To Our Clients and Friends

As regular readers are well aware, our forward expectations for stock prices depend (1) on the amount of surplus liquidity in the financial system, coupled with (2) the outlook for corporate profit increases over the intermediate term. At this writing the economy is clearly recovering from the COVID pandemic-induced recession. First quarter gross domestic product (GDP) showed the first increase in more than a year, as it rose 6.4% on a quarterly basis, and 0.4% on a year-over-year basis. Year-over-year inflation rose 1.9%. Hence nominal GDP has increased over this period by less than 2.5%. At the same time, Broad Money Supply (M2) has increased 19.5%, vastly greater than nominal GDP. The 10-year Treasury yield has risen over the past few months but only to a current level of 1.6%, not much competition for stocks. Ergo, there is a vast amount of surplus liquidity circulating in the financial system. At the same time, due to sharp cost reduction programs at major corporations, earnings for those companies that have so far reported results for the first quarter of 2021 have risen by 60% on a year over year basis. Thus, the combination of substantial surplus liquidity and strong earnings growth has supported a 50% increase in the Standard & Poors 500 Stock Index.

Under the influence of an extremely accommodative monetary policy, and the fiscal stimulus provided by the Administration's $1.9 trillion program, which has already been enacted, as well as the likelihood that at least some portion of the roughly $4 trillion in additional proposed spending will be approved, all set the stage for a booming economy this year, next, and most likely beyond. Reflecting the payment of stimulus checks, Personal Income rose 21.1% in March and the Savings Rate was 27.6%. All of this provides plenty of wherewithal to sustain increased Personal Consumption. Corporate profits should reflect this pace of economic growth.

The major risk to stock prices over the near to intermediate term is that inflation exceeds significantly the Fed's goal of 2% average. There is much debate on both sides of this issue. So far, the recent increase in inflation has resulted from the "base effect," as current inflation readings compare with the depressed levels in the early months of the pandemic. There are some notable exceptions such as semiconductors, which are in very short supply, and timber, which is benefitting from robust housing construction as well as the tariff imposed on imports from Canada. The Fed continues to believe that any further near term boost in inflation will prove temporary, and will not require any change in its policy of a 0%-0.25% Federal Funds rate and its monthly purchases of $120 billion of Government and Agency bonds. The FOMC still wants to see inflation run above 2% for some time before it deems a change in policy to be warranted.  Chairman Powell has indicated that before undertaking any changes in this policy, the Fed will provide ample advance notice.

Of course, a further rise in interest rates will compress the valuations (P/Es) of the leading growth companies, particularly those in tech and social media. Our portfolios are heavily weighted toward these issues, along with healthcare, but we are on the lookout for more economically sensitive names. We do believe that the moment Chairman Powell announces that the Fed is contemplating a change in policy, even if that move is not implemented immediately, there will be a significant downward adjustment to stock prices. While it may seem a little cavalier, we expect fairly smooth sailing until that time, albeit it with considerable daily and weekly volatility.

As always, we thank you for your confidence and trust.

 

2019 Year End Letter

As one who has written more than fifty year end letters to clients and friends, I can attest with total confidence that most of these efforts are exercises in futility.  Rarely do Wall Street pundits, myself included, correctly predict the course of stock and bond prices in the year ahead.  When our forecasts do turn out to be correct, more often than not, it is due to factors that were not considered at the beginning of the new year.  In simplest terms, the direction and extent of equity prices next year will not be a linear move.  The stock market’s overall trend will depend on the rate of increase (or decrease) of corporate earnings, the overall rates of inflation and interest rates, the initial and projected year-end valuations of stocks and bonds, as well as the degree of surplus financial liquidity, i.e. the growth of the money supply (M2) compared to the growth of Nominal GDP.  All one can do at the beginning of the year is to outline a base case, with the understanding that investors must be quick to revise their thinking should changing circumstances demand it.  Needless to say therefore, one must begin with a number of assumptions.

The U.S. economy is on track for another year of modest expansion, as the sum of labor force growth plus the increase in productivity – real GDP – is likely to increase at about a 2% pace, give or take.  Any higher number would require a surge in productivity, a recovery in capital spending, or in net exports.  The latter will depend greatly on the trade-weighted value of the dollar, and on an economic recovery in China, the EU, and Japan.  We will remain alert to these possibilities, but for now, our base case is for 2% real GDP growth.

Inflation is unlikely to reach the Fed’s 2% target, as the three “3 D’s,” debt, demographics, and disruptors will continue to keep a lid on prices, along with competition from cheap imports from the emerging markets to the U.S.  Therefore, overall profit growth for the S&P 500 Stock Index will be restrained and will be driven by a relatively small group of large growth companies dominated by defense, tech, healthcare and social networking.  Thus, our base case for S&P 500 profits is for a mid-to-high single digit increase against a backdrop of restrained pricing power and low inflation.  Under these circumstances, the Federal Reserve’s Open Market Committee (FOMC) is likely to remain on hold for 2020, so overall short term interest rates should remain low and support at least current equity valuations.  Any increase in P/E’s would require a more rapid growth in money supply plus expectations later in the year that the expansion will continue into 2021.  Notwithstanding the Fed’s recent injections of liquidity into the overnight money markets, we would not expect money supply (M2) to accelerate from its most recent torrid pace, which we view as temporary.

As the year comes to an end, the S&P 500 at about 3200 seems fully valued based on trailing earnings.  Even assuming an increase to $180 in 2020, the forward P/E is just below 18.  This represents a 5.6% earnings yield, and compares with BBB bond yields just short of 4%.  Thus, stock prices should be able to advance in line with earnings, but are unlikely to do much better.  Since the financial crisis of 2008, investors have been selling stocks and adding to their holdings of bonds.  If this trend were to reverse, there could be a speculative blow-off of equity valuations.  This is not our base case, however.

While these assumptions, incorporated into our base case, seems reasonable at this time, one can be sure that there will be other factors, some related to domestic politics, others related to larger geopolitical events and still others we cannot imagine at this time.  All in all, we are coming off a year of nearly a 30% gain in the S&P 500.  While the critical factors discussed above seem likely to continue, it is a real long shot to expect a similar gain in equity prices next year.  Indeed, history suggests that after a year of enormous gains, the early part of the new year will see a short-lived but significant correction.  As a final note, with the 10-year Treasury bond providing a yield of 1.90%, there is a significant risk, that even with the modest growth we are projecting, that yield will not remain this low.  As an example, a move to a 2.5%-3.0% 10-year yield would trigger significant losses to bondholders.

October Letter to Clients and Friends

During October, the S&P 500 Stock Index rose 2.0% to a level of 3037.56, which represents a year-to-date gain of 21.2%. The principal driver of the October gain has been better-than-expected corporate revenues and earnings. At this writing, with 68% of the 500’s constituent companies having reported, 79% have exceeded consensus earnings estimates. Management’s guidance has generally been restrained, but this does not lead us to change our 2020 earnings forecast of a 6% gain to $175 per share. This suggests a forward P/E ratio of a bit over 17, equivalent to a forward earnings yield of 5.8%, still substantially above BBB bond yields. Although the manufacturing sector remains in a mild recession and exports are weak, residential construction is picking up as household formations, employment, consumer incomes and household net worth are all rising, while mortgage rates have declined significantly. Inflation remains restrained in the U.S. and abroad, due to globalization, technological advances and intense competition, as well as demographic factors.

Financial system liquidity remains plentiful. The inversion in the Treasury Yield curve has now been reversed as the 10/2 spread is positive by 17 basis points. Credit spreads have tightened since June. Broad money supply (M2) is still growing at a 6% rate, substantially above nominal GDP growth. The FOMC has just reduced the Federal Funds rate by a quarter point to a new range of 1.50%-1.75%. Monetary stimulus globally is well-underway, and there are some early signs that business conditions in Europe are bottoming out.

On the political front, there seems to be some progress toward a watered-down deal with China, though recent history suggests one should not get too far out in front until a deal is actually signed. Our own view is that China will take a very hardline stance on the most critical issues, especially intellectual property, joint ventures, and tariff reduction. Nevertheless, Trump needs a win to counter the very real impeachment threat that he faces.

The earnings reporting season began in mid-October, and although many of our portfolio companies have yet to report third quarter results, those that have reported have universally exceeded Wall Street consensus estimates of revenues and earnings. We have reduced our cash position modestly to reflect these results, and the favorable seasonality from November through April. As always, we will be alert to any deterioration in the economic and corporate fundamentals, and we will take appropriate action should circumstances warrant it. Needless to say, we will also carefully monitor the stated policies and plans of the various presidential candidates.

September Letter

During September the Standard & Poors 500 Stock Index rose 1.7%, bringing the year-to-date return to 18.7%.  The Index was not as volatile as during August, but it was up and down with significant intraday moves.  Historically, September, and particularly October, have been volatile months, and this year may reflect that pattern as well.  The US economy has continued to slow, with growth in consumer employment, incomes, and spending offsetting the deepening recession in manufacturing.  Exports also continue to lag due to the strength of the Dollar and the economic weakness in China, Europe and Japan, and disruption caused by BREXIT.  The trade war with China drags on, as it has for several months with no resolution, not even a limited agreement, anywhere in sight, and most likely not before next year's presidential election.  The domestic political situation has also contributed to market volatility which will likely continue, given the emerging candidacy of Elizabeth Warren as well as the attempt by Democrats to impeach the president.  (Recently, there has been a backlash among big donors from Wall Street.  They are concerned that Warren is a candidate with firmly held views and principles which she is unlikely to compromise.  Were she to be elected, the repercussions for American capitalism and equity values would not be good, to say the least.)

By the middle of October, most constituent companies of the S&P 500 will be reporting third quarter revenues and earnings.  With one notable exception, our portfolio companies exceeded analyst expectations in the second quarter, and we are hoping for similar results this time around.  Nonetheless, market turbulence is to be expected during the reporting season.  Managements' forward guidance will, as always, be important.  We are encouraged that, globally, inflation remains low and financial system liquidity plentiful, as US money supply (M2) growth is running at about a 7% annualized rate, well above an approximately 4% nominal GDP pace.  Both 10-Year Treasury (1.7%) and BBB bond yields (3.9%) are extremely low, and High Yield bond spreads are tight.  A global monetary easing cycle is now underway, which in time should improve overall economic activity.  As we noted a month ago, equities are not particularly cheap, but in the current environment they do not seem dangerously overvalued.  We have raised our cash positions and will continue to operate defensively until there are convincing signs that economic growth is re-accelerating.

 

August Letter to Clients and Friends

Following a modest rally in July, August was volatile and weak, with the S&P 500 Index declining 1.8% to end the month at 2926.46, which is a 16.8% gain for the year to date, but well below the 20.8% gain at its peak in late July. The US economy is clearly slowing. GDP is rising at about a 2.0% pace as employment and household incomes continue to grow. Manufacturing is clearly in a recession reflecting the uncertainty emanating from the White House, as Trump wages a useless trade war against China, as well as soft exports due to the strong Dollar and weak foreign economies. Boeing's problems and the oil price decline are also weighing on growth. Further interest rate cuts by the Fed will not stimulate growth as long as the trade war with China goes on. The Chinese economy has clearly weakened, which is causing the European Union, particularly Germany, to fall into recession and Japan to stagnate. Despite this adverse macro backdrop, US corporations are managing to eke out modest profit gains. We are particularly pleased that virtually all of our portfolio holdings exceeded consensus estimates for second quarter revenues and earnings. At this point, the S&P 500 is valuing 12-month forward S&P earnings at 17 times, not particularly cheap, but not dangerously overvalued as long as the economy maintains a modest growth trend. If M2 continues to rise at much faster pace than nominal GDP, interest rates should remain low and financial market liquidity plentiful.

The market volatility emanating from Trump's trade policies, as well as some of the ridiculous reforms being proposed by various Democratic candidates for the White House, is magnified because trading volume in August is typically quite light, and therefore markets are extremely thin and price moves are exaggerated in both directions. The ETFs and the "algo" traders also increase daily volatility. We do not expect that the trade war with China will end until some time in 2020. Accordingly, the risk of a recession continues to rise. We have raised cash in our accounts and, for the moment at least, believe the amounts are suitable for the environment. If the macro backdrop looks to deteriorate further, we will not hesitate to add to our reserves. In the meantime, we are monitoring a short list of candidates for reinvestment, once the environment shows signs of improving.

July 2019 Month-End Letter

The S&P 500 continued a modest uptrend in July, gaining 1.3%, to close at 2980, producing a year-to-date gain of 18.9%, well in excess of the very small gain so far in overall corporate profits.  Nearly all of our holdings exceeded Wall Street consensus projections for both revenues and profits.  Extremely rapid money supply growth has kept bond yields under pressure and enabled equity valuations to expand.  At month-end, the 12-month forward P/E ratio of the Index stood at about 17.5.  While not dangerously high, given the current level of interest rates, investors should recognize that equities are no longer undervalued at present.  A strong quarter to quarter gain in household consumption coupled with a sharp increase in Government spending enabled second quarter total GDP to rise at a 2.1% rate.  In fact, Real Final Sales to Domestic Purchasers rose 3.5%.  However, business investment, foreign trade, and residential construction were all weak.  A strong dollar, the Boeing shutdown, weak economies abroad and the trade war with China are all weighing on the various manufacturing sectors.  In our judgment, there will not be a resolution this year of the trade/tariff war with China.  This will weigh heavily on global growth until there is a satisfactory resolution.

In an effort to stave off further weakness, the FOMC reduced the Federal Funds rate by one quarter point to a range of 2.00%-2.25% on July 31st, and signaled that further cuts could be forthcoming if deemed necessary.  In addition, the Fed indicated that its balance sheet reduction program will come to an end in August, two months earlier than expected.  We are skeptical that further easing of monetary policy will be of much benefit, since household consumption is not likely to increase at an even faster pace, and as long as growth in China, Europe and Japan, all interrelated, is sluggish, the manufacturing sectors will remain weak.  In this environment, the Fed's 2% inflation target is unlikely to be reached given the impact of globalization, technological advances, and fierce price competition from a vast array of disruptors.

Despite meager profit gains, the stock market has already given investors terrific returns this year, albeit driven by a small number of tech-related giants.  These companies have become generously valued, to say the least, as investors are willing to pay up for secular growth in an economy that is growing slowly.  The equity market is ripe for at least a pause during the remaining summer months, if not a more significant correction.  Since our foremost obligation to our clients is protection of their capital, we have lately been moving to a more defensive posture for the intermediate term.

June Monthly Letter

Following a 6.6% decline during May, the Standard & Poors 500 Stock Index enjoyed a 6.9% recovery during June.  In our May letter, we noted that without exception, every one of our portfolio holdings met or exceeded their targets for first quarter revenues and profits, as forecast by a broad consensus of Wall Street analysts.  Accordingly, despite the widespread decline, we made no changes in our positions, for which we were rewarded as the Index rebounded to an all-time high at the end of June.  

The second quarter is now complete, and during the next few weeks, corporations will report their Q2:19 results.  Because a number of data releases during recent weeks have pointed to a slowdown in the entire global economy, including the U.S., we do not expect particularly robust results, but there are already a few signs that the U.S. and other major economies are bottoming out.  Accordingly, revenue and profit results in the second half of 2019 should see an improvement, and overall valuations seem reasonable especially in light of the current level of interest rates.  More important, our holdings encompass the fastest growing sectors of the U.S. economy, including technology, healthcare, social networking, etc.  In the meantime, as we have discussed previously, the financial markets will continue to be volatile, as investors must contend with a raft of geopolitical factors, including the tariff wars with China and the EU, plus the cockeyed proposals being put forth by candidates for the Democratic nomination for president.  In addition, there are the ongoing tensions with Iran and North Korea, and the likelihood of a "hard Brexit," as well as the crisis on our southern border.

Nevertheless, investors should bear in mind the remarkable ability of our major corporations to adjust and adapt to these distractions, and the continuous evolution of technological advances that continue to create new and significant investment opportunities.  We remain highly convinced of the profitability and growth potential for our major holdings and expect no significant changes in our portfolios over the months ahead.  Needless to say, if circumstances warrant, we will communicate our thinking promptly to all clients.

March Quarter Investor Letter

We continue to believe that equities are reasonably valued and will likely provide worthwhile returns in 2019, but the near-term outlook calls for a healthy dose of caution.  After a 14% decline in the S&P 500 during the fourth quarter of 2018 left stocks deeply oversold, the 12% rally in the first quarter has rendered equities somewhat overbought.  Consequently, a consolidation/correction within the bull market should not surprise any investor.

Several factors are at play here.  First, there is no doubt that GDP growth in the March quarter was sharply below the 2.2% gain at the end of last year.  The abrupt slowdown in the quarter reflects the government shutdown, severe winter weather, weakness among most of our trading partners in Europe and Asia, the roughly 7% year over year increase in the exchange value of the Dollar, as well as some typical quirks in first quarter seasonal adjustments.  As a result, corporate earnings are likely to be disappointing at best.  Moreover, palpable fear that the economy is headed for a recession has resulted from the recent inversion, albeit modest, in the 3-year/10-year Treasury yield curve.  Historically, inversions, with short-term rates rising above longer-dated yields, have presaged recessions, often with very long lags, but not always.  More important, however, it is a credit crunch, not a curve inversion per se, that brings on a recession.  There is no sign of one, now or on the horizon.  It is our view that, while growth will slow, no recession is likely this year and probably not even in 2020.  Long-term bond yields are under pressure because there has been a flight to safety as yields abroad, particularly in Germany and Japan are negative, and inflation is "missing in action." Also, the Federal Reserve has indicated that there will be no increase in the Federal Funds rate this year, and perhaps not even in 2020.  The futures markets are actually predicting there will be at least one rate reduction this year.

Regardless of these factors, in the past couple of weeks there has been an injection of fear in the minds of investors, who see sluggish retail sales, flat to lower industrial production, soft commodity prices (ex-oil) and an overall decline in interest rates.  They are moving to realize some profits from the strong March quarter rally.  Price moves in individual stocks are volatile and exaggerated because of the thin trading markets as well as the activities of algorithmic traders and ETFs, about which we have written frequently in the past.  Layered on top of the various fundamental factors are concerns regarding the slow progress of a trade deal with China, the chaos emanating from the Brexit efforts, and the often absurd and outrageous policies of taxation, regulation and spending put forth by various candidates for the Democratic presidential nomination.

Nevertheless, there are now a growing number of data points that suggest economic growth will pick up beginning in the June quarter.  We still believe that overall S&P 500 profits can reach $170, which suggests a forward price/earnings multiple of 16 and an earnings yield of more than 6% compared with roughly 4.8% for current BBB bonds.  As long as there are no serious, cycle-ending imbalances in the economy, and as long as the labor force continues modest growth without triggering wage-push inflation, and there is some improvement in productivity, a modest rise in corporate earnings should support higher equity prices.  In short, the next couple of months may be volatile and difficult, but for the year as a whole, we expect worthwhile returns from equities.

February Letter

Over the past few months, it has become abundantly clear that the U.S. economy is slowing down.  It took much too long for Fed Chairman Powell and most of his fellow FOMC members to see the contemporaneous data that most of us on Wall Street had been observing for weeks.  GDP growth this year is likely to be about 2% (+/-), whereas growth last year came in at about 3%.  The second half of this year is likely to be stronger than the first.  Inflation remains at less than 2%, even as employment and wages continue to rise at a modest pace.  The benefits of globalization, technological advances and many intensely competitive on line retail markets are all keeping a lid on pricing power.  Moreover, money supply growth and bank lending are proceeding at non-inflationary rates.  Corporate profits rose about 20% last year, benefiting significantly from the reduction in the corporate tax rate.  In the context of a 2% growth rate economy, profits this year are likely to advance at less than a double digit pace.  Nevertheless, we continue to expect that S&P 500 earnings will reach $170 this year.  At 2800, the Index is valuing this outcome at 16.5 times, for an earnings yield of 6.1%, still significantly above corporate bond yields.

At this writing, the S&P 500 has advanced 11.1% since the beginning of the year.  While this is outwardly a very large number, bear in mind that stock prices declined by 14% in the fourth quarter of 2018, before the FOMC came to its senses and reversed its policy of monetary tightening.  As we noted last month, market volatility is likely to remain high.  We expect to take advantage of price corrections to initiate or add to positions in well situated companies.

As always, there are risks to any forecast.  We believe there is little chance that the US economy will overheat any time soon, which would bring forth a tighter monetary policy.  On the contrary, the risks to growth stem largely from international and geopolitical factors, all of which are well known.  We do keep an eye on the strength of the US Dollar, as it affects both our exports and the translation of foreign-source earnings.  Growth in Europe has slowed to a crawl.  Growth in China also continues to come down.  China is now using both fiscal and monetary stimulus to increase its growth rate.  The ECB continues to pursue an accomodative monetary policy, as does the Bank of Japan.  If a trade deal with China is not soon forthcoming, and if the Administration raises tariffs sharply against not only Chinese imports but also those from the European Union, then all bets are off, and our forecast and our investment strategy will change dramatically to a maximum defensive posture.

To Our Valued Clients and Friends

To say that 2018 ended on a miserable note would be the understatement of the century. The economy grew at roughly a 3% rate. Corporate profits rose in excess of 20%. Employment and wages had solid gains. Inflation was barely evident. Interest rates remained extremely low. Indeed, real interest rates were nearly zero. Admittedly, there was a mild reduction in excess liquidity, but that had been ongoing well before the collapse of stock prices in the 4th quarter. December was the worst year-end month for equities since 1931. Because 85% of trading volume is accounted for by algorithmic traders and ETFs the price moves have been magnified way out of proportion to economic and corporate fundamentals.

What happened? In a word: INCOMPETENCE. Incompetence at many levels of government, particularly the White House, the do-nothing Congress, and the Federal Reserve Board for starters. Trump and his misguided advisors started an unwinnable trade war with China, whose economic growth has now slowed enough to ignite a global economic slowdown from which the U.S. is not immune. In the meantime the Fed, which has raised the Federal Funds rate 9 times since 2015, seems oblivious to the disinflationary structural changes in the economy over the past decade and appears unaware that the economy is already slowing due to the lagged effect of its policy. One or two more rate hikes in 2019 plus its autopilot shrinking of its balance sheet could well tip the economy into recession. Together these two issues have terrified investors all over the world.

However, we strongly believe there will not be a recession in 2019. GDP growth will fall below 2%, but corporate profits should rise at a single digit pace, even without the incremental benefit of the 2017 corporate tax cut. A number of high growth sectors, many technology based, will increase earnings at double digit rates. Overall, equity valuations in the aggregate have fallen from about 18 times forward estimates to less than 14 times, implying a forward earnings yield in excess of 7.0 %, which is nearly 3% higher than the BBB bond yield. Indeed, numerous well situated, high quality equities are now valued at between 5 and 10 times profits. Once the fear among investors abates, today’s equity prices will be seen to offer the best opportunity in many years.

For that to happen, however, the misguided policy of the Fed must change, and the trade war with China must end. Until investors see daylight on these two issues, stocks will languish around current levels. That said, the worst of the sell-off will be over once tax loss-motivated selling ends and ETF outflows taper off. December 31st cannot come soon enough for all of us.

We are ending the year with large cash balances in our clients’ accounts, minimized tax liabilities, a group of undervalued core holdings, and a strong degree of caution and patience. We will commit cash reserves carefully as the macro- and political backdrops begin to show improvement.

There are 21 examples in recent history in which violent sell-offs not followed by a recession have quickly led to extremely large price rebounds. We thank each of our clients for their forbearance during this most difficult period. We have high conviction that 2019 will be a year of significant financial rewards.