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Investment Review/Outlook

Current Investment Outlook

As long-term readers of our client letters are fully aware, we have been consistently bullish about the prospects for equity markets ever since the double-bottom in late 2008 and early 2009. And, of course, we presented a very different view in our most recent January letter. We are not particularly proud of that forecast, because the things we were worried about are terrible - and they have mostly come to fruition in the first quarter of 2022. Our view remains the same. Despite a nasty on-going correction, and a significant bear market in individual securities, we recommend staying invested in quality companies with bright future prospects.

The issues of concern today are inflation, rising interest rates, and war. A combination of these factors is certain to slow our economy, and maybe push us into recession, but the economic outlook in general remains healthy. For the past year, we have been worried that inflation was not going to be "transitory" and that the risks of war - not just in the Ukraine - were high. That view has been correct, and that is why the market has struggled over the past several months. We can't say when that circumstance will change, but keep in mind that the stock market bottomed in April of 1942, a mere four months after the attack on Pearl Harbor. Markets can discount good news months, quarters, and even years in advance. We think that the odds are high that we are still in a secular bull market, so we don't want to get shaken out of our investments by some temporary news that is admittedly quite horrific.

So, where are we today? We have a market which has turned its focus to short-term developments and is less confident in longer-term prospects. In addition, with higher interest rates and a more near-term focus, price-earnings (PE) multiples have contracted. And, this is especially true for companies with great prospects well into the future, but no current earnings. We have mostly avoided this sort of investment, but we have a few - and they have suffered serious declines in the first quarter.

As we have argued for about a year, the inflation picture is bad and worsening. The March CPI inflation number was +8.5% (+16.8% according to John Williams of Shadow Government Statistics). The primary causes of our high inflation - beyond the extraordinary increase in money supply - are way too much government spending on top of the post-COVID recovery, supply issues primarily from China, and our government effort to reduce substantially our dependence on fossil fuels while shifting to alternative sources of energy. These trends are not going to reverse suddenly and improve. Interest rates have begun to reflect higher levels of inflation, along with the new Federal Reserve policy of raising short rates and reversing its asset purchase program. These circumstances will combine to slow the economy and, as a worst case, send us into recession.

The Federal Reserve has found itself in a difficult situation for years. Over a decade ago, it introduced a "free money" policy to combat the Financial Crisis. Just when they were thinking of reversing that policy, along came the Pandemic, and the free money remained. Now, with inflation surging, the Fed has little choice. They are clearly behind the curve, meaning that the time has long since passed to take effective action. This means that their restrictive actions today will be less likely to curb inflation as quickly or as strongly. The bottom line is that they will raise rates and the economy will be slowed, but inflation will persist above the Fed's target.

The Russian invasion of Ukraine is a horror of unmeasurable proportions. But, there are two reasons why it went from unlikely to possible and then inevitable. Our departure from Afghanistan was hasty and ill-planned, and it gave a signal to our adversaries that we are not a reliable friend of our allies. And, our energy policy has sent oil and gas prices through the roof, providing a war-funding gift to Putin whose country is little more than a gas station and wheat exporter. The uncertainties at this point are how much longer the fighting continues and how much Russia will be able to claim of Eastern Ukraine. Any territory they take over will be long contested, so we should expect isolated hostilities for many years to come. The only good news about this war is that the world has seen the resolve of the Ukrainian people, and the U.S. and other NATO countries have shown an unexpected degree of unity and purpose in supporting the invaded country. That message is not lost on China as it considers seeking to claim Taiwan as its own.

In the face of all of this, GDP is expected to grow 2% in 2022, following a 5.7% increase in 2021. Some 69% of companies are beating revenue estimates and 79% of companies are beating estimates of earnings. The economy is strong, consumers (in total) are in good financial health, and there are trillions of uninvested cash waiting to be put to work somewhere. This could sustain the long bull market despite whatever correction we are seeing so far in 2022.

After a long period of strong outperformance, growth stocks lagged value stocks in the first quarter. There are two factors at work here: first, with higher interest rates the reduced valuation of future earnings for growth stocks far out into the future, and, second, the fact that many exciting growth stocks have no earnings at present, despite their bright prospects, causing a further reluctance to price the future generously. Many emerging technology companies have fallen 75-80% from peak levels. We have tended not to own many of such names, but we have not emerged completely unscathed. Many of these stocks will recover to new highs - and relatively soon - but not in the next quarter or two.

Following two very strong years, the stock market has taken a pause so far this year. This is the sort of thing we worried about in our January letter. In our view, however, it would be a mistake to withdraw from the market. We have friends who left the market in 2009 and have never come back. Few successful investments never suffer from periods of doubt and market uncertainty. Buying quality stocks at reasonable valuations is always a good strategy. That remains our mission today. The S&P 500 remains in correction territory, while the NASDAQ has touched a bear market decline. Energy, utilities, and consumer staples have led in the first quarter. The market has been tested but has significant underlying strength. This is the perfect time to look for unrecognized value.

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