The year 2022 was not a good year for the markets. The Dow Jones Industrial Average, S&P 500, and NASDAQ all had the biggest annual declines in fourteen years. Bonds, traditionally a source of stability, faired almost as poorly. A 60/40% portfolio, consisting of equity and debt, lost 17%—the worst performance in over 50 years. The primary reason for these terrible results was the rapid rise in interest rates as the Federal Reserve, recognizing that inflation was an escalating—rather than a temporary—problem, suddenly reversed course from quantitative easing to quantitative tightening.

We cannot overemphasize the importance of Fed policy, which determines the amount of money available and, hence, economic activity. Earnings are driven by the direction of economic activity and, over time, the equity markets correlate to the direction of earnings, or earnings per share. The debate among economists and strategists now seems to focus on when the Fed will ease its monetary stance and how badly earnings will be affected. We think the Federal Reserve has made it quite clear that interest rates will remain higher and monetary policy tighter for longer than most observers expect. Key to their thinking is that a monetary policy of stop-and-go, similar to that which resulted in a severe recession in the 1970s, must be avoided at all costs. As of November, wages for part-time and full-time workers were 6.2% higher than in 2021, and Chairman Powell has gone on record as saying that wage growth of 3.5% would be consistent with the Federal Reserve’s 2% inflation target.

Leading Economic Indicators, published by the Conference Board, have declined year-over-year to levels consistent with the onset of recession. The Treasury yield curve is deeply inverted, while on the inflation front the ISM Backlog, the ISM Manufacturing Prices Paid, and the Chicago PMI Prices Paid indexes remain in contraction. All of these indexes lead the Consumer Price Index (CPI), which is one reason to expect the CPI to fall significantly over the next year. Earnings will follow suit.

The remarkable thing about today’s economy is the strength of consumer spending, which has been fortified by government subsidies and a tight labor market. This strength is not what the Fed wants to see in its fight against inflation. We expect, therefore, that it will be difficult for the markets to mount a sustainable advance until there is tangible evidence that the Fed believes that their intended results are successful.

January 2023    

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Stocks continued to fall in the third quarter with September, true to form, once again proving to be the most difficult month of the year. For the quarter, the S&P 500 fell 5.3%, the Dow Jones Industrial Average lost 6.7%, and the NASDAQ dropped 4.1%. The NASDAQ 100 (QQQ), populated with mega-cap growth companies, broke below the key technical level market watchers were eyeing, the June 2022 lows, and may be signaling another leg downward.

The two primary issues facing investors remain the central bank’s efforts to arrest inflation and a deterioration of the corporate earnings outlook. These come as the FOMC remains committed to taking the benchmark interest rate to at least 4.25%, and perhaps higher. With the Conference Board’s leading Economic Index now in contraction for six consecutive months, shipping rates and orders in free fall, commodity prices well off the high and many now at pre-COVID levels, investors are becoming increasingly concerned about both faltering growth and the Fed hiking too aggressively into a recessionary economy. The most recent Chicago PMI, a bellwether for economic activity, came in at 45.7, firmly in contraction and far below economists’ estimates.

On the positive news front, the Atlanta Fed, in a surprise move, upgraded the outlook for the third quarter for the U.S. economy, sharply revising real GDP growth estimates from 0.5% to 2.4%. The main driver for the revision was the strong uptick in personal consumption expenditures. Clearly, the consumer has exhibited some firepower, but it remains to be seen whether this is temporary. With weakening leading economic indicators and a deeply inverted Treasury yield curve, we should remain skeptical.

The Federal Reserve has made it quite clear that fighting inflation is its number one priority and, we think a Fed “pivot” towards easier money is premature. The jobs market remains strong, with initial claims for unemployment at record lows, and hiring consistently above 300,000 per month. As long as jobs remain widely available, it is unlikely the Fed will ease its policy stance on interest rates.

With the twin headwinds of further tightening and earnings estimates falling, it is too early to declare the end of the bear market. We believe, however, we are getting closer to that end rather than the beginning. While high-quality growth companies should remain long-term holdings, our position continues to be that a higher-than-average cash level and allocations to short-term investments is a sound tactical strategy in the current environment.                                                                                                                                  October 2022    

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The S&P 500 declined 21% in the first half of 2022, the worst showing since 1970. More persistent inflation than the Federal Reserve had forecast is forcing it to tighten monetary policy into a slowing economy. Russia’s invasion of Ukraine has been an additive to inflationary pressures, especially in energy and agricultural commodities. COVID lockdowns and fiscal responses in the past two years distorted supply chains and consumption patterns throughout the global economy. The repercussions are profound. Workers left the energy and many services sectors. Durable goods consumption was pulled forward at a time factories remained supply constrained. These distortions lead to a lagged inventory build now present at precisely the wrong time as consumers are tightening belts in response to food, rent and energy inflation. With the Fed fighting to catch up to inflation, these stresses make it likely the US will experience a recession in the coming months, and indeed may already be in one. The actual timing and severity will only be known with hindsight.

Inflation is pressuring corporate margins and forcing consumers to curtail discretionary spending, reducing aggregate demand. This, in turn, will flow through to negatively impact corporate earnings. So far analysts’ estimates of forward earnings have remained resilient, and the market’s decline to date has been largely a compression of the multiple investors are willing to pay for those earnings. The final market lows will likely be accompanied by a reduction in earnings estimates.

Regardless of whether a recession occurs or not, the stock market is unwinding a liquidity-driven run-up from the extraordinary monetary policies enacted during the COVID crisis. Market bottoms are emotional and take time. While the tell-tale characteristics of a final market capitulation are not evident yet, we are well into the process of forming a bottom.

Investors should not lose hope, as there are some silver linings. Strong earnings and shareholder returns—in the form of dividends and buy-backs—have propelled the market in the past two and a half years. The S&P 500 finished the first half of 2022 17% higher than the end of 2019, before COVID, however second quarter trailing twelve-month S&P earnings are estimated to be 43% above pre-COVID levels. While the pace of growth should decelerate from current expectations—and may pause—growth will resume again. A variety of secular growth areas from batteries and electric vehicles, to hydrogen and solar, to genetics and big data (to name just a few) will continue to provide ample growth opportunities for companies in many industries.

Historically, markets bottom in the midst of recession, not at the end. The market is a discounting mechanism and the decline in the market to date has discounted a lot of the dour news cited above. This year marked the sixth time in history that the S&P 500 declined over 15% in the first half.  On each of those occasions the market rallied in the second half.  It is too early to say the low is altogether in, but we are significantly on the way.

                                                                                                                          July 2022

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The first quarter of 2022 will probably be remembered for two seminal events: the Federal Reserve’s pivot from quantitative easing to quantitative tightening, and the start of hostilities in Ukraine. While either of these events in and of itself would probably give the markets pause, the combination resulted in a 4.6% decline for the S&P 500. The NASDAQ lost 8.9%.

As expected, in mid-March the Federal Open Market Committee (FOMC) raised its federal funds target rate by one quarter of a percentage point to 0.25%-0.50%. At the same time, the Committee unveiled economic projections with sharply higher inflation and federal funds expectations, while lowering anticipated economic growth for 2022. The numbers were in sharp contrast to those released in December when Omicron, rather than Ukraine, topped the list of worries.

The war in Europe, which so far has proven to be a stalemate and is unlikely to be resolved any time soon, has disrupted activity on a number of fronts. These include upheavals in the markets for energy, food grains, and a number of key materials, all the while further disrupting already stretched global supply chains.

Inflation in the U.S. and in Europe is now above 8%, a 40-year high and well in excess of what was expected as recently as December. More troubling, especially in the U.S., are signs that the underlying drivers of inflation have broadened from goods to services, exacerbated by tight labor market conditions. Inflation psychology has shifted significantly, and while longer-term inflation expectations have not yet become unhinged, they are increasingly at risk of doing so.

The Federal Reserve, now finding itself well behind the curve, has given clear signals that it is shifting to a more aggressive tightening mode, to include more rapid and larger rate hikes as well as balance sheet runoff. The U.S. consumer is still in good shape, but recent wage gains have been overtaken by inflation. Most analysts are still forecasting decent economic and corporate profit growth, both this year and next. We question, however, whether these projections will be realized, given tightening monetary policies, continued conflict, and emerging weakness in other parts of the world. Mortgage rates in excess of 5% are already having an effect on the U.S. housing market.

We ended our January letter with this sentence: “As a practical matter, this outlook requires increased allocations to defensive quality equities and higher cash cushions.” We continue to believe this is the case today. 

                                                                                                                            April 2022

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2021 was a good year for investors, but dominated by the performance of six large companies. In fact, it was the third good year in a row, and with only minor pullbacks—a highly unusual circumstance.

2022 has not started out on a good note. COVID has caused supply chain disruptions, and a combination of unprecedented fiscal and monetary stimulus has boosted inflation to a thirty-nine year high. Inflation, and the Federal Reserve’s belated policy response to slow it, are battering both stocks and bonds.

Perhaps most importantly, minutes of the December Federal Reserve Open Market Committee disclosed that the Fed will not only be winding down its securities purchases, which have pumped trillions of dollars into the financial system, but will also reduce its holdings of treasury and mortgage–backed securities. These actions, which could begin in March, would tend to drain liquidity and tighten financial conditions.

The Fed’s policy pivot actually looks relatively mild in the face of inflation figures, which on a headline basis has reached in excess of seven percent. If there were three

0.25% rate hikes by year end to 0.75 – 1%, that would still leave the real federal

funds rate in negative territory when measured against some optimistic projections that inflation will cool to less than 3% by the end of the year.

In addition to Federal Reserve policy, Washington D.C seems to be in perpetual turmoil and the fiscal stimulus provided this year will pale in comparison to the last two years. Investors have never liked uncertainty, and we are seeing this both in terms of domestic policy and international turmoil.

On the brighter side, unemployment is low, and both our economy and corporate profits should expand this year. Expected corporate profits may be too high, however, since they assume a smooth reopening of the economy and that inflation will normalize. Market returns have always been influenced by corporate profits and interest rates, and in a higher inflationary environment with rising interest rates, it is the level of corporate profits that may determine equity returns.

As a practical matter, this outlook requires increased allocations to defensive quality equities and higher cash cushions.

January 2022

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Our July letter noted that it was time for some caution—a recommendation that proved premature until the last week of the quarter. Stocks produced slightly positive returns in the third quarter, primarily driven by upward earnings revisions and easy money. In some respects, money has never been easier. A quick calculation comparing the yield on the U.S. Treasury 10 year inflation-protected security and the expected inflation rate would indicate that money is free. Many corporations are taking advantage of this by raising capital, and it would appear that investors have come to grips with the fact that our Federal Reserve will most likely start slowing its massive securities purchases as soon as year-end.

Most, if not all, of the fears we mentioned in our July letter have not been resolved. A Democratic-controlled Congress has not been able to coalesce around a spending bill designed to support both physical and human infrastructure. The nature of the tax increases necessary to fund this spending remains unknown. Leverage and imbalances in the Chinese property market were laid bare by the Evergrande implosion, which in turn heightened focus on the slowing growth profile of that economy. COVID-induced global labor shortages colliding with increased demand for goods have stressed the global transportation industry, slowing the delivery of goods. Witness the fleets of vessels waiting to unload into west coast ports, and UK gas stations waiting for truck drivers to deliver fuel. Production slowdowns during the COVID pandemic across a variety of material producers from fossil fuels to metals have not reversed quickly enough to meet resurgent demand. Companies across many industries have raised prices to offset increased labor, material, and transportation costs, stoking fears of a persistent inflationary environment. These fears are soon to be inflamed by increases in rent in the U.S. as eviction moratoriums end. The U.S. labor market is in the paradoxical situation of having five million fewer people working than prior to the pandemic despite businesses clamoring for employees. While extraordinary unemployment benefits have largely expired, consumer balance sheets remain unusually strong, and the many reverberations of COVID continue to keep workers on the sidelines.

There is reason to think many of these negatives will recede in the coming year. The surge in the COVID Delta Variant was responsible for transportation and supply disruptions as workers were unable to report to factories and ports. The ebbing of that spike, coupled with positive news on the efficacy of booster shots, suggests that COVID-related disruptions should end sooner rather than later. As history has shown, the cure for high prices in oil and base metals is high prices, which catalyze increased production. The U.S. oil industry has the capacity to ramp up production. While the Federal Reserve may begin tapering its quantitative easing program in November, this monetary support will still be coming into the markets until June of next year. Lastly, with the turnover of the Fed governors there is the potential for a Fed with even more dovish tendencies next year.

In spite of more persistent inflationary data, credit markets are well-behaved, and demand for goods and services remains strong, all suggesting a still growing economy. Though productivity gains many companies have been able to protect margins and maintain a growth outlook into next year. With a yield under 1.7% on the 10-year Treasury, the bond market still does not offer a compelling alternative for capital preservation or accumulation. Instead, select areas of the equity market continue to provide the most viable solution for protecting wealth and purchasing power against inflation.                                                 

October 2021

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The second quarter of 2021 was a good one for the popular averages, but—similar to the first—was notable for its rotation from value to growth, and small capitalized companies to large, then back again. Volatility and speculation picked up, adding to the difficulty for portfolio and fund managers to outperform, and most did not.

The story for the year may be the rapid rebound in the U.S. economy, but earnings growth has been and still is the story for most companies as we enter the second half of 2021. It has been nothing short of remarkable. Before the pandemic, 2021 earnings growth was expected to be just shy of 11%. But thanks to unprecedented massive government stimulus, these expectations were rapidly revised higher. At the start of the year consensus estimates were for growth of about 23%. Today earnings growth is approaching 40%. These numbers are obviously unsustainable, and 2021 earnings may be beginning to eat into 2022’s growth rate. From an historical standpoint, since 1950 the compound annual growth rate for S&P 500 earnings has been slightly above 6%.  Similar to how earnings growth has been robust, equity market returns have far exceeded their historical compounded returns of just shy of 8% since 1950.

Our April letter pointed to a robust equity market but with clouds in the future. Since then we think these clouds have intensified. Without further enactments, the effects of fiscal policy stimulus are fading, a divided Congress is pushing its own priorities, monetary policy is becoming more confusing, COVID-19 variants are emerging, regulators are becoming more aggressive, and geopolitical challenges are building.

We continue to believe the fading fiscal policy tailwind is one of the more important of these impacts on the economy, corporate profits, and equity prices. Regardless of what happens with the infrastructure package, the U.S. will have at least a $1.5 trillion fiscal drop in 2022. This is primarily because infrastructure spending takes years to be distributed, new social spending is just offsetting what has been spent, and tax increases, if included, are immediate. $2 trillion of COVID aid is not the same as $2 trillion of infrastructure spending. The net impact, under the most optimistic scenario, is roughly $130 billion of new spending, which hardly dents the $1.8 trillion run-off. Without a new round of rebate checks going out, there is the possibility that the U.S. is headed for its largest fiscal contraction since the drawdown of WWII.

Of course, a lot of this is conjecture at this point, and will remain so until we see what actually comes out of Washington D.C. There are also offsets to the fiscal cliff: corporations and U.S. consumers are flush with cash, jobs are plentiful and wages are rising, U.S. corporations are increasing cap-ex intentions to meet resurgent demand and the realignment of global supply chains. Importantly, productivity is surging, thanks to technology and automation investments, partly caused by the COVID shutdown.

We continue to believe that we are in a secular bull market that is characterized by higher corporate profits and lower long term inflation. There are enough uncertainties, however, that near term caution is advised.  

July 2021

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While stocks advanced in the first quarter, the market has clearly changed its tone. Last year’s theme was quality growth, but as the economy has started to recover, investors’ attention has shifted to more cyclical investments, only to be followed by almost daily rotation between these two groups. We get the sense that there is some uneasiness about the future, and the markets may be starting to fear policy errors coming from Washington D.C.

To be sure, the immediate future seems bright. As Q1 2021 reported earnings get underway, it would appear that S&P 500 earnings per share growth will again outpace end-of-quarter estimates, as it has done in 36 of the last 37 quarters. Consensus is for 31.5% year-over-year growth, nearly double the gains predicted at the start of the year. The New York Fed also reported that consumers are more upbeat about spending. The median expected growth in household spending rose to 4.73%, the highest since December 2019. In addition, fewer and fewer companies are reporting poor sales as their single most important problem—a measure that is at its lowest since the start of the pandemic, and equal to where it was in March 2019.

As the pandemic is still ongoing, parts of the global economy continue to face renewed lockdowns. But the end game still appears to be the availability of effective vaccines, which would in turn allow most, and perhaps eventually all, of the economy to reopen.

Against this backdrop, inflation is increasing. Pipeline inflation pressures have been building in PPI readings. The U.S. CPI rose 0.6% month-over-month in March, with the core up 0.3%. Thus far, while outsized increases in U.S. inflation look tied to re-openings, we cannot be sure of this correlation. The Central Bank remains committed to an easy monetary policy as its focus is on unemployment and under-employment, rather than price stability.  The more 0.3%-or-higher readings we see, however, the harder this posture will be to maintain.

Earlier this year, the new presidential administration proposed, and the legislature passed, the largest spending bill in our country’s history, in the name of COVID relief. Now it would appear that $3.5 trillion of additional spending will be proposed, in the name of infrastructure improvements. This beacon of effort, however, will be accompanied by large tax increases on both individuals and corporations. The major problem is that the spending will be spread out over several years, while the tax increases would start immediately in 2022. This could affect the economy negatively at the same time that inflation is accelerating.

We are fundamentally bullish on the markets’ outlook, but with the increase in volatility, suspect investors are beginning to realize there may be some disconnects in the rosy forecasts. Positioning parts of the portfolio for an inflationary environment is prudent. However, even if inflation fears accelerate, certain corners of the equity market remain preferable to bonds. Indeed, some caution may be in order.

                                                                                                              April 2021

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We believe the market is in an uptrend but the near-term forecast is decidedly unclear. It’s been a wild ride so far and President Trump testing positive for the coronavirus may only be the first of many October surprises. The market’s rapid decline to the bottom on March 23^rd resulted in an historic rally to record highs in September. The rally seemed to ignore the unraveling of the U.S.-China relations, antitrust actions against big tech, the potential for a Fall coronavirus wave, and a potential Democratic sweep portending tax hikes for both corporations and some individuals. A future potential negative may be a contested presidential election.

Yet the market has parsed through these concerns and the outlook for the economy and investors is not all grim. From depressed levels, economic growth continues to build. The Atlanta Fed US real GDP tracking estimate for the 3^rd quarter is at +35.2%. Notably, the following economic indicators are above pre-lockdown levels: small business optimism, homebuilders housing index, non-defense capital goods spending and household durable goods consumption. ISM services remains firmly in expansion territory, with the employment component growing for the first time since February.  The unemployment rate was nearly halved from April’s level of 14.8% to 7.9% in October and 500,000 people per week are coming off the unemployment rolls.

Positively, as a result of the lockdown, some companies have grown stronger at the expense of their smaller competitors. Accelerated investment in technology, a surge in e-commerce, and forced expense streamlining have allowed dominant companies to grow even more dominant. They are enjoying improved margins, operating leverage, and earnings growth as demand returns. S&P 500 earnings expectations have steadily increased since bottoming on May 15^th, and positive earnings revisions now stand near all-time highs.

Several factors are supporting the market. Inflation is not broadly visible, the Fed issignaling a rate increase is not in the cards for the next two years, market breadth is expanding, and credit remains well-behaved. The fiscal and monetary stimulus enacted thus far has backstopped consumption, though more is likely necessary and post-election, it is a near certainty. With prospects of continued growth off depressed levels and no attractive alternative in the bond market, equities should continue to enjoy tailwinds regardless of how the election is finally resolved. We continue to stress buying quality equities with good balance sheets and long term growth potential.

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While 2020 will undoubtedly be remembered as the year of the coronavirus, for investors it has also been a year of extremes.  By the end of March, the S&P 500 average had fallen 20%, the worst three-month performance since 2005’s fourth quarter. Yet the second quarter saw an equally historic move to the upside with a 20+% gain—almost matching the gains in the first quarters of 1987 and 1975. While the coronavirus and measures necessary to combat it caused the decline, it was the unprecedented response by the Administration, Congress, and the Federal Reserve that fueled the swing back. Money has literally been thrown at nearly everyone and everything—people, banks, corporations—with $2.5 trillion in responses so far and a $3 trillion expansion of the Fed’s balance sheet. It would appear that still more is on the way.

For the moment, the response seems to be working, From depressed economic levels  we continue to see some very large growth rates. In June the manufacturing Purchasing Managers Index returned to expansion territory in the U.S., rising to 52.6 with a surge in the new orders component. The Conference Board survey of consumer confidence rose to 98%, with increases in both the present situation and expectation components. The U.S. job report was also generally strong with non-farm payrolls up 4.8 million. But the effects of lingering unemployment are still being felt and at the last reading, was an elevated 11.1%. Initial jobless claims were 1.427 million for the week ending June 27^th and continuing claims were 19.29 million in the week of June 20^th.

High unemployment is unstable economically and politically, and with restaurants, hotels, and airlines, working at 50% capacity, at best, it will be difficult to get back to 2019 levels of GDP in a social-distancing world. Fiscal policy has patched the income gap over the past several months, but more is likely necessary. The second half of 2020 will be further complicated by the congressional and presidential elections. It would appear that former Vice President Biden is leading in the polls, and he is proposing $4 trillion in tax increases spread out over the next 10 years, or roughly 1.5% of GDP. How realistic these proposals will be in a still-struggling economy will be open to question, and difficult to forecast.

In spite of the uncertainties we face, we are optimistic that the American spirit of resolve and entrepreneurship will lead to a better future. Localities that have embraced proactive steps to mitigate the spread of the virus have been successful and there are more than 165 COVID-19 vaccines in development, including 27 currently in the human trials phase. Therefore it is a question of when, not if, businesses and economies return to sustainable growth, in spite of the virus.  With all its fits and starts, the economy is gaining steam, most household balance sheets are flush with cash, and both Congress and the Federal Reserve have pulled out all the stops. In particular, history has proven that it does not pay to argue with the Fed.  

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