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Quarterly Letter to Clients
Indices at quarter-end (March 31, 2021):
Dow Jones Industrials: 32,981.55 1Q'21 +7.76% YTD +7.76%
Standard & Poor's 500: 3,972.89 1Q'21 +5.77% YTD +5.77%
Twelve months ago, a virus shut the world down and the stock market bottomed. Since that time, stocks have steadily pushed upward, based upon the anticipated re-opening of business. We finished the first quarter with the indices 10% above previous all-time highs. What comes next is the big question. There is an old axiom on Wall Street, “buy the rumor, sell the news,” which could also be read, “buy the hope (of re-opening), sell the reality.”
Except for those at the bottom of the economic spectrum, and, of course, those who suffered from the virus, the damage done to the nation’s business seems to be abating. There seems to be consensus that a full re-opening and "normalcy" is likely within the next 12 months at the outside.
The first quarter saw two significant changes in the market. First was the move up in interest rates, with the 10-year Treasury moving from 0.91% three months ago to about 1.7% as I write this. (Remember, rates go up, bond prices go down.)
It is noteworthy that as recently as August the rate was about 0.5%. The absolute numbers are small, yes—who wants to put out money for 10 years at 1.7%?—but still rates have more than tripled in the course of seven months.
The market prices of all bonds, not just Treasurys, were tamped down because of this move, but the more ominous implication is that of inflation, which I have discussed in prior letters, and which I feel has the most potential, over the longer term, to damage our financial lives.
The immediate psychological implications cannot be ignored. If you own bonds, you felt the hit in prices this past quarter. Fortunately our bonds have relatively short maturities, which helps to soften the decline, so our holdings did better than longer-dated bonds. Small comfort.
In my opinion, bonds are likely to be a drag on our portfolios for some time going forward, which is why I have bought approximately zero new bonds in the last 18 months. Even before that time my appetite for bonds was greatly diminished. At 1.7% for 10 years can you blame me?
I have been moving bond money gradually into income stocks, and I am not alone in moving from fixed income to equity. I am not particularly happy about this. The prices of such stocks have not languished. Bonds are supposed to offer a measure of safety that stocks lack. But I have also been around long enough to know that sometimes what is supposed to be just isn't. High-quality companies, with good dividends, are not likely to hurt us if we have patience. Bonds, though, are almost certain to fall in price over the coming years.
The prices of stocks are tied to interest rates, so perhaps you would expect the averages to fall. As I noted above, that did not happen. What happened instead was that the “hot” stocks cooled off, and the dowdy stocks led the markets up. This is the second significant change; the rotation out of the high-growth/high P/E companies into the more mature, lower-P/E stocks. Value stocks, long laggards, have come back strongly, and in the first quarter outpaced the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google).
At least in part that move is fueled by a desire for income. I cannot say that the “hot” names will lag for any long period, but I have always been cautious about buying at elevated metrics. As always, it is important to select companies selling at reasonable levels.
An additional threat to stock prices is the move to raise corporate taxes. Philosophically, I cannot argue. Why should I personally be paying nearly twice what major corporations pay? And should we not, as a nation, at least try to balance our spending with our income? Philosophy aside, if corporate taxes do go up, that means that earnings will be lower, and that usually means lower stock prices, and no one wants that. We have a conundrum.
There is a strong positive factor for stocks that we must note: the trillions of dollars dropped from heaven onto the masses below. That money certainly found it’s way into stocks, and the effect is not likely to disappear very quickly.
As mentioned, my biggest fear is inflation, which is not likely to be an immediate concern. Overall, I am positive on the economy going forward, though I recognize that stocks may well level off, or even decline. If that happens, well, I always have a “buy list”. Solid companies with decent dividends selling at reasonable prices—not too much to ask, is it? It is my constant hunt.
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