For the first quarter of 2022, returns on cash were far better than that for common stocks or for bonds. The Standard and Poor’s 500 Index was negative and the broad-based Bloomberg Aggregate Bond Index was even more negative. Our portfolios, in general, were down less than both asset classes, and for that, we can only thank our conservative disciplines that have served us well for over 42 years.
As we begin our second quarter, we have virtually no long-term bond exposure in portfolios. The simple fact that Federal Reserve’s Chairman Powell has announced an aggressive interest rate policy against inflation is enough of a sign that we have some rough sailing ahead. Our observations and analysis tell us that if the Fed acts according to plan, the trip will likely get a lot rougher than the market expects.
Higher interest rates affect the valuation for stocks, bonds, and real estate as well. Within these asset classes, valuation involves discounting future profits and other forms of income into a present value. Using a higher interest rate lowers the present value. For stocks, the valuation yardstick relates to the price-to-earnings ratio (P/E ratio) or current price-to-cash flow per share. Accordingly, if the Federal Reserve creates a bad bond market by sharply raising interest rates, we can expect rough sailing for the stock market as well. While we don’t yet have the answer to the question “How much is too much?”, we will soon get the answer through experience. We have some signs showing up in the Nasdaq where most of the high-priced growth stocks fell sharply. A drop in the prevailing price-to-earnings ratio will continue to affect these issues, and accordingly, we take the weakness in the Nasdaq as a serious indication of things to come.
We fear that the Fed may be treating the inflation problem incorrectly—we don’t agree that this inflation problem is coming from too much money chasing too few goods. Perhaps some of it might be, but we feel that the supply side shortages are COVID related, or more importantly, policy related. We can certainly attribute the price of oil to President Biden’s prohibition against drilling and the closing of pipelines. Our oil production drop of over 1 million barrels per day can clearly be attributed to these policy actions.
There are countless EPA regulations and restrictions placed on miners and agricultural producers that are affecting the prices of commodities, but are these rapidly rising commodity prices caused by too much money? Could it be government policies instead?
In discussing the problems of the shipping industry with a large bulk shipper, he was asked how the fuel efficiency mandates were affecting business. His answer was that all mandates will be met. How? …by running all the ships at half speed! It now takes much longer to get products to their destinations. In the meantime, shipping rates have increased. All transportation costs have increased because of fuel prices, but is this inflation caused by too much money chasing too few goods?
Throw a war into this mix and there will be more distortions to the supply chain. The worst signs are coming from government, where anti-business attitudes are clearly on display. Congress, on one hand, asks the oil companies to invest more into their business to increase oil production, while on the other hand warns them about having to cut prices to their customers. What kind of a business proposition is that? There seems to be a lack of understanding of free markets and capitalism in Washington. This is the root of most bad policies today, and the convoluted cause of our current inflation. In fighting inflation, we hope the Federal Reserve will come to realize this.
Looking forward, we can best describe our strategy as avoiding deep declines while looking for opportunity that may present itself because of policy changes or mistakes. Overall, we seem to be heading into a recession caused by the Fed’s interest rate policies. How fast and how hard the increases hit will give us an idea of how severe the slowdown will be. Fed policy is now our primary concern and will likely remain so for the coming quarter.
The election will move into focus by the end of the third quarter and hopefully the Fed induced recession will be in the rearview mirror by then.
This market correction represents opportunity for us. We simply must manage safely in the interim and gradually re-set our portfolios for the recovery which is out there somewhere. We thank you for your continued confidence.