More Clouds on the Horizon

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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Some Uncertainty On The Horizon

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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2020 Third Quarter Review – The Final Stretch

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 23rd 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 3rd 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 15th, 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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2020 Second Quarter Review – Don’t Argue With The Fed

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 27th and continuing claims were 19.29 million in the week of June 20th.

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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2020 First Quarter Review – Seeing The Forest Through The Trees

The first earnings season of the coronavirus recession is coming up soon, and the results will not be good reading. Through February it appeared that the economy and corporate earnings were on track for a steady expansion, but by early March it was clear that this would not be the case as the full extent of what we were facing became apparent. Current analyst estimates are for S&P 500 earnings to fall 5.5% in the first quarter, 13.3% in the second, and 3.8% in the third. There is consensus in forecasting positive growth in the fourth quarter, which assumes that the country goes back to work over the summer. The three biggest drags on the economy will be in the energy, industrial, and consumer discretionary spending sectors, and it is quite possible that nearly all current economic data series will show record weaknesses. Unfortunately, with the novel COVID-19 virus having no immediately effective drugs or vaccine, there was only one option: shutting down economic activity to slow the spread and buy time for doctors and scientists to apply current treatments and devise new pharmacological solutions. This resulted in 6.6 million U.S. unemployment claims for the final week in March—on top of the 3.3 million claims from the prior week. These statistics are expected to increase in April.

In response to this national emergency, the Federal Reserve Bank cut its benchmark interest rate to near zero and began a campaign of open-ended bond purchases. The Fed’s moves will prevent credit from drying up and allow companies to borrow cheaply. Most global central banks have created similar programs.

On March 27th the CARES Act was signed into law at the urging of the Administration and a congressional majority. This will be the biggest fiscal stimulus package in modern history, totaling almost $2.3 trillion or approximately 9% of U.S. GDP. It specifically targets households, with $250 billion in direct payments to tax filers and an additional $250 billion going to expanded unemployment benefits. $367 billion is earmarked for loans and grants to impacted small businesses. An additional $425 billion goes to the Federal Reserve to provide loans and liquidity via the Fed to financial markets. Support to state and local governments, hospitals, and farmers totals $330 billion. Additional stimulus packages are in the works by the Federal Reserve, the Administration, and Congress. All of these measures are unlikely to actually stimulate growth, at least until the economy is no longer shut down. Rather, they are a means to cushion the economic impact from the virus containment policies. 

Forecasts of the economic downturn and recovery vary wildly, but most see a recovery underway by the end of this year, and historically equity prices anticipate a recession end by about four months. Clearly, enough money is being pumped into the economy to make the recovery vibrant when it takes hold, with low interest rates and more progressive economic and regulatory policies. We believe the lows for the popular averages registered on March 23rd may have been what technicians would call ”the internal lows,” accompanied by maximum selling pressure. The lows may be tested again, but if so, and with less selling pressure, we can assume that a new upturn is in place.

As such, we are optimistic about the future. 

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2019 Fourth Quarter Review – Welcome to the New Year

What a difference a year makes. A year ago market volatility, an escalating trade war, a hit to capital spending, and an inverted yield curve seemed to be moving simmering concerns about a global recession toward a full boil. Low inflation, however, gave the Federal Reserve and other central banks room to maneuver. The central banks eased monetary policies, liquidity surged with real U.S. GDP growth stable at roughly 2%, and the equity markets closed at an all-time high.

As we enter the new year, some uncertainties have been cleaned up—and replaced by new ones. As we asserted would be the case in our April 2019 letter, predictions of an imminent recession proved to be inaccurate.  We also have more clarity as a result of a treaty soon to be signed between the U.S., Canada, and Mexico, a Phase I agreement with China, and a decisive vote on Brexit. That said, the possibility of making further progress with China remains unpredictable, impeachment proceedings and elections loom, and a new threat of conflict in the Middle East has emerged.

A U.S. soft landing, not a recession, remains our best forecast for 2020. First-quarter GDP will undoubtedly be weak in the U.S. as the announced Boeing production cuts reduce growth. We assume the Boeing hit to the economy will be temporary and the remainder of 2020 has enough strength to avoid further deterioration. Consensus is that GDP growth should again come in around 2% for the year, corporate profits should rise 6-to-8%, accelerating as the year goes on. The global economy outside the U.S. already shows some signs of picking up. Global bond yields are moving higher with Chinese industrial production and retail sales increasing year-over-year in November.

From an equity standpoint, the defining moment for us was the complete reversal of Federal Reserve policy from tightening to one of accommodation and a fresh injection of liquidity. This policy would also appear to be global with China’s central bank lowering its reserve requirement ratio by 0.5 percentage points, effective January 6th. Easy money, rising profits, relatively full employment, and low inflation are the ingredients for rising equity prices, and we would expect further progress in the new year. Our biggest fear would be a rise in inflation which could cause central banks to reverse their current monetary policy.

We wish all our clients and friends a healthy, happy, and prosperous new year.

January 2020

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2019 Third Quarter Review – The Home Stretch

Stocks rose modestly in the third quarter, but the S&P 500 is roughly flat versus a year ago, while bond yields are down approximately 160 basis points. The Federal Reserve raised interest rates in September and December of 2018 and cut them in July and September of this year. Corporate profits have slowed and will most likely be down on a year/year basis for the quarter just ended, but are forecast to improve in the fourth quarter as earnings comparisons become easier. The net effect is that weaker earnings and much lower interest rates have offset each other when it comes to equities.

The U.S. economy is in decent shape but still slowing, while the U.S. consumer and employment rates are the bright spots. Manufacturing is very weak, primarily due to trade. The weakness started abroad in 2018, but is more evident in the U.S. with the U.S. Purchasing Managers Index (PMI) for September at 47.8. Anything below 50 signals contraction. The export component was 41.0. Manufacturing is a small part of the U.S. economy but matters for corporate profits—which are a leading indicator for capital expenditures and future job growth. The weaker PMIs have caused some economists to forecast a 2020 recession, but we disagree. The PMIs have a long lead time and both monetary and fiscal stimulus recently have been revived, both here and abroad. The most likely scenario is for the U.S. economy to keep expanding at the 1 ½ to 2% rate. A favorable resolution to our trade issues, particularly with China, would increase these odds.

With all the negative headlines around, there has been talk of the end to the U.S. bull market, which now has passed its tenth year. Again, we find fault with this reasoning since none of the usual symptoms are present. To begin with, bull markets do not end with investors in a cautious mode but with euphoria, something far from present-day sentiment. They also typically feature heavy inflows into equity market funds, the opposite of what has been currently happening. A further condition is a big pick up in merger and acquisition activity, as well as initial public offerings, and, instead, both remain restrained. Lastly, market tops are associated with rising real interest rates and widening credit spreads. In contrast, current credit spreads are well-contained, and interest rates are falling, not rising.

In our July letter we referred to the fact that sometimes it pays to listen to the markets themselves, rather than the headlines. We see more evidence that this should continue to be the case today. The market internals are strengthening both in terms of advances and participation, and the percentage of stocks with an upward sloping two hundred-day average has recently reached a new high. Also worth noting is the calendar, since mid-October usually marks the start of the year-end rally. With any favorable resolution to our current trade disputes, we would not be surprised to see the popular averages at new highs.

October 2019

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2019 Second Quarter Review – The Powell Put

While the second quarter initially appeared to be a losing proposition for investors, stocks turned sharply higher in June as Chairman Powell of the Federal Reserve reversed his hawkish stance to one of accommodation. It clearly was a major change by the Fed, and reinforced the thesis that the bull market in equities is alive and well and may have several more quarters to run.

What caused Powell to reverse his view is still the subject of major debate, but in our opinion the change was justified. The U.S. and major world economies are slowing. Domestically, a leading manufacturing survey indicated that the number of new orders will be much lower in July compared to June. Though manufacturing is not a large share of the economy, orders are a leading indicator and correlate well with profit growth. We would expect, therefore, that the second quarter’s S&P corporate profits will not be too exciting. The Fed can and should ease interest rates not only because of the current slowdown, but also because inflation has been consistently below its target range, parts of the yield curve are inverted, and there is global weakness as a result of trade friction to consider. China’s real GDP is still slowing, Japanese exports remain challenged, and the European Central Bank would appear to be favoring further stimulus. All of these factors put upward pressure on the U.S. dollar and make it less competitive due to our higher interest rate environment.

Though there are still many unresolved domestic and international issues, progress has actually been made in addressing several former flash points. The U.S. government was not shut down and our Mexican border wasn’t closed. The Federal Reserve seems to be in a holding pattern, and rate cuts are planned. China has introduced new domestic stimulus measures, and OPEC has led the way in stabilizing oil prices. The biggest stumbling block remains the absence of a U.S.—China trade deal, but there are hopeful signs that negotiations may begin again soon. It clearly is in the best economic interest of both countries that a compromise be reached.

In spite of the apparent global and domestic issues, the advance in equities has been impressive, and sometimes it pays to listen to what the markets are telling us. Importantly, the advance has broken out with more issues and sectors participating. The advance/decline line is at a new high while more cyclical and financial companies are receiving renewed bids. Perhaps the markets are telling us that reduced earnings expectations will be better than expected, that we will have renewed economic growth, and that stocks can move higher in a stable and benign interest rate environment.

July 2019

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2019 First Quarter Review – Stay Involved

While the last quarter of 2018 turned out to be one of the worst on record, the first quarter of this year will likely be seen as one of the best. Santa Claus showed up right on time, and the January 4th follow-through confirmed that we are still in a major bull market.  Perhaps most of the credit should go to Federal Reserve Chairman Powell, who reversed his interest rate tightening campaign and more or less guaranteed no further increases this year. We suspect, however, that the other defining factor was that investors finally realized that business is good and should get better in a low-growth, low-inflation, and low-wage-pressure environment. We think the economic expansion will continue for many quarters to come, a positive backdrop for equities.

To be sure, the business environment was always good with personal income and spending rising, while the core PCE deflator, the Fed’s favorite gauge of inflation, is below 2%. With such numbers, the Fed had no choice other than to shift to a neutral policy. We did see a slight inversion of the yield curve on the short end, but this has happened several times in the past without dire consequences. For the moment, we look at it only as a warning sign. A curve that was 25 basis points inverted for roughly a quarter would be more worrisome.

There are still a number of things that need to go right to sound the all-clear signal. We still do not have a U.S./China trade deal. Brexit, while postponed, is still on the horizon, as is the U.S. raising the debt-ceiling and other political considerations. Progress is being made however, and we expect to see more in the future. The most recent economic numbers are the most promising: The U.S. Manufacturing PMI was 52.4 in March—solidly in expansion territory. Though U.S. retail sales took a dip in February, both January and March were higher, with March showing the strongest increase in the past 18 months. Construction spending rose 1% in February. These are all indications of a slow-but-continuing economic expansion.

Since Standard & Poor’s started keeping score back in 1926, the index has delivered double-digit returns in the first quarter 14 times. There were only four years when the S&P 500 didn’t go on to post a 20% + year, and of those four only 1930 saw a decline. We expect that there will likely be normal pullbacks, particularly after such a strong first quarter and a fairly sloppy earnings season, but we are optimistic for the remainder of the year. We also like what we see in the equity market itself, with broadening participation and some of the more cyclical areas showing strength. These and other data points suggest more economic strength than currently forecast. One of our favorite indicators—copper vs. gold—is telling the right story. Copper, the most widely used industrial metal in the world, is rallying, while gold, the symbol for a safe haven, is not.

April 2019

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2018 Fourth Quarter Review


The S&P 500 fell 6.2% last year, not including dividends. Volatility picked up as central banks became less accommodating with both federal funds hikes and balance sheet drain. The European Central Bank also started tapering. Most asset classes struggled while the U.S. yield curve flattened. Equity market volatility intensified in December and consumer confidence fell, partly in reaction to hawkish remarks by the Federal Reserve. Earnings, however, grew an estimated 22% last year, and perhaps a little bit more. The result of these seemingly contradictory factors? A contraction in the market’s price/earnings ratio—the fifth largest decline since World War II.

So far this year the S&P 500 is up 5%—and we expect further increases ahead. An analysis by UBS recently looked at 26 cases since WWII of meaningful price/earnings declines for U.S. stocks in a single year. It found that the median returns the following years were 16%.  Much will depend on the manmade headwinds negatively impacting the major economies. It would appear that the U.S. Federal Reserve has come off autopilot and may slow interest rate hikes. Investors are also starting to predict a possible resolution to the U.S./China trade discussions. No trade war escalation will eradicate a major headwind—though keeping the recent tax cuts in place, along with increased government spending, will more than offset current trade risks.  The removal of the tariffs should improve capital spending, the life blood of future economic growth, which has been hobbled in recent months. Additionally, 2018’s combined incremental benefit of consumer tax cuts and lower gasoline prices could increase in 2019.

While we have a constructive outlook on the future level of equity prices, we don’t think it is time to blow the all-clear signal just yet. A lot of what we have talked about is solvable but the resolutions still lie in the future. If we factor in the host of global economic problems and the disarray in Washington, there is reason for some caution. U.S. economic growth will probably slow to around 2.5% this year and corporate profits to the low single digits. But slowing economic growth and profits should not be confused with negative growth. Historically speaking, the former outcome does not end in a recession or a bear market. Our concern is the damage done to the equity markets in a very short period of time resulting in the worst correction since 2011. After such corrections, it often takes the market several months of volatility before it establishes a base from which to move sustainably forward.

January 2019

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