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Quarterly Letter to Clients

July, 2021

Indices at quarter-end (June 30, 2021):

Dow Jones Industrials: 34,502.51 2Q'21 +4.61% YTD +12.73%

Standard & Poor's 500: 4,297.50 2Q'21 +8.17% YTD +14.41%

Someone recently quipped that the analog version of bitcoin is the wooden nickel. I guess I am just an analog traveler in a digital world, but I am a skeptic when it comes to cryptocurrencies.

If not for several sharp moves in both directions, I might be tempted to say that the second quarter was a sleepy period. Stocks rose most of the quarter, hitting new highs, with the S&P and NASDAQ outpacing the Dow Jones. The 30 Dow stocks tapped the brakes the last couple of weeks. Bonds edged a little higher. It feels like a lot of people are waiting for the first shoe to drop, but the market is stubborn and why not? The economy is brisk. Overall, though, it does look and feel a bit “toppy” to me.

Interest rates had begun rising during the first quarter, but fell back during the second: the benchmark 10-year treasury bond moved from a yield of 1.7% back to 1.5% in rough terms. It is not just bonds that are affected by rates: there is an inverse relationship between interest rates and the stock market, which is not to be ignored.

Unemployment is in the area of 5.8%, historically not far above average, but more recently a tad high. Inflation has pushed up, as expected, and why that did not bring yields up is anyone’s guess. Perhaps it is just a matter of time. Most likely, the Street is waiting to see if the inflation figures will hold or are merely temporary.

The job of the Fed is to keep inflation within an acceptable range and to keep employment relatively full. They are in a tight spot at the moment, as they would like for unemployment to be about a percentage point lower, and must keep rates low to make that happen.

To that end they continue to pump money into the economy, which is inherently an inflationary act. It is a tightrope performance; which to choose, too much unemployment or too much inflation? Where’s Goldilocks when you need her?

Then again, perhaps they want higher inflation in order to more easily accommodate the massive debt incurred over the last 20 years.

In any event, at the moment, bonds promise poor returns, and stocks, while technically vulnerable to inflation, look like the only place where we might maintain our spending power. And don’t forget that all of that cash the Fed is pumping out eventually ends up in stocks.

Sometimes I save articles that I find interesting, and recently I looked at a few from the mid-1990s. It is surprising how relevant they are to today’s markets. P/E ratios were in the mid-20s, not much lower than they are today. The market was frothy, as it is today. There were a handful of tech stocks that led the market, and that sold at extreme multiples, just like today.

The Dow Jones closed 1995 at 5177, and recently touched 34,800, so that seems different. (That move equates to an annual gain of just under 8%.) Interest rates were about 6.5% for the 10-year treasury, while corporate bonds could be had to yield 8%, versus today’s very low single-digit figures. That’s a big change. It’s notable that high-quality bonds matched stock returns over that quarter-century. Don't count on that happening again.

Here is what is important: that 8% per year over 25 years masks periods of sharp declines, notably during the first 8 years of the new millennium. Think of it: even though one-third of that 25-year period was in decline, even though the market lost 25% during those 8 years, still we managed to post very attractive gains.

Yeah, I know, I am running out of 25-year periods. Man plans and God laughs, but still we plan.

The point is that you have to hold on, that all meaningful gain comes from time, and not from timing. Perhaps the next 25 years will not be as fruitful, or perhaps they will be even more generous to shareholders. We cannot know anything more than that there will be drama. But we can do what has always worked, invest and wait.

Jim Pappas