The Financial Advocate: Winter 2022
As we began the New Year, markets have been over-whelmed by an obsession with “price discovery.” The issue at hand is best characterized by several questions:
- What are securities worth when the Federal Reserve shifts from exceedingly accommodative to restrictive policies?
- What does inflation do to the price of securities?
- How do increases in interest rates change the value of my investments?
As you can see, “PRICE” is the issue at hand. At VWM, we seek to profit from investments in companies that are best characterized as high-quality, well-run businesses. We believe that in the long-term, this perspective will reward our investors. However, in the short term, the questions we just mentioned are changing the lens through which many view these securities (and many, many others). That is causing an uptick in volatility.
The US is the most dynamic economy in the world. It is the creator of new industries and cutting-edge tech-nologies. For the most part, we are limited only by our own creativity. As such, our economy is dominated by technology. For clarity, between communications, e-commerce, and information technology, the S&P 500 is approximately 40% “tech.” Tech moves our markets. By comparison, Europe has about 15% in this category. Other markets have even lower representations.
Consider these examples. Agriculture has “gone tech.” Deere openly calls itself a “precision farming” com-pany. It uses software to maximize crop yields, minimize fertilizer waste, and even time crop planting cy-cles. Companies finding themselves short on labor are increasingly looking to add robots to supplement hu-man labor. Since robots are expensive, new companies are cropping up where you can rent your next human replacement. Don’t forget automated driving. In the years to come, the next 18-wheeler driver might be a robot! Just for emphasis, the military is increasingly technologically driven – think drones and pilotless air-craft. Truly amazing.
Why are we stressing this digital transformation of our lives? Let’s go back to John Deere & Co. When you make a tractor and sell it to a farmer, these dollars are transferred in real time. When you sell a farmer a pre-cision farming system to regulate irrigation, planting and fertilizing, your profits are now earned over the length of the contract – measured no longer as a one-time sale, rather in years. What does that mean to a company’s stock value? Dollars earned in the future are worth less than current dollars, especially when in-terest rates and inflation are rising. Why? Because those earnings have to be “discounted” by inflation and current interest rates. The higher the discount rate, the lower the value of those future earnings. Through the pandemic (and mostly since the Great Recession), the discount rate has been very low. In the first weeks of 2022, that rate is starting to drift higher.
Starting in the fall, Federal Reserve policy began shifting to a “tighter” posture. Read: higher interest rates to fight higher inflation. So, with this adjustment at the policy level, investors are now trying to “discover” the right price for all these new technologies and the income streams associated with them! As a result, the markets have had a rough period of high volatility as previous “growth darlings” are now old news and in-vestors want to be paid in current dollars, not “future growth.”
This price discovery phase is causing a rotation across sectors in the equity markets. We have discussed this in earlier newsletters, but let’s spend a moment on this phenomenon again. What industries have been largely left behind by technological advance of our economy? Oil, industrials, materials (think stone, iron ore, cop-per), most utilities, banks, and even consumer staples. (No one is revolutionizing corn flakes to our knowledge). Be-cause these products trade in current dollars, there is little risk of “future growth discounting.” If you look today for the top performing stocks of 2022 (this is a very, very short-term view), do you think you’ll find software, cloud compu-ting, artificial intelligence, robotics, electric vehicles, bio-tech or any other cutting-edge industry at the fore? No. In fact, most of these industries are being actively sold , lead-ing to declining stock index performance. Instead, you will find performance in mining, steel, banks (the brick and mor-tar kind), fossil fuels and yes…corn flakes!
It may be a valuable and profitable exercise to join the rotation… for a while… Then what happens? Since these truly old-world industries are rather mature, they can’t grow at attractive rates. So once their price is fully exploited, investors will … do what? They will turn back to the same growth companies they previous-ly sold! If you were lucky enough to catch the wave perfectly (impossible by every known standard), you would have sold your growth companies (paid taxes), bought the “old” industries, and watched them rise, then sold them (paid taxes again), then initiated positions in the growth favorites, so you can play the next rotation (to pay taxes again). Can you see the common theme here?
We would argue that you can tilt in the direction of current market favorites, but be mindful that true wealth is built over time by investing in great companies that grow year-after-year. That is exactly the current posi-tion of VWM’s managed portfolios. While not ignoring the current rotation, we will be very judicious to not sell long-term winners to “play” the current rotation. You did not hire us to “play” with your money; we will not lose track of the goal for our investors in wealth creation and risk mitigation.
We will close the portfolio discussion with a few comments about Federal Reserve policy. The Fed is begin-ning a tightening cycle. Monetary conditions were made extremely loose to combat the dislocations caused by COVID. It is time for the Fed to “normalize” its activities. This will mean slightly higher interest rates and more restrictive Fed policies. The goal will be to keep employment up while driving inflation down. We expect to be discussing the Fed for years to come. It will take a LONG time for policy to return to a “normal” stature.
When was the Fed last in a “normal” position? 2007! That’s right – the Fed has added unusual liquidity and market involvement since the Housing Crisis of 2008. That was 14 years ago. Our portfolio managers, two of whom were active during the hyper-inflation 1970’s, are able to add clarity and perspec-tive to manage Federal Reserve cycles. In essence, the Federal Reserve could not enter a tightening cycle unless…the economy was very strong! We do not fear the coming cycle that appears to be spooking most market participants. A strong economy will create profits. Profits drive stock prices. Stock prices drive wealth creation. We will manage this cycle as we have managed the ones that came before. Portfolio management is a process, not a destination.
Global Alpha: As the leading growth portfolio in our firm, Global Alpha has had a choppy start to the year. The portfolio has morphed to include a higher percentage of assets in traditional industries while strad-dling the fence with the growth industries of the future. There is no getting around the bull market in energy, industrials and materials as the world begins to reawaken after COVID. However, core growth industries will continue in software, cloud, semiconductors, biotech and the like. The portfolio has not gone on defense as we believe the economy remains in a growth cycle. The Fed and any potential slowdown of economic activi-ty will be watched carefully.
Global Balanced: There have been gradual adjustments to asset class and sector exposure in Global Balanced over the past quarter. As a result of the rising interest rate environment, the fixed income component of the portfolio is now centered on short-term bonds, adjustable / variable rate bonds, and inflation-adjusted Treasuries. In the alternatives space, we have been rewarded with increased exposure to commodities. Internation-al equities now focus on developed Europe and emerging mar-kets in Asia with the specific exclusion of China. On the do-mestic equities front, we have deemphasized tech and healthcare and broadened diversification into select energy, ma-terials, and real estate holdings.
Moderate Allocation: In the final quarter of 2021 we continued to trim equity positions that outran their fun-damentals. For taxable accounts we took losses in positions to offset gains where possible. We will reduce equity positions further if we observe a deterioration in the economic outlook. Fixed income investments re-main challenged by climbing interest rates as a result of increasing inflation. Therefore, we are holding more cash than usual and looking at non-traditional approaches to fixed income. For example, we recently initiated a position in a currency fund that benefits from a strengthening dollar. We will use increased volatility to look for new opportunities in high-quality companies that pay dividends. Additionally, we will take further actions in the portfolio’s fixed income holdings to mitigate rising interest rates if necessary.
*This is a new section to The Financial Advocate. Roger Klein has been writing on complex market topics for over 40 years. His readers have come to appreciate his concise descriptions and interpretations of com-plex financial topics. Below is an excerpt from his most recent client letter.
What are these negative returns in January telling us about the future? The answer is “nobody knows.” While 2021 was defined by economic recovery and amplifying inflationary pressures, 2022 is going to be defined by changing monetary policy. This shift is already underway as the Federal Reserve has begun to reduce its quantitative easing (QE). The Fed expects to end QE by March 2022. At its peak, the Fed was purchasing $80 billion of Treasury securities and $40 billion of mortgaged-backed-securities (MBS) each month.
The Fed expects to begin raising its target interest rate beginning in March. The big question on Wall Street is how many hikes will we see in 2022? Once again, nobody knows. The most common expectation is four or five rate hikes putting the year-end target interest rate in a range between 1.00% and 1.25%. We will be watching the behavior of interest rates, especially the shape of the yield curve. Nobody wants to see an in-version of the yield curve where short-term interest rates exceed long-term interest rates. Yield curve inver-sion is an early warning flag of recession.
Nobody is forecasting a recession. A target interest rate is beginning this monetary policy tightening phase at zero. The Fed is projecting that the target interest rate will be at 2.5% in the long-run. The current 10-year Treasury note yield is approximately 1.8%. We will be watching the path of these two key interest rates.
This quarter’s financial planning topic is “debt management and review.” With interest rates still low and likely to rise, now is an excellent time to evaluate the cost structure of your debt obligations. Talk to your financial planner about refi-nancing mortgages, consolidating debt, and potentially paying down different lines. It is also a good time to explore the availability of different lines of credit through various financial institutions.
As always, we appreciate your patronage and continued support. Stay warm!
Nick Ventura, CFP® CPWA® President / CEO