Equity accounts are participating in the stock market’s breathtaking performance with returns in mid-double digits at the halfway mark. We anticipated this direction but have to note that the magnitude was greater than expected, particularly after last year’s gains. Rotation between growth and value stocks continues, and the portfolio retains balance in the two factors with focus on individual companies. Sizable positions in a cutting edge semiconductor designer and a leader in wealth management/capital markets added to relative returns in the second quarter. Balanced accounts are benefiting from strong gains in their equity component while the fixed income market has been muted.
The stock market’s strength does not mean that there are no longer macro threats. It more reflects a push out in the timing of these issues. Below are the ones at top of mind:
Peak Rate of Growth
We agree that both the economy and corporate profits are currently/will shortly be at their highest percentage gains on a year over year basis. Some of this is simply comparing to the depths of the 2020 pandemic. Additionally, most of the recent stimulus check spending is probably behind us. However, this does not mean that the economy has peaked. Far from it, as employment is growing, consumer net worth has never been higher, and we are only a year into recovery. Our view is that peaking growth rates (2nd derivative) will more impact the internals of the market (growth vs. value) than its overall direction. Accordingly, we have reduced exposure to the Industrials sector and re-deployed into more secular growers.
Yes, inflation is back (looking at our bills we wonder if it ever left). The Federal Reserve has labeled the current spike as “transitory,” and the bond market agrees. The length of “transitory” has not been defined so one has to delineate a bit here. Much of the uptick in inflation has come from commodities where bottlenecks (shortages) have caused supply to fall short of robust demand. Our experience reminds us that there is nothing like high commodity prices to cure high commodity prices. Please take a look at the 50% decline in lumber futures since early May as an example. Other shortages, particularly in the transportation sector, will take longer to resolve. As an aside, it is extremely difficult to attract new qualified truck drivers so freight rates offer no relief. This leads us to our largest concern regarding inflation, upward pressure on wages across the board. We cannot be sure until enhanced unemployment benefits expire, but sense that labor inflation is being underestimated.
Federal Reserve Policy
Communication out of the Fed’s most recent meeting was interpreted as hawkish, and the timing of future interest rate increases was pulled forward. However, we are most likely looking at over a year of stable Fed Fund rates. More critical to our thinking is the timing of the Fed’s tapering of its buying program (quantitative easing). Experts estimate that quantitative easing has depressed market interest rates by 0.75 to 1.00%. It appears that the Fed is now starting to “talk about talking about” tapering but we simply cannot credibly determine the timing.
Tax Rate Increases
The legislative process has served to push tax increases out of the headlines for now. Our thesis that moderate Democrats in the Senate will determine the final outcome remains intact. All that said, our opinion is that tax rates (corporate and/or personal) are headed higher.
New York Yankees
Approaching the All-Star Break at over 10 games out of first place, a wild card berth seems to be our only hope. While there is still time to pick up some new talent, this is not a matter of filling in a hole or two. Despite a $200 million payroll, their team statistics are mediocre in terms of batting (including their hallmark slugging) and fielding while their ace starter and previously “lights out” closer appear to miss the sticky stuff more than most. (Okay, the Yanks are not a market issue but are still on our minds.) most. (Okay, the Yanks are not a market issue but are still on our minds.)
There are plenty of other concerns, but right now we have:
- An expanding economy
- An accommodative Federal Reserve
- Negative Real Interest Rates
So far, that is a good environment for stocks.
Turning back to the portfolio, although constructed stock by stock, it does contain some thematic concentrations. Along these lines, we recently added to our exposure in the internet advertising sub-sector in both search and social media. We believe that they represent a unique intersection of secular and cyclical trading at reasonable valuations. The growth of internet engagement is well documented and was accelerated by the pandemic. We anticipate that much of the increase in usage will be retained despite reopening. From the cyclical side, it is important to understand that advertising is the heart of these companies’ revenue stream. Advertising has always benefitted from economic expansion, particularly a consumer-led recovery. Regarding valuation, GAAP earnings estimates place these stocks at modest premiums to the overall market. Adjusting for large net cash balances brings valuation down significantly. A little more digging reveals that both managements are investing/spending considerable amounts on new products and services (virtual reality, autonomous driving, etc.) that are not yet producing meaningful revenues. In other words, valuation looks even more attractive understanding that results today contain money losing ventures that may represent enormous profits in the future. Of course, there are regulatory and legislative risks for both companies. That has been the case for a couple of years, and the stocks have climbed that wall of worry to date.
As a Firm update, we are delighted to announce that Brian Turner will be joining Atalanta as Senior Vice President/Senior Analyst. Most recently at Levin Easterly/Levin Capital Strategies, he has over 25 years of experience in health care investing. We are thoroughly impressed with Brian’s research methodology, judgement, and dedication to his craft.
Best wishes for a healthy and fun summer.