The difficulty lies not so much in developing new ideas as in escaping from old ones.
John Maynard Keynes
Our insights, reflections and musings on the most timely topics relevant to managing your investments.
What is the real rate of growth? GDP growth rebounded in the fourth quarter of 2021. After slowing to 2.3 percent in the third quarter, the initial reading for fourth quarter is 6.9 percent. Does that mean we are back to the solid growth of early 2021? It doesn’t feel that way.
After two big up years, the market has begun 2022 on a down note. This is how markets work: two steps forward and one step back. There is plenty to worry about, so what is an investor to do?
After a good year for the market, we seem to be ending on a sour note as the market has been mostly down this month going into the last week of trading. Will it continue or will we have a Santa rally? Only time will tell, but my money is on Santa pulling through.
The market today is much like army golf – covering a lot of ground but going nowhere. Why all the volatility? There have been many excuses given by the media, meanwhile we continue to get inflationary signals. Now that inflation is back, every other economic data point must be looked at in this light.
Inflation is a fact, and it is impacting everything from the cost of travel to the Thanksgiving dinner itself. The people impacted the most are those who were already barely making it inside their budget. Still, it is Thanksgiving, and even in a year with high prices there is still much for which to be thankful.
What is the real rate of growth? GDP growth rebounded in the 4th quarter of 2021. After slowing to 2.3 percent in the third quarter, the initial reading for 4th quarter is 6.9 percent. Does that mean we are back to the solid growth of earlier in 2021? It doesn’t feel that way.
While 6.9 percent seems like healthy growth, we must factor in that inflation is 7 percent. Also, when you average the 2.3 percent and 6.9 percent, the second half grew at 4.6 percent versus more than 6 for the first half. Is it any wonder that people do not feel as if the economy is doing well?
Factor into that 6.9 percent growth the fact that more than 4 percent of that was inventory-building, and the picture becomes a little clearer. What this tells us is that 3rd quarter was not really as bad as reported. However, most of the activity last quarter was simply companies getting their supply chains sorted, so it isn’t as good as it sounds. The 4.6 percent average is probably a good way of looking at it, realizing that there is a clear pattern of slowing growth.
On top of this, payroll provider ADP reported that its clients reduced their payroll by 300,000 jobs last month. The expectation was for a growth of 200,000 jobs. While they are among the largest in the industry, ADP is only one payroll provider, and their report does not always foretell the official government employment situation report. Still, this is not a good data point for the economy.
In contrast, corporate earnings have been largely positive, which should not be unexpected in an inflationary environment. It won’t be universal, but most companies will benefit, on paper anyway, from inflation. It makes revenues seems higher and can be a boost to nominal profits, if the expenses are paid before the revenues come. Of course, that isn’t real because next month’s expenses will be higher, but they aren’t in the reports.
Inflation often provides a small boost to demand as well. Those who can afford things have a little more urgency to make that purchase today, because if they wait then it will cost more in the future. All that does is move consumption from next month into this month, but as mentioned, “earlier next month” isn’t in a report. By the time they have to report on next month prices will be higher still, and we do this whole convoluted inflation dance all over again.
This puts the market in a quandary. Earnings will be strong, at least in nominal terms, while real growth continues to slow. Last week the market seemed focused on the poor state of the economy; this week they are focused on earnings. Next week? Who knows?
In the long term company earnings should win out, but in the short haul, markets are likely to be choppy. Careful selection is likely to be very important, remembering that we are investing in companies, not trading pieces of paper. (I know there is no more paper, but it still sounds better.) Many companies will benefit from this environment, and ultimately their stock price will reflect that reality.
Chuck Osborne, CFA
~What is Real?
After two big up years, the market has begun 2022 on a down note. This is how markets work: two steps forward and one step back.
There are indeed things to worry about: inflation being number one, with the cost of living is rising at the fastest rate since 1982 (although in 1982, inflation was heading in the other direction). Covid is not going away; Russia is about to invade Ukraine; and China’s economy is now growing at only 4 percent as economic freedom is losing out to communist rule.
There is plenty to worry about, so what is an investor to do? The first thing we have to do is remember what we are supposed to be doing. We don’t invest in politics, or even economies; we invest in companies – specific companies.
The reason prudent investing is always done from the bottom-up is because there is always something out there to worry about. The glass is always half empty, which means it is always half full. Inflation is high because demand is high, and companies are able to raise prices. While that is painful to consumers, it is good – or at least appears to be good – for company financial reports. I say appears to be good, because it isn’t real, it is simply inflation, but businesses will report higher earnings nonetheless. That will ultimately lead to higher stock prices.
Inflation has this effect for most businesses, which is part of what is driving the market. Underneath the surface what we are really seeing in the beginning of 2022 is a rotation out of the fast-growing technology stocks that have driven the market for a decade and into under-appreciated value stocks, such as financials and energy. Through Friday, January 14, the value indices – Russell 1000 Value and Russell 2000 Value, representing large and small companies respectively – are the only positive major domestic indices.
This transition really began towards the end of 2020, but markets do not move in straight lines. Mid-way through last year the old-guard technology stocks made a comeback, but the longer-term trend is still towards value. This bodes well for small company stocks, international stocks, and just about any area of the stock market that hasn’t participated in the last decade of growth.
Still, the overall direction thus far in 2022 is going the wrong way. One never knows exactly what the market will do, and it could continue this downward pressure for a while; however, we believe this is simply a rotation. It would not be surprising to see lower returns in 2022 than over the last few years, but we would be surprised if the market does not end the year in positive territory. Meanwhile, lower prices are an opportunity.
Two steps forward and one step back is the normal market rhythm. We never really like it when we take the step back, but look on the bright side: how many times have we been able to say “this is normal” over the last few years?
Chuck Osborne, CFA
~Two Steps Forward, One Step Back
After a good year for the market we seem to be ending on a sour note, as the market has been mostly down this month going into the last week of trading. Will it continue, or will we have a Santa rally? Only time will tell, but my money is on Santa pulling through.
It has been an odd year for markets. We began with great optimism as we were rapidly recovering from our reaction to the pandemic…then we hit the brakes. With an evenly split Congress, this administration somehow believed they had a mandate to be the most progressive in history. What people had asked for was an administration that would stay off of Twitter, be polite, and return to normalcy. We were literally sick and tired of big and bold; we wanted small and competent. That isn’t what we got.
The result is a supply chain nightmare and the highest inflation we have seen in nearly 40 years. In the stock market we began the year with value stocks and small company stocks leading the way after a lost decade; as GDP growth slowed this trend reversed, at least temporarily.
We have had a year without an official 10 percent correction, yet 98 percent of the S&P 500 companies have been down 10 percent or more at some point. Rotation has kept the index itself up. Other areas have corrected, including small company stocks.
We have recently been stuck in a range going up and down and up again. The latest leg has been down. Most of this simply seems like the investors are done for the year. This is not a commentary on 2022; it is simply a function of the market. Mutual funds are paying out significant capital gains after the market has rallied from the pandemic lows in the Spring of 2020. They must raise cash to do so, and this is forced trading. What losses investors have need to be realized by year-end to offset some of the last 18 months of gain.
This is what seems to be driving the market down, not any pessimistic view. As a result, one would think Santa is still coming. The market has gone down, now it is time to go back up. The real direction is flat. How will that change in 2022? I think we just have to wait and see, which is apparently what most other investors are doing.
Meanwhile, I know in my house, and I hope in yours, Santa is coming. Merry Christmas and Happy New Year!
Chuck Osborne, CFA
~Santa is Coming to Town
It is called army golf: Slice the drive to the right, find the ball; hook it way left, find the ball; slice it right…you get the picture. We call that playing army golf because it is just like marching in the army – left, left, left-right-left. That works marching in step with the rest of the platoon, but it is not so great on the golf course. You cover a lot of land without going anywhere.
That is where we are in the market today. Of course, in the stock market it isn’t left-right-left, it is up-down-up. Yet, for all the big moves from week to week, the truth is we are going nowhere. Actually, we are still heading up, just slowly. While the daily and weekly price movements have been dramatic, the trend is still upward.
Why all the volatility? There have been many excuses given by the media (that is their job, after all): The new omicron strain of COVID-19; the slow-down in economic growth; more supply chain fears. All of these things are real issues, but I suspect the reason is simpler than that. Most big investors are just not trading at the moment, and that leaves only fringe players making moves. This tends to exaggerate movements as there are not many people willing to take the other side of any particular trade. Historically this is where brokerage firms would step in with their proprietary trading desks, but that doesn’t happen now, so we get exaggerated moves.
Meanwhile we continue to get inflationary signals. This week we saw labor costs rising and productivity falling. There is nothing wrong with higher labor cost; that means people are making more money. However, what one wants to see is an increase in productivity, or at the very least no change in productivity – this means people are getting paid more and are making more stuff, which keeps inflation down while wages grow, which is what economists call real wage growth. Today, to the extent wages are growing, they are simply being dragged along by inflation. In fact, while workers may have a higher wage, they are losing ground to the cost of living. When wages go up and productivity goes down, we have more money chasing fewer goods…in other words, inflation.
Now that inflation is back, every other economic data point must be looked at in this light. With inflation at 6.2 percent, GDP must come in above that level in order for real growth to be taking place. Wages must grow beyond that level for anyone to actually get a real raise. This is what makes inflation so insidious. The nominal economic numbers will be inflated along with everything else, but in reality, we are going backwards.
From an investor’s perspective, inflation kills bonds and savings. Any return less than the rate of inflation is in reality a loss. Bonds can still play the role of reducing volatility in a diversified portfolio, but they will detract from the long-term return, not add to it. Savings get destroyed, since every day the actual purchasing power of one’s savings drops. Stocks are the hedge against inflation. This does not mean that there will be no volatility and stocks will just climb – that happens only in fantasies. Over time, however, corporate earnings will inflate right along with everything else. It could be real or it might be just because of inflation, but revenues will rise. This, in turn, will eventually be reflected in the stock price.
Ideally, we need policy-makers who were serious about tackling inflation. However, that would mean tightening money supply, reducing government spending, and perhaps most importantly, reforming government regulations that do little other than raise costs. We need Fed chiefs like Paul Volcker, who was nominated by Jimmy Carter. We need administrations who understand that less is more when it comes to government regulation, like Jimmy Carter, Ronald Reagan, and Bill Clinton. We need to once again allow economic reality to trump politics.
That is out of our control, however, so in the meantime we will focus on the hand we are dealt. We may be marching up and down, but the bull market is still intact, and stocks remain the best hedge against inflation.
Chuck Osborne, CFA
So, how do you cook your turkey? This year my sister-in-law and family are joining us for Thanksgiving. They have traditionally fried their turkey and offered to do so for our gathering. That was fine with me – I have had fried turkey only once, but it was tasty. I do have to admit that of all things Thanksgiving, the turkey is not high on my priority list, but it is for my brother-in-law and he was happy to fry away (and doing so clears our oven for other adventures), so that is what we will do this year.
I was explaining this to a client last week who is also a fan of the fried turkey. He, however, was trying something new this year – partly because it is fun to try something new, and partly because the peanut oil he uses to fry the turkey has become expensive. The day after we met, The Wall Street Journal ran an article about the high cost of cooking oil. Inflation is everywhere we look.
The latest reading of the consumer price index (CPI) came in at 6.2 percent, which is the highest rate of inflation in 31 years. It is not going to go away until the policy causing it goes away: That means interest rates have to be allowed to go up, and government must get spending under control. Those things were hard enough to accomplish in 1980, when people may have had political differences but at least agreed that facts are facts, and everyone has to live with the facts whether they like them or not.
Inflation is a fact, and it is impacting everything from the cost of travel to the Thanksgiving dinner itself. The people impacted the most are those who were already barely making it inside their budget. The unmistakable lesson of the government policy of the 1960’s was that it caused the malaise of the 1970’s. These fundamental relationships do not change; the only thing that has changed is that in our modern economy everything happens more quickly. In both periods we had policy designed to stimulate economic demand, with policy simultaneously aggressively attacking those who created supply. This combination has always produced horrible results everywhere and every time it has been tried.
What is an investor to do? The good news is that over the long haul, stocks are the best hedge against inflation. Who really gets hurt is the saver. Stable value options inside of retirement plans are now providing annualized investment results of approximately 2 percent; that is safe in that there will be no market volatility. However, with inflation now more than 6 percent, this means that same saver is losing 4 percent of purchasing power every year. That kind of annual bleeding will wreck many risk-averse savers.
There is more than one risk in investing, and it is often the less obvious ones that are actually the most dangerous.
Still, it is Thanksgiving, and even in a year with high prices there is still much for which to be thankful. In keeping with our tradition, here is my list:
I am thankful…
~ that my in-laws are paying for the cooking oil;
~ that we will be having a normal Thanksgiving in our home;
~ that the other schools in the ACC are really bad at football, thus Wake Forest made it to the top ten for the first time in school history;
~ that Wake Forest is currently undefeated in basketball while Carolina has already lost two games;
~ for my children, who are growing and learning in real – not virtual – classrooms;
~ for my family, immediate and extended;
~ for all of my friends; and
~ for Mama’s pumpkin cheesecake and my loose-fitting pants, which make enjoyment of said cheesecake possible.
~ Finally, I am thankful for you, our clients and friends. Your trust in Iron Capital is our greatest asset, and we value it every day of the year.
Chuck Osborne, CFA