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!