Category: Uncategorized

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.

Blake

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 21^st 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

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[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

During the 2^nd 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 2^nd 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.

Markets

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.

Blake

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.

Blake

Interest Rates are Low?  Who Knew?  

The chart below shows the change in the interest rate of the 10 year Treasury bond over the last 34 years.  The early 1980’s were the tail end of a period of high inflation and interest rates.  Many of you probably remember having CD’s paying interest in the double digits.  In 1981 policies were enacted by the Federal Reserve that started a drop in interest rates that, as the chart below shows, has not really ended since.  Earlier this year the interest rate on the 10 year treasury hit a record low…the US has never seen interest rates this low.   In fact, if you put it in a broader historical context the current interest rate environment is the lowest the world has ever seen.  We won’t bore you with the details of Grecian, Roman, Byzantine and British Empire interest rates but it is true – interest rates have never been this low.  

The real effects of this on people’s lives are clearly visible.  On the positive side home, vehicle and unsecured financing is inexpensive.  This has allowed people to free up cash flow by reducing their interest costs and households have been slowly reducing their debt the last few years.  Total household debt relative to US Gross Domestic Product is the lowest it has been in over a decade. 

However, the negative consequences of low interest rates are starting to weigh heavily on investors and the economy.  Our economy is built upon a system of credit and interest and it is becoming apparent this system is impaired in a low rate environment.  Banks rely on the ability to lend money out for more interest than it costs them to hold it (net interest margin).  As interest rates entered into unprecedented lows their margins shrank and now depositors receive little to no interest while paying fees on their accounts.  Similarly, insurance carriers rely on interest payments from a bond portfolio to reduce premium costs and increase profits.  As income received from their investment portfolios have decreased insurance premiums have increased.  Pension funds who had generally counted on – foolishly in our opinion – an 8% annual rate of return to pay future liabilities are now facing a reality where 40% of their portfolio is only earning 2% – or less – interest.  That makes it kind of hard to earn the 8% they – and their pensioners – are counting on.  While low interest rates may have assisted in the avoidance of a total economic collapse if they continue too long our economic system may slowly break down.

What we think is more likely to happen is an attempt to return to normal via central bank raising interest rates. We have been waiting for this for a long time.  Admittedly, this low interest rate environment has lasted far longer and been more extensive, than we expected.  It could continue to go on longer than we expect.  But the commentary among the “economic and political elite” has begun to change.  The US Federal Reserve is receiving a lot of pressure to normalize rates and it appears they may resume that process soon.  

A World with Rising Interest Rates

This creates a very real risk to investors.  There is an inverse relationship between interest rates and the value of a bond.  If interest rates go down – like they steadily have for 30 years – then the value of a current bond goes up.  If interest rates go up then the value of a current bond goes down. Once this process of raising rates begins bond holders will be dealing with something they have not had to deal with in 30+ years – the value of their bonds going down.    

As Jack would remind us, the way people invested when he started as an investment manager 40 years ago this would not matter.   People would purchase a bond by directly lending the US Government or a company $10,000, for example, collect interest for 10 years and then at the end 10 years the entity would give them back their $10,000.  Whatever happened to the price of the bond along the way did not matter.  The investor got their $10,000 back at maturity no matter what the value of the bond did.  

But it does not really work like that anymore.  30 years of decreasing interest rates, an industry “scaling” their business models to maximize profits, and the creation and adoption of Modern Portfolio Theory (the en-vogue investment management theory of the day) have essentially changed how individual investors access the bond market.  Investment products have been designed and built around a bond market that steadily increases in value. The principal protection element of bonds (you get your $10,000 back the end of 10 years) has been at best limited and at worst eliminated through the management style of bond funds.  Bond fund managers rarely (very rarely) hold a bond till maturity.  In fact, the execution of a portfolio following Modern Portfolio Theory results in the creation of divided bond classes grouped by the maturity date of the bond.  This grouping forces the manager to sell their bond holdings prior to maturity, even it has to be sold at a loss. 

With the winds of change upon us we are being forward thinking in how to manage a bond portfolio in a rising interest rate environment.  There are methods to mitigate this risk.  Some strategies have already been implemented in portfolios and others will be implemented as conditions warrant. 

China

In the 2016 Quarter 1 commentary we wrote the following:

The Chinese market and economy have made a lot of headlines over the past year.  The Shanghai Exchange experienced massive volatility in 2015 and the resultant conversation of the financial pundits was that the Chinese economy was headed for a hard landing.  We have never quite understood the general consensus of the financial world towards China.  They have painted a picture of a country laden with debt, lower economic growth prospects, and highly overpriced stock markets (sounds familiar).  But to every one of these arguments there exists fundamental misunderstandings about China.  In the interest of brevity, let’s examine just one…overpriced stock markets.

In the Quarter 1 commentary we addressed the overpriced stock market.  In the Quarter 2 commentary we addressed lower economic growth prospects.  And this quarter we will wrap this up by addressing the misconceptions of China being overextended in debt.  

Wait a minute…there’s actually two sides to a balance sheet?  

During the last decade total debt in China – consisting of corporate, household, government and bank debt – has increased from roughly 150% of China’s Gross Domestic Product (GDP) to over 250% of China’s GDP.  That’s a lot of debt. In fact, when you take into consideration that the denominator in the equation has also increased significantly during that time period the increase in debt gets really big: total debt has gone up 465% in the last decade.  

Our recent experiences in western culture make these numbers very worrisome.  In the US, we have witnessed the danger of an over-leveraged economy: the 2006 housing crisis and the subsequent Great Recession beginning in December 2007.  But to every balance sheet there are two sides: assets (what you own) and liabilities (what you owe).  What is being largely ignored in the case of China is the asset side of the balance sheet.  

Let’s take a look at the household debt burden in China within the context of the real estate market.  In the last few years many pundits have expressed concern of a growing bubble in Chinese home prices.  Home prices have increased roughly 9% – on average – every year for the last 10 years.   In our economy those high increases would be troubling.  But Asian cultures tend to look at savings and debt differently than western culture.  In short, they save more and they go into less debt. A few statistics to consider:

• Wage increases have averaged roughly 13% per annum for the last 10 years, which outpaces the home price increases.
• In order to buy a home in China a 20% down payment is required.  That is not a banking standard.  It is a law.  That is if it is your first home.  If you are buying an investment property (second home) 30% is required. 
• A 2014 study showed that 15% of all real estate purchases were paid with 100% cash.
• According to a China Household Finance Survey in 2012, average household debt amounted to only 11% of home value; the median household debt was 0%.   
• The same 2012 survey indicated that if home values fell 50% only 14% of mortgages would be underwater.  

Those stats paint a very different picture than an over-extended, over-leveraged consumer.  And a similar picture could be painted for corporate and government debt: there are assets to support their level of debt.  Even the structure of the debt (state financed in a closed system) makes the debt level more palatable.  While Chinese debt has grown excessively during the last several years it appears to be at manageable levels. 

That is not to say there is no risk here.  In our opinion this increase in debt is going to continue for some time.  China has aspirations for their currency (Yuan) to be used more heavily in international transactions and as a reserve currency.  In order for that to happen there needs to be more volume of Yuan in the market.  In a fiat currency system, money is created and put into circulation through debt.  If China wants more Yuan in circulation then more debt will be required.  Continuing to fuel this debt may put more strain on the Chinese economy.  While we do see long term value in investing in China we will be closely monitoring the situation watching for meaningful economic deterioration. 

As we examine the global landscape, China – and other select Emerging Markets – continue to have the greatest potential for long term growth.  We believe patient investors who endure the volatility often experienced in these markets will see long term gains.  We also see developed markets – such as the US and Europe – struggling to obtain meaningful economic growth.  As central banks and governments make more decisions and businesses and individuals continue to adjust to an economic environment very different than it was a decade ago we believe markets will continue to be volatile.  Throughout these developments we will continue to invest in areas where we see value and the greatest potential for long-term growth.

Blake

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 Group, LLC a Registered Investment Advisory Firm.