Over the past four months, a tremendous amount of uncertainty has returned to our lives. The nightly news is filled with unpleasant—and at times deeply unsettling—footage. The Delta variant of COVID-19 has strained hospitals, with many states once again near or at full capacity in their intensive care units.
Over the past thirty days, events in Afghanistan have also resurfaced painful memories from the Vietnam era for many American veterans, as scenes from Kabul bear undeniable resemblance to those from the fall of Saigon. Meanwhile, the political environment in Washington has reverted to partisan rhetoric, even as a bipartisan infrastructure bill has yet to reach the President’s desk for signature. Even basic public health measures—such as COVID-19 vaccinations or wearing masks indoors—have become political declarations.
Amid all of this uncertainty, it can feel surreal to see the stock market trading near all-time highs. Yet, that is exactly where we find ourselves today.
Key Questions
- Interest Rates and Inflation: Will they stay this low?
- Earnings and the Economy: Will COVID derail the reopening?
- Tax Rates and Political Risks: Will Washington spook the stock market?
- Opportunity: Where do you see opportunity today?
Answering Those Questions
After a sharp rise in the yield curve to start the year, bond yields then decreased significantly in the second quarter. The benchmark 10-year Treasury, which had been creeping toward the 2% level in March, saw its yield plummet all the way back to 1.1% in July. Today, the yield on the 10-year Treasury is back around 1.3%. This rally in the bond market contributed to the underperformance of many value stocks, including our bank positions and other economically sensitive companies.
There are many views on why bonds rallied while value stocks pulled back, but the most reasonable explanation is that large institutional investors were placing bets on the delta variant of the coronavirus slowing or derailing the global economy, as countries were forced to refocus on pandemic management.
Over time, it is our view that both interest rates and inflation are likely to move higher, but not to levels that would be detrimental to the overall economy.
We are long-term investors who make investment decisions based on the fundamental characteristics of the businesses we own. The depth and duration of this wave of the pandemic is not something we attempt to time or trade. We view it as tragic and unfortunate for all those affected, but not something that materially impacts the earnings outlook for most of the companies we own. As such, we will continue to look for opportunities to rebalance within our portfolios when individual holdings move irrationally during short-term events such as this.
In general, we believe the worst economic damage from the pandemic is behind us and that the key to returning to normalcy will come with higher vaccination rates across the globe.
The Washington question is an interesting one, with dozens of secondary questions embedded within it. The balance of power in the Senate—and arguably the House—has returned to a small group of moderates in the middle. The fate of the bipartisan infrastructure bill remains uncertain, as more progressive members of the Democratic Party have attempted to tie it to a larger spending package. Your personal view on these bills likely shapes your perception of this legislative gamesmanship, but there are several straightforward takeaways.
The bipartisan infrastructure bill would benefit many of our holdings, including Deere, Chevron, and Emerson. The larger proposed spending package would help some of our other holdings as well, though likely with negative implications for others.
The prospect of higher taxes remains, but the likelihood of monumental tax increases has fallen dramatically. While the midterm election is still more than a year away, that timeline will move quickly for the party currently holding the majority. We believe modest increases in both corporate and personal income tax rates are possible, but the magnitude of those increases is no longer expected to be consequential. As long as this remains the market’s expectation—or becomes the legislative reality—we see little long-term impact on the earnings outlook for most of our holdings.
“I’m convinced that there is much inefficiency in the market. When the price of a stock can be influenced by a ‘herd’ on Wall Street—with prices set at the margin by the most emotional person, the greediest person, or the most depressed person—it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”
— Warren Buffett, from The Super-Investors of Graham & Doddsville
Though many market indices are at or near all-time highs, we see tremendous opportunity across many different areas of the investment universe. Some of you may have noticed that we have been steadily increasing our exposure to foreign companies over the past year. We have identified significant valuation discounts between many foreign companies and their American peers—often when the fundamentals are nearly identical, or even slightly better, for companies domiciled outside the U.S.
The U.S. economy has benefited from extremely large fiscal support and from our ability to provide vaccines broadly across the population. Only a few countries have had similar access to COVID vaccines, which has allowed more of the U.S. economy to reopen and return to more normal conditions. While this transition is unlikely to be smooth or easy, the rest of the developed world—as well as some of the largest emerging market economies—should benefit from vaccine implementation over the next year.
As that occurs, we expect an earnings rebound for many of our holdings. It should also help global interest rates move back toward more normal levels seen prior to the pandemic, which in turn could support local currencies strengthening against the U.S. dollar. As American investors holding shares of foreign companies, we would directly benefit from a weakening dollar relative to currencies such as the Japanese yen, British pound, and the euro.
Absher Wealth Portfolio Recap
After a busy first quarter of trading, activity inside client accounts returned to a more normal pace during the second quarter and throughout the first two months of the third quarter. We added London Stock Exchange Group to both the Tactical and Core Models in the second quarter. The only other significant activity within our model portfolios involved routine rebalancing trades.
The largest additional purchases completed since the beginning of the second quarter included M&T Bank, Abbott Labs, Tokyo Electron, and Chevron. We also reduced positions—specifically within IRA accounts—in holdings such as Costco, Nike, Microsoft, and Deere. It is worth noting that we made substantial purchases of Costco during the first quarter when shares were trading below $310, and later trimmed a similar-sized position just a few months afterward when the stock was trading above $440. That represents an unusually wide trading range for a company with business characteristics as stable as Costco’s.
Our portfolios are focused on owning companies that we believe offer a strong margin of safety alongside growth opportunities, all while trading at reasonable valuations. The characteristics we use to assess margin of safety include profitability, balance sheet strength, free cash flow, and barriers to competition. This focus on fundamental strengths allows us to remain patient investors, prioritizing long-term value creation rather than reacting to short-term market volatility.
“It’s waiting that helps you as an investor, and a lot of people just cannot stand to wait. If you didn’t get the deferred gratification gene, you’ve got to work very hard to overcome that.”
— Charlie Munger
Vice Chairman, Berkshire Hathaway
Closing Comments
The stock market has been exceptionally strong over the past sixteen months, and there continue to be pockets of increased speculation. While we see many positives in the months and years ahead for the economy, we also recognize areas of concern, including rising inflation and the aging population across the developed world.
Over time, the global economy should return to full capacity, which would support meaningful earnings growth. American consumers, in particular, may be positioned to increase spending, supported by higher savings balances and improving confidence driven by strong asset growth over the past year.
We make our investment decisions based on the fundamentals of each individual company—not on macroeconomic forecasts. That said, we do consider economic risks, such as rising inflation, as part of our decision-making process. Our highest priority is protecting the affluence our clients have built over their lifetimes from the corrosive effects of inflation.
Our success requires discipline and patience. We remain cautiously optimistic about the year ahead and will continue to look for prudent opportunities to improve both the quality and upside potential of client holdings.