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Partners in Building Wealth

Investing In Face of Uncertainty

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Fourteen years of low interest rates and a higher stock market lulled investors into believing any downturn in the market would just be a blip on the screen.  That is, until this year.  A generation of investors have never seen a true bear market or negative returns for an extended period of time.

Market declines are humbling.  Stocks and bonds both fell at once in the first five months of this year,  which is not the norm. It makes some sense after the strength in both markets over the past ten years and the appetite for risk as the markets moved higher.  Stocks especially were the only game in town until this year because returns were so low from the alternatives, including bonds.

The S&P 500 ended 2021 on a high note, increasing 28% for the year. This followed stellar stock returns in 2019 ( 29% ) and 2020 ( 18%).  In 2019 globalization meant competitive prices around the world while new technologies thrived, allowing corporate America to operate more efficiently.  We were worried about continued deflation then and very low interest rates drove investors to take risk.  The dividend yield on the S&P 500 matched the yield on the 10-year Treasury, driving investors to stocks and long-term bonds in a hunt for return.

Fast forward to today. Inflation is real.  Food prices and prices at the pump, to name a few, are higher than seen in decades. Supply shortages from the war in Ukraine and the closed economy in China linger on. China is beginning to resume normal activity, but resolution of the significant supply interruptions is not imminent, even as China opens its economy. There will be a rush to ship goods and the ports will be jammed for some time.

Covid surfaced out of nowhere in early 2020 and the US economy was shut down.  Governments pumped trillions of dollars into the economy and this stimulus money, together with vaccinations, prevented a deep and long-lasting recession. This left US consumers with strong balance sheets, plenty of cash,  low levels of debt , and a pent-up desire to spend.  Demand for goods and services has been strong, while supply has been limited.  The lack of Russian oil in the markets has helped fuel inflation at the gas pump.  Strong demand in the face of limited supply resulted in inflation of over 8%.

This is not the 1970s when mortgage rates were at 13%. 30-year mortgages today are 5.27% and clearly not at double digit levels. Signs of a slowing housing market are evident, but the job market is strong, with unemployment near the lowest level since 1969! Wages are rising and 11.4 million job openings are hard to fill.

The Federal Reserve is committed to fighting the inflation battle, causing fears they will go too far, and  our economy will be thrown into recession. This fear of recession, the uncertainty around China, the war in Ukraine and persistent inflation are enough to drive the stock market lower, especially coming off such strong years.  The bond market is responding to the Federal Reserve’s announced move to raise rates.

We will have to live with these numerous uncertainties while the current situation lingers. These are clearly strange times, and it is impossible to know when the global issues will be resolved or if the Fed, in the fight to tame inflation, goes too far, resulting in recession.

Investors are understandably more negative ( or bearish ) than they have been in some time.  The S&P 500 is down 13% this year through the end of May while the bond market is off 9% – a perfect storm!

The Stock Market

The price/earnings ratio of the S&P 500 at the end of 2021 was 21x, at the very high end of historical levels and reason alone for the market to pull back.  Today, the relationship between earnings and prices is much more reasonable, at 16x. Unprofitable companies have imploded, with some down as much as 50%.  Small company stocks are down more than large stocks and value has outperformed growth.

Investor sentiment is very negative, and earnings expectations may still need to come down.  Analysts expect earnings on the S&P 500 to grow 9% in 2022.  Companies like Target, Costco, and Walmart as well as some industrial companies are feeling the pinch.  Their costs are rising, including employment costs, and they have yet to pass along these increases to the consumer.  The end result is lower profit margins.

There has also been a shift in consumer behavior, away from more profitable  goods such as bicycles to more lower margin staples, such as food. This is especially true at the low end of the economic spectrum. This reallocation of spending will continue until inflation is lower and will result in reduced expectations for some companies and sectors.  Companies that can raise prices to offset their higher costs will be in favor until inflation subsided. However, stocks of high-quality companies that already reflect this increased profit risk and have fallen more than is warranted are attractive. Double digit market declines offer opportunity as well as risk.

Our view is that this fear is a crowded trade!  Yes, the market may have a few more months of this volatility and maybe another leg down.  When things get this negative, the risk is good news sends the market higher, leaving worried investors with too much cash in the dust! At some point in the not-too-distant future all the bad news will be priced in the market and any sliver of hope will send stock prices higher. Long-term investors need to take advantage of lower stock prices and appreciate the chance to buy quality companies at attractive valuations.  This has not been the case the past three years.

A diversified stock portfolio of quality companies, bought at an attractive price,  will do fine over time.  Investors who loaded up on high risk, emerging companies with no earnings or cash flow have been burned and it may take some time for them to come back to stocks.

There has been a shift away from companies that promise returns in the future to those that provide returns today.  Dividends matter, especially for retired investors.

Stocks can move lower, but there is no loss unless they are sold. And … we know that the stock market recovers even from the steepest declines. How low this market goes or when it recovers is not known.  We are a long way from the excessive valuations of 2021 and many quality companies are at attractive prices. Don’t be afraid to take a longer-term view and find well-priced quality companies worth owning for years.

Warren Buffet said “ Price is what you pay.  Value is what you get”. Double digit market declines offer a rare opportunity to buy strong companies at a fair value and good price.  Don’t let fear and uncertainty get in the way.