February 2024

Be Careful What You Wish For

Christopher P. Lorenz

It seems apropos that Groundhog Day is here again and like the comical movie starring Bill Murray, I feel like we are replaying the same investment narrative over and over. Last year at this time I wrote about the plethora of economists, market pundits and strategists proclaiming the recession as a forgone conclusion. It’s a year later and the commentary hasn’t changed much. I’m still waiting for Chicken Little to run through my office proclaiming “the recession is coming; the recession is coming”! While the tiresome recession debate continues today, at least we can now look back at last year’s predictions and determine whose were accurate. Fact is, investors who positioned their portfolios for an immediate recession missed out on significant opportunities and sizable gains.

The economy continues to surprise many investors who had portfolios positioned for a recession and/or elevated inflation. The economy is very hard to predict more than six months out, yet the financial media obsesses about it and many investment firms try to position portfolios based on these long-range economic predictions. Last year showed how poorly economists and investment strategists are  at prognostication. This is why we choose to make our investments based on each company’s results and forecasts, as their track record is much better at predicting their results. We utilized those metrics  last year and outperformed many of the advisors that were predicting recession. Our hope is that our portfolio companies can perform well in any economic conditions with the understanding that there will be challenging periods that we will need to weather. As long-term investors it is very important that we avoid overreacting to every economic rumor, slowdown or growth period.

The market had a ferocious year-end rally as it became clear that inflation was hitting many of the Federal Reserve’s goals without doing significant damage to the economy. There are many theories of why that occurred, but I believe that much of the inflation came from a disruption of the supply chain aided by wage gains that help consumers pay higher prices. Many industries remained at recessionary levels last year, but some emerged from the slowdown and saw accelerated earnings. This reinforced my belief (shared by some other very smart portfolio managers) that we were living through a multi-year rolling recession, but not a full-blown downturn. Even in normal times the economic cycle impacts different industries at different times meaning that a well-diversified portfolio will have some investments that excel when others lag. Last year was a good example of that as faster growing companies did quite well and the slower growing, more defensive companies lagged.

We are currently in the middle of the fourth quarter corporate earnings season providing a real-time look at business strength and guidance for next year. 2022 and the first half of 2023 had negative earnings momentum, but that momentum has inflected upward. So far, Q4 2023 earnings are 6% higher than Q4 2022. More importantly, the businesses that were lagging are improving, and those who have already shown growth are sustaining that upward trend. In my opinion, Wall Street’s 12% annual earnings estimates for 2024 are overly optimistic because our current higher interest rates dampen economic growth. Meanwhile, economists and strategist forecasting a “long and lasting lag[WL1]  of negative impact from higher interest rates” sounds exactly the same as it  last Groundhog Day.

The economy is slowing as intended by the Federal Reserve and there was significant stock buying in December and January, which some people attribute to the “Fed Pivot.” With inflation running at acceptable levels and economic growth slowing, some investors are hoping the Federal Reserve is ready to reverse course from raising to lowering interest rates. I believe that the Fed is done raising rates, but I don’t yet think we should cheer the prospect of dramatic rate cuts. The economy is slowing but still doing well, unemployment is stable and corporate earnings have started to grow once again. What more can we ask for? Thus far our economy has digested enormous interest rate hikes. For the Fed to start easing rates, they will need to see serious deflation and economic slowing. As I said last fall, I would rather have stable interest rates than a slowing economy. Thus, “be careful what you wish for” because a dramatic drop in rates could be the sign of an economy falling off a cliff.

Additionally, higher rates have increased income derived from cash and bonds allowing us to lower equity allocations without lowering income. In the past, investors needed stock dividends to help generate income because the yield on bonds was so low. This pushed investors up the risk ladder as they reached for stock dividends as income. While higher interest rates are a headwind for the economy, it is also beneficial for retirees and people living off investment assets.

As I look at our portfolios, I see accelerating earnings, the highest portfolio yields in 15 years and CEO’s that are far more optimistic than a year ago. We can take down total portfolio risk by reducing equity allocations without reducing income and own US Treasuries with an actual risk-free return. That said, the economy still needs to digest the financial tightening, which has the potential to push us into a recession. The debate will rage on and Chicken Little economists continue to have a case for recession, but the case is getting weaker. What I have always told my clients is that “there is always a recession coming”. The question is; when, and I don’t think we can predict that?  Last year proved that making bold investment call based on the specter of a recession can have high opportunity cost.

In the meantime, those of us who don’t try to predict the unpredictable can rely on diversification to mitigate risk and allow our portfolios to compound over time. We are trimming our tech winners from last year, adding to sectors that underperformed and enjoying the yield from US Treasuries.  

Happy Groundhog Day!

November 2023

Ding-Dong The Witch is Dead

Christopher P. Lorenz

This morning investors are chanting, “ding dong the witch is dead” cheering October’s Consumer Price Index report (CPI), showing inflation’s continued decline. If inflation is under control the Federal Reserve can stop raising rates allowing bonds to rally, and interest rates to fall. Stock investors need stable interest rates to effectively discount the value of future earnings, so if higher rates lead to lower stock prices, it isn’t surprising that the market is rallying now as rates drop.  

While the S & P 500 has achieved impressive returns this year, it doesn’t paint an accurate picture of the market. Large technology companies dominate the Standard & Poor’s 500 index, because the index, by design, puts more weight on large companies. The S & P 500 equally weighted index was barely positive, until last week. 

In my last note on the market, I referenced the numerous crosscurrents impacting the market resulting in muted gains for the broad market. On the one hand the economy has been stronger than predicted. Last year at his time most economists believed we would have entered a recession by now, but it has not materialized. Earlier this month we learned that economic growth expanded by over 4% in the previous quarter, which is quite strong. On the other hand, strong economic growth may encourage the Federal Reserve to continue raising interest rates, which could potentially drive the economy into the long-predicted recession. If one believes today’s CPI report is a lasting trend, then the risk of the Federal Reserve overtightening is reduced. 

It is my belief that the Federal Reserve has raised rates enough to curb inflation, which has dropped significantly already. If that is the case the focus can shift back to corporate earnings, which is the most important driver for stock prices. Corporate earnings and revenue have been weak for 18 months as the economy recovers from the COVID hangover. COVID had an enormous impact on consumer spending and other macro-economic trends, some parts of the economy, like technology are accelerating and other parts, like manufacturing, remain at recessionary levels. 

The economy is slowing, and that is expected, but we invest in businesses and our focus is trained on revenue growth and earnings. After several quarters of very weak revenue and earnings the data is improving and next year is expected to show double digit earnings growth.  I think those expectations are likely too rosy, following two years of profit contraction and should be met with tempered enthusiasm by investors because we don’t yet know how the rates will impact various segments of the economy. 

Thus, we live in an odd world where good economic news is viewed negatively by stock investors, which I find very frustrating and short sighted. A broadly robust economy is more important than simply the low interest rates. That said, for the first time in a dozen years investors have other ways to generate income and returns, including cash and bonds made attractive by the rates being at fifteen-year highs. 

Over the long run, stocks will outperform bonds and that is why we maintain the stock allocations we have, but we are happy to own bonds and hold cash as we wait for clear data that the improvement in corporate earnings is sustainable.  

March 2023

The Rolling Recession

Christopher P. Lorenz

If you were lucky enough to spend the past three months on a beach in the Caribbean or ski lodge in the Rockies and just opened your quarterly investment statement for the first time in a while you will be relieved to see positive returns so far this year. For the rest of us who have been watching the market and listening to the nightly news the constant bombardment of negative commentary around the macro economy, inflation and regional banks, the past three months haas been stressful. The positive returns posted by the S & P 500 and Nasdaq Composite have been hard earned gains and surprising to many. 

The economic discussion for the past 18 months has been dominated by a looming recession caused by a drop in consumer spending and corporate earnings. Unfortunately for the doomsayers, consumer spending and corporate earnings have held up well. As each quarter passes the recession gets pushed out a few quarters. The logic from those calling for a recession makes sense. The Federal Reserve raised interest rates dramatically last year and that will reduce consumer demand and economic activity but we still don’t know when, and by how much. 

Earnings for the S & P 500 were down 10% last year, which is understandable since the previous two years were very strong, but we have yet to see recession level contraction. There are many economic indicators that are flashing red, which could indicate we are closer to that long-predicted recession. Also adding to the concern is that interest rates hikes take over 12 months to impact the broad economy.  While it might turn out that we are on the precipice of recession, the first quarter of 2023 turned out ok as GDP, employment and corporate earnings grew nicely. Once again, the predictors will need to push out the start of the recession. 

Even though our economy is resilient, and employment remains strong, the Federal Reserve will beat inflation by slowing down the economy with interest rate hikes or in its own words, “by breaking something”, or both. The recent collapse of Silicon Valley Bank reflects the stress created by rapidly moving interest rates and reflects something “breaking”. With that said the banking entire system is not broken because it isn’t a monolith. Our banks are unique in several ways ranging from size, to region, business sector and the type of customers they serve so they all have different market conditions to consider. The one thing that impacts them all and makes them similar is that their businesses are built around interest rates. Banks borrow at one interest rate they lend at another. Additionally, banks need to hold collateral for the bank deposits they take in and they buy US Treasuries to hold as collateral. By raising interest rates dramatically, the Federal Reserve has increased the costs for banks to borrow and it also made their collateral less valuable. SVB had a very unique regional and business customer profile, and their deposits were highly concentrated in small number of customers that had enormous deposits, which we easy to move. Their unique customers, and the bank’s poor management made it overly sensitive to higher rates and resulted in the bank’s shareholders losing all of their money. The stress created by interest rates hikes that crushed SVB is affecting all banks, but most regional banks and the large ones, are in much better shape and handling the stress well.   

The banking stress will result in slower business activity and add another headwind for our economy, further testing its resilience. Banks have already been tightening lending standards, which may make the recent bank stress less impactful since tightening was already underway, but it will reduce economic activity further.  There is always a recession in the future because we have a dynamic economy that speeds up and slows down and that’s good because it weeds out poorly run companies and creates space for other companies to flourish. For investors it’s a chance to buy high quality companies at a discount and doesn’t permanently impede appreciation in the long run. So, the hard question isn’t whether we will have a recession, it’s “when”? 

I see one of two scenarios playing out. We will either have a technical recession in the next few quarters or we will continue to experience a “rolling recession. We have already been experiencing a rolling recession that has impacted different business sectors at different times but haven’t lined up at the same time to create a technical recession. The economy experienced two consecutive quarters of negative economic growth in early 2022, which wasn’t considered a technical recession because employment remained strong. For example, housing had a rough year last year as higher interest put buyers on hold. The auto industry was severely damaged by supply chain issues in 2021 and early 2022 but are now doing well because supply chains have improved. There are other business sectors that experienced recessionary conditions that are now improving. Inversely, there are some industries, like banking, that are now facing recessionary pressures. 

The lasting impact from COVID on the economy are the unique crosscurrents, some that show recession and some, like employment, that point to a strong economy. Regardless of the crosscurrents, the fact is that we have very low unemployment rates and when Americans have jobs, they spend. It will be very difficult to notch a technical recession with strong employment like we have and trying to predict a recession is extremely hard. 

The macro-economy isn’t a great predictor for stock returns and that is why we don’t focus on the macro economy. Instead, we invest in individual companies and focus on how they are performing in all types of conditions, recession, or boom times. Our companies are doing well, and have yet to make dire warnings about a recession but also remain cautious due to the unpredictable nature of the impact from the rate hikes. 

My concern has shifted from worrying about inflation to worrying about how impactful the rate hikes be on the economy and corporate earnings. S & P 500 earnings fell 10% last year, which brought stock prices down 30% at the lows last year. Earnings estimates for 2023 have come down significantly already but estimates vary wildly depending on the dept of a recession. I believe our portfolio companies are well positioned for a recession if it occurs because it has been a concern for the past year. If a sailor sees a hurricane two weeks away, there is plenty of time to alter course and prepare. One pundit said this would be the most widely anticipated recession of all time. 

Like the sailor preparing for the storm, our portfolios are prepared. We have higher than normal cash and bond positions, which we will use to take advantage of a recession driven pullback. For the first time in a while investor are being paid to wait since bond yields are very attractive. We have been buying two-year treasuries yielding over 4% so we are getting paid to wait for the skies to clear. 

Whether we have a technical recession or not isn’t that important, there are numerous headwinds for the economy that we need to digest. Corporate America is adapting and has been preparing.  Growth stocks got crushed last year but are leading this year. This means that the “rolling recession” I have seen is showing up in stock leadership. We remained invested in growth stocks last year and are being rewarded for that now. Thus, staying on the course and remaining diversified will allow us to benefit regardless of where the leadership comes from. Recession or not there are headwinds we need to subside and it is my belief that we can emerge from this period and build new momentum for stock prices by the end of the year.

June 2022

Turbulence is Okay

Christopher P. Lorenz

Early this morning, as I watched international markets to glean some insight on how our markets would open, an old maritime quote came to mind: “the floggings shall continue until morale improves.” I searched the internet for its author and found that it isn’t attributed to any one captain or naval officer, but it has lasted the test of time because it highlights how difficult it can be to change pervasive negative sentiment. But, sometimes negative sentiment is actually a catalyst for change. 

In March of 2020 my screens looked as red as they do this morning, so I started calling clients to discuss what I referred to as “maximum pessimism” and that it was possibly the time to set aside the fear and structure portfolios for a recovery. 

Investor sentiment took yet another blow with Friday’s release of the Consumer Price Index, showing that inflation remained at peak levels in May. Many had hoped, as did I, that May would show inflation softening. While the news remains bad, the May data is in the rearview mirror, and what is important is the current data in June and beyond. The first part of June has seen softening of important categories, like used cars and building materials. Lumber markets, which I watch closely, have been halved in many parts of the country and mortgage applications have slowed taking some of the froth out of the housing market. So, despite these data moving in the right direction, Friday’s CPI release pushed the pessimism gauge to the moon. 

If you read anything about markets this weekend you know that finding an optimistic investor was akin to finding a unicorn. It once again feels like “maximum pessimism.” Does that mean I think we are at the bottom of this pullback, no, but it does mean that I believe it’s time to pivot. In my experience “maximum pessimism” is when prices for the highest quality companies, start to drop like the poorly run companies. Microsoft, Home Depot, Blackstone and many others are off more than 20%, yet their business outlook remains healthy. As a long-term investor looking out several years, discounts like these are important opportunities. 

Inflation is sticky and takes time to work through the economy, even if governmental efforts are successful. Investors will price in the improvement before the data shows any and smart investors won’t try to “pick the bottom.” I am pivoting my outlook towards structuring portfolios for a recovery. I am not shifting strategy dramatically, but the risk reward ratio improves when stock prices reflect maximum pessimism. I have been dollar cost averaging many positions as the market has moved down and some stocks are now trading at prices that are far below what I believe is their intrinsic value. 

Current pessimism is in indicator of how hard it will be for the Federal Reserve to slow the economy without pushing it into a recession. As investors, we need to remember that markets move before the data is received and thus stocks will rebound before the economy rebounds and that is the positioning we want in our portfolios. This bumpy ride isn’t over, and we will need a few months of positive data before we know the impact of the efforts to curb inflation. It is impossible to know when that reversal will commence, or the “bottom” is in place, but my experience with market pessimism gives me comfort that as a portfolio manager its time for me to pivot from bracing for impact towards looking at the opportunity of forward returns. 

Please call, email, or text if you want some details about how this pivot will be implemented. I am not making dramatic changes right away. We will likely see more downside as we wait for better inflation data and market bottoms are a process not a moment and, in that context, I am looking forward and starting to reposition for better times.  

March 2022

Keep The Course

Christopher P. Lorenz

Spring is on our doorstep, life in New England seems to be returning to normal, and I have never been so appreciative to live in a free and peaceful place. We have a messy democracy and many in our society face enormous challenges, but when I inspect the international landscape, we are blessed to live where we do. My friends and family have as much work as they want, businesses are highly profitable, schools are open, and kids are back on the field playing sports. These anecdotal observations provide me with confidence, pride and relief. Then I turn on the TV and my bubble is burst. As an investor these two observations strike me as contradictory and makes it extremely difficult to know what, if any, changes should be made to our strategy. 

Over the past few year’s investors have been blessed with double digit gains in the midst of an international health crisis. It makes sense that after achieving large gains in asset values that there would be a pause or even a step backward. Market downturns have catalysts, and 2022 ushered in multiple negative events impacting the macroeconomy and legitimately frightening investors. Inflation and higher interest rates are felt by everyone, and reflect an economy that is moving too fast, but markets have proven that they can do well during the rate hiking cycle that historically follows an overheating economy. Unfortunately, just as this international health crisis wanes, we are experiencing geopolitical turmoil, not only testing the strength of our investments, but also, our collective humanity.     

It is understandable that investors are nervous and there is a temptation to make investment decisions based on emotional reactions to what we see on TV. These are stressful times to invest and it is my job to help clients mitigate the stress and make sound, mathematically informed decisions (tax consequences and recover times) that allow you to stay on track with long term financial goals. I started managing investment portfolios in 1998 and since then I have helped clients navigate multiple deep recessions, the 9/11 tragedy and numerous market dips. That experience helps me remain calm in the face of calamity and allows me to maintain a steady hand and focus on our portfolio companies regardless of circumstance. In every market disruption over the years, it has proven wise to stay the course with slightly lower stock allocations and higher cash levels, which we currently have in our portfolios. During the course of my career, I’ve also learned that trying times often present the best investment opportunities. 

A short-term pivot to cash or overly defensive strategy can lower your chances of achieving long-term goals. My focus as a portfolio manager is assuaging my clients fear and shifting the focus to thoughtful, long-term investment decisions. I am constantly reviewing each client’s needs and if there is excess liquidity, I look for opportunity. There are numerous companies in our portfolios which are performing quite well, and are worth adding because their stock prices have dropped.  

When I look back at my client updates from the past two years, I’ve frequently used the term resilient to describe our economy’s ability to handle adversity and change. While I am deeply saddened by the events in Ukraine, I don’t believe it will lead us into recession. Our portfolio companies and our economy are resilient, and should the market be shaken, my experience allows me to see opportunity in tumultuous times. 

In time, our portfolios will grow as they have previously and we will achieve our long-term financial goals.  

Please reach out with questions and concerns.