In the children’s book “Snow” by Uri Shulevitz, the story starts with gray skies and no precipitation. Then one snowflake falls. A child reacts excitedly – “it’s snowing!” - but an adult dismisses it as just one flake. Then there are two snowflakes, and then three. The child expresses delight but each time is told by an adult it is nothing and will melt. Even the news declares that there is no snow. Finally, the snowfall picks up, and the town is covered in snow.
There were flakes of inflation throughout the second quarter skies. Prices at both the consumer and producer level surged, in some cases by an amount not seen in decades. The Case-Shiller home price index rose 14.6% for the year ended April, the fastest growth since the measure was created in 1987. The median existing-home sales price rose 24% year over year in May. The story of rising prices has been playing out for months, and the adults at the Federal Reserve (the “Fed”), and many commentators, are dismissing it as “transitory.” Chairman Powell assures us that these rising prices are no big deal and that the Fed has the tools to manage inflation, even though it is reacting far later than it has in the past to such risks.
It is possible they are correct that this inflation is temporary. Supply bottlenecks resulting from labor shortages and other factors have thrown off the supply/demand equilibrium for various products and services. Contributing to this is pent-up demand that is being unleashed by an economic reopening and additional demand provided by stimulus checks and enhanced unemployment benefits. These factors will surely abate. But there has also been rapid expansion in the money supply. It’s impossible to know how much of the recent acceleration in prices is due to the transitory factors and how much is due to too much money in the system or other secular forces. It’s also hard to know to what degree such inflation may become embedded into people’s expectations, which is the real risk because a pervasive belief that prices will consistently rise perpetuates the problem, as employees routinely demand wage hikes, stores systematically raise prices, and so on. There has been upward pressure on wages recently, given the labor shortage. This may ebb to some extent as people come back into the labor force, but there may also be some contributors to the acceleration in wages that are more permanent in nature.
For what it’s worth, market-based measures of long-run inflation expectations are elevated but have recently come down a bit. This decline may have helped fuel the rotation in the second quarter back to the beloved growth stocks, which outpaced the value stocks by a significant margin for the three months, ending a two-quarter losing streak. While some of these growth companies have solid fundamentals – and we invest in a few - our sense is that many continue to be pushed to extreme levels by loose Fed policy, low long-term interest rates, and other factors.
We have always believed that investing is about positioning for the future, not grabbing onto what is working now or what is obvious now. This is especially relevant today, as market trades (bets on a group of stocks that rely on a certain condition or conditions being present) persist for a while but then, when conditions change, end suddenly and painfully for those in on the trade. In our view the low-interest rate/long-duration/growth trade has a poor risk-reward even with the outsized growth opportunity for many of its representatives, so we are largely avoiding it. Empirical Research Partners tells us that the quintile of the market whose performance is most correlated with the returns of Treasury Bonds is trading at a record high relative valuation. Conversely, the quintile of the market whose returns are least correlated with Treasury Bonds is priced at a near-record discount. The first list (the stocks most correlated with bonds, i.e., dependent on interest rates staying low) is replete with the growth darlings of recent years. The second list (the stocks least correlated with bonds) is full of more lowly-valued companies such as banks. Given the strong relative performance of the lowly-valued cohort from November through March, the fact that this valuation gap remains is remarkable.
For the low-interest rate/long-duration/growth trade to continue working, interest rates almost certainly need to stay low. We acknowledge that this is within the realm of possibility, but to us the strategy feels like picking up coins in front of a potential avalanche.
It was another quarter of positive returns for stocks, the fifth in a row, with the geometric (not compounded) average return for the S&P 500 above 11% for those five quarters, which of course is high. And this is on top of the strong returns in the 2010s. It’s been a tremendous run, and we believe it is important to keep expectations for future stock returns in general in check. The better that stocks have done in the last few years, the higher people’s expectations about future returns tend to go. But history and logic show that it should be the opposite. Long periods of strong returns are followed by long periods of disappointing returns. Of course, we don’t know in advance when the shift from strong to poor takes place, but we do have a general idea about future expected returns for stocks based on various valuation metrics. Stock returns for the next, say, ten years, are likely to be significantly below historical averages. With its support of the bond market the Fed has pulled stock returns forward; people currently are willing to pay a higher multiple on company earnings (another way of saying they are willing to accept lower future expected returns) because bonds and other savings instruments carry low expected returns as well.
It’s also important to remember that whether average compound annual returns for the next ten years are 5%, 2%, 0%, or -3%, there will be peaks and valleys. Returns won’t be nice and consistent. And people who are bullish and eager to buy stocks will be less so after the prices have been marked down by 20%. As always, our mindset is to generate the best returns for our clients over a long period of time, by taking risks when and where we believe it is appropriate and avoiding them where we believe the upside is not worth the risk.
