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Quarterly Letter to Clients
Indices at quarter-end (September 30, 2022):
Dow Jones Industrials: 28,725.51 3Q'22 -6.66% YTD -20.41%
Standard & Poor's 500: 3,585.62 3Q'22 -5.28% YTD -24.77%
I apologize for this report being a little late. We were struck by hurricane Ian, and I was unable to work for several days. Our house sustained only minimal damage, but we had no power or water. We were lucky to have been able to stay in a very comfortable hotel for a week. Then we returned to Connecticut until the power was restored.
In my letter of June 30, I said that stocks were likely to continue to fall. In July and August stocks advanced by 20% in what was (now in hindsight) apparently a summer rally. I felt a bit humbled, and regretted making a public prediction. If you are in this business you must make predictions, but you don’t have to share them with the world. It can be, and often is, embarrassing. By September, though, stocks resumed their fall, with a vengeance.
The war in the Ukraine has not ended and has perhaps heated up; inflation is still at unacceptable levels; and interest rates, to my eye, need to go much higher in order to bring inflation down. If you were Jerome Powell would you want to be remembered as the Fed Chair that failed to control inflation? I expect him to do whatever is in his power to stabilize the dollar.
Stock prices, ultimately, are related to the earnings of their underlying companies. Rising rates, inflation, and a strong dollar all hurt earnings, and thus dampen prices. So it’s no surprise that stocks are down 25% this year. Or that bonds are having one of their worst showings in decades. We would certainly get a strong boost if the war reached a resolution.
For some time now my thinking has been along these lines: QE, (Quantative Easing) injected trillions of dollars into the economy, and that must be reversed (via QT—Quantative Tightening) if inflation is to be tamed. I don’t think that you can do that without causing a recession. And a recession will not be easy to induce, with employment full and so much of that pandemic cash still sloshing around.
Lately I have begun to think that maybe our inflation problem is a matter of comparison with year-ago numbers. Perhaps prices jump, then stabilize at that higher level. If that scenario comes to pass we might well be left with a Fed that overshoots; a Fed that continues to dampen the economy by raising rates and drawing money out.
Either way, we are looking at higher rates, lower earnings, lower P/Es, and probably a recession. The only solution is an unknown quantity of time and patience on the part of investors. And maybe a bit of luck.
This is not the worst bout of inflation in my adult lifetime, that honor goes to the late-1970s era. But this is pretty bad. Several of our inflationary periods were caused by shortages in the oil supply. This one is because of the “liquidity” (read: cash) that helped us to avoid a meltdown during the worst of the pandemic. Extra cash chasing fewer goods (due to supply constraints) equals higher prices for the same goods; the definition of inflation.
So we avoided a meltdown during the pandemic and now we must pay the piper. Maybe it will make you feel better to remember that inflation helps the government to repay its debts. It may also be some comfort to recall that after each bout of inflation the stock market resumed its march higher. The only question, again, is one of time; how long until this problem is solved, and will we have the patience to wait it out?
We won’t know when the bottom has been reached until that day is history. What we can do, and have done, is to prepare for the storm. We have significant cash balances which help to cushion the fall, and further give us a bit of psychological comfort. These funds will provide the ability to buy when things are so cheap that they cannot be ignored. Further, our investments are conservative in nature, and should rebound as the economy and the market recover.
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