General Principles

Last year was another good year for investors. The major U.S. stock indexes closed near record highs, but the story was more mixed under the surface. I thought it might be helpful to remember what guides us in our financial planning and investing decisions. As a reminder, here are the general principles you and I are following:

  • You and I are long-term, goal-focused, planning-driven investors. The best course is for us to formulate a detailed financial plan and to build diversified investment portfolios that match the goals in our plans. We do not develop portfolios based on headlines, what’s “hot”, market movements, or some pundit’s view of the economy.
  • Inflation is in the headlines, but stocks historically have been very effective against inflation. Let’s consider stocks starting in 1965. I don’t think we’re headed into this kind of inflation, but the historical comparison might be helpful – and please remember that this was one of the most difficult stretches for stocks in the modern era precisely because of inflation. Earnings per share in the S&P 500 Index were $5.30 in 1965. By 1981, the earnings per share had climbed to $15.18.[1] In words, S&P 500 earnings nearly tripled. Inflation was almost identical over the same period – up just over 3 times.[2] Then the roaring bull market of the 1980’s started, and stocks have trounced inflation ever since.
  • We understand that diversification means investing in a variety of stocks that include small and mid-sized companies, foreign companies – both developed and emerging markets, real estate, bonds, and sometimes commodities. Diversification typically works wonders by helping us stay invested because it smooths out the highs and the lows of investment markets.
  • We believe in continuously acting on a rational plan versus reacting to current events. Unless our goals have changed, there is generally little reason to make significant changes to our investments.
  • We do not believe the economy can be forecast with much precision. Covid was the ultimate example of this. Likewise, investment markets cannot be consistently timed. We’re therefore convinced that the most reliable way to capture the long-term return of stocks is to ride out their periodic drops in value.
  • There are dozens if not hundreds of benchmarks in the investment world. While benchmarking can be important to evaluate a particular fund or strategy, it can easily lead us astray when we compare one to a diversified portfolio – too many benchmarks would be needed. Regardless, the performance of our investment portfolios relative to any given benchmark over an arbitrary time period is ultimately irrelevant to our investment success. You can beat a benchmark but still go broke in retirement. The most important benchmark is our financial plan, which indicates whether we are on track to achieve our financial goals.
  • We always make sure that we have enough cash (and bonds) for near-term expenses not covered by other (retirement) income so that we can more easily ride out the periodic drops in stocks prices.

Current Observations

  • The U.S. economy continues to recover in dramatic fashion. Earnings estimates were continuously revised higher for U.S. companies as 2021 progressed. Frankly, we’ve never seen so many earnings surprises to the upside.
  • The government provided massive monetary and fiscal relief. Reasonable minds might differ on whether the federal government provided too much or the right amount of relief. But the bottom line is that a tremendous amount of money was injected into the economy, and this helped households and businesses navigate through the government shutdowns and the worst pandemic in 100 years.
  • Inflation is proving to be more than “transitory”, and the labor force participation rate remains stubbornly low. It remains to be seen if these trends persist. We now have, in effect, supply-side inflation, and we haven’t seen this since the 1970’s oil embargos. But there is good reason to believe management teams have considerably more control over the current supply problems than we than we did in the 1970s.
  • Inflation has been surprising to the high side, but there are reasons for optimism. First, companies are now spending huge amounts of money to improve productivity[3] – post-pandemic, it’s become clear that companies must innovate and evolve. If successful, this should offset inflation. Second, technology continues to evolve, even accelerating, and technology is inherently disinflationary. Third, we have a declining birth rate and an aging population. Contrast that with the 1970’s when the Baby Boomers came of age and created a large mismatch in supply and demand. These are powerful, structural reasons to believe that inflation will retreat in the next 12 to 24 months.
  • If inflation is as bad as some media outlets claim, then one might wonder why gold hasn’t moved higher, most commodities are off their highs (some significantly lower), bond yields remain stubbornly low, and the dollar remains strong. Speaking historically, these are not inflationary signs.
  • It appears that the tax proposals set forth by the new administration have lost support. Reasonable minds might again differ on whether we need changes to the tax code. As investors, however, some of the proposals that have lost support can be viewed as a positive.
  • Large U.S. stocks had quite a run in 2021, but small and mid-sized companies are now looking quite attractive. The price-earnings multiple for smaller companies has dropped below large companies, and this is unusual.[4] While this is not necessarily a criterion for investing – and it’s certainly not a prediction – diversified portfolios like ours with exposure to small and mid-sized stocks could benefit nicely in 2022.

2021 Overview

Overall, large U.S. companies performed very well in 2021 along with many “value” companies that had been beaten down in 2020. I’m not sure there is ever a “normal” market, but 2021 was certainly not normal given the virus and massive government stimulus. As an example, Macy’s was up 135.38% last year while Amazon struggled to stay positive and was only up 2.38%. Macy’s was thought to be destined for bankruptcy prior to Covid. Many in our industry are calling this the “reopening trade.”

Real estate and commodities also performed very well. Bonds were mixed to negative. And small and mid-sized growth stocks along with foreign stocks had a very tough year, especially late in 2021. We saw hot inflation readings come through late last year, and Omicron piled on by fueling fears that more lockdowns and labor shortages would continue to feed inflation.

The sentiment turned decidedly negative towards many of the smaller growth and foreign companies near year-end. At the risk of getting too technical, inflation that leads to higher interest rates can cause growth stock prices to decline because future earnings are discounted back to present value at a higher rate of interest…in other words, current valuations are less. At least that’s the consensus reason for the turbulence. And higher interest rates could mean higher borrowing costs for these companies. Lastly, I believe that there was a fair amount of selling at year-end for tax positioning, especially among the more innovative and disruptive growth companies that performed so well in 2020 but struggled in 2021.

I sense that many investors could be overreacting to the inflation data. Yes, the inflation readings have surprised to the high side, but traditional readings of other asset classes don’t indicate 1970’s style inflation at this time. Gold, bond yields, and most commodities as mentioned above have all recently been trending down or holding steady. I’ve been humbled by markets often enough to recognize that I could be wrong, but I believe that inflation should settle down as the data points turn more positive in 2022. Despite the recent negative sentiment, the fundamentals appear to be strong in the smaller, innovative growth positions we’re holding, and when sentiment and fundamentals detach, it usually represents opportunity.

Thank you for continued trust and confidence. I am available by phone if you would like to speak. We wish you and your family a Happy New Year!

[1] https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm
[2] See https://www.bls.gov/data/inflation_calculator.htm
[3] https://www.yardeni.com/pub/capspendind.pdf and https://www.economist.com/leaders/2021/05/27/firms-are-rediscovering-their-love-for-capex-good.
[4] https://www.yardeni.com/pub/stockmktperatio.pdf. See Figures 3 and 4.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
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