Headwinds

The first quarter of 2022 was the most volatile period for markets since the start of the pandemic, and the second quarter isn’t looking any better!

Last quarter I mentioned 4 risk factors. I should have mentioned the fifth: war.Two of the risksreceded, covid and slowing earnings. Of the other two risks, inflation is proving stickier than many expected, but the Fed has yet to do anything that could be construed as a mistake.

As the second quarter of 2022 begins, there are four major issues to watch:

The Russia-Ukraine War: Will the conflict expand, (Russia vs. NATO?) and, if not, how long does it continue to elevate commodity prices and choke off economic growth to a greater extent?

Inflation: It keeps getting worse. Higher inflation isn’t just making the Fed more aggressive with rate hikes, but at some point it will begin to compress corporate margins or destroy consumer demand.

Quantitative Tightening: In the next month, the Fed will announce its plans to reduce the balance sheet, known as Quantitative Tightening. That will be another form of tightening policy – one that could slow growth if it happens too quickly.

The Fed: The Fed is raising interest rates. At the start of the year, the market expected four 25 bps rate hikes. Now, the market may get four 50 basis point rate hikes between now and year-end.

We can also expect to hear headline speculation regarding an inverted yield curve. The important factor is the level of real interest rates. When interest rates are a couple of percent over inflation, that is the kind of monetary tightening that can slow an economy. We are a long way from that. However, since rates will be rising coincident with the Fed’s balance sheet runoff, the effect could tip us into recession sooner than it otherwise would.

Bottom line, we should all brace for more volatility in the second quarter. The outlook is not bearish, but I expect short-term market volatility. Realistic expectations are important. Prepare adequate liquidity to weather the storm as your circumstances require.

These issues that will drive near-term volatility. Longer term, earnings will drive markets higher.

Investing involves risks witch may include loss of principle. Past performance does not guarantee future returns.

Higher Still?

The good news is the stock market had another great year. The S&P 500 was up 26.84% in 2021. That is on top of the 16.26% in 2020 and 28.88% in 2019. That’s quite a run, even if it started on the back of a down year in 2018.

On the other hand, the S&P 500 is overvalued by most standards. By comparison, the Vanguard Total International Stock ETF, was up only 9%. More telling is the price to earnings ratio. The S&P 500 trades for 21.15 times earnings while the non-US Vanguard ETF, VXUS, trades for 13.2 times earnings, a 37.6% relative discount. (based on Morningstar data)

If you have a diversified portfolio, your investor returns have lagged the S&P 500, where performance was driven by large cap tech stocks.

When will things reverse? I cannot say when, but I can imagine how it might happen. In the words of John Maynard Keynes, “The market can stay irrational longer than you can stay solvent,” the timing is unpredictable. The predictable factor is that it will likely require a catalyst to put the market on sounder footing.

Potential catalysts include:

  1. A worsening COVID scenario with new variants and higher case counts
  2. Persistently high inflation
  3. A Fed policy mistake (watching the yield spread between 2- and 10-year Treasuries)
  4. Slowing earnings growth as Fed stimulus recedes.

If one or more of these events occur and earnings expectations decline, I think a 20% correction would be reasonable. The math of a 4% decline in earnings and an 18 P/E multiple fits such a scenario. But things can go right too, so timing a correction is not a sound strategy.

The prudent course is to plan for liquidity needs and maintain a diversified portfolio and perhaps more cash than usual. Think of cash as an option to buy stocks cheaper if they go down. A 20% correction is not fun, but it is to be expected. When it happens, a little cash goes a long way. One more thing… when the market goes down 20%, you only lose 20% if you sell low. The bigger issue is how long it takes to recover. It has always recovered. Whatever you do, don’t sell low

The Pause that Refreshes

The S&P 500 closed the 3rd quarter with a gain of about 14.7% YTD, despite recent volatility that brought it down about 5% off the highs. (International holdings continued to lag, causing diversified portfolios to generally come in a bit lower.) There are several issues creating enough headlines to spook the market, including inflation, the debt ceiling and potential Government shutdown, tax increases, supply chain disruptions, Fed tapering and the yield curve, and the continuing Covid pandemic. What could go wrong?

I could analyze each issue and explain why they might be more bark than bite, or why they are probably already factored into the market. However, I do have a real concern that the market will have to reckon with, valuation. The market is priced to perfection at about 20x 2022 earnings. Interest rates need to go up for long-term economic stability, and the market valuation math means the market valuation multiple needs to decline. The decline in valuation will not be absolute since it will be offset by presumably rising earnings. Theoretically the multiple could contract without a nominal decline in the market, given sufficient earnings growth, especially in an environment with a healthy dose of inflation. However, I expect interest rates will go up and the market will have an adjustment on the order of a 10% decline sometime within the next 6 – 12 months.

That would be a healthy part of normalization and allow for better long-term returns. Part of the past 3 years gains can be attributed to the Fed’s persistent stimulus. We may be beginning the pause that refreshes. The underlying economy is sound. Supply constraints are preferable to waning demand.

Investing involves risk, including possible loss of principal. Choose wisely.

The Underlying Strength of the Economy Is Unchanged

The underlying strength of the market has not changed. The pandemic is likely to end soon, perhaps by Memorial Day. Disbursement of the just passed $1.9 trillion stimulus is pending, with an additional likely $2.2 trillion coming with Biden’s just proposed American Jobs Plan to be spent over the next 10 years. Finally, the Fed remains committed to keeping rates low until they can persistently hit the inflation target of 2%.

With rising inflation concerns and a 4th COVID wave, crosscurrents made it a bumpy ride. At the end of the first quarter of 2021 the S&P 500 gained about 6.2%. I will spare you the economic scenario analysis and leave it at this. The long-term trend is up, but the short-term is impossible to know. I think the US equity markets are about 5% overvalued. Given the amount of stimulus and the fading pandemic, valuation is not a big concern.

Press On

Last year we wondered about the biggest risk to the markets. Was it the threat of persistent low-interest rates and the implied inflation threat, Government budget deficits, tax hikes, or valuations? Media and headlines covered pundits’ messages illustrating what could go wrong.

In retrospect, none of that mattered. The problem was something no one talked about because no one knew about it. A virus-induced pandemic ensued and led to a shutdown of large parts of the economy.

The important takeaway is that the greatest risk might be what you do not see coming. If you are not aware, it is hard to prepare. However, I will point out one more time that I covered the bases by listing plagues among several caveats to my sanguine outlook.

Like earthquakes in California, you know they will happen. You will not know when. In the stock market, we seem to have a big one, a 40 to 50% decline, about once every 10 years. We also average about two recessions every 10 years. Despite dramatic declines, the long-term trend continues up as billions of people around the world get up every morning to do something productive to improve their lives.

I do not know when the market will go down, but history shows that it always comes back. Most of the time recoveries occur within a few years if not months. Some risks are more apparent than others. But for whatever the reason for a correction, the important thing is to avoid selling into a distressed market.

Source Yahoo Finance, S&P 500 Total Return 1/1928 to 1/2021, Monthly, Log Scale

Planning requires anticipating how much money you are likely to need from your portfolio and reducing risk in part of your portfolio to reduce your potential need to sell in a distressed stock market.

Now what about 2021? The 5 key drivers of current market strength include Federal fiscal stimulus, vaccine rollout, divided government, dovish monetary policy, and no double-dip recession. Each of these factors favor continued gains, but none is certain. Near term, I can make the case that the market is on the expensive side. I do not think the options (cash, bonds, hard assets, real estate) are more attractive on a risk-adjusted basis.

As Calvin Coolidge observed, “Nothing in this world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent. The slogan Press On! has solved and always will solve the problems of the human race.” I remain focused on long-term value creation.

With 2020 behind us, we’ll press on.

Investing involves risk, including loss of principal. Past performance does not guarantee future returns.

3Q 2020 Update

The 3rd quarter of 2020 is in the books. The S&P 500 total return for the 3 months was 8.47%, including the -3.92% decline in September.

With only 5 weeks until the election, at least that source of uncertainty will be resolved. I do not think it makes a great deal of difference to the markets which candidate wins. Of the Democrats’ proposed tax increases, only the corporate rate will affect investors earning under $400,000 per year. Even then, Democrats might not be too keen on raising rates too soon in a shaky economy.

The better news is that the economy is not the same as the stock market. The economy is what is happening now. The stock market is built on earnings expectations. Perhaps the bigger issue that will drive stock market expectations is when and how the COVID issue will be resolved.

The optimism that drove the S&P 500 to 3,500 was not sustainable in the absence of a vaccine. However, earnings, the prospect for additional stimulus, and economic data continue to support the S&P 500 near the recent lows near 3,200. I look for earnings and accommodative Fed policy to support valuations, and COVID resolution to catalyze the continued reopening of the economy into 2021. That should support further earnings and market gains.

About That Little Correction

I attribute every stock market correction or bear market to one of two reasons. Either valuations were too high and needed to correct to reconnect valuations with reality, or there could be a real-world problem (pandemic, war, recession, taxes, regulation, rising interest rates, etc.) that creates concern about the value of future cash flows.

In my last quarterly update from July 1, I observed, “Near term, the market does not seem to have a lot of upside until we have a Covid-19 vaccine.” Now we know how bad I missed on that prediction. The S&P 500 rallied 14.9% from July 1 to September 2, with the help of the best August returns in about 30 years.

Using the Morningstar Market Valuation chart, the market was about 1% overvalued on July 1. Earnings in July and August were strong, and analysts’ estimates moved higher. Still, by September 2, the chart indicated that the market was overvalued by 8%. The greater the variance of the market from fair value, the more likely the market price is to correct to the analysts’ more rational view. That is what just happened. As of the close on September 8, the market was back to 1% over fair value. However, the S&P 500 was still 6.9% higher than on July 1, when the quarter started. The difference is that earnings exceeded analysts’ estimates and fair value estimates were adjusted accordingly.

What does this mean? It means we need to buckle up for the ride, considering all the reasons to run for the hills. Volatility will not hurt you. As I described, that uncomfortable market experience you just had made you better off. Today the S&P 500 tacked on another 2.01% gain to rebound from part of the correction. That puts us about 3% over fair value, but well within the normal range. For reference, I usually cite 10% above or below fair value as a level to make tactical allocation adjustments, sometimes called market timing, because I think risk becomes materially asymmetric.

Let’s hope the 3rd quarter ends on a good note.

Investing involves risk, including loss of principal. Past performance does not guarantee future returns. Sources include Yahoo Finance and Morningstar.

Halftime 2020, at Last!

As I suggested last quarter, the market has responded positively to a better understanding of Covid-19 and how to treat it. Political polarization, on the other hand, is likely to only increase into the election this fall. Social unrest is a problem, but rioting has given way to more rational discussions of legitimate issues.

 Despite the upheaval, the S&P 500 is only -4.04% YTD, and that is from a level that might be considered 5% overvalued by the Morningstar indicator.

In terms of the Morningstar market valuation indicator, the market ranged from 78% of fair value on April 1, to 5% overvalued on June 8. We finished the quarter 1% undervalued. Recovery has been driven by Government stimulus, business reopening, progress in controlling the virus, and hope for a vaccine. As we open the 3rd quarter, only the Government stimulus remains as a tailwind.

Near term, the market does not seem to have a lot of upside until we have a Covid-19 vaccine. The market anticipates a vaccine by early 2021. Although the market may pop on headline vaccine news, a development that could cause a sustainable rally is likely to me months off. Beyond that, we need to reckon with the 600-pound gorilla at the end of the vaccine tunnel: the election. While most administrations take more credit than they deserve regarding market movements, the current polarization could have a major adverse impact if the Democrats win both the Presidency and the Senate, opening the door to a progressive tax, spending, and anti-business policy in general.

So which direction do I think the market will move next? Last quarter I suggested, “we should see better than average returns in the not-too-distant future.” Now, however, I am less inclined to speculate about the short-term given the range of possibilities and the lack of near-term earnings visibility. Longer-term, the trend is still up. Earnings are almost certain to improve as business and employment normalize post-pandemic. The real question surrounds the rate of growth.

COVID-19 Attacks Portfolios

People are emotional. I strive to be a realist, at least in financial matters. I expect the medical crisis to get worse. The market is in panic mode since the near-term is unknown. The main issue for markets is how long before people can go back to work? That will determine which and how many businesses might not survive under current management and ownership. I believe that the Government’s response is appropriate and will prevent an extended financial crisis by helping to bridge the gap. Furthermore, I believe that the medical community is making great progress in addressing the medical aspect. Testing will be available for most workers in a matter of weeks, enabling healthy workers to return to their jobs. The news on the development of treatments and vaccines is encouraging.

What’s the outlook for long-term investors? The S&P 500 closed the first quarter at 2,584.59. If it takes three years to achieve prior closing highs (3,386.15 on 2/19/2020), the annual return would be 10.32%. We’ve seen unprecedented volatility with 10% up and down days. Selling now runs the risk of missing the bottom. Although virus related news flow will likely get worse, the market tends to turn up before the headlines improve.

I concluded my last quarterly update with a prescient observation, “caveats include non-economic events such as wars, plagues, systemic failure, and meteor strikes.” “Plague” is my vernacular for highly contagious disease. The COVID-19 pandemic is worse than war financially. Wars don’t shut down small businesses and can even stimulate production.

According to the Morningstar Market Valuation Chart, the market is now about 20% undervalued. Markets tend to overreact in the face of uncertainty. The stock market is a discounting machine, but we don’t know what to discount. We are down 27% from the February high. Since we were about 7% overvalued in February, the 20% discount to fair value is consistent.

The volatility is dizzying. If you’ve ever been on a boat in rough water, you might have experienced seasickness. One of the best remedies is to focus on the distant horizon. Volatile markets are like that. In the short term, all bets are off. The medical news is sure to get worse. The issue is when the markets will be able to see past that. When we get past the virus and go back to work, how long will it take to get back where we were? I don’t think it will take 3 years, and maybe only a fraction of that. If I’m right, we should see better than average returns in the not-too-distant future.

If you are having second thoughts about your portfolio and think you’d prefer something less volatile, now is not the time to make that change. The time to de-risk is when markets are optimistic and setting new highs. Unfortunately, you’ll feel complacent. That’s why I frequently remind clients to plan for liquidity needs, to avoid the need to sell in a down market. Extremely low interest rates make this a risky time to de-risk with bonds. As I suggested in last quarter’s letter, some risks don’t show up in economic leading indicators. A virus that causes the Government to shut down business for more than a month, who would have imagined?