Will Rates Sink the Market?

People are concerned about whether to remain invested in stocks & bonds hearing the Federal Reserve is seeing 3.4% inflation now and that they intend to keep interest rates low while continuing market stimulus. Fed Chairman Powell also said should the Fed’s forecast about inflation not be transitory they may have to raise interest rates earlier than 2024. Puzzled about what to do next, some analysts, particularly those in the “Value” investing camp, argue that stocks are overvalued if you apply Warren Buffett’s best economic indicator, the Market Cap to GDP ratio. Plotted it clearly shows market valuations are ahead of Gross National Product produced. The fallacy of this of course in this view is that GDP is projected to be 250% greater than normal coming off the pandemic even by the Fed’s guestimates.

“Growth” investors are fearful because current Price Earnings ratios (P/Es) of 35-40 clearly indicate prices are out of bounds. After all, the stock market is a leading indicator pricing in new information, so current prices already reflect post pandemic spending, full employment, and supply chains normalizing. If that is the case, then the Dow Jones and S&P500 indices are overbought, and it is likely they retreat from their highs unless earnings can support these high prices. This argument is completely true, but the factor not considered is certain sectors like financials and energy are below their historical valuations and small cap stocks just corrected by 20% on average.

The Modern Portfolio Theorists (MPT) using their discounted cash flow models which discount future cash flows (dividends) and terminal values of companies (capital appreciation) out in time (10 years into the future) recasting them in today’s dollars argue current S&P500 price and earnings indicate the S&P’s expected return is negative. This calculation assumes the market is an efficient pricing mechanism, that investors earn more in stocks because investors are being compensated for taking market risk, and that future growth rates can be forecast 10 years out into the future. Obviously if history is any teacher, they cannot with any great accuracy given technological change is now constant. That said, the market does usually revert to its long-term average return of @10%. The previous ten-year average, annual return has been 13.2% according to Goldman Sachs. However, given that the cost of capital has been held artificially low since the Great Financial Crisis of 2008- 2009, the index is not wildly overvalued by MPT metrics, though we could suffer a modest 15-20% correction to align with the long-term average again.

What do we think? As a Total Return manager working to keep money compounding, we favor growth at a reasonable price and believe many companies are overvalued. We agree with Benjamin Graham, the father of Value investing who famously said: “In the short run the market is a voting machine, but in the long run, a weighing machine”. We also long ago realized it was foolhardy to diversify and own a little bit of everything. We believe quality prevails in the long term. Mr. Buffett, Graham’s student at Columbia, recently opined in Berkshire’s annual shareholder letter that: “Diversification is a protection against ignorance,” arguing it is better to hand-pick companies than own them all. Of course, this message is in sharp opposition to advice he gives investors to own the S&P500 for the long term. He recommends owning the S&P500 because doing so keeps investment costs low and provides diversification or “event risk” protection if you cannot pick stocks.

Arguably most people do not have the financial know how, or don’t want to spend their time doing so. But Mr. Buffet’s S&P500 advice is not prudent and is directly at odds with the tenant of compounding, and indeed Value investing too, as it violates a principle of finance called the Time Value of Money—a dollar today is worth more than one in the future because you can invest it today and earn something on it. Value investors principal axiom is: Low Price = Value, but the equation is faulty. Value ≠ Low Price. To be true the inverse of an equation must be true. Stock prices of companies decline for real world reasons (accounting, management, pricing, competition, etc.). Meeting challenges to turnaround a company takes time, years in many cases, so Value investors often hold a lot of dead money. The real problem with buying and holding a market index however is you have zero risk management in place. Without risk management you do not just need diversification, you need careful asset allocation. The reason is because if you hold an index and your $100,000 falls to $50,000 in a market correction, you lost 50%, but to get back from $50,000 to $100,000 requires 100% return. That is, you lost money and probably 7-10 years’ time to get back even!

ProActive’s methodology was formulated years ago, and the core of our investment approach is to be a conviction investor. Do research to find the best opportunities and invest in companies with quality management, great franchises, and strong financial statements. We do not over-diversify and do not use fixed allocations and automatically rebalance back to some prescriptive mix based on risk tolerance. Instead, we strive to adapt to the changes in the markets. We diligently monitor account holdings seeking to improve our portfolios. But above all we take corrective action when we are wrong because the most important factor for successful financial outcomes is to keep money compounding. It takes skill, discipline, and patience to seize opportunity when it comes your way. Eventually panic causes people to throw out the good with the bad, or Momentum investors and Hedge funds sell to take short term profits in great companies.

Recently we had a correction in small company stocks and have taken advantage of it. We still hold some cash because we see many stocks with a greater margin of downside risk than upside opportunity. Cash held is emergency money as well as dry powder to buy into good companies at better prices. We hold some bonds as well but believe bonds will not be the haven of yesterday should increasing interest rates be the eventual trigger for the next market correction.

We don’t have a crystal ball. Our premise is that Central Banks, including our Federal Reserve, will keep stimulus spending and quantitative interventions going to thwart a near term market correction not wanting to additionally deal with dismal consumer confidence so near to coming out of the Covid pandemic and shutdown. We also believe the Fed is concerned about debt levels and their best long-term policy is a prolonged period of Financial Repression—letting inflation run 3-4% while keeping interest rates low to gradually tax fixed income holders with negative real returns (interest earned minus inflation = the real return). This was the policy adopted after World War 2 and is our most reasoned view of future Monetary policy. On the Fiscal or Tax policy side, Republican congressional leadership has pledged not to raise taxes. Democrats have made no such pledge and want to raise taxes as well as spending. Likely we will get more stimulus spending (an infrastructure bill) and an agreement on a G7, and maybe a G20, global minimum tax on corporations (15%) in the near term. Then just before the expiration of the Trump Tax Cuts and Jobs Act at year end 2025 (which incidentally cut business taxes, standardized personal deductions, and eliminated personal exemptions and state and local tax deductions) see changes that raise personal income taxes, or should Republicans win back control of Congress, further whittling away individual tax benefits like the Married Filing Jointly benefit and Child Tax Credits. But in our view, it is unlikely we will see any cooperation to raise taxes during the Biden tax years which will certainly exacerbate the need to do so later.

In summary, we continue to adhere to our investment discipline that has proven itself over time—the biggest element of it is keeping careful watch of money entrusted to us to manage. Certainly, history will record these years as an unprecedented time. We pray that our elected leaders will see the merit of working together for the common good our nation. Meanwhile, the US Dollar affords America tremendous advantages. We are blessed to have 70% of countries in the world using the dollar. It may not last forever, but in any near-term panic people rush to what they know and that is our currency. Thank you for your continued confidence. We are on watch and will take corrective action to your best advantage.