With COVID, Afghanistan, the southern border, Hurricane Ida, and Congress spending trillions at a time, along with the threat of higher taxes and inflation – Is it reasonable to remain bullish?
Let me explain why we are:
First, a little history. There have been three and I believe, now, four economic revolutions. The Agricultural Revolution started around 8000 BC when humans began to move away from hunting and foraging, to farming. Had these been farming businesses, we would talk of the immense increase in production, with sharply rising profits.
Beginning around 1760, came the Industrial Revolution with the transition from hand production to machines. New chemical and iron production processes were spurred by steam and waterpower. Businesses became much more profitable as they manufactured many times more products with the same sized labor force. The number of jobs grew quickly and so did the population.
More recently, the Technology Revolution has encompassed numerous periods beginning in 1870, with the most recent phase, the Digital Revolution, beginning in 1975 with the shift from analog to digital processing. Business, of course, flourished as a result, with earnings growing at rates not imagined previously. Of course, that has made companies worth more on a P/E basis. Certainly, we would pay more for a company with $10/share earnings that is growing at 20% per year, than one with the same $10/share earnings that is growing at 4%. Hence, P/Es deserve to be higher today than previously (at least for those higher growth companies, which happen to dominate the S&P 500 today).
And finally, what I will call the Productivity Revolution, began around 2009 and was given a boost after COVID-19 shut down many businesses. As companies began to reopen, they found attracting labor to be more difficult than expected. Via robotics and better software, along with other improvements, business has become much more productive, with fewer employees. The result has been economy-wide corporate profits for Q2 were up an outstanding 9.2% from Q1 and up 15.8% from the pre-COVID peak in late 2019. S&P 500 average Q2 net profits were 13%, above the very good 5-year average of 10.6%.
These figures let us update our S&P 500 forecast. I am using a Capitalized Corporate Profits Model from Brian Wesbury at First Trust. It is a model he introduced to me some ten years ago and I’ve been using it since. The model looks at corporate profits, annual profit growth, discounted by the 10-year Treasury rate
Though we think the current 10-year yield of 1.3% is being held artificially low by the Federal Reserve, we believe it will be low (below 2%) through, at least, 2022. To keep our forecast conservative, we discount current profits using a more cautious rate of 2.0%. Plugging that rate into the model with the Q2 profits generates a fair value estimate for the S&P 500 of 6,130 or more than 35% higher than today’s 4525.
How robust is this fair value estimate? Well, if corporate profits fell 36% (and the 10-year rose to 2.0%) the market would be at “fair” value today – roughly 4,520. The same result would occur if the 10-year yield more than doubled to 2.7% while profits remained flat. In other words, the market is rising for a reason…profits are up and the threat from higher interest rates remains low. As a result, we think it is prudent to raise our 2021 year-end forecast to 5,000 on the S&P 500. Based on these numbers and no significant changes, we would expect 2022 can be another good year too.
Risks to this forecast. 1) The US could “lockdown” the economy again over the Delta variant. 2) The Fed could raise rates more quickly. 3) Tax hikes could be pushed through with current legislation.
Rightly or wrongly, we don’t think the US will lockdown again. At the same time, last week’s “Jackson Hole” speech by Federal Reserve Chairman Jerome Powell made it clear that monetary policy is likely to remain very dovish for the foreseeable future. The Fed may start to taper, but it will do so slowly, primarily because it thinks inflationary pressures are temporary. Also, the Fed views Delta as a risk to economic growth. And the taper will likely consist only of less bond purchases, rather than any rise in the Fed Funds Rate.
Yes, we are fully aware tax rates are likely to go up if Congress can pass an all-Democratic budget bill. But we think the kinds of tax hikes that would be likely to pass are already priced in, including a top regular income tax rate of 39.6% (versus 37%), a corporate tax rate near 25% (versus 21%), a top capital gains and dividends tax of 24% (versus the current 20% or President’s Biden’s proposed 39.6%). These can likely be easily absorbed by the economy overall, assuming they don’t parallel a rising Funds Rate.
Adding to this theme, we believe the long-end of Treasury rates (10 and 30-year) will maintain historically low. With the rest of the world mimicking our Fed, our rates are relatively high and attractive. With our 10-year rate at slightly less than 1.3%, it compares very favorably to others. The German 10-year is at a negative 0.44% and their 30-year rate is a dismal 0.03%.
Still more bullishness for business may be found in Consumer Savings, which are at decades highs. With consumers flush with cash, corporate earnings are likely to stay on an upward trajectory. Even inflation will help with many corporate profits as many corporations are able to raise their prices by more than their increased costs. Keep in mind that when making widgets, only the materials and energy typically have an impact. Often, labor is a small percentage of the cost and many other base costs don’t rise at all, or very slowly. Manufacturing facilities warehouses, and office space tend to be locked in for years, with only slight annual increases. Typically, 80% of the inflation rate will fall to the bottom line of profits. If we have 5% inflation, profits will increase by 4% (80% of the 5%).
Oil – West Texas and Brent
Two days after Joe Biden became President, we started buying oil and gas companies, though we owned almost none for four years under President Trump. At first that may seem backwards. After all President Trump wanted to become energy independent, thus he favored oil. At the same time, it is well known that President Biden is not a fan. In fact, his first act as President was to cancel the Keystone Pipeline. That was followed by announcements that would restrict oil exploration on federal lands and ANWR drilling was ceased.
When you think about it in the context of supply and demand, we predicted that oil prices would drop under a supply side Trump and would rise sharply under a supply restrictive Biden. That has certainly been the case. We favor the smaller producers over the multi-national conglomerates. The larger companies tend to be diversified among green energy and other areas, while the smaller producers tend to be solely oil and gas. They benefit much more from the rise in the price of a barrel of oil, so for the most part, we have concentrated on them.
Though we took some profits over the past few months, trimming our positions, we have remained overweight in the sector. Last week we began to slightly increase our exposure again (especially in our more aggressive accounts). This time the impetus came from overseas. Not from OPEC, but rather from Israel. The new Prime Minister Bennett arrived in Washington to talk strictly about Iran and their nuclear advancements. He strongly believes they have advanced too far for any nuclear deal to have any relevance in 2021. With the threat that a nuclear Iran is to Israel and the world, it is likely that Israel will make some kind of strike on Iran’s nuclear facilities sometime soon. Any disruption in the area, on top of the Afghanistan situation, could quickly cut oil supply, causing a several months long spike in prices.
Regardless of Middle East supplies, and any potential short-term spike, we expect oil to remain range bound in the $60 to $70 per WTI barrel. As prices approach $60, new exploration drops and supply becomes tighter. As it rises to $70, new exploration rises with it, increasing supply to higher than demand, causing prices to drop again. This range could rise over time as the world begins to reopen our economies in a “post-COVID” environment, naturally increasing demand.The Case Against Rebalancing:
I have recently received some questions about why we don’t rebalance our portfolios and wanted to give our stance on the lack of benefit (and detriment) rebalancing can have on a portfolio.
The 25-year chart below, from a white paper by YCHARTS, demonstrates that not rebalancing has greatly out-performed rebalancing, regardless of the type of rebalancing. The more often rebalancing is done, the worse the result. We’ve often said that rebalancing is a lazy way to look like something is being done. The data appears to show that it is actually worse than doing nothing. It is hard to imagine that the idea of selling winners and buying more of your losers, will be a good action – all based on a calendar – not on a change in fundamentals. In the past 25 years, the best Rebalancing model below, reduced returns by 67% per year on average
We believe in and incorporate sector rotation. It is based on changes in economic conditions. These may be the result of elections resulting in changes in regulations, taxation or other major shifts. Pandemics, wars, or a myriad of other major events can change which sectors of the economy are favored or not. Using the prior example again. BCM held more oil and gas companies during the 8 Obama years, very few during the 4 Trump years, and overweight the sector again, under President Biden. The oil sector overall declined about 40% during the four years of the Trump administration. For managers that consistently rebalanced throughout those years, it would have resulted in buying more shares in the oil sector as it dropped and selling technology companies, which doubled during the same period.
Again, we hope everyone is able to resume their pre-COVID life and enjoy the rest of this year, seeing friends and family, along with the other activities you will enjoy.
The Beck Capital Management Team
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