Q3 2021 Market Update

October 28, 2021
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In Q3 2021 the Wilshire 5000 Total Return Index declined -0.21%, the All-Country World Index declined -1.26%, and the Barclays Aggregate Bond Index declined -.02%. Since quarter-end, the markets have rallied a bit and as of 11/8/21, they have gained 24.67% / 19.04% / -1.15% respectively. *Data provided by Folio Institutional (1)

Q3 was a bit of a pause on the yearly growth, but markets again roared back to all-time highs in October. This year has continued solid returns, pushing accounts well ahead of our planning targets. As mentioned last quarter, the upswing should serve as a continued lesson in 2 main ways. Please allow me to emphasize the key lessons again this quarter.

First, it is NEVER wise to time the markets or try to make any decisions on macro-economic situations (stimulus, covid, elections, federal reserve actions, etc..). Investing is a long-term game with many ups and downs. Because we do not know the exact timing or exact amplitude of the ups, we must simply stay in the game until we get the rewards.

Second; we must expect a period of undersized returns is much more likely in coming years. When or how this period manifests itself, we have no idea. Spending time guessing about something that requires no action is a fool’s game. A game we will leave to click-bait media and advisors who enjoy chasing their tails.

“People have always had this craving to have someone tell them the future. Long ago, kings would hire people to read sheep guts. There’s always been a market for people who pretend to know the future. Listening to today’s forecasters is just as crazy as when the king hired the guy to look at the sheep guts. It happens over and over.” -Charlie Munger

As always, Evergreen Wealth strives to ignore short-term price fluctuations and instead focus on the intrinsic value growth; that is the long-term earnings power of investments within our portfolio holdings. Given enough time, this earnings power should flow into equity returns and offer a reasonable rate of return for meeting your long-term objectives. We believe that in the long run, owning a diversified group of high-quality businesses at a fair price provides an amazing way to compound capital. Since we will never change this philosophy, we will continue to focus all our energy on picking great companies at a fair price. Mr. Market will sort out the long-term returns on its own clock.

General Thoughts

Over the past 5 years, the Earnings per Share (EPS) of the S&P 500 has grown at over a 13% annualized rate, providing a fundamental reason for markets to ramp higher. The S&P 500 will have a composite EPS of near $210 for 2021, which translates to a 4.50% earnings yield. Much of the EPS growth has been supersized from the injection of money in response to the pandemic. We expect a slowdown in EPS growth and return to a more normalized level of 4-5% over coming years. This return to normal could add volatility back into markets as many companies return to more normalized output levels. In the meantime, we see the biggest risk as Inflation! Inflation has fully arrived. The CPI is now up 5.4% from a year ago. Some of this will be temporary, but not all of it. Below is a good take from economist Brian Wesbury that highlights what we are facing:

Housing rents were held down artificially until early September, due to limits on evictions. Once nationwide eviction limits ended, rents escalated in September and we expect more of the same for the foreseeable future. That’s important because rents make up more than 30% of the CPI.

 

Given the likely pace of inflation in October, the “real” federal funds rate (the funds rate adjusted by inflation) is running at about -5.6%. That’s a record low, even more deeply negative than the -5.0% in early 1975 and -4.8% in mid-1980, both of which were at the end of recessions, not almost a year and a half into a recovery, like we are right now.

 

In other words, the current economic environment doesn’t just warrant tapering, but rate hikes. Unfortunately, rate hikes aren’t happening anytime soon. We wouldn’t be surprised by just one rate hike at the very end of 2022, but the start of a hiking cycle could also be postponed until 2023.

The problem with monetary policy is that the M2 measure of money is up 36% since February 2020, versus a trend of about 6% annualized pre-COVID. That surge in M2 is like a cow that’s been eaten by a snake…gradually moving through. As long as the Fed doesn’t regurgitate the extra money, the cow isn’t going away, which, in this case, means a devaluation of money relative to goods and services.

Our primary job as planners and managers is to preserve spending power over a lifetime. The strong performance above plan targets during the past 5 years is largely a result of our positioning relative to inflation. Our asset allocation has leaned into equity strong portfolios with companies that hold a certain level of pricing power. This philosophy has allowed us to get out ahead of the spending erosion that inflation can bring.

In 2015, Warren Buffet addressed how to handle inflation in this way:

“The best business to own is one that doesn’t require continuous reinvestment because it becomes more and more expensive as the value of a dollar drops. The best businesses during inflation are the businesses that you buy once and then you don’t have to keep making capital investments subsequently,” Buffett said, adding that “any business with heavy capital investment tends to be a poor business to be in during inflation and often it’s a poor business to be in generally.”

In our own words; we aim to own companies that hold higher margins, produce lots of cash from organic activity and have lots of opportunities to re-invest that cash for a reasonable rate of return.

Our best defense against inflation is finding companies who can pass along every price increase or benefit directly from price increases. Owning a wonderful company that holds pricing power is key to surviving inflation long term. Think about a company like Microsoft that recently raised its prices substantially but continues to add customers. Or Visa who gets a percentage of transactions, and as prices increase the amount they get will increase. Owning the toll road on price increases is a good long-term business. Finding these companies and entering at a fair price will provide us the best chance of continuing to outpace inflation and preserve spending power long term!

Conclusion

Markets have remained strong and accounts are well ahead of planning objectives. Markets are certainly not cheap anymore, but with the 10-year bond yield near 1.51%, the alternative for money is very low. As inflation continues north of 5%, it remains important to maintain a healthy equities position to maintain purchasing power. Our focus continues on finding companies that produce strong organic cash flow now and many years into the future. As we move closer to 2022, we are expecting some choppiness to return into the markets and in many ways will welcome the opportunity to add some fresh positions at better prices. For now, we will continue to enjoy the strong year and keep searching for opportunities to add wonderful companies and investments. It is a tremendous honor to help steward your assets and retirement journey during this time. Thank you for your trust!

Disclosures

(1) Data reported by Folio Institutional. (2) Data reported by Y-Charts Data, www.ycharts.com.

Index results such as the Wilshire 5000 and S&P 500 do not reflect management fees and expenses and you cannot typically invest in an index.

Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.