INVESTMENT QUARTERLY

TINA

At the end of the third quarter this year, stocks, as measured by the S&P 500 index, were up 15.9% while intermediate bonds were off 3.8%. Fed established interest rates were still at 0.25%, an all-time low, and early Gross Domestic Product estimates came in at 2 percent versus a 6 percent growth expectation when the quarter started. The drop in GDP was greatly influenced by shortages and supply chain difficulties to the point that analysts are predicting significant shortages and late deliveries of Christmas products. Since holiday sales are a big part of the retail industries’ performance, this could be a big drag on fourth quarter performance as well.

Inflation has reared its ugly head to a solid 5.4% this year. Most of us know that this statistic does not really represent what we are seeing in stores and at the gas pumps. Economists are debating whether this inflation is transitory or indicative of longer lasting negative economic impact. Optimists say that as soon as the supply shortage ends, price inflation will return to normal. One economist sees the inflation as a supply problem. With the government pumping up the monetary base of the country, 20.4% this year through August, there is currently too much money chasing too few goods, resulting in strong inflation pressure as prices get bid up due to the scarcity of goods. This economist does not see production increasing sufficiently in the near term to offset the supply shock we have experienced. There is evidence that we may be approaching a wage driven inflation pressure as many jobs are going unfilled around the country and unions are beginning to strike for higher wages to keep up with rising costs. With large consumer companies, like Procter and Gamble, announcing significant price increases because of increased costs, it doesn’t look like inflation will be transitory.

As inflation takes hold and extends its visit, it is likely that businesses will find their profit margins squeezed. Margins today are at all-time highs, one of the reasons for the high price earnings ratios of stocks. If these margins are reduced there will likely be a decline in earnings. A decline in earnings is generally followed by a decline in the price earnings ratio resulting in lower prices for stocks. This outcome is projected by those analysts who see “stagflation” as the likely future of the market. Stagflation is when economic growth is sluggish and inflation is above normal, resulting in lower stock prices. As the proverbial economists say after laying out one answer, only to follow it up with “but on the other hand”, if inflation is moderate, it could reflect a growing economy and provide support for better equity prices. 

The equity market has run counter to the COVID economy prior to this year’s recovery due to the huge growth in the money supply and low interest rates as we mentioned earlier. When the Fed begins to withdraw the liquidity it has added to the market later this year by tapering its bond purchases and ultimately raising interest rates to stop the inflation, it will be reversing all the things that made the stock market defy the economy over the last bull run. If the rule of unintended consequences is still applicable it will likely end the bull market. Until this happens, it is still likely that the market will continue to climb the wall of worry.

No, I didn’t forget TINA. The acronym stands for “There Is No Alternative” and is an explanation as to why stocks are doing so well, and bonds are offering dismal returns. With inflation at 5.4% and 30-year bonds yielding 2% for Treasuries and 2.9% for single A rated corporate bonds, the inflation rate turns the current bond yields negative. This phenomenon has caused many investors to rethink the traditional 60% equity and 40% bond portfolio allocation, particularly if the bond portfolio is going to have a negative return. One alternative has been high quality stocks with above average dividend yields that potentially offer a positive total return during this inflationary period. In fact, low bond and savings yields have pushed many investors into the equity markets for better current yields. There are no guarantees in the investment world, so this strategy requires careful monitoring to determine when the fundamentals of the market are likely to turn negative. It is not a “set it and forget it” alternative. One does not want to sacrifice principal for a short-term yield advantage, even though government policies have severely damaged the investment earnings prospects for elderly citizens who heretofore have avoided risk by investing in FDIC insured accounts. Even though bond returns may suffer during inflationary periods, short term bonds will protect principal during corrections.

The wild card in all this is COVID and the success of Merck’s new drug in eliminating the worst effects of the virus. If it is approved for emergency use by the end of the year we could be on our way to regaining normalcy after eliminating the effect of shortages and supply chain issues and giving people a positive outlook toward returning to work. Let’s hope for the best.

My partner, George Kimball, has been diligently working on updating our website for the last few months. I hope you get a chance to check it out at

www.needhamadvisory.com

.  For those who would like to get their statements from us electronically there will soon be a link to do so. If you do not want to be changed to electronic statements, please let us know.

We are also now accepting new accounts. If you know anyone with investment, tax, estate and financial planning, or other financially related questions, we would appreciate your referring them to us. Give us a call at 978-681-8821 to get started.

Robert B. Needham, CFA