Back to Quarterly Letters

Back to Quarterly Letters || Previous Letter || Next Letter

Quarterly Letter to Clients

January, 2022

Indices at quarter-end (December 31, 2021):

Dow Jones Industrials: 36,338.30 4Q'21 +7.37% YTD +18.73%

Standard & Poor's 500: 4,766.18 4Q'21 +10.65% YTD +26.89%

You may wonder why I spend so much time discussing rates; the reason is because they affect the stock market so importantly. I know, this is pretty boring stuff, but bear with me. Rates and inflation are the factors that worry me at the moment. I am old enough to remember the period 1979-1981, when both soared, and it is not a fond memory. And now there's Covid.

This past year, especially, I have warned about inflation, and we are now seeing that particular dragon finding his roar. Briefly, for the last two years, the Fed has pumped money into the economy to the tune of $120 billion per month. (They accomplish this task by buying back government debt.) Now they will begin to "taper," which does not mean they are stopping the flow, but rather that they will reduce the amount of money they push into the economy. Initially they planned to reduce the stimulus by $15 billion per month, going from $120B to $105B to 90B, and so on, reaching neutral around July of 2022.

But now they have decided that inflation is more of a problem than they thought, and they are accelerating the taper so that the stimulus will end by March. Once they have finally stopped the flow of cash, they will begin to raise rates, and the current expectation is that, starting in March, they will lift rates three times during 2022, by 0.25% each time. Raising rates is the Fed's first line against inflation.

In my view, it will not be quite enough, and I expect rates to continue to rise for a couple of years (not necessarily in a straight line). I would not be at all surprised to see rates on an upward trajectory for a more extended time period.

I further expect that in order to control inflation they will have to begin pulling money out of the economy, and that is when the real pain may begin to show. If they (meaning we) are lucky, inflation will be dampened, leaving prices at an elevated level, and the pain will be minimal. If not so lucky, the economy will contract and prices will remain high and climbing. It may take a bit of magic, but perhaps there is a rabbit in the hat, and maybe they can control inflation without constricting the economy. Given the current robust conditions, it is not unreasonable to hope that they can accomplish that feat.

Covid, interest rates and inflation worries notwithstanding, stocks were strong during the year, with only a bit of softness as the calendar turned. Valuations do seem stretched.

A good friend works at a foreign company that provides a service called "buy now, pay later" or BNPL. There are a number of new firms with similar offerings. They contract with merchants, who are paid in full, and these companies collect in four payments from the buyers. We can have a discussion about how this differs from conventional credit cards, but suffice it to say that the public companies involved in this space have attracted quite a bit of attention. One of them is named Affirm, and I had a conversation with my friend about that company's stock price. My position is that the price is not attached to reality.

Affirm is not alone in being grossly over-valued in the market today. Leaf through ValueLine and you will notice that many of the "hot" stocks of the day have a price-earnings number that is shown as "NMF"--not meaningful. Earnings are non-existent.

Maybe I am just too old. I don't mind buying young companies that do not yet have earnings, but I am sensitive to the price that I might pay. I like to see a logical, attainable path to a level of profitability that justifies the investment.

Affirm was $157 on the day that we had that discussion, and traded recently under $100. But even at that price buyers are discounting the future out past my probable life span. You can find more than a few other companies selling at such extreme valuations.

So I doze at my desk and fail to match the market's performance, at least in years like this. It is in the down years when I make my bones, when quality, earnings and dividends become paramount.

When you have something to lose, meaning a lifetime's accumulation of wealth, you do not have the stomach to venture into NMF valuations. Logic may not enter into the equation, until markets start to fall. That is when logic and hard numbers become important.

Holding on to your money is just as hard as making it. We know that the market will fluctuate, we expect it. The best that we can do is to try to find solid companies selling at reasonable prices. If we buy today and the market goes down tomorrow, will we remember that fact five years from now?

I wish you a happy and healthy New Year.

Jim Pappas