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 Investment Review/Outlook  Market Highlights Current Investment Outlook Stock Highlights
Investment Review/Outlook

Current Investment Outlook

Equity markets continued to advance in the second quarter, with the S&P 500 rising 8.5%, bringing the gain to 15.2% for the year to date. This means the total return since the end of 2008, close to but not even the market low, was more than 500%. In a period like these twelve and a half years, with the market offering a six-fold gain, you do not want to be cute. You want to be in the market and own good companies with fair valuations and modest business risk. Most people did not. They were shaken out of the market with fear and either stayed on the sidelines for a long period of time, or several long periods, or the entire time. We feel we have served our clients well by arguing throughout this period to stay in the market and be confident.

While there have been subtle shifts in our tone over these years, we have maintained a positive view about the future prospects for our equity markets. We still hold that view, but there is an important and not so subtle change in our outlook today. Why? Inflation. Many will insist that our current burst of inflation will be temporary. We do not think so and believe that much higher inflation is here to stay. What this means is much more complicated.

Normally, higher inflation would directly relate to higher interest rates. This is not the case today, because pure market factors are not setting market rates. U.S. and worldwide Central Banks are purchasing securities in order to keep rates low. And, many institutions are involuntary buyers in the fixed income market. Periodically, you will see rates decline perplexingly, as these unnatural buyers step into the market. As such, interest rates are much lower than they should be today, and this will continue to be the case for a significant time into the future. Even though these buyers will keep a lid on rates for some time, our view on bonds is negative, because the only practical future direction for rates is higher, and today the real return on bonds (the current return less inflation) is negative. Some $18 trillion of debt still trades at negative rates. With inflation, cash is similarly unattractive, as are bond-substitute stocks (such as utilities).

Remembering that $4.5 trillion of institutional cash remains on the sideline, what does the higher outlook for inflation mean for stocks? In a normal circumstance, rising inflation would tend to lead to higher earnings, but later translate to lower valuations. Today, stocks may get some benefit from inflation through earnings, but the pressure on valuations will be delayed because of the current lid on rates. Investors must be very careful. Growth companies can do well, but companies with fixed contracts will not. Companies will be attractive if they can pass on inflation and much less so if they get caught in a cost-price squeeze. Taken together, this means that stocks can continue to do well in this environment, but not all of them. Individual stock analysis and stock selection will be key.

The June inflation numbers, 5.4% for the CPI and 7.3% for the PPI, were much higher than expected and were the highest since 1992. The Administration argues that this is temporary, but opinions are beginning to shift rapidly. Professor Jeremy Siegel believes we will see monthly numbers in the 7-9% range over the balance of this year. Prices are rising for lumber, housing, energy, used cars, bacon, milk, and bread. The cost to build an average home has just risen by $40,000. Housing, food, and gas price increases tend not to be temporary.

The monetary situation is in flux but still expansive. The Fed is buying $120 billion of bonds each month, but there are conflicting signals as to when this will slow. The Fed balance sheet has grown from less than $1 trillion in 2008 to a remarkable $8 trillion today and the money supply has grown by similar proportions. The M2 measure of money supply generally grows at a modest and steady pace, but it has swelled by over 32% in the past year and a half. When more money chases a fixed amount of goods or securities prices have to rise. This is likely to mean higher stock prices and higher inflation.

The economic data is good, as we continue to recover from COVID. The momentum of the recovery is strong, and the biggest risk is a significant hike in tax rates, a prospect that is lessening at the moment. Vaccines have helped tremendously, and we believe we are much closer to herd immunity than officials want to admit, as they press for the unvaccinated to get in line. Stimulus plans might throw as much as $6 trillion into the economy, with the possibility of more to follow. Benefits are so generous that there are 9 million jobs unfilled, with millions sitting at home cashing checks from the government. Unemployment is down to 5.9% and the participation rate is back up to 61%. Households have built savings up to $2 trillion during the Pandemic, and this money will be substantially spent in the coming years. GDP rose 6.4% in the first quarter and is expected to rise 8% in the second. Corporations are beating consensus most of the time for revenues (88%) and earnings (86%).

COVID is receding, even though there are fears about the Delta variant. The vaccinated have a low risk of catching this variant, and if they do, virtually no risk of hospitalization or death. The days of politicians telling people what to do are winding down, and that’s a good thing.

During the Pandemic, some $24 trillion was added to Global debt, raising the total to a record $281 trillion and a debt-to-GDP ratio of over 355%. This circumstance will have to be addressed in the future, but it will not be in the near term. While governments accounted for most of this increase, corporations added $5.4 trillion, banks $3.9 trillion, and households $2.6 trillion. At the same time, household net worth rose to $136.9 trillion, a 16% increase from 2019. Debt payments compared to disposable personal income fell to 8.2%, the lowest level since 1980. Taken together, households are in good financial health, while governments are in exceedingly poor health. They like to think that they are all fighting for us, but what they are really doing is spending our money like drunken sailors!

China remains a central figure for a multitude of reasons. We will touch several key points with little elaboration, but remember this: be suspicious of the opinion of a person or entity that happens to be in a compromised position with China. For example, you should never trust the view of a corporation which manufactures product in China using slave labor – or one that is paid by the Chinese Communist Party. So, here are the observations. First, since March of last year, we have been certain from our research that the Coronavirus did not emanate from the wet market. Rather, it came from the Wuhan Virology Lab, and the only question now is if it was by mistake or on purpose. Second, China is currently cracking down on domestic capitalism. This is but the latest confirmation that their market is manipulated and therefore unfriendly to foreign investors. American institutions have never had direct ownership of Chinese securities, and they are now waking up to this fact. Third, in order to manufacture in China, you have to make a pact with the devil, and U.S. corporations are beginning to diversify their sourcing to other countries. And, fourth, China remains militarily ambitious by at least two means: by infiltrating all of our domestic institutions to effect opinion and steal technology and by building up their military at a breakneck pace. Finally, we are starting to counter their worldwide port and infrastructure strategy. This is not a good time to drop our guard.

Stocks are trading at a high 21.5 times 2021 earnings of $199 for the S&P 500, but this is justified with the 10-year Treasury at 1.23%. With rotating leadership, the first half was led by energy, real estate, and financials, and the second quarter was led by real estate, technology, and energy. In a healthy sign for the markets, growth and value keep trading leadership roles. We remain vigilant, balancing quality and valuation, and maintaining a focus on individual stock selection.

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