last 10 years, it is hard to fathom an extended period where the S&P 500 doesn’t perform exceptionally well, but history has shown there can be long periods of low to no growth in developed stock markets. For example, the United Kingdom’s FTSE 100 index is today just slightly above the value it was in 1999, i.e., last century. I was wearing Reebok Pumps and Starter brand hats when Japan’s Nikkei 225 Index hit its high-water mark in 1989.  We could site several well-reasoned explanations for those paltry returns but they both start with the same over-arching factor…valuations. 1999 was the height of the dotcom boom when tech companies were selling at ridiculous multiples.  1989 was the height of the Japan craze where markets had assumed that Japanese companies had discovered the secret sauce to perpetual growth (sound familiar?)[iii].  Even the S&P 500 has had these periods. If you refer to the graph from B of A, the 10 year forward returns for the S&P 500 from 1998, 1999, and 2000 were negative. With current market valuations, me might be staring down a similar period.

This doesn’t mean we need to run for the hills, go all to cash, or bury our head in the sand. There are many of different paths the market can take, even if performance isn’t what it has been. We are not suggesting “crash and burn” is inevitable. In fact, the current market could continue to be supported for some time. If S&P 500 earnings grow robustly like many predict, valuations will be more reasonable, though still a long way from historical norms. Also, “the market” is more diverse than most people think. The S&P 500 performed poorly in the first decade of the 21st century but there were pockets of domestic equities that did well and many foreign markets, like emerging markets, had strong performance. We believe similar pockets of more reasonably priced assets exist today.

Chinese Regulatory Crackdown

Much of the market turmoil experienced in the third quarter was stimulated by developments in China. The Chinese Communist Party (CCP) has taken several regulatory actions over the last year aimed at reducing big tech influence, shifting capital investment to different industries, eliminating the inflating costs of private tutoring, reducing carbon emissions (or more accurately stated, reducing reliance on fossil fuel imports), and reigning in overextended debt in the construction development sector. These actions have reverberated across markets as corporate profitability in some sectors has been directly impacted or, as in the case with the private tutoring industry, eliminated (private tutoring companies now must be not-for-profits). In addition, Evergrande, the country’s largest and most indebted real estate developer, is on the verge of collapse. They have missed several note payments to their bondholders and further note defaults look likely.

Unraveling the decisions of the CCP – their motivations and the long-term impacts – is difficult, to say the least. Some of the world’s most successful investors have contrasting points of view regarding China. For instance, Ray Dalio says that investments in China can’t be avoided and should be embraced. In contrast, George Soros has labeled China as un-investible. Some have labeled Evergrande as China’s “Lehman moment.” Others see it as a small hiccup on the road to fix structural problems and promote Xi’s “Common Prosperity” doctrine.

Diverse opinions concerning China is nothing new. For the last two decades, we’ve been reading about the impending collapse of the Chinese economy while at the same time reading about China’s eventual assumption as the world’s greatest super-power.  The reality is probably somewhere between those extremes. It is the second largest economy in the world and the largest by population. The country has experienced unprecedented economic growth during the last 30 years. The development of a large – and growing – middle class has created opportunities for growing corporate revenue. We also tend to view China not just the through the lens of the CCP. The corporations we own equity in support the life and livelihood of thousands, likely millions, of Chinese families.

In our view, recent events don’t change that over-arching outlook. We certainly don’t like the regulatory actions taken by the CCP (we believe in the superiority of a free market society. Also, we see some of these actions as discouraging entrepreneurship, productivity improvements, and innovation) but we see the intended utility of them. We also recognize that whatever the CCP does, it will be in the best long-term interest of the CCP. The timing of these regulatory changes is with purpose. It comes at a time when the country is benefiting from the re-emergence of the global economy. GDP growth was 18% in Q1 and just under 8% in Q2. This is a time where some short-term economic pain can be taken in favor of longer-term goals. But the recent regulatory actions do impact the risk profile of the country. The actions of the CCP have caused a lot of market volatility and have in some specific cases (private tutoring companies) destroyed wealth. In recognition of these increased risks, we are diversifying more broadly across Asia.

Inflation – Energy Prices Soar

Inflation continues to be at the center of debate and concern across markets. In July and August, inflation remained at over 5%. September results had not yet been released at the time of this writing, but inflation is expected to be lower (we’ve heard that before) as there are signs that many of the largest inflation contributors, such as airline fares, hotel fees, and used car prices, had decreased. However, the supply bottlenecks contributing to inflation don’t appear to be loosening up. In fact, they might be getting worse. We continue to have faith in supply side economics: as prices increase, purchasing will slow and this will help bring equilibrium back to the supply chain. That process may be a bit of a grind, and take some time, as the global economy muddles through an unprecedented whiplash of demand.

More concerning as of late is the recent surge in energy prices.  Power shortages are acute in China and India right now. Warm weather and the strong economic recovery have pushed energy demand to an all-time high. In addition, the central Chinese government is pressuring its provinces to reduce their carbon dioxide emissions, a difficult task for a country reliant on coal for 70% of its energy generation. The nation has started rationing power and forcing day-long factory closures.  With winter around the corner, China and India are both looking to liquified natural gas (LNG) imports to help fill the gap. Unfortunately, Europe also relies on LNG imports for much of its energy production and, in this global economy, increased demand in Asia – along with other factors – is pushing the price of natural gas to all-time highs across the globe.

The price of crude oil has also been increasing, recently rising to a 7 year high.  Oil may be seen as the red headed step-child of energy generation but that child is still the main breadwinner for the family.  Oil, along with its other carbon emitting siblings, can also be stored or produced at varying rates to adapt to variability in energy demands. In contrast, wind production and solar conversion can’t be ramped up during, for instance, hotter or colder days when energy consumption peaks. Renewables also present a problem when mother nature decides not to behave herself. For example, the share of electricity provided by renewables in the United Kingdom dropped in the spring of 2021 from the year prior because there was less wind and fewer sunny days.  Texas, of all places, also had to deal with this reality last winter when an ice storm froze wind turbines across the state. The cold snap had pushed up energy consumption and decreased energy output at the same time. With colder weather just around the corner in the northern hemisphere, energy demands will increase and already stretched power grids will have to increasingly rely on carbon emitting sources of energy.

Oil producers seem loath to meet this increased demand with increased production.  The Organization of the Petroleum Exporting Countries (OPEC) is unwilling to increase their production beyond the already outlined planned increases.  US energy producers have largely shifted towards a capital model that focuses on paying out cash to shareholders in the form dividends and share buybacks instead of reinvesting for growth. That is unlikely to change as the political climate makes the regulatory risk of investing in expanded production too high to entice companies and shareholders. Bottom line: be ready to pay higher prices at the pump and write bigger checks for your heating bills this winter.

Looking out to the longer-term, this same story of energy shortages is likely to play out time and again over the coming years as the world attempts to shift away from carbon emitting sources of energy.  Governments will be toeing the line between reducing their carbon emissions and keeping people warm, fed, and traveling at a reasonable cost. One has to look no further than the US, whose administration is pressing OPEC to increase production while at the same time taking regulatory steps to reduce domestic production and transportation. Traditional energy producers are looking less willing to play the game. Rolling power outages and spikes in energy costs are probably here for some time. Some will call it growing pains. Others will call it self-inflicted foolishness. Either way, oil and natural gas aren’t going away, and the price is likely to go up in the near term. We will all be paying more at the pump but the energy positions in our portfolios should fare well.  We will continue to look for opportunities to invest capital at an acceptable level of risk.Blake

[i] https://www.ft.com/content/225cb41f-2cfc-42de-9066-d0ce86a2fed7

[ii] https://www.gmo.com/americas/research-library/gmo-7-year-asset-class-forecast-august-2021/

[iii] https://www.ft.com/content/99a8158d-d08c-4de9-9712-2301b9497779

2021 Q2

During the 2nd quarter, the economy continued its recovery from the economic shutdowns of 2020. Consumer spending, which makes up roughly 70% of US economic activity, has been strong. The job market has been in good shape, with the main challenge being employers filling open positions. It seems every business has “now hiring” signs posted. Banks are flush with capital. Many corporations are in an improved position compared to the beginning of 2020. While the pandemic was a challenge for most businesses, the support provided by the Federal Government and Federal Reserve gave opportunity for companies to borrow additional money, extend credit maturities, and lower overall interest costs.  With the economy seeing huge gains from government stimulus, companies are looking to report high earnings from the Second Quarter.

Within the last few weeks of the quarter, economic data started to deteriorate. It’s not a collapse, but things are not looking as promising as they once were. Several financial institutions have downgraded their economic growth expectations for later this year and into next year. There has also been a surge in COVID cases domestically and internationally as the Delta variant of COVID aggressively spreads. If global governments react with the same lockdown measures as they did in 2020, this will also put pressure on the economy. In addition, several of the protective measures implemented by the government are set to expire soon. The increased unemployment benefits are scheduled to cease in September, and the continuation of the eviction ban is in question. These could also have a damaging effect on the economy as lower income families deal with higher costs and less cash flow.

Questions still abound about the long-term health of the US Economy. The accommodative actions of the Federal Government and the Federal Reserve gave corporations the opportunity to retrench and restructure their debt, an opportunity they welcomed with open arms. US corporations issued more debt in 2020 than any previous year. While this was a boon in the recovery, as the economy cycles, many businesses will likely find themselves over-leveraged. All these gains have been achieved by unprecedented government support. Granted, this support was necessary in the wake of lockdowns. Without government support, economic recovery would have taken years, if it ever recovered at all. But this is now the second consecutive recession where massive government stimulus was necessary for recovery, and each step has required greater measures to be taken in support of the economy. In the process, the government has taken on more debt and may have created an economy reliant on low interest rates and easy monetary policy.

Inflation, Inflation Everywhere

Anyone notice prices going up lately? That’s a bit of a rhetorical question. I think at this point, everyone has noticed the increased cost of stuff (that’s technical jargon): used cars, houses, lumber, clothes, food, gas…it seems like everything has become more expensive the last few months. That’s not just perception. Inflation has arrived. The 12-month inflation rate in April, May, and June was 4.2%, 5.0%, and 5.4%, respectively.  That’s more than twice the average over the last 10 or so years.  Prices are going up, and we are all seeing it.

The question being openly debated in the financial news is, how long will this higher level of inflation last?  If you listen to the talking heads out there, there are a few contrasting viewpoints.  Leading one side of the argument is the Federal Reserve, who sees this period of high inflation as “transitory.” They state that this is the result of coming out of a period of lower inflation and congested supply chains, temporary issues they believe will eventually work themselves out as the economy transitions from closed to fully open. The counter argument is that we are witnessing sustained high inflation due to unprecedented direct government stimulus into the economy and the ongoing support of the Federal Reserve. 

Each side of the argument has its merits. Inflation was barely existent in 2020 and was historically low in the period between the Financial Crisis of 2008 and the 2020 pandemic.  If you look at inflation in that broader context, the high inflation figures experienced during the 2nd quarter could be partially attributed to a “base-rate effect.” Several industries, like the travel industry, dropped prices significantly in 2020 and are now increasing prices aggressively as demand has returned. The bottlenecks in the supply chain are largely the result of businesses decreasing inventory and production during the pandemic and then having to manage a sudden spike in consumer spending and government earmarking as the economy re-opened. Plus, the shipping and transportation industry can’t seem to get enough employees. Goods and materials are sitting in ports with no one to unload them or transport them to their destination. In short, there’s a mismatch between supply and demand right now. Arguably, the numbers also support this argument that inflation is more of a result of these short-term factors as opposed to a long-term trend: if you remove the certain components of CPI related to re-opening (i.e. hotel & air travel, computer chip shortages, used car prices, etc), the inflation surge is not much of a surge.

The counter-argument is somewhat compelling as well. Money supply (the amount of dollars in the financial system) increased by 25% in 2020 because of the massive stimulus efforts by the Federal Government and the Federal Reserve. Banks are flooded with deposits from corporations and individuals who have basically stashed their stimulus dollars. In fact, some banks are having to re-work their capital structure because they have so much cash in deposits. If that money starts getting into the economy, the mismatch between supply and demand could persist.

The difference between those two positions comes down to whether or not the high inflation rate will be sustained.  Price increases in some areas where inflation is really hot, such as used cars and housing, will likely temper as consumers begin to balk at the rising prices. Supply chain issues will eventually work out, as it is within businesses’ financial interest to quickly move base goods and products and as pent-up demand from the pandemic fades. If forward looking economic indicators are correctly showing a decrease in growth, that should also have a taming effect on inflation as well. As these economic forces work out, what we see as the most likely outcome is inflation settling in a slightly higher range than in the last decade as the deflationary impacts of globalization and decreasing working-age populations begins to counter-act inflationary pressures.

The path to that end may be volatile, and we also could be flat wrong. We’ve often remarked on economists’ inability to accurately predict inflation, and while it’s a nice ornament in the office, our crystal ball does not help us see any clearer than theirs. There are a number of unknowns that could continue to push inflation higher. Another stimulus package from the Federal Government may threaten to overheat the economy and add fuel to inflation. In addition, the savings amassed through stimulus could make its way into the system if consumers at large begin to expect higher sustained inflation.  If people believe they will have to pay a higher price for a good or service if they wait, they are more likely to spend now to avoid paying more later.  This can create a feedback loop…the consumer spends because pricing is going up, companies respond to the demand by increasing prices, and consumers again spend because pricing continues to go up.

So, we must move forward with a watchful eye towards inflation. Regardless of what happens with inflation, there are still some immutable facts. Good companies will continue to make money, and hard assets will retain value. We will continue to look for those kinds of positions and manage our bond exposures to react well in a rising interest rate environment.


During the 2nd quarter, the US stock market rose to some new high-water marks. Honestly, we continue to scratch our heads in wonder about the performance of the market as it continues its steady upward climb. Prices are optimistic and seem to be ignoring any future risks. It appears that a large volume of stimulus money has landed in financial market pushing arguably overstretched valuations higher and driving an increase in speculative behavior. In the last few months, shares of several companies whose business models have been seemingly left behind by market trends, like GameStop and Blackberry, have been revived by day-trading retail investors crusading against hedge funds who had shorted the shares. The price chart of lumber from April to the end of June looks like an outline of the Matterhorn. It went from $840 per thousand board feet in mid-April, peaked at around $1,700 in mid-May, and ended June at $716.  Bitcoin started the year at around $20,000, ran up to just over $60,000, and is now sitting at around $32,000 and is trending upwards.

This isn’t normal market behavior (although Bitcoin can go Wild-West at any moment), and prices don’t move this much purely based on fundamentals. It’s hard to explain a 100% increase and then a 70% drop in the price of lumber over the course of 2 months solely based on supply and demand.  Logjams of that magnitude don’t pile and then break free that quickly.  This was textbook speculative market behavior.

Times like this require an increased degree of caution and an eye on long-term valuations. Benjamin Graham, the often-coined father of value investing, believed one of the biggest challenges to investors was recognizing when the market had turned from investing money to speculating in money. There is a difference between the two. Investing is buying an asset for its value and long-term cash generating qualities whereas speculating is betting on future market movement (there is room for nuance here that we won’t get into). Speculation isn’t all bad. There is room for speculation in a portfolio. How much is dependent on the investor. But it is important to acknowledge when you are making a speculative bet and often in markets like we are experiencing the crossover from investing to speculation can be subtle. As the market continues to climb, it’s easy to ignore the fundamentals, ignore the mounting risks, create justifications for higher and higher valuations, and put your faith in the everlasting bull market, may it never die.

While that approach may work for a time, it can be detriment to long-term returns. It is a well-supported argument that the biggest indicator of future returns is current valuation. That’s why most of our focus will continue to be on the fundamentals: buying good companies at good prices or owning funds that focus on the same. There are some remaining corners of the market where those can still be found. They’re not going to space or talking about creating things like the metaverse, but they will generate cash, a lot of it. And we get to own that cash generation for a reasonable price.

Looking farther out, we do see a lot of innovation on the horizon. The medical industry, in particular, is witnessing technological change that has been previously unseen. Technological advances in energy, transportation, and the way we work are also taking place. While we see a lot of opportunities to invest in these markets, they seem priced for perfection at this moment. We will continue to look for opportunities to invest capital at an acceptable level of risk.


2021 Q1

Good news…this commentary is a wee bit shorter than the last. That was a marathon. Kudos to you if you made it through the entire thing. This one will be a bit more manageable.

What a difference a year can make.  Last spring, my wife and I celebrated Easter with just our children in our home. I still remember my disappointment, that I wisely kept to myself, when I learned Easter family pictures would still be required.  Getting a 3, 5, 7, and 9 year old to cooperate for photos is never easy and the process usually ends with someone in tears. Somehow, we managed through. Pictures were taken but soon erased as my daughter went on a crusade to remove any evidence that daddy had shaved his beard off during quarantine. Apparently, the site of my clean-shaven face while cycling through the photos on the iPad was just too traumatic for her.  She even brought it up this year as she told my wife a couple weeks before Easter, “Last Easter wasn’t very good because Daddy shaved his beard off. I hope that doesn’t happen again.” Her wish was granted…things were more normal for us this year. Pictures were expected, we spent the day with our extended family, and my facial hair was in full bloom.

Similar stories are being told across the country as much of the nation continues to revert to normal life. More people are returning to offices, sporting events have spectators, restaurants are filling up, and summer vacation plans are being made. This activity translates is showing up in the economic numbers.  Official GDP numbers for 2021 were not released at the time of this writing but the number is expected to be big. Massive government stimulus has effectively pushed the economy forward. If current estimates do continue to play out, the US economy will be “recovered,” (meaning, total GDP will be equal to pre-pandemic numbers) by sometime in the second quarter. 

The stock market outpaced the economy, reaching the milestone of “recovered” late in 2020. It continued to grind higher during the first quarter of 2021, closing on March 31st near it’s all time high. Much of the reporting around corporate earnings seasons has been positive. Companies are optimistic about the recovery and believe revenues will continue to increase over the next year as the consumer becomes more active and the government continues to support the economy through stimulus. From some perspectives, things look bright for the immediate future.

The market is not without risks. Valuations across the US financial markets have returned to their pre-pandemic high water marks by almost every traditional valuation metric. By a price to earning measurement, the Nasdaq hasn’t been this expensive since just prior to the 1999 tech bubble. On a price to sales measurement, the S&P 500 is more expensive than at any other point ever. Professor Robert Schiller’s Cyclically Adjusted Price to Earnings ratio is at 37. That is a historical high surpassed only, again, by the Tech Bubble in 1999.

Beyond valuations, signs of excess continue to surface in various places as stimulus cash is looking for places to go. Special Purpose Acquisition Companies (SPAC’s) have attracted large amounts of capital the last 6 months. SPAC’s are shell companies that raise cash and then look for a company to purchase. Investors are gladly handing their money over to SPAC’s (there’s even a rap song about them…I kid not), despite having no clue what exactly they will be investing in. In another sign of excess, the price of cryptocurrencies has risen precipitously over the last 6 months. The long-term viability of crypto has somewhat solidified the last few years but the price appreciation may have gotten ahead of itself as some currencies have recently experienced price increases of 100% or more in just a matter of days. There are many other examples out there of money looking for places to go that we could site. Bottom line, there is a lot of money out there sloshing around and it sloshes indiscriminately. This will likely continue until something knocks the market off its tracks.  When that happens, people will be a little choosier where their money goes.

Inflation may do the trick, as it appears to be mounting on the horizon. Material costs are in fact going up. The increase is extreme in some markets, such as lumber. These prices are starting to put pressure on profit margins as the increase in material cost eats into the profit companies realize on the sale of their product. This kind of pressure at the corporate level can only last so long before companies begin passing the increased cost on to the consumer.

An uptick in inflation could spell trouble for the market. Initially, company earnings will be impaired before they shift the price increases to the consumer. But more importantly, inflation might cause the most damage for equities, because of the response it engenders from the Federal Reserve. Consider that one of the justifications for today’s high valuations on corporations is the lack of decent alternatives. As Buttonwood pointed out in the January 30th Economist, when valuations were at similar levels in the late 1990’s, the yield on inflation protected bonds (TIPS) was almost 4%. In contrast, on March 31st, 2021 the yield on 10 year TIPS was -.67%. Yes, that’s a negative symbol in front of the number. You are effectively paying the government to borrow your money. Not a proposition many are interested in (A side note here – money has been flowing into TIPS as of late because of inflation concerns. We are not convinced that’s the best hedge in this scenario. For one, the interest rate is negative so to make money, inflation must happen. Secondly, utilizing ETF’s and/or Mutual Funds to purchase TIPS mutes the inflation protection because of portfolio turnover. Lastly, it can be a highly illiquid market. We went window shopping for some TIPS the other day and there weren’t a lot to buy).

Interest rates impact value all the way up the chain. With Treasury Issues yielding nothing or next to nothing, investors are willing to pay more for equities. If inflation causes the Federal Reserve to raise interest rates, then fixed income instruments become more attractive. That would likely have a negative impact the price of equities. While rate increases may still be some time off, we should remember that the market tends to be forward thinking when it functions appropriately. If the market sees inflation ticking up, it may put pressure on prices, regardless of the current action of the Federal Reserve.

So, it appears we are stuck balancing on this fragile wave of stimulus induced growth, riding it higher and higher while trying not to fall off the increasingly steep back of the wave. While domestic markets are richly valued, factors such as positive momentum, increased stimulus measures and positive economic growth could continue to drive it higher still. In many ways, short term economics look good. Global economies will likely have a banner year and consumers have $2.5 trillion more in savings than they did prior to the pandemic. Maybe it could work. That said, a lot of what is being conducted right now is a grand experiment. While continued government stimulus and intervention make things look good in short-term, how it plays out in the long-term is unknown.  Are we setting the nation up for greater long-term growth or are we creating an increasingly fragile system reliant on debt and government funding? Time will tell.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


2020 Q4

Fair warning…this is a long one. 2020 was quite the year, and there’s a lot to talk about. If it makes you feel any better, I left out more than I put in (I don’t even touch the election…you’re welcome).

We hope everyone is doing well and adjusting in this ever-changing environment. To say there was a lot of change in 2020 would be the understatement of all understatements. This was a challenging year for everyone, for some more than others, but we all experienced some level of challenge or, at the least, inconvenience.

I’m not one to put much stock into the New Year. Very rarely do things in life tie up as neatly as they do in movies or books, and the sense of finality we get from seeing the closing scene of a movie or the turning of the next chapter of the book rarely happens in life, especially once you pass the educational milestones of our youth. For me, the New Year doesn’t really represent any closure…life will be much the same as the calendar rolls from December 31st to January 1st. I admit, I am probably in the minority in this way thinking, especially this year. As December rolled around, the excitement surrounding the close of 2020 and looking hopefully towards 2021 was palpable. As the COVID vaccine circulates, people are looking forward with great anticipation for the return of some level of normalcy. This social zeitgeist is important as we look ahead economically. If and as normality materializes, people will likely let loose: travel, eating out, spending time with friends, going to the movies, all of those activities we all had to abstain from in 2020. As the year presses on, and the pandemic hopefully abates, activity will pick up, and we are likely to see some big economic numbers. 

Any economic gains in the next year will occur with the backdrop of massive economic damage. Service sector jobs lost in the shutdowns won’t all be coming back in the next year. Corporations that had spent the last 10 years bingeing on debt just had to double down and borrow more to make it through a pandemic. For many companies, the increased debt will strain their cash flows going forward and remove growth capacity. Business closures and permanent work from home arrangements are changing the commercial real estate market. Though we expect things to improve, we also don’t know what will happen with COVID. New mutations of the virus appear to spread faster, and the vaccine rollout is proceeding at a much slower pace than the country had hoped. This reality may require more severe lockdowns before herd-immunity is achieved. This has already happened in the UK, and they are looking at another loss in GDP. Financial markets and the economy will have to move forward on shaky and uncertain ground.

If you read the annual predictions of what the “pros” think is coming for markets in 2020, you will find people in opposite corners. In one corner, we have the doomsday predictions: the market got too far ahead of itself in 2020, is not recognizing the massive damage done to the economy, and is bound to come back to reality in a scene reminiscent of the 1999 tech bubble pop. In the other corner, market euphoria: we are about to reach the other side of the pandemic, the world is about to party like it’s 1920, and trillions more in stimulus will be passed this year, which will drive economic activity and the stock market to all-time highs. The reality is, it’s anyone’s guess what the market will do this year. As we’ve said many times before, where the market moves from one year to the next isn’t about math or predicting events, it’s the response of the unpredictable masses to the unknowable future.[i]

Consider 2020. What if I told you in November 2019 that in 2020, governments around the world would shut down their economies for months in response to a pandemic, and the US stock market would still post double digit gains? You might have sent me to see Nurse Ratched. I would have probably gone voluntarily. That’s what happened though. True, you didn’t have all the information. I didn’t tell you that central banks and governments responded with never-before-seen levels of stimulus. Nor did I mention the concentration of market gains in tech stocks benefiting from demand shifts caused by stay-at-home orders. But you never have all the information, and it’s anyone’s guess how the masses will respond. History can be a guide, but as I read the various opinions floating around, I’m reminded of what Will and Ariel Durant, authors of the 10-volume The Story of Civilization, said: “History is so indifferently rich that a case for any conclusion from it can be made by a reflection of instances.”[ii]Is it 1999 or 1920? Is it the end of a stock market party or the beginning of one? I can make a case for either. I could also make a case for neither.

With uncertainty ahead, we continue to be disciplined in our selection of investments. In global markets, we see pockets of euphoria and pockets of reasonable value. To an extent, we have tried to position the portfolio with investments of reasonable value. Emerging Markets, Asia, renewable energy (particularly solar), and biotech are all positions we held at the beginning of the pandemic and will likely continue to hold for the foreseeable future. Going into the pandemic, we believed they represented good long-term value. We held to that belief, and they performed very well over the course of the year. During the year, we also made a lot of changes. We usually don’t go into specifics in our commentary, choosing rather to discuss this in client meetings, but given the events over the last year, we think it’s fitting to provide some additional information. Here are some of the adjustments we made to portfolios over the last year:

  • Allocation to precious metals was increased, adding silver to the portfolio back in April. We plan to maintain this higher allocation as debt loads balloon, risks remain elevated, and direct economic stimulus adds to money supply.
  • There were a couple corporate positions added that we had been watching for a long time.  Market turmoil priced these very attractively, and we were able to purchase them with a good yield. A few of these companies should benefit very well if there is more turmoil in the corporate bond market, as we expect there will be. 
  • We shifted some assets from a very conservative income fund (FPA New Income) to a more opportunistic multisector bond fund (Guggenheim Total Return). We saw the pandemic as a catalyst to an increase in corporate defaults resulting in volatility in the debt market. We wanted a fund that would be opportunistic in the chaos. Defaults did go up, the fund was able take advantage of some volatility, but the Federal Reserve actions stabilized corporate bond markets, at least for now.
  • In early November, we added a small cap fund (invests in smaller companies). As we highlighted in the Q3, small caps have seen three years of flat performance while large caps have had stellar performance. The performance disparity increased in the first part of 2020 as the market – rightfully so, in our opinion – saw an increased risk in small companies. By the third quarter, these companies had been largely left behind in the market rally and looked to be priced at good long-term value, on a selective basis (there’s a lot of bad out there too).
  • We added a precious metal miners fund (technically, we implemented this the first week of 2021). With suppressed precious metals prices over the last several years, these companies have had to tighten their belts, increase their operational efficiency, and reduce their debt in order to be profitable. Generally speaking, they are now sitting on clean balance sheets and high operating margins. If metal prices stay at their current levels, future earnings will be good and will only get better if precious metals prices go up, which we suspect they will. 
  • As prices went down, we added to several of our existing positions. This is especially true in the energy sector. Prior to pandemic, we believed the energy sector was very cheaply priced. The pandemic made them even more so, and we added to several positions as prices went down.
  • There were a few positions we did not want to carry through the pandemic that we eliminated.  A few were sold early in the year at losses. One in particular, a pipeline fund, had extensive losses. That one hurt. But we were able to reallocate the capital from those investments and put it to work in other places that we’ve mentioned above.

Our long-term clients will likely recognize this as many more changes relative to activity in the past. It is true, we don’t have a lot of turnover in our portfolios. We tend to buy positions that we believe are well priced and have potential ahead of them, and we often hold those positions for several years. But market chaos tends to create opportunities.  In the chaos of the last year, we were able to add—or add to—several quality investments at very reasonable prices. They should serve the portfolio well in the long-term.

What is going to happen with all this debt?

This commentary has already reached its normal length. If you’ve had enough, this is a good place to stop. This next section is a bit of bonus dealing with a subject that we think will have huge long-term implications but doesn’t have much immediate impact on our investment thinking (though it does have some). We also hope it will provide a little understanding as to why many in the Federal Government believe they can continue creating money out of thin air without considering the cost to the future.

In response to the pandemic, the Federal Government passed two stimulus packages. These measures blunted the losses in the economy, given our elected leaders’ decisions – right or wrong – to shut down large swaths of the economy.  But at what cost? The US Federal Debt at the start of 2020 was $23.2 trillion. It ended the year at over $27 trillion. That’s almost a 20% increase in one year. This trend is unlikely to change. President Biden said the recent stimulus package passed in December was just a “down payment.” With Democratic control of Congress, some expect to see $2 trillion more in stimulus packages. Federal Tax revenue per year is “only” $3.4 trillion. Almost half of that is payroll tax, which goes straight to Social Security and Medicare programs. There is no room for any stimulus in the budget. Any additional stimulus dollars will go straight to the Federal Government’s debt.

This has left many wondering, how does all this debt get paid for? Many politicians and a few economists are now concluding that it doesn’t need be paid for, arguing that the amount of Federal Debt doesn’t matter. Enter Modern Monetary Theory (MMT), an economic theory that is starting to influence more policy decisions and will have very real impacts on our lives and your investment portfolios.  

The basic premise of MMT is that a currency issuer (like the U.S., which issues dollars and whose debts are all in dollars) cannot run out of money. Since all our debt is in dollars, which the US Government creates, it cannot possibly default on its debt. If a debt comes due, the government can pay it by simply creating more money. Under this premise, the fact that we have a $27 trillion debt load means virtually nothing and taking on more debt has no impact on the government’s ability to further spend. Want to introduce a social program, like a jobs guarantee, or cover all healthcare cost or provide free college to all? You first need to find money in the budget to cover it, right? Nope…in MMT, the budget does not matter. You can spend without consideration of whether the government can afford and what it does to the Federal Government Balance Sheet.

This can be difficult to wrap your mind around at first, because we are so used to looking at finances through the lens of our personal budgeting. You have income and if you spend more than you make, you must borrow to pay for the shortfall. If the borrowings get too high, you can’t pay your debt, and you go broke. We tend to look at the Federal Government the same way. They have income in the form of taxes. If they spend more than they bring in then they have to take on debt to cover the shortfall and if the government debt gets too high, they go broke.  MMT would tell you that’s not an apples-to-apples comparison, because you are a currency user, whereas the Federal Government is a currency issuer. You can’t create money to cover your shortfall. The Federal Government can.

The next natural question to ask is, if debt doesn’t matter, why doesn’t the government print as much money as it wants? To be clear, MMT does not propose that the Federal Government can print money with no limit. It’s not a governmental blank check. It shifts the limiting factor from debt to inflation. Inflation is the constant increase in prices of the goods and services in the economy over time. We are familiar with this concept. It’s why a burger costs more today than it did 20 years ago. Most economists argue that a little inflation is good, but there is a point where there is too much inflation.  There are a lot of historical examples of inflation going off the rails. The classic example is Weimar Republic in 1923, where the cost of a loaf of bread went 250 marks in January to 200,000 million marks in November. That’s not good. People were literally taking wheelbarrows full of cash to the market to buy a loaf of bread. This inflation was, in part, a result of too much money being printed. So, in the world of MMT, keeping inflation at a reasonable and manageable level is the limiting factor to how much money the government prints.

MMT was a fringe theory just 10 years ago. We remember looking into it then as we saw it as a natural outcome to the massive money printing that happened in the wake of the financial crisis. Over the last 10 years, we have seen it rise to more prominence. Progressive liberals have adopted it as a means to fund many of the social programs they would like to see implemented. We expected it be a prominent component of the 2020 election. COVID-19 moved the focus elsewhere, and it never became a primary topic. But, it was functionally implemented when the government provided unprecedented monetary support to the economy with barely a nod by either party to what it would do to the debt level of the US Government. There was more pushback on the second stimulus. After it passed the Senate, Senator Rand Paul gave a speech about how its passing represented the adoption of MMT. We believe he’s right. With more stimulus measures coming in the future and a Democrat-controlled government that would like to see trillions spent in infrastructure, renewable energy development, health care, and many other social programs, MMT will be the counterargument to many congressional leaders’ opposition based on incurred debt.

Should this be concerning? Maybe. There is much about MMT that makes sense. For one, the US Government can’t run out of money. The government can’t default on debt that’s repaid on money the government creates. In that sense, debt isn’t a limiting factor. So, what is the concern?

We see a couple problems with MMT. First, it assumes economists have some predictive accuracy on inflation. Before a new program is implemented, the idea is to evaluate whether that would cross the tipping point of creating too much inflation. Sounds nice but the last 10 years have been rather condemning on the idea that economists understand inflation. Relying on our limited understanding of inflation, and what causes it, to red-light/greenlight projects seems a little foolhardy.

The second, and more worrisome, problem we see with MMT is once you cross into unwanted inflation, how do you get back? Dr. Stephanie Kelton is the one of the leading proponents of the theory. Interestingly, Dr. Kelton once worked at the University of Missouri Kansas City (UMKC) and the founder of our firm, Jack Kynion II, called her up one day to hear about this out-there philosophy. From those humble beginnings, she’s risen to be a thought leader on MMT. She recently released a book called The Deficit Myth, where she discusses the basic premises of MMT and outlines many challenges in the US that could be addressed by shifting our thinking to MMT. Dr. Kelton’s suggestion in the book is that government could use their money creation powers to provide for a host of social and infrastructure programs, like jobs guarantee, fully fund healthcare, renewable energy infrastructure, infrastructure at large, and college education, among others. Once inflation starts to pick up, you throttle back. That’s where we fear it breaks down. Let’s say we start going down this road of funding all these programs and somewhere along the way inflation starts to go nuts. What’s next?  MMT proponents suggest that congress would act to adjust taxes and government spending. Here is Dr. Kelton as she suggests adjustments to current monetary and fiscal policy:

Or maybe congress could help fine-tune the economy with better real-time adjustments to government spending and taxation?[iii]

You want Congress to do what?!? Fine-tune? Real-time? Those terms don’t compute with Congress. All these decisions will be politicized. If the inflation threshold is crossed, which social programs do you take away? Which congressional representatives will sign up for hosing their constituents? Increase taxes? To who, how much, and how? These are questions that don’t get answered quickly, and they’ll be answered largely in the self-interest of our representatives. If we are counting on them to make quick decisions to reel in inflation, we will likely be left with a lot of inflation.

Regardless of our beliefs toward MMT, we believe we will see a greater shift to this mode of thinking. In the next few months, there will likely be $1.9 trillion in stimulus. Then, there could be additional funding proposed for other social programs. The support in Congress for the programs will likely be there, but as dissent is raised, the rallying call will be MMT. In fact, Dr. Kelton – who once worked for Senator Bernie Sanders, who will be chairing the Senate Budget Committee—has been placed on President Biden’s economic team. We will likely hear more and more often that the deficit doesn’t matter. We will be watching this closely as it will directly impact our day-to-day financial lives and investment portfolios. We will continue to look for opportunities to invest capital at an acceptable level of risk.


Text Box: Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Limited Co. a Registered Investment Advisory Firm.

[i] For more pontifications on the limited usefulness of investment professional prognostications, see our 2016 Q4 commentary. Don’t have one? Request a copy here: bstanley@finadvs.com

[ii] Lessons from History by Will & Ariel Durant, Page 97.

[iii] The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy by Stephanie Kelton, page 55.

2020 Q3

A Big Third Quarter Jump and Then, a Slow Grind

As the economy continues its recovery from economic shutdowns, third quarter GDP growth came in at around 32%, annualized.  Even with that gain, the economy is still far from where it was. The output gap – where we are now versus where we would be had COVID never happened – is still around 4%-6%. While that might not seem like much, it represents roughly $1 trillion of economic output.   Closing that gap will prove to be difficult. The easy gains – if you can call $2.2 trillion in government stimulus and $3 trillion in liquidity via the Federal Reserve easy – have been realized. As the muddy water from economic shutdowns and massive government stimulus clears slightly, the toll of the pandemic response will start to come into focus.

Overall, unemployment is decreasing but long-term unemployment (longer than 27 weeks) is on a precipitous rise as more furloughs turn into permanent layoffs. Prime age labor force participation has weakened. This is likely due to parents dropping out of the labor market to support their children schooling at home.   At the end of June, 16% of FHA mortgages were delinquent, setting a record on data going back to 1979[i].  Corporate defaults and bankruptcies are also on the rise. Total corporate defaults in 2020 surpassed the full-year 2019 number by July 1st, a trend that is unlikely to slow[ii]. The already weakened retail sector has been hit especially hard with bankruptcies. As of this writing, JC Penny, Neiman Marcus, Brooks Brothers and 24 other retailers have filed for bankruptcy in 2020 and more are expected[iii].  With these problems mounting, the road back to economic norms will be long and difficult.

COVID still looms large over the economic recovery. In Europe, case numbers had been low due to stricter lockdowns but are now on the rise, eclipsing levels seen in the first stage of the pandemic. In the US, numbers are still stubbornly high. Among developed nations, it seems only countries in Asia (New Zealand and Australia have also kept numbers low) have been able to consistently keep case levels low.  Those low numbers are due in part to their people having recently experienced epidemics as well as more draconian governmental measures that people in the western world would likely find unpalatable. As an example, when someone tests positive in South Korea, they are placed in a government-controlled quarantine unit.  Just try implementing that policy in the US. To use my favorite Midwestern colloquial, that dog won’t hunt.

As case numbers rise, it is unlikely we will see lockdowns in the US at the same level as in March, but some government regulations will likely be reinstated or persist. Local governments across the country are likely to enforce bar and restaurant closures early in the evening, limit large gatherings, etc. Also, while pandemic “fatigue” appears to be prevalent, people’s decisions are still impacted by the virus as they continue to play it safe. This will continue to suppress economic activity and slow jobs recovery.  Governments around the world will try to counteract slow economic activity with additional stimulus. European countries have announced their intentions for the next round of stimulus, and eventually, the US government will come to an agreement on their next round of stimulus. Timing is still in question. It won’t happen before the election is decided and how quickly it happens afterwards will likely depend on the results. Congress, the White House and Joe Biden are all in agreement that stimulus is needed but negotiations continue about the amount and where it should be spent. The election will determine which party has, or will have, the leverage to get more of what they want.

A Bifurcated Market

The market recovery that began at the end of March has managed to hold together with a few bumps along the way.  Growth companies, specifically technology, have performed extraordinarily well and have been driven to valuations not seen since 1999. Some current conditions do warrant higher than historically average valuations for some companies. First, interest rates are, again, at an all-time low. Fair Value in the financial world is, in part, a relative measure. Lower interest rates from government securities will generally result in investors being willing to pay a higher price for a company’s shares relative to their earnings.  Secondly, it does appear that the pandemic has sped up some economic/market transitions: with many people working from home, the need for online collaboration tools and cloud-based services increased significantly, almost over-night. Furthermore, COVID shifted even more retail shopping online. Companies benefitting from these trends, like Microsoft, Google, and Amazon, have attracted a lot of capital the last few months pushing their prices to all-time highs. 

The question is whether valuations have run too far ahead of financial results and reached levels that indicate “irrational exuberance.” For example, Tesla’s stock price has quadrupled(!) this year. It is currently worth more than Ford, GM and Toyota combined but has a fraction of their revenue. Its valuation currently sits at over 100x current and future earnings. We will freely admit that a price to earnings measurement and a comparison to traditional car companies is not enough to argue that Tesla is over-priced (though it is), but the differences are so extreme that some eyebrows are perpetually raised. The reality for Tesla and many of the other highly priced growth stocks may not be as bright as the market’s perception. 

As the market beams with optimism regarding tech stocks, it drowns in pessimism in other parts of the market: healthcare, small cap stocks, value, banking, and energy have not enjoyed the same recovery in price as growth and tech. Again, this makes a degree of sense. The pandemic, the election, and court challenges have created uncertainty in healthcare; smaller companies are especially challenged by the COVID environment; cyclical stocks tend to rebound towards the bottom of an economic cycle; banks’ profits will be challenged by negative interest rates and a flat yield curve; energy is suffering from suppressed oil demand. But also again, the under-performance in these assets is extreme enough to raise an eyebrow or two. For example, in the last decade, companies classified as “value” have had the worst price performance relative to growth companies in two centuries[iv].  Performance in 2020 has widened this gap as the Russell 1000 Growth Index gained 24.1% through Sept 30 while the Russell 1000 Value Index lost 11.7%. This spread in performance may mean that the reality for some of these value companies may be brighter than perception. 

Just as COVID looms over the economic recovery, it also looms over financial markets. Optimism could easily subside if COVID cases continue to rise, and governments implement economy dampening restrictions. We still believe the economic reality has yet to be fully revealed. Government stimulus has been effective in avoiding catastrophe but many of these measures are only a temporary relief from the economic symptoms of COVID shutdowns, not a cure. It is as critically important now as it has ever been to have a focus on valuation. We will continue to look for opportunities to investment capital at acceptable levels of risk.  


Past performance is not a guarantee of future earnings.  Asset allocation does not assure a profit or protect against loss in a declining market.  Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Limited Co. a Registered Investment Advisory Firm.

[i] https://www.npr.org/sections/coronavirus-live-updates/2020/08/18/903524495/a-record-number-of-homeowners-with-fha-loans-are-late-on-payments

[ii] https://www.fitchratings.com/research/corporate-finance/2020-global-corporate-defaults-to-date-top-2019-full-year-total-01-07-2020

[iii] https://www.retaildive.com/news/the-running-list-of-2020-retail-bankruptcies/571159/

[iv] https://www.ft.com/content/fc7ce313-92f8-4f51-902b-f883afc1e035

2020 Q2

After a tumultuous first quarter in the markets, government and monetary intervention along with the hope of a V-shaped recovery have fueled a market rebound that is nothing short of remarkable.  The S&P 500 lost 34% from its peak on February 19th to its low point on March 23rd.  As of this writing at the end of June, the market price is right around where it was on January 1st. That seems almost unbelievable given that we sit at double-digit unemployment and are staring down the largest calendar year economic contraction since the budget cuts following WWII.

Despite the exuberance, the market optimism still sits on fragile ground. In mid-June the Federal Reserve remarked that they did not expect a full economic recovery till the end of 2021. That news, along with renewed fears of a second wave of the virus, sent the market down by 5% in a day. The market immediately rebounded over the next few days as the Federal Reserve announced the initiation of their corporate bond buying program. We expect that this kind of news/response will continue as the markets balance the realized and persistent economic damage the virus is causing against the highly accommodating policies from the Federal Government and Federal Reserve Bank. 

In our last commentary, we outlined several unknown questions related to the virus and the economic damage it has caused. Most of those questions continue to be unanswered. The public commentary surrounding the economic recovery has pretty much abandoned the concept of a V-shaped recovery but appears to be optimistically looking ahead to a steady uninterrupted economic recovery. A lot must go right for that to happen. For instance, there cannot be a second wave of COVID-19 that causes the economy to shut down. We are going to “stay in our lane” as the saying goes by not venturing an opinion here, but if history is any indication, the probability of a second wave is high. There were three influenza pandemics in the 20th Century: the 1918 Spanish Flu, the 1957 Asian Flu, and the 1968 Hong Kong Flu. Each of them had a second wave. There are already resurgent pockets of cases in certain areas of the globe. Beijing has re-instated lock-down procedures due to a new outbreak in cases and here in the US several states that re-opened early have seen upticks in the number of reported cases. Second wave or not, COVID is likely to be with us for some time, and will continue to negatively impact the economy.  

In addition, we still do not know how damaging it was to close the economy for two months. Across the economy, short-term concessions are being made: landlords are deferring rents; corporate lenders are relaxing covenants so corporations don’t enter into technical default; PPP loans to small and mid-size businesses kept employees on payroll; and increased unemployment benefits supported people who were “temporarily” laid-off. Those are all temporary measures. Eventually, landlords and lenders will expect payment to be made, companies will begin to assess how many employees they really need to retain, and the government will not likely continue to pay people more to stay at home than they were earning in their jobs. As these short-term concessions end, the ripple effects may threaten a steady economic recovery.

Corporate Debt

What is becoming apparent is the impact all of this is having on Corporate America’s balance sheet. While corporate cash flow is more complex than our personal finances, they are the same at the most basic level. Like you, companies have bills to pay…rent, loans, interest, etc. In order to pay those bills, they need access to cash. That cash can come from one of three places: income, savings, or borrowings. The economic shutdown reduced income substantially for many – probably most – companies. For those companies who no longer had the income and did not have enough savings to pay their bills, their only remaining option was to borrow funds. That’s exactly what corporations did in historic amounts in the 1st and 2nd quarter. At one point, corporate debt, as a percentage of US Gross Domestic Product, jumped 10% in a week.

A lot of this money is being borrowed by companies who were not in good shape going into the crisis. The loss of income and increase in debt are threatening technical default for many borrowers. Lenders are currently sympathetic. Many have allowed corporations to report last year’s earnings in order to delay or avoid default. Some companies have even adopted a new earnings acronym. Many of you might be familiar with the term EBITDA. It stands for “earnings before interest, taxes, depreciation, and amortization.” It’s supposed to provide investors/debt-holders with a realistic view of how much money a business is making. It’s not a concept we particularly care for, but I digress. Now, some companies have adopted a new metric, EBITDAC…earnings before interest, taxes, depreciation, amortization and – wait for it – coronavirus. Yes, they’re providing a number of what they would maybe-might-have-earned had COVID-19 never happened. If only we could all live in such a fictional world.[i] 

All this is occurring with the Federal Reserve providing a significant backstop for corporations. When corporate debt markets buckled in March, the Federal Reserve promised the purchase of investment grade and “recently investment grade” corporate debt. This had the immediate effect of attracting money back to corporate debt markets. This lowered interest rates and gave corporations access to money. These corporations would have otherwise been left out in the cold. While those measures provide companies with the ability to pay their current bills, the additional debt will make it more difficult to pay their future bills or invest in the growth of their business. There were already a large number of what has affectionately been termed “Zombie Corporations,” companies who have more debt service costs than profits. With the amount of debt being taken on by corporations, this number will only increase.

Financial Engineering

It doesn’t seem possible for corporations that can’t pay their bills to continue borrowing money forever. It flies in the face of good, common sense in fact. Actions taken by the Federal Reserve, however, have served to distort free capital markets.

Their intentions seem to be good. If corporations go bankrupt, people lose jobs. When people lose jobs, they stop spending money. When people stop spending, corporations make less, and then have to lay off more people. The cycle continues, and in healthy and mature economies, it finds equilibrium. Eventually hiring will resume, people will have more money to spend, corporations earn more and hire more people. The Federal Reserve partially fills the role of smoothing those cycles but in the last two crises (Financial Crisis of 2008 and COVID-19), the Federal Reserve has stepped in with ever greater measures of support for financial markets than it had before. Actions thought unimaginable before 2008 are now commonplace. We may look back in another 5 years saying the same thing about 2020.  The result, though, is a system increasingly reliant on outside support.

Federal Reserve actions not only does create a reliant system, but also distorts what should be the natural capital flow in free markets. In a free capital market, well run and profitable – or potentially profitable – companies will attract investments, while poorly run, unprofitable companies will lose the capital support of investors. This motivates corporate operators to run their companies prudently without taking undue risk. It also ensures that companies that should not remain in business due to mismanagement or changing market forces don’t survive. With the support of the Federal Reserve, it appears corporations who shouldn’t continue to attract capital are not having a problem finding capital.

One particular example we saw in the first quarter was Cinemark. As a movie theater operator, the last several months have been particularly hard. Most, if not all, of their revenue was gone due to shutdowns. They needed cash, and when the corporate bond market buckled in March, it didn’t look like they were going to be able to borrow it. Then the Federal Reserve announced its intention to buy corporate bonds. Immediately, capital flowed back into markets, interest rates came down and the liquidity was available for Cinemark to issue a new round of bonds. That’s a win, right? Maybe, but will the current movie theater model survive in a post-COVID world? I hope so. I love going to the theaters, but I wouldn’t want to bet on it right now. Until the Federal Reserve stepped in, it didn’t look like there we many people who were willing take that bet either. That’s happening over and over again in the markets: companies are getting capital that maybe shouldn’t be.

Even with the Federal Reserve’s efforts to keep capital flowing in corporate debt markets, we have still found some good yield within the public and private debt markets. This is a sector we have avoided the last couple of years in anticipation of a turn of the credit cycle. Interest rates had been too low to justify the risk. That changed in the first quarter. With an asset manager who has particular talent in managing credit risk, an attractive yield can now be obtained at an acceptable level of risk. We have taken this opportunity to increase our exposure to debt markets. If equity markets become volatile again, these assets should continue to pay good yield. Plus, the capital is protected so long as the manager has been adequately selective about their lending or purchases. We believe the managers we have chosen have and will continue to exercise the proper prudence. As always, even in this environment, we will continue to look for opportunities to investment capital at acceptable levels of risk.  


[i] https://www.ft.com/content/85d6f19c-0eea-4f70-a906-40b03d862f03).

2020 Q1

First of all, our prayers are that you and your families are staying safe. We are living through a strange and unprecedented time. Just a few of months ago, we were looking at calm markets with a slowing but growing economy. That quickly changed as COVID-19 hit the US, and the economy basically shut-down. The impact on financial markets was severe. Never have US financial markets displayed the kind of volatility in such a short period of time. In a matter of weeks, the market dropped almost 40% and then quickly recovered much of the ground it had lost. Along the way, we witnessed asset price fluctuations like we have never seen before, including during the 2008 Financial Crisis. 

With financial markets struggling, the Federal Reserve stepped in with a massive volume of purchases, expanding its balance sheet by $2 trillion in less than a month.  It took years for that to happen after the Financial Crisis in 2008. To provide the economy and individuals some support, the Federal Government also stepped in to provide stimulus checks for individuals and payroll support loans for businesses.  Never has there been a greater effort from the Federal Reserve and the Federal Government to prop up an economy.  

All of this makes the future more uncertain than usual.  The modern world has never experienced a period where the global economy shut down for months, and no one alive today has faced a pandemic of this magnitude.  This leaves a lot of questions about how events will play out:  How long will it take for the economy to “re-open?”  Will there be a resurgence or a second wave of COVID-19?  How soon will a vaccine or treatment be available?  How much damage has been done to the economy?  How willing will people be to return to normal social activities?  And longer-term, what effect will all this new debt have on economic growth going forward?  These questions are being weighed and considered in the press and by governments around the world but knowing the answers just isn’t possible.  The innumerable predictions, the media commentary, and government talking points are all just speculation.  Valuable speculation (that’s a rare thing) but still speculation.  Even in uncertainty, there are a few things we can have a high degree of confidence in, which have informed and will continue to inform our decisions about how to handle portfolio allocations going forward.   

First, the US economy and the global economy will recover but it will take some time.  Financial markets seem to be pricing in a “V-shaped” economic recovery: the economy crashed quickly, and it will jump right back up.  We see that as optimistic.  It may be a V-shaped recovery, but it’s going to look like a V my five-year-old wrote, meaning that the right side of the V is going to look very different than left side.  Parts of the economy are at an absolute standstill and re-starting does not happen with the flip of a switch. A strong initial jump is possible, even likely, but it will take time for people to fully return to their normal activities. The 30+ million recently unemployed will not all find their jobs waiting for them. It took 3 years for GDP to recover after the 2008 Financial Crisis.  We would not be surprised if this recovery were to take that long, or longer.  

Second, and related to the first point, a lot of bad economic data and corporate earnings reports will come out over the next few months.  Again, estimates on how bad are all over the board.  We have seen estimates ranging from a 10% total reduction in GDP to a 40% total reduction in GDP. Corporate earnings will not look any better. Over the next few months, we will begin to understand the toll levied against the economy. As we have said many times before, we cannot predict what the market is going to do over the next few months, but as of right now, financial markets appear to be overly optimistic.  We believe there is more pain to come in the markets as the damage assessment becomes clearer.  

Third, this situation will result in winners and losers among countries and companies.  Countries with the capacity to spend financial reserves, take on more debt and expand their monetary base without immediate adverse consequences will probably come out of this ok.  In contrast, over-indebted countries with insufficient financial reserves will have a much more difficult time.  Similarly, companies with strong balance sheets and a capacity to spend during this crisis to increase market share will ultimately come out of this stronger.  In contrast, smaller companies or over-leveraged companies will struggle to access cash or, in the event Federal Reserve keeps bond markets liquid, will come out of this with more debt and less cash flow.  

Fourth, corporate debt markets will be volatile.  Market reactions in March shined a big spotlight on the corporate debt market asset bubble that we noted back in our 2018 Q4 commentary. Certain areas of the bond market dropped precipitously in price. Actions taken by the Federal Reserve brought some calm to those markets, but the problems are not going away.  Coming into 2020, corporate defaults were on the rise and Rating Agencies were warning of a coming wave of rating downgrades.  Now that the global economy has shut down for two months, we should expect even more corporate defaults and ratings downgrades.  

Lastly, the Federal Reserve and the Federal Government will continue to pull out all stops to support the economy.  As we noted above, the concerted efforts by these two institutions to provide liquidity in the markets and stimulus to the economy has been unprecedented.  This will continue, although the pace of help from the Federal Government will likely slow as the process to pass stimulus packages becomes increasingly politicized.  

With those factors in mind, we will continue to hold our high-quality positions and look to be opportunistic about buying high quality growth assets at reasonable prices.  We have already executed on a few opportunities and if market volatility persists, more of those opportunities should come around.  It’s important to note here that we are looking for good long-term opportunities.  New positions may experience immediate priced declines, but if done correctly, these opportunities will pay handsomely in the long run.  We have also made some adjustments in the portfolios to take advantage of the dislocations that are likely to occur in the corporate bond market. 

Hovering over these decisions are the actions taken by the Federal Reserve which will continue to have implications across financial markets.  For comparison, in the wake of 2008 Financial Crisis, as the Federal Reserve pumped liquidity into the financial system, markets shrugged off poor economic data and began to climb.  We are mindful this could happen again.  Given the uncertainty, we need to carefully manage risk while maintaining exposure to potential market growth.   The weeks ahead are likely to be challenging, regardless of what the market does.  Each one of us is having to live through this situation in our own way.  For some of us, this virus presents very little risk to life or livelihood.  For others, the risk is high.  Many of us probably haven’t left the house for 5 or more weeks, except to get groceries. That’s hard for some of us but enjoyable for others.  Some of us work in healthcare or have an essential job that requires going to work and risking exposure.  We want to thank you for risking yourself and your loves one on others’ behalf.  Whatever your situation, our prayers are with you. We will continue to look for opportunities to investment capital at acceptable levels of risk.  

2019 Q3

The third quarter brought a lot of movement in the domestic stock market but by September 30th the S&P 500 had not gone far from where it started the quarter. Geopolitical concerns continue to create a lot of uncertainty.  In the Q2 commentary, we mentioned the smoothing of trade negotiations between the US and China.  About 27 seconds after we hit “print,” President Trump announced the whole thing was falling apart.  This, along with Brexit drama, recession expectations and slowing corporate earnings growth, appear to have the market’s mood moving from cautious optimism to slight pessimism. 

Economically, the US and global economies continue to show signs of slowing.  Many countries across the globe are teetering on the edge of recession, defined as two consecutive quarters of GDP contraction.  Germany and the UK experienced economic contraction in the 2nd quarter.  Italy is also hanging on by a thread.  On the other side of the Atlantic, Mexico and Brazil both contracted in the first quarter and narrowly grew in the second quarter.  Checking in with the other hemisphere, Singapore and South Korea each had a quarter in the first half of the year where their respective economies contracted.   The slowdown in Chinese economic growth is also evident.  

Back at home, economic data is rosier but still pointing to a slowdown.  The US consumer is pulling their economic weight (almost 70% of US GDP) with continued strong spending.  In contrast, production and manufacturing activity both fell in the first and second quarter and the trend is expected to continue when Q3 numbers are reported.  With portions of the economy in a recession, it is reasonable to expect the rest to eventually follow.  That said, the strength of the US consumer – whose spending makes up 67% of GDP – will likely keep us out of recession territory for at least the next couple of quarters.   

Where’s the Value and Why it Matters

As we approach the turn of the economic cycle, we are continually reviewing portfolios to assess risk while we scour the financial markets for value.  Domestically, depending on what valuation metric is used, the US market is anywhere from slightly overvalued to highly overvalued.  If corporate earnings continue to fall, market valuations will become richer until the stock market reacts to the downside.  Looking internationally, European markets are also highly valued but not as much as the US.  That does not necessarily make them a better buy…they have a lot more fundamental issues than US markets. When we survey the entire world, though, the best value continues to be in emerging markets.  Admittedly, we have argued this position for some time (and we will argue a little more later in the commentary). We have also allocated our portfolios, in part, based on this position. 

Why pay so much attention to valuations?  Current valuation tends to be one of the largest determinates of market performance.  Increases in the price of a stock (and cumulatively, the stock market) happen for several reasons.  One is the performance of the company.  In the most basic terms, if a company manages to increase their revenue and their profits, the value of the company increases.  The other big factor is an increase in the price investors are willing to pay for those profits.  This measurement is called the Price to Earnings ratio (PE).  We have referenced this ratio many times over the years…let’s take a deeper dive into what it is and why it so important to consider.

Imagine you are a kid looking to get into the lemonade stand business.  You don’t want to start this lemonade stand from scratch (but of course the lemonade will be made from scratch…you can’t run a proper lemonade stand with Country Time) so you start looking at lemonade stands to buy.  After days of beating the streets on your bicycle performing due diligence on the local stands you narrow it down to two.  They are both perfect…on busy streets with lots of foot traffic, nice table set-up, a great chair to sit in and located under a shade tree.  There is only one difference.  The first makes $50 per day; the second makes $30 per day. 

You approach the owner of the $50/day stand and the young lady there says she’ll sell it to you for $1,000.  Next, you go the $30/day stand to talk to that kid.  He says he’ll sell it you for $270.  How do you determine which one is the better buy?  The most basic way is to look at the price of the stand relative to what it earns (Price-to-Earnings).   The owner of the first stand is asking 20x daily earnings for the stand: $50 x 20 = $1,000. The other owner is asking 9x daily earnings: $30 x 9 = $270.  Which is the better deal?  The second stand because at 9x vs 20x you can buy the second at a lower multiple of earnings.  Another way to think about this: it will take you 9 days to earn your $270 back on the second stand and 20 days to earn your $1,000 back on the first (lemonade stand season is short…that 11 days makes a big difference).  So you shell out your $270 and you’re in business.  

Our lemonade stand transaction is a simplified example of what happens in the stock market.  Just as the two lemonade stands were selling at different price to earnings (PE) multiples, individual securities sell at varying PE multiples and, cumulatively, varying stock markets (Dow vs S&P vs Emerging Markets vs Europe, etc) trade at different PE multiples.  Recognizing this is important because if an investor buys an investment at a lower PE their likelihood of making money through a phenomenon called Multiple Expansion increases. Multiples expansion occurs when the PE investors are willing to pay for a stock increases. Below is a basic example from John Neff’s book, On Investing.  Mr. Neff was the manager of the Vanguard Windsor Fund for over 30 years.  He had incredible success through his career, out-performing the S&P 500 by over 3% per year.   

In his example, he shows, with very basic math, why the price paid for an investment is critical.  His example has two identical scenarios

Static P/E Expanding P/E
Current Earnings Per Share $2.00 $2.00
Current Market Price $26.00 $16.00
Current Price/Earnings 13:1 8:1
Expected Earnings $2.22 $2.22
New P/E 13:1 11:11
New Market Price $28.86 $24.42
Appreciation 11% 53%

– same current earnings and same expected earnings – except for the price you pay for the stock.  His example demonstrates what happens to investment returns when you buy a stock at a lower PE and then the stock later trades at a higher PE.  The performance of the company is the same but when you purchase it at a lower PE it has more room for price appreciation.  In this example, a lot more room. 

So, that’s a nice example but how much does this come into play in actual market returns?  A lot.  In every bull market since 1900, multiple expansion has contributed over 50% of the total price growth of the stock market.  For example, from 1982 to 1999 the PE investors were paying for the market went from 9x earnings to 30x earnings.  This multiple expansion accounted for 52% of the price growth of the market during that time.[i]  But multiple expansion is a finite source of return. In each historical case, the market hit a point when it recognized that price increases based on further multiple expansion no longer made sense.  Think back to lemonade stand…you paid 9x earnings, $270, for the stand.  Would you have paid 20x at $500?  What if it was 30x at $900?  There will come a point, if you are not already there, where you will say, nope…that’s too much.  Investors essentially do the same thing with the market.

That is why there has been a strong correlation between the current market PE and future returns.  Historically, when the aggregate PE of the stock market is high, relative to its historical average, future returns for the following several years are lower relative than when current PE is low (yes, I have data to support this but I’m trying not to turn this into a journal article[ii]).  The reason? PE’s tend to be mean reverting. When there’s a triggering event that draws investors’ attention to high PE’s they start selling, they sell past the average PE to a low PE where the market eventually bottoms. 

GMO, a large institutional investor, maintains a 7-year Asset Class Real Return Forecast based, in part, on this concept of mean reverting PE’s. They look at current market values, make some estimations regarding future growth rates of earnings and profit margins and then come up with an expected return for each market.  Below is their most recent forecast.

The chart has a large spread between their expected performance of US Large Cap stocks and Emerging/Emerging Market Value stocks.  Most of this spread is due to the difference in current day valuations.  Over the last couple of years (2018 and 2019 year-to-date), Emerging Markets have continued to under-perform relative to domestic equities.  Earnings growth has been good but they have not had the returns from multiple expansion that domestic equities have received.  This has resulted in a large value discrepancy between Emerging Markets and Developed Markets.  Emerging Markets growth stocks have not been this cheap relative to US Growth stocks since 2002 (see chart below). 

In the 5 years following 2002, Emerging Markets out-performed domestic markets by a wide margin.  Will history repeat itself?  It’s impossible to say.  Remember the old Danish proverb: Making predictions is hard, especially about the future.  But there are a couple take-aways from the facts: First, domestic equities are facing heavy headwinds.  If return from multiple expansion is tapped out, or nearly so, the market will need to rely on revenue earnings growth and profit margin increases for return inspiring performance.  Not a very promising prospect when the economy is staring down a recession and profit margins (also mean-reverting) are close to an all-time high.  Second, it means domestic equities have a lot more room for multiple contraction.  In other words, in a bear market, they arguably have farther to fall.  Even though Emerging Markets are viewed as the riskier investment, right now, they may not be.    

In the late stages of bull market cycle, which is where we believe we are, is a time when few investors are looking at fundamentals for investment decisions.  The places where assets are over-priced are often the ones that get the most attention (becoming more over-priced) and the ones that are priced remain unfavored until some event – usually not a good one -makes people look around. When that happens, an old investing adage becomes topical again: Valuations don’t matter until they do and when they do, they are the only thing that matters.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


[i] Active Value Investing: Making Money in Range-Bound Markets by Vitaliy N. Katsenelson, page 55 for data through 2005.

[ii] Ibid, page 53 for data through 2005.

2019 Q2

The resilience of the US Stock Market continued in the 2nd quarter.  The economy is still growing, although more signs of a slowdown are appearing.  Due to some good posturing, Q1 corporate earnings did “surprise to the upside,”, but corporate earnings growth did slow, as we speculated in our Q1 commentary.  The slowdown in earnings is expected to continue as corporation report Q2 earnings. There was also some progress, or at least lack of regress, in the trade war between US and China.  At the G20 conference on June 30th, Presidents Trump and Xi agreed to continue disagreeing on friendly terms (without additional tariffs).  There’s no trade deal yet but the two fighters have returned to their corners…for now. 

The stock market and bond market continue to flash conflicting views on the economy.  The stock market points to continued growth; the flattening/inverting yield curve, to a recession. These conflicting views are not necessarily surprising.  An inverted yield curve typically occurs months before a recession (it’s happened with no recession as well), while the stock market tends to make huge gains in the lead-up.  In other words, the inverted yield curve is usually the guy who shows up early to the party, while the stock market tends to be the one who shows up late and surprised to learn there is a party. 

Market sentiment does feel strange right now.  Typically, an over-optimistic, sanguine sentiment presides late in the market cycle as the gains make their final push into an economic slowdown.  If we are in the stage of the cycle we think we are, this is usually when the money that’s been sitting on the sideline for years is dumped in but there has not been a lot flow into domestic mutual funds and ETFs so far this year.  The flow is positive but not by much.  Where is the money coming from that’s pushing the market so much higher?  A large contributor appears to be Corporate Share repurchase programs.

Corporate Share Repurchases

A share repurchase program is when a company utilizes capital (cash) to purchase their own shares, thus removing shares from circulation.  In 2018, corporations – in the S&P 500 – purchased over $800 billion of their own shares.  That set a record.  In fact, it blew past the old record.  According to Goldman Sachs, corporations will set yet another record in 2019[1].  This represents a huge transfer of capital into the markets.  If the Goldman Sachs estimate is correct, by the end of 2019, $1.7 trillion dollars will have been pumped into the stock market in two years.  Seems like a lot of money, right?  It represents almost 7% of the total value of the S&P 500.  It’s a lot of money.

Share buy-backs can be an effective tool to return money to shareholders, because they are more tax efficient than dividends.  Presuming the seller of the stock had a gain and held the stock in a taxable account, they would owe capital gains tax as opposed to the ordinary income tax they would owe on a dividend.  There are also benefits to the remaining shareholders.  Reducing the number of outstanding shares increases the percentage ownership of the remaining shareholders.  For example, if I own 10 shares of a company that has 100 total shares outstanding, I own 10% of the company (whew…that was hard math).  If the company purchases 50 of the outstanding 100 shares but I hold on to my 10, I am now the proud owner of 20% of the company.  That should make my shares a whole lot more valuable.  What a deal.  This is functionally what we see happening in the markets right now.  Companies are buying back their shares in record numbers, increasing their shareholders’ relative ownership.   

The potential benefits of share buy-backs cannot be argued against, but there are some troubling aspects of the current bonanza (to steal the technical term from the graph above).  For starters, what happens to markets when companies reduce their buy-back programs? If the folks over at Goldman Sachs are correct (and why would we ever think otherwise), these repurchases will go on for some time, but they won’t last forever. Data suggests that the capital for these repurchases has come from two main sources.  The first is additional debt.  In our 2018 Q4 commentary we commented on the US Corporate Debt Binge that has occurred over the last 10 years.  A lot of this additional debt appears to have funded share buy-backs.  This is somewhat speculation.  It is difficult to directly connect that these borrowed dollars went to purchase shares.  But when you examine the data of newly issued debt along with data on how capital was deployed, the connection is hard to deny.  Jeffrey Gundlach, the currently anointed “Bond King”, claims the two are related[2].  If anyone would have a “feel” for where the capital has come from and where it is going, I think it would be him.

The second source of capital for buy-backs is repatriation of corporate dollars held overseas.  Over the last several years, companies have accumulated large accounts overseas as a tax shelter against higher American corporate tax rates.  In many cases, companies were borrowing money to finance operations as opposed to bringing it into the US.  To encourage the repatriation of this money, the recent tax code revision featured a special rate for repatriated dollars.  The idea was for companies to use this money to invest in their business and grow the economy.  A lot of it appears to have gone to share buy-backs instead (this does not necessarily mean the money does not go to grow the economy…see Jamie Dimon’s comments below).  

What these two sources have in common is they are kind of one-shot deals.  Corporations can only access so much debt.  While repatriated dollars are a result of earnings, the volume is high because it was built up over years.  These one-shot deals have likely been huge contributors to positive market performance the last two years.  Markets go up when there are more dollars looking to buy than there are owners looking to sell.  In the last two years, corporations appear to have been the overwhelming net buyers.  What happens when that money slows down?  Will that bring about the turn of this extraordinarily long bull market?  Maybe.  It will certainly have an effect. How much is hard to tell.   

Impaired Corporate Performance?

Another concern to consider is how these share buy-backs will impact corporations’ revenue and earnings going forward.  There is always an opportunity cost when deploying capital. In the case of share buy-backs, companies may be missing an opportunity to improve their balance sheet or invest in future growth. CEOs are responsible for making these “capital allocation decisions”…how best to use cash to increase shareholder value.  In his most recent annual report, JP Morgan’s Jamie Dimon spent a couple of paragraphs on buy-backs, specifically on what circumstances need to exist for him to consider buying back JP Morgan stock.  Here’s what he had to say:

We much prefer to use our capital to grow than to buy back stock. We believe buying back stock should be considered only when either we cannot invest (sometimes as a result of regulatory policies) or we are generating excess capital that we do not expect to use in the next few years. Buybacks should not be done at the expense of investing appropriately in our company. Investing for the future should come first, and at JPMorgan Chase, it does.

However, when you cannot see a clear use for your excess capital over the short term, buying back stock is an important capital tool – as long as you are buying it back at a reasonable price. And when companies buy back stock (which we only do when it is at a price that we think adds value to our remaining shareholders), the capital is redistributed to investors who can put it to good use elsewhere. It does not disappear. We currently have excess capital, but we hope in the future to be able to invest more of it to grow our businesses.

In his view, stock repurchases are almost a measure of last resort.  It’s a good tool when there are not enough opportunities to invest excess capital into the growth of the business.  But as pointed out above, a lot of companies are not using excess capital.  They are financing the purchases with debt.  While it provides the immediate satisfaction of increasing the coveted and overly reported Earnings Per Share metric, it does not help the company in the long term.  The borrowed money comes at a cost (interest) and will have to eventually be paid back.  Debt should be used to finance growth, not engineer accounting.  The former can be responsible management; the latter is short-term thinking at its finest. 

Also, as Mr. Dimon points out, if a company is going to repurchase shares, they need to do it when they can get a good price, which makes us question the timing of current purchases.  To create shareholder value with buy-backs, CEOs should execute the programs when their stock is cheap. In his book, Creating Shareholder Value, Alfred Rappaport gave the opinion that repurchasing fairly priced stock added no value to shareholders, and buying overpriced stock would destroy shareholder value over a long period of time.  Opinions may differ as to whether stocks are currently expensive, but I don’t think you will find many people arguing that they are cheap.  If they are expensive, then corporations may be participating in the greatest destruction of shareholder value in history. 

You might think, hey, these are CEOs, really smart people who would not make such a bad decision.  It may be true that they are smart but that does not mean they are good at capital allocation.  William N. Thorndike wrote a book, The Outsiders, where he chronicled the decisions of successful CEOs.  In the first couple of chapters, he draws from some of Warren Buffet’s writings to make the points that one, in rising through the ranks of business, CEOs may have never had to make capital allocation decisions, and two, CEOs are as subject to “groupthink” as anyone else.  With little to no experience with deciding how to invest money and under peer pressure to look like other CEOs, the fact they are overpaying for their stock is not necessarily surprising.  In fact, it may be typical.  The last time buy-backs were north of $600 billion was in 2007, when the market was reaching its peak.  To be fair, this does make some sense.  Corporations will have the most amount of cash towards the end of an economic cycle, but they are not forced to use the cash for share repurchases.  I would rather have my corporations hang on to their cash, or even pay down debt, until they find good investment opportunities. 

Having used up cash and increased leverage, these share buy-backs have likely put corporations in a position where they won’t be able to weather storms or be as prepared to invest when the economy troughs.  It puts another strike against the current corporate health and, to us, further emphasizes the need to be mindful of company balance sheets.  We will continue to look for opportunities to invest capital at an acceptable level of risk.


[1] https://www.ft.com/content/19435b4e-6c2f-11e9-80c7-60ee53e6681d

[2] https://finance.yahoo.com/news/corporate-stock-buybacks-rise-schumer-sanders-172223775.html