The Path to Great: Part I - The Problem with “Good”
FIVE THINGS YOU SHOULD KNOW
- Equity Markets – finished up in this choppy week with U.S. stocks (S&P 500) up 0.41% and international stocks (EAFE) gained 0.28%
- Fixed Income Markets – also saw gains this week with investment grade bonds (AGG) up 0.29% while high yield bonds (JNK) remained unchanged.
- New Executive Order – This week President Biden signed a new executive order aimed at promoting competition across American industries, with one of the main targets being the shipping and rail industries which has become increasingly monopolized and foreign-owned. The administration also plans to keep pressure on China’s human rights records with more companies added to the economic blacklist.
- Recovery Gap Widens – The global pandemic recovery success continues to widen between developed countries and emerging market countries. In the U.S. this week Biden all but announced an end to the pandemic saying the country had achieved “independence” from the coronavirus, with the U.K. also planning to lift all virus-related legal measures on July 19th. Meanwhile Indonesia, Bangladesh, and Russia reported record-high cases this week as the delta variant of the virus continues to surge.
- Key Insight – [VIDEO] In this week’s video Dave and Jon are back to share the stories around some incredible trips they just took, how our planning process helped them enjoy those trips even more, and how that process can do the same for you. [ARTICLE] Tim shares his thoughts, and those of some famed investors, on the current economy, the Fed and how dividends have once again proven their worth to investors.
INSIGHTS for INVESTORS
The Current Outlook
Despite a number of new all-time highs in the market, the level of skepticism is still high among traditional investors (the “meme-stock” crowd, and its favorite stocks/crypto, are another matter altogether). Such “fear” (see chart below) would strongly suggest this market still has considerable legs and rarely in history has a bull-market ended with such investor sentiment.
You may recall Sir John Templeton’s timeless quote, “Bull markets are born on PESSIMISM, grow on SKEPTICISM, mature on OPTIMISM and die on EUPHORIA.” While many parts of the crypto and/or meme stock markets match the euphoric definition a couple months ago, classic stocks would still appear to be in the second stage.
Such skepticism isn’t isolated to only investors but is seen in analysts’ earnings expectations as well. As a result of this, coupled with the tremendous catalyst of over $2 trillion dollars in consumer’s savings accounts after the highest year of savings in over 20 years, companies are reporting blow out earnings which is also propelling stocks for the time being.
JPMorgan summarized the situation well stating, “Since the onset of the pandemic, earnings have surprised to the upside by a significant margin. While analyst estimates are typically reliable, it seems likely that many models grossly underestimated the strength and pace of the economic recovery, leading to earnings projections that were overly pessimistic. That being said, with the 2Q21 earnings season approaching, we believe that earnings will come in well above current estimates, and are forecasting an earnings surprise of 14.6% for the S&P 500. This would represent a decline from the 23.7% surprise observed in 1Q21, but would still be above the long-run average of 7%. Going forward, earnings growth will hinge on the resiliency of profit margins. Revenue growth should remain robust through year-end, but at the same time, companies will continue to be faced with cost increases due to supply chain disruptions and higher wages. If firms can defend margins by increasing prices, inflation may move higher, pushing the Federal Reserve to pull forward its plans for tightening and potentially weighing on earnings growth. However, if firms find that demand is elastic and price increases lower revenues, they will need to find alternative levers to preserve profits. The bottom line is that earnings growth seems likely to slow as we approach 2022, but this does not seem to be reflected in analyst estimates. This suggests that estimates may need to decline if a trend of elevated surprises is to continue.”
While things are ever-changing, Tom Essaye keeps it simple stating, “the “Four Pillars of the Rally” remain largely in place. The Fed isn’t reducing accommodation until the end of the year, and QE will be ongoing well into 2022, infrastructure is actually gaining momentum in Washington and something is still possible, the pandemic continues to recede globally and the recovery is strong. As such, we view any 10%-ish pullback as an opportunity to add more stock exposure, again tilted towards value and cyclicals.”
The Fed and Its Likely Impact on Future Markets
Plenty of investors, including yours truly, have complained about the post-financial crisis reality of an overactive Fed, but this is part of the game for now.
That said, US markets still seem to have their view of the Fed’s actions, or need for them, a bit out of whack. Contrast Australian markets which rallied this week on their central bank’s announcement that they would begin to slow their bond purchases after they correctly viewed it as signaling a strong economy, with that of our markets a few weeks ago falling due to the Fed stating they were “thinking” about tapering despite historic economic numbers.
Famed manager Bill Ehrman commented on the current state of things saying, “We are not surprised that the Fed finally began to talk about tapering as the economy and inflation are stronger than initially projected. Still, it is a mistake to think that the Fed will act precipitously and end the economic expansion. Their actions may extend the growth. We still expect the Fed to talk about tapering in the fall, begin the actual tapering next year, conclude it by year-end 2022, and start hiking rates by mid-2023. What is wrong with that?” (emphasis added)
Goldman Sachs echoed similar sentiments in support of the Fed’s opinion that this recent bout of inflation is likely to abate pointing out, “Over the past three decades, US core inflation has remained low and relatively stable. Recent price pressure stemming from economic reopening and recovery has increased the latest May US core PCE print to 3.4% YoY. While elevated, history shows that even in low inflation regimes, episodes of higher inflation has occurred and proved transitory in the past. We expect this time to be similar.
Blackrock weighed in as well acknowledging the Fed needs to be mindful of inflation, but also pointing out strong growth is supportive of risk assets too. They believe the Fed likely still has time before it must taper stating, “Even with the upgrade [edit: to their inflation projection], their latest average inflation projection for the next three years only just sits at the bottom of the range of what could be argued to amount to a defendable make-up for past inflation undershoots [edit: see also the GS chart above]. Our bottom line: We believe the Fed’s new outlook will not translate into significantly higher policy rates any time soon. This, combined with the powerful restart, underpins our pro-risk stance. Large cash balances held by investors and no obvious signs of financial vulnerabilities give us additional confidence. We prefer to take risk in equities and remain underweight bonds on valuations.”
However, when discussing risk assets they recently noted, “We see equities in developed markets (DMs) outside the U.S. as better positioned to capture the economic restart over the tactical horizon, as the powerful restart broadens out. Potentially higher taxes and more regulations could pose challenges to the strong performance of U.S. stocks, yet we would expect the eventual tax increases to be less than proposed by the administration.”
Focus on what you can control and/or count on – Diversification and Income
Everyone who went piling into growth stocks with little to no earnings, crypto and/or meme stocks have been learning a hard lesson about diversification of late, with many of those positions down 20% or more. Anecdotally, but perhaps no less important to consider, were the calls and questions about such “investments” that had my phone ringing quite often in February and have virtually ceased – I can only imagine the damage some people did to their wealth.
On the other hand, for those who believe investing (as opposed to speculating) is about buying into great companies to share in their profits, rent to them and/or make smart loans to them – you are finally getting your day in the sun.
As it relates to profits, despite an unprecedented challenge to the economy in 2020 from the shutdowns, dividends overall did well. Furthermore, we witnessed many active managers do an even better job of maintaining their dividend income levels through security selection.
Building a portfolio around solid cash flow, not market timing or over-reliance on total return, is what solid retirement plans are built on. I love the chart below, because it shows not only how resilient dividends are in the modern era, but how much they’ve grown over time. This is not only a great way to build wealth, but also hedge against inflation and rising costs.
Closing Thoughts
Many investors feel the next crash must be around the corner, and while volatility is a part of life, history and facts would suggest not only are markets in a relatively healthy position but, perhaps even more importantly, your retirement can be secured through many types of markets with the right approach.
If you didn’t get enough, or still have concerns on topics such as the mounting deficits, the following link shares a great piece from Brian Wesbury this week on deficits and the dollar.
https://www.ftportfolios.com/Commentary/EconomicResearch/2021/7/6/twin-deficits-wont-tank-the-dollar
Have a wonderful weekend,
Tim and the team at TEN Capital