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Investment Review/Outlook

Current Investment Outlook

As we feared, the first half of 2022 offered negative investment returns. And yes, looking back, we wish we had done more selling, given our extremely cautious view. But, this is where we are today. So, now we need to address what brought us to this point, and what is the outlook for markets going forward.

The primary problems for the market today are high inflation and rising interest rates, both of which have been caused by excessive growth in the money supply, too much fiscal spending, and policies restricting the production and distribution of energy supplies. The Federal Reserve has pivoted and reversed its easy money policy, but there has been little to no movement beyond the Fed.

Curiously, there are mixed signals on the inflation front. The June numbers were awful, with 9.1% for the CPI and 11.3% for the PPI, the highest readings in forty years. At the same time, energy and commodity prices dropped significantly in June. For example, the price of copper more than doubled from its 2020 low, but has declined by 25% in the past few months as it appears that we may be facing a worldwide recession. What should we conclude from these conflicting points of data? We believe that commodity prices will be volatile, but that inflation is going to be a persistent problem for months to come.

Markets were weak in the first half, with the Nasdaq down 29% and the S&P 500 down a fraction less than 20%, the technical definition of a bear market. Many healthy and technologically strong companies saw their stocks decline by more than 70%, so the damage has been much more severe and widespread than the indexes suggest and we are most certainly in a cyclical bear market.

Entering 2022, the stock market had completed two strong years under COVID (when companies showed how they could survive and actually thrive in that environment) and thirteen years of strong appreciation. With the expectation that a market price-earnings multiple of 21 was at risk in the face of rising rates, we thought that stocks were unlikely to keep rising. But, it wasn't our view that inflation and rising rates would drop the market as far as it has in the first half of this year.

We tend not to write about Presidential politics, but 2022 is a "mid-term" year between Presidential elections, when the party in power typically loses seats in Congress. How a President responds to domestic challenges and foreign and external events matters and the difference in this regard is highly relevant today. Joe Biden might want to study the lessons of history. Let's look at what happened to four previous Presidents: two Republicans and two Democrats. George H. W. Bush had to deal with the first Iraq War, and received strong bi-partisan support, which he lost quickly when he raised taxes to fund government spending. He became a one-term President. Similarly, George W. Bush was dealt the externalities of 9/11, the bursting of the tech bubble, and Katrina, but managed to muddle through in an undistinguished way. He was able to get re-elected, but only barely. Jimmy Carter inherited the aftermath of the 1973 OPEC Embargo and U.S. Wage and Price Controls (giving us out-of-control inflation). Thought by most observers to have been an ineffectual leader, Carter actually made an incredibly good appointment in Paul Volcker at the Federal Reserve, and deserved credit for cooling inflation four or five years after he lost his election to Ronald Reagan. But, the best example of how to respond to adversity would have to be Bill Clinton. He made note of the cost of higher interest rates during the year before his 1994 mid-term losses, made a massive mid-course correction, and would soon be heard to say that "the era of Big Government is over." Despite having an over-active libido, Clinton is regarded as one of our best Presidents. Now, let's look at today. Biden's energy policies have been a classic case of a soccer "own goal," triggering raging inflation and conveying a huge financial gift to resource-rich Russia as that country funds its horrific invasion of the Ukraine with energy sales at inflated prices. Biden could have - and still could - tame inflation surprisingly quickly with a commitment to find oil and gas reserves and help to bring them to market. But, it seems that he won't do that, and energy prices are likely to stay high and raise the costs of doing business throughout our economy - both here and overseas.

Inflation is the primary cause of financial loss in the stock and bond markets today. In about 18 months, inflation went from an outcome the Federal Reserve couldn't create whatever they did to a problem it desperately struggles to solve. Despite signs in recent weeks of reversals in energy and commodity prices, inflation is likely to stay persistently high for some time, especially in the sense that costs and prices have reached a new plateau from which they are unlikely to fall for a very long time. And, as Europe remains beholden to Russia for its supplies of natural gas, a shutoff of pipelines could literally freeze out several countries next Winter. In the meantime, as we learn from the folly of others, we can look at Sri Lanka to see how not to establish a sound energy policy. It is no exaggeration to say that the country now has no food, no energy, and no money.

In response to our burst of inflation, interest rates have been rising and will continue to do so for some time. While it was slow to act, the Federal Reserve is now committed to taming inflation. It has ended its asset purchase program and is raising rates with noteworthy determination. Nevertheless, real rates remain negative at near-record lows and unlikely to turn positive for years to come. This means that income investors of top-rated credits are not earning close to the current rate of inflation.

It matters internationally what rate of inflation a country experiences and how fast its economy is growing. Exchange rates reflect relative levels of interest rates and underlying economic growth. Countries generally want to maintain a strong currency in relation to other nations around the world, because a strong currency preserves a nation's wealth and reduces the costs of imported goods and services. In contrast, a weak currency, particularly if it becomes entrenched, can reflect or lead to the collapse of a country's economy and often lead to the overthrow of its government. A strong currency is consistent with a strong economy and forces a nation to keep increasing productivity to stay competitive. Today, the U.S. dollar is strong, reflecting our high and rising interest rates and the relative strength of our economy. Even though we may be in recession at this very moment, we do not share the risk of the sharp declines that we may see in many European economies.

Faced with raging inflation and rising interest rates, our economy is clearly slowing. It may or may not meet the technical definition of a recession, but that's not the question. The economy today is clearly receding, and that is an unwelcome interruption of the growth we hope to see resume. First quarter GDP was down -1.6% and there may be a -2.1% decline in the second quarter. With inflation hitting a 40-year high, both consumer confidence and business confidence have declined substantially. There remains a dichotomy in which the wealthiest Americans are in a position to weather the current storm, but middle and low income families are in a serious struggle. As part of its plan to cool the inflationary pressures, the Federal Reserve is likely to raise rates by 75 basis points this month and another 25 basis points in September.

Considering all of these issues, the prospect for corporate earnings remains surprisingly good. The estimate for S&P 500 earnings has been reduced from $245 to $230, cutting the growth rate for 2022 from 9% to a 3-4% gain. Most companies continue to beat estimates, although the percentage is declining and could fall further. It feels as if companies should be reporting much worse earnings than they are. We are all waiting for the next shoe to drop - and that will be more frequent earnings disappointments.

The stock market has experienced its worst start of a year since 1932. For what it is worth, history says that the next six months should provide positive returns - and great opportunities for stock picking. By valuations, we think this should be the case, but the price behavior (or technical patterns) remains soft, so we cannot be at all sure about the timing. Market valuations have dropped from a price-earnings ratio of 21 down to below 16 currently. While recent market lows have been around 16 times, some forecast a further drop to 13 for this market cycle. The key point is that we believe the market is in a major correction (or bear market) within a long-cycle or secular bull market that will eventually take the market to much higher highs. For that reason, we remain cautious, but disinclined to do wholesale selling at this point. Using the language of our January forecast, we no longer believe we are in a declining market.

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