Category Archives: Blog Post

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.

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.

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?

Quarterly Update – 1Q19

The market peaked in early October, 2018, and came very close to the official 20% decline that defines an official “bear market.” The real issue is not the depth of the decline, but how long it takes to recover. After the market roared back (+13.06%) in the first quarter, we are nearly there.

Last quarter I shared a chart I use, that indicated the market was valued at 88% of fair value. Today, that reading is about 98%. There is a natural regression to fair value. We’re about where we are supposed to be, not cheap but not too expensive.

There has been a lot of talk in the media about the “yield curve” and what that means about recession risk. I wrote a blog post on the issue the day the curve inverted on March 22. Link here: https://www.daltonfin.com/2019/03/22/what-volatility-looks-like/.  Sure enough, the inversion was transient, with the 3-month T-Bill currently at 2.4% and the 10-year Treasury Note at 2.41%, virtually flat.

(Caution –  the next 2 paragraphs are on the wonky side)

The spread between the 10 and 2-Year Treasury is Worth Watching. When it goes negative, it is inverted.

The main problem with conventional yield curve analysis is that current conditions are a lot different from past circumstances, after 10 years of central bank intervention. The absolute level of interest rates has not been this low in any prior inversion analysis. To illustrate why this is important, consider an economy with no inflation. If the interest rate is the price of money, how much would you need to be paid to lend your money to the U.S. Federal Government? Now, add that rate to the expected inflation rate to get the level that the 3-month T-Bill should yield today in a normalized environment. Anything short of that is like a morphine drip to the economy. The Fed is trying to wean us, but that requires balancing the market’s tantrums (see December) which can become a self-fulfilling prophecy if a stock market decline causes a slow-down.

The Fed only controls the short end of the curve. The market controls the long end. When bond traders bet the Fed will cut rates, they buy the long end because interest rate changes compound and prices move inversely to rates. Increased demand on the long end causes long rates to fall. The greater concern is when the Fed starts cutting short rates. That signals trouble because they have more information than anyone else. What does the Fed do when they see trouble? They cut short rates to juice the economy. The problem is, there’s usually trouble on the horizon when that happens. The good news? That’s not the case today.

Volatility is the price of equity returns. We can manage risk if we understand your liquidity requirements. If we can anticipate distributions, we can reduce or eliminate the possibility of being forced to sell when the market is cheap. That’s what converts a temporary loss of capital a permanent loss.

What Volatility Looks Like

It is hard to fathom the sway in sentiment from yesterday to today. Yesterday markets soared despite Biogen’s dismal news about a failed clinical trial that caused it to drop about 29%. Markets closed up strongly (S&P 500 +1.09%). Market analysts attributed the broad market strength to investors getting more comfortable with the Fed’s dovish stance.

Today, alarm bells went off because the yield curve inverted. This shouldn’t surprise anyone. The curve has been flattening for a while. The gap between the 3-month and 10-years yields is viewed as a leading indicator. It will be important to see if the inversion persists. The indicator’s success rate as a recession predictor increases when the inversion lasts more than 10 days. This is day 1. That was enough to send the S&P 500 back down -1.9%.

At the end of the day, there is no material, fundamental change. Sentiment changed, and that creates volatility.

Investing involves risk, including possible loss of principal. Past performance is not a guarantee of future returns.

Zoom Out

Time brings perspective, and now might be a good time to reflect on that. This month has been exhausting for investors. The damage is relative. If you invested last month and need to sell now, you might have a problem. But if you are a prudent investor with a 3 to 5-year time horizon, I think you’ll be just fine. This is normal volatility. For perspective, consider the following views of the S&P 500.

First, consider how you feel. The chart below shows a 5-day view. Pretty lousy, huh?

Next, we’ll zoom out to a 3-month view. Not much better.

Now let’s see how the index has done over the past 12 months.

As the above chart shows, it has been like a roller coaster, but it is still positive. Now let’s zoom out to the 2-year view. I think most investors would be pleased with the 29% gain they would have received from the SPY, an ETF that tracks the total return of the S&P 500 including dividends. These charts show just the index, excluding dividends.

Finally, here’s the 5-year view that shows the accumulation of retained earnings created by millions of people going to work every day. This is more like it. Now our scary stock market looks more like a not so uncommon speed bump along the way to greater prosperity.

Exhale and have a nice day!

Charts from Yahoo Finance. Past results are not guaranteed. Investing involves risk, including loss of principal.

Risks to the Market

Two risks to your financial future include inflation and market declines triggered by asset price bubbles.

Inflation has not been a problem in the U.S. for over 30 years. Three of the biggest market declines in the last 100 years included in the Great Depression, the tech bubble and the more recent Financial Crisis. Each of these events was related to price bubbles. High stock valuations preceded the 1929 and 2000 corrections, and real estate speculation precipitated the 2008 crisis.

The fuel for asset bubbles is cheap credit that encourages risky behavior through leverage. Why does this matter? There is widespread concern, not unfounded, about the effect of rising interest rates on stock prices. But presently, short-term rates are still less than inflation. We need a positive real interest rate to support healthy economic incentives and to discourage speculation. Normalization requires more interest rate increases, contrary to President Trump’s tweets. The improving economy supports current market valuations.

The real risk of higher interest rates occurs when it begins to limit investment in otherwise productive projects. The problem with low rates is it encourages bad investment.

Recession Strategy

I am seeing a lot of ink about how to prepare for the next recession. Clients want to know what we’re doing to prepare. Investment companies are asking me which funds I think are best for the next downturn.

The real issue is not how deep the correction will be. The real concern is the duration of the decline. How long will it take to get back to even? The problem is not that the stock market will go down. The real problem is if you need to sell stock when valuations are low to fund current living expenses. That converts a temporary loss of capital into a permanent loss of capital.

I’ve been investing since the 1970’s. My education and career have focused on economics and finance. What have I learned? In my view, valuation risk is easy to observe, but timing a correction is still difficult. I recognized that the S&P 500 was overvalued in 1998, but it doubled again before getting cut in half in 2000. I observed in 1999 that the market would either go down by 50% or trade sideways for 10 years while earnings caught up. I had no idea I would be right on both counts. Despite that, a diversified portfolio including small cap, international and bonds fared much better.

Systemic risk is harder to recognize. I didn’t see the 2008 crisis coming. But it really wasn’t a stretch to see what asset class was overvalued, i.e. real estate. But then you needed to understand that banks and credit agencies were operating in a corrupt system underwritten by government agencies, that mortgage defaults would create a downward spiral as underwater homeowners defaulted, forcing prices ever lower.

We accept the unpredictable nature of corrections, and that unique circumstances precipitate them. Today, credit seems to be the most mispriced asset class, driven by government intervention. But bonds are math, and the effects of normalization should be more moderate than a speculative equity correction unless there are forces involving leverage that are not on my radar – like the mortgage security market. Still, the recovery of the past 10 years made staying invested worthwhile. We just needed to hedge for liquidity needs over the next 3 to 5 years to emerge unscathed.

What does all this mean? I believe that a heightened level of concern about the next recession or correction is healthy. As investors de-risk portfolios, valuations will be earnings driven, and that’s a good thing for fundamental investors. Certainly war, policy mistakes, and scandal can impact markets, but these events have nothing to do with the duration of a market expansion. They can happen at any time, so why should the risk seem greater now?

My favored strategy continues to be the bucket approach. One of the key benefits of a financial plan is that it identifies anticipated liquidity needs. Given that most market downturns are resolved in less than 3 to 5 years, it is prudent to establish reserves equal to your liquidity needs in something with less risk than the stock market. Accepting risk in the short-term is gambling, and gambling with what you can’t afford to lose is a bad idea. Investors have time on their side as companies continue building wealth even while the market doesn’t always correlate with that. Be prepared, be vigilant, and stay the course until fundamentals indicate otherwise.

“WE’RE BUYING STOCKS THIS MORNING, AND I’D RATHER BUY THEM CHEAPER, BUT I’VE BEEN BUYING STOCKS SINCE MARCH 11th, 1942, AND I REALLY, I BOUGHT THEM UNDER EVERY PRESIDENT, SEVEN REPUBLICANS, SEVEN DEMOCRATS I’VE BOUGHT THEM QUARTER AFTER QUARTER. SOME OF THE BUYS WERE TERRIFIC, SOME OF THEM WEREN’T AT SUCH GOOD TIMES AND I DON’T KNOW WHEN TO BUY STOCKS, BUT I KNOW WHETHER TO BUY STOCKS, AND ASSUMING YOU’RE GOING TO HOLD THEM, WOULDN’T YOU RATHER OWN AN INTEREST IN A VARIETY OF GREAT BUSINESSES THAN HAVE A PIECE OF PAPER THAT’S GOING TO PAY YOU 3% IN 30 YEARS OR SHORT TERM DEPOSIT THAT PAYS YOU 2% OF THE SORT.” WARREN BUFFETT, August 30, 2018

Investing involves risk, including loss of principal. Past results do not guarantee future results.