The pessimists have had plenty to talk about the last 18 months. Coming into 2023, the general consensus was that we were headed for recession, perhaps a nasty one, and that stock prices would remain under pressure. That hasn’t happened. If the Federal Reserve continues to raise the short-term interest rate, a nasty recession could still arrive. But it’s fair to say that the economy has handled the higher interest rates better than expected. We remain in difficult times, so before getting to Current Observations, let’s review the principles we’re following and how we do it.
Why We Follow Principles
- We do not believe the economy can be forecast with much precision. Covid was the ultimate example of this. Even the Federal Reserve, with over 400 Ph.D. economists on staff, was embarrassingly mistaken in its forecast of “transitory” inflation.
- Likewise, investment markets cannot be consistently timed. We’re therefore convinced that the most reliable way to capture the long-term return of stocks (over 10% annually) is to ride out their periodic price declines. In inflation-adjusted terms, stocks have outperformed bonds and cash by a wide margin – the math is powerful over time.
- Stock ownership is the only asset class that truly captures the upside of human ingenuity and creativity. We know that the engine of wealth building in stocks is the compounding effect and reinvested dividends. We must never unnecessarily interrupt that compounding.
- Individual investors historically have underperformed their own investments because they too often buy and sell based on emotions. As my long-term mentor, Nick Murray, says, “Stocks are returned to their rightful owners during bear markets.” Never forget that, for every pessimist/seller, there is an optimist/buyer for the stock trading hands.
- We believe in continuously acting on a rational plan versus reacting to current events. If we are reacting, it most likely means that our emotions are involved. Unless our goals have changed, there is generally little reason to make significant changes to our investments.
- The historical data underscores my conviction that the essential challenge to long-term successful investing is not intellectual, but temperamental. It is how one reacts, or chooses not to react, to stock market moves that ultimately determines our failure or success as an investor.
How We Do It
- Planning. You and I are long-term, goal-focused, planning-driven investors. The best way to stay focused on the long-term is to formulate a detailed financial plan and to build diversified investment portfolios that match the goals set forth in our plans. We do not develop portfolios – or go to cash – based on headlines, what’s “hot”, market movements, or some pundit’s view of the economy. Planning helps us remember that short-term price movements in markets are irrelevant to our long-term goals.
- Diversify. We diversify by investing in a variety of stocks that generally include small and mid-sized companies, foreign companies, bonds, real estate, and commodities. Diversified portfolios have been challenged at times since Covid arrived, but historically diversification has been very effective because it helps us stay invested by smoothing out the highs and the lows of investment markets.
- Cash and bonds for short-term goals. We always make sure that we have enough cash (and bonds) for near-term expenses not covered by other (retirement) income. This helps us ride out the periodic stock market declines.
Current Observations
- The recent rise in stock prices since last October has been a pleasant surprise. However, it has not been a broad-based rally. The large gains have mainly been concentrated in eight mega-cap technology stocks that investors believe will benefit from artificial intelligence. The NASDAQ index rose 32.7% in the first six months of the year while the Dow Jones Industrial Average rose only 3.8%.
- Beginning in mid-June, however, the rally began to broaden. Potentially, this could be a very positive sign. Strong bull markets are generally not sustainable when only led by a small handful of companies.
- All eyes remain on the Federal Reserve and whether they continue to increase the short-term interest rate. Inflation is clearly coming down, but the Fed continues its “hawkish” tone that they will keep at this until they feel that they’ve won the fight on inflation.
- Here is a chart that should be getting more notice. It shows the 6-month annualized consumer price index (CPI) with and without shelter prices. According to Scott Grannis (and others), shelter prices lag the reality of the housing market by around 18 months – and shelter prices have been a huge driver of inflation over the last two years. If we strip out shelter prices, CPI is down to less than one percent (on this 6-month annualized basis). Yet, the Fed seems overly focused on the labor market as the principal driver of inflation. If we can get inflation down and raise wages without throwing people out of work, what’s not to like? So far, that doesn’t appear to be the thinking at the Fed.
- The S&P 500 index dropped from 4766 to 3839 in 2022. That’s a drop of 19.4%. Further, the index bottomed out on October 14th at 3,583 for a drop of 24.8%. However, the companies in the index increased their dividend payout ratio by a whopping 15.4% last year.[1] In other words, 2022 was a fantastic year to reinvest dividends! – a high dividend payout ratio while stock prices were depressed. If you ever doubt the ability of stocks to fight inflation, keep this in mind: stocks in the index have, on average, increased their dividend payouts by 6.95% annually over the last 10 years. It’s a remarkably similar number over 20 years at 6.93%.
- Earnings in the S&P 500 companies declined 2.8% in the first quarter. If we consider that, going into first-quarter earnings season, estimates were calling for a decline over 7%, the first quarter was an unqualified success. Companies are navigating the inflationary environment better than expected. Earnings reports for the second quarter start this week.
- Compared to large companies, small and mid-sized companies continue to trade at very low “P/E multiples”. A “P/E multiple” is simply the price of the stock divided by the estimated earnings for the next year. Normally, small and mid-sized companies trade at a higher P/E given their ability to grow faster because investors are willing to pay more for that potential growth. According to Yardeni Reseseach, large companies are trading at a 19.0 P/E while small companies are at 13.2 and mid-sized companies are at 13.6.[1] I can’t tell whether it’s a buy signal from God, but I think it’s safe to say that this should eventually correct. And when it does, we could see a powerful rally in small and mid-sized companies.
- We’re not hearing much about the health of banks lately. I still consider this to be a concern. But apparently merger and acquisition activity has picked up in the banking sector, and some experts are saying this should help firm up the weak areas of the banking system. Let’s hope they’re correct.
- There has been much concern about how the U.S. economy will run out of steam once the government “stimulus” funds are spent by consumers. Well, maybe not so fast. I read an interesting piece from Yardeni Research discussing the amount of net worth owned by generation. The Baby Boomers own almost $75 trillion (with a T) of net worth, which is over half of the net worth in the U.S….and they are just starting to spend it. The Boomers are not the frugal Silent Generation. The net worth owned by the Boomers dwarfs the excess savings of roughly $0.5 trillion that remain from the pandemic.
Bottom Line: A “soft” landing in markets looks more likely, but the Fed could still spoil the recovery if they remain aggressive on rate hikes. In the meantime, stay patient, stay disciplined, and stay invested.
