Quarterly Letter

October 2021 – Quarterly Letter

By November 2, 2021 No Comments

November 3rd, 2021

Market performance over the last three months was a bit choppy. After peaking at 4,536, the S&P 500 fell to 4,300 before recovering to new all-time highs. This marks the third time the S&P 500 has dropped between five and ten percent since the market bottomed on March 23rd, 2020. Since then, the S&P 500 is up almost 100%. For 2021, the S&P 500 is up 22%. Over the last ten years, the market has increased a remarkable 14% annually.

The forward price-to-earnings ratio of the S&P 500 has come down a bit over the last year. It currently sits at 22, down from 24 this time last year. 22 times earnings has been a rich valuation throughout most of history. During periods of low interest rates, you could still achieve a solid return from valuations in excess of 20. When interest rates are over five percent, a p/e ratio greater than twenty is a problem.

Interest rates are increasing this year, but they are starting from a historically low level. Only the most pessimistic fixed income analysts project long-term government interest rates to increase to three percent any time soon. The bond market is suggesting that inflation is a temporary issue. Long-term interest rates have not moved decidedly higher. If interest rates stay within their current range, we can project that valuations will also stay relatively stable. If people are willing to pay $60,000 per bitcoin, I’m comfortable projecting stable valuations for the world’s best companies.

Investors price the market based on the next twelve months’ earnings. The consensus estimate for 2022 is $220. For 2023, the consensus projects S&P 500 earnings to be $235. Using the current valuation of 22x earnings, the S&P 500 will be worth 4,800 at the end of this year and 5,240 at the end of next year. From the current level of 4,575, the S&P 500 should appreciate by 14% between now and the end of next year.

Despite concerns about higher taxes, supply chains, labor shortages, and the possibility that Evergrande of China could be the next Lehman brothers, stocks are up 40% over the last twelve months.

Evergrande is a Chinese real estate developer. It’s one of the largest real estate developers in the world. It has taken on a huge amount of debt that it seems unable to fully pay back. The initial concern was that the collapse of a company the size of Evergrande could lead to a Lehman-style credit crisis. Investors are looking past Evergrande based on the expectation that the Chinese government will bail it out.

The Chinese credit crisis is less likely to spread to the rest of the world. Relatively few investors outside of China have any exposure to their debt. The debt is mostly in the hands of local Chinese real estate buyers. The Chinese government will have to figure out who will absorb the losses, but a global credit crisis seems unlikely.

Supply chain and inflation concerns are most responsible for September’s mild pull-back in stocks. Since then, the market has soared 8% higher. Since the S&P 500 bottomed, the Baltic Dry Freight Index dropped 40%. The benchmark for overall freight prices dropped 10%. Lower shipping costs are resulting in higher profit margins which leads to unexpectedly strong earnings.

We are in a rare period when one party has control of both congressional houses and the presidency, but the size of the majority matters. The Democrats need unanimous support within their party to push their agenda over the finish line. Consensus building among 50 senators is next to impossible. Eventually, they’ll find a compromise budget that reflects some of their priorities, but not all. One policy priority that is struggling to gain any traction is tax increases.

Investors assumed that a Biden presidency would lead to sharply higher taxes. The initial proposal called for $2 trillion in new taxes. Approximately half of the revenue comes from higher corporate taxes. Higher corporate taxes would reverse a substantial portion of the cut from the Trump administration. Wall Street analysts factored higher corporate taxes into their earnings estimates for 2021 and 2022.

The Biden administration is struggling to find consensus. Moderate Democrats are resisting higher taxes and the Biden administration seems willing to hold off on tax increases to save the rest of their agenda. As is often the case, funding new spending from the deficit is politically easier than increasing taxes to pay for the new spending. Eliminating the risk of higher corporate taxes directly results in higher estimates for corporate earnings. Stocks are rallying as the probability of tax increases falls to near zero.

The risk is that too much deficit spending can lead to excess inflation. The first sign of trouble would come from a weakening dollar and rising interest rates. This would force the Federal Reserve to rapidly taper down the amount of quantitative easing, and potentially raise short-term interest rates. The market knows that quantitative easing will eventually end, and that interest rates will eventually increase. The question is whether the economy will be strong enough to sustain a recovery without the present stimulus.

As the recovery from COVID continues, fixed income is suffering through one of the worst years of the last two decades. Total returns on government bonds are negative. Prices of corporate bonds are down a couple percentage points, but the higher yields are leading to a slightly positive return. We tend to buy and hold fixed income positions. Generally, we earn at least as much as the yield to maturity at the time of purchase. Fixed income is a tool best used to stabilize a portfolio. It allows our clients to earn some return—generally around 4% each year while increasing the predictability of the portfolio’s return.

The primary investment objective for almost all our clients is growth. As the last few years have shown, there are few places where this growth is as achievable as the stock market.

Eric Barden, CFA