Sterling Partners Equity Advisors Portfolio Commentary – Summer 2022
Is It or Isn’t It?
That’s the question on everyone’s mind these days. It’s understandable because there are so many conflicting data points. We have pointed out in the past that a good thing to do to achieve certainty in stock market returns in the short-run is to avoid owning any stocks — or sell the ones you have; although we don’t recommend that, the market returns in the long-run have historically been pretty good. One thing we know for sure is our 2Q 2022 performance was worse than we like relative to our Russell 2000 value benchmark, and we will discuss the details of those results following this letter.
It certainly makes sense why markets are down this year. With negative GDP, rising inflation and interest rates, a war, collapsing consumer sentiment, and big economy-jolting energy price increases, it feels a lot like 1974, 1979, 2000, or 2008. There’s half a chance we are already in a recession that will be labeled after the fact, something that has happened frequently in the past. Market momentum is negative, retail sales are weak, housing is slowing, auto builds are down, the yield curve is inverted, disposable personal income has been slipping, even video streaming is down, and PE multiples are falling. In other words, good hunting grounds for a value investor.
At the same time, it’s also hard to make sense of record real wage rates, near peak personal consumption expenditures, near record low unemployment, and the Michigan consumer sentiment index at a 70-year low. A combination of the gut punch of post-Covid inflation, war, interest rate hikes, and then both a bear stock and bond market have obviously hit sentiment hard, but not yet employment.
In one post-Covid graph that looks pretty interesting (see chart), historically low unemployment rates seem entirely caused by a growing percentage of the working-age population moving into retirement. While some of this is undoubtedly a post-Covid appreciation for leisure, the demographics say that baby boomers are finally retiring and taking many of their non-college taught skills with them. In what could be a long trend, there seems to be an excess of lawyers and bankers and a shortage of truck drivers and construction workers. Hard to say if that’s bad for the economy.
But again is it or isn’t it?
There is a lot of negative data, but it’s quite possible we are in a slowdown created by the economy working through more than the normal number of global supply and demand shifts at the same time. We try to keep in mind that most of the numbers that are making people nervous are rough estimates. With GDP and the CPI releases, it seems that a good dose of skepticism regarding the accuracy of these estimates is warranted, particularly as real GDP growth hovers near zero. Is GDP capturing all the productivity that has been created by the recent mass adoption of new technology? Is the CPI estimate capturing the difference between pricing and productivity gains in fast-paced new products and services cycles? Does the CPI basket change frequently enough when web-based product discovery and substitution are now weaved into consumer behavior?
The stock market itself has historically been the best predictor of recessions. This decline did cross the threshold of the definition of a bear market and, therefore, is likely an official market prediction. But in another somewhat unusual case this time, the average market decline so far can be almost entirely accounted for by the mathematical impact of higher interest rates dialed into the denominator of the present value calculation. Does that make the market decline less predictive? Or is it in fact more predictive because earnings declines have yet to be dialed into market estimates?
A lingering question that is key to where we go in the near term is what happens to inflation? Are general price increases a mathematical reaction to wartime-like levels of growth in the money supply? Undoubtedly yes. Are some price increases simply the natural market reaction to a post-Covid period when everyone wants to do everything at once, creating scarcity and higher prices for those who want to be first in line? Again, almost certainly yes. Are some price increases the natural market reaction to shortages caused by a major generational shift in world trade patterns and, therefore, a short-term incentive to build more capacity or invent a new approach? Again, we think yes. And while it’s easy to understand how higher rates can shock buyers and postpone big-ticket lifecycle purchases, a recent history that includes periods of higher housing starts and higher auto builds at a time of higher rates suggests that long-run demand goes beyond interest rates.
For the stock pickers among us, the flip side of a rising inflation and interest rate environment is that it creates opportunities for companies with proprietary products and good balance sheets to raise price and expand margin and earnings faster than competitors. The flip side of historically low sentiment is the opportunity for multiples to improve. Those two paths to good returns, expanding earnings and/or multiplies, say absolutely nothing about the timing, by the way. But in the long run, economic growth equals population growth times productivity growth, and whether properly measured or not, we remain pretty optimistic about that.
Click here for our most recent performance, and please open the .pdf below to see our Director of Research’s thoughts about our best and worst contributors to our performance in the quarter.
Thank you for your interest in Sterling Partners Equity Advisors.
Kevin E. Silverman, CFA
Chief Investment Officer
Please direct any inquiries to:
John A. Schattenfield
Head of Distribution
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