September 30, 2024

“Our portfolio doesn’t depend on our being right about the twists and turns of the economy.  It depends on our understanding the prospects for our companies and what is discounted in their share prices.”  

Bill Miller

Our investment strategies delivered positive returns in the third quarter, with all of our Security, Defensive, and Traditional Equity strategies posting gains.  Our flagship Dividend Growth strategy led the way during the quarter, advancing 10.1% net of fees and expenses.  Year-to-date, all of these strategies have generated meaningful positive returns. 

We are also seeing promising traction with our exposure to specific real estate lending investments primarily in the Lehigh Valley, Pennsylvania; Austin, Texas; and parts of Florida.  These gains have been achieved despite difficult geopolitical and domestic political environments.  

The ongoing conflict in Ukraine and escalating tensions in the Middle East continue to impact markets.  Domestically, the political climate has grown increasingly heated, with contentious Presidential, Senate, and House races between Democrats and Republicans.  The rhetoric from all levels of the federal government has intensified, with debates, a bombardment of media campaigns, and rallies targeting voters nationwide.

Despite the angst fueled by ongoing wars and domestic political drama, we believe earnings and interest rates played key roles in the gains mentioned above.  Declining inflation (Chart 1), growing gross domestic product (Chart 2), and declining short-term interest rates (Chart 3) also were, in large part, responsible for these strong results.

The previous charts illustrate what some describe as a “soft landing,” where inflation continues to ease while economic activity sustains growth with a moderate slowdown.  We do not, however, see a recession in the foreseeable future.  Also, in our opinion, declining inflation and lower interest rates contribute to stock market valuations remaining at reasonable, although not cheap, levels.  Chart 4 depicts what we believe are reasonable levels for the stock market, as represented by both the S&P 500 Index (market-cap weighted) and the S&P 500 Equal Weighted Index:

For the soft landing to occur and valuations for equities to remain at reasonable levels, corporate earnings must continue to grow.  We believe this to be the case with large-capitalization, mid-cap, and small-cap companies.  As an aside, our suggestion in the last quarterly letter that small-cap and more value-oriented strategies would rally played out in the third quarter.  International investments also demonstrated impressive signs of life.

Chart 5 reflects Wall Street consensus expectations for earnings growth of the S&P 500 Index in the coming year.  If the earnings come in as forecast, this is particularly noteworthy as it suggests that the market, as a whole, is not overvalued in our opinion:
 

Chart 5 shows consensus projections for strong earnings growth in 2025 compared to 2024.  While we anticipate earnings growth next year, we believe this projected gain is overly optimistic.  In our view, this projection will come down over time, reflecting factors such as decreased consumer demand, uncertainty from a new administration as well as continued geopolitical strife, but we still expect reasonable earnings growth next year.  This will require more scrutiny on a company-by-company basis, making it a stock picker’s market across all market capitalizations.  In our view, the performance of individual companies, driven by their specific earnings growth, will be the primary differentiator.  The rising tide probably will not lift all companies equally. 

The backdrop to cautious optimism in our Security, Defensive, and Traditional Equity strategies is a slowly growing economy, decreasing inflation, falling short-term interest rates, and the absence of an imminent recession (which we do not foresee until late 2025 or later).  We anticipate that companies delivering earnings growth in a declining interest rate environment should appreciate in line with their earnings growth.  In the case of our Dividend Growth strategy, we anticipate appreciation in line with projected dividend growth of at least 7%, which should be well above the anticipated inflation rate.  That being said, it is difficult to fully predict the impact of AI on numerous companies, including those that have less obvious ties to technology.  

The charts above support our cautious optimism, which is justified by this dynamic combination of earnings growth and a supportive environment that will benefit equities, as well as real estate.  We believe real estate will particularly benefit from a slower-growing economy accompanied by declining short-term interest rates.

A final piece of the economic growth puzzle is employment.  It is clear to us that employment has somewhat weakened this year.  While still relatively strong with an unemployment rate of 4.1%, this does reflect an increase from the recent low of 3.4% in April 2023.  There is a theory (the so-called Sahm rule), which states that when the three-month moving average of the unemployment rate rises by 0.5% or more from the lowest three-month average over the previous twelve months, the economy is entering a recession.  Although this rule was recently triggered, we, and the rule’s namesake, do not believe it necessarily applies given the current unique economic situation we are facing.  Currently, consumers continue to spend more on average, with wage gains for many outpacing inflation.  The following two charts illustrate the recent record on unemployment and consumer spending:

Considering various economic factors (including earnings, employment, inflation, and interest rates), we believe that investing for the long term is still reasonable although not inexpensive.  That said, there has been a notable rotation within the equity markets.  Value-oriented companies such as our dividend growers, rallied in the third quarter as did small-cap companies across both growth and value.  The Magnificent Seven had comparatively mixed results in the third quarter despite putting up by and large strong earnings.  We anticipate these trends might continue in the fourth quarter.  This reinforces our longstanding view that our clients should maintain diversified portfolios with exposure extending well beyond the Magnificent Seven.

The Election

One cannot avoid the vitriol of this election cycle.  It is unique in American politics to see a sitting President well into the election cycle bow out.  It appears, in our opinion, that concerns over his mental acuity and negative polling contributed to his decision.  The Vice President was anointed to replace President Biden without a primary process.  Her opponent is former President Trump who has contested the outcome of the previous election.  

The country seems equally divided, suggesting this could be a very close election.  Additionally, both the Senate and the House are contested, with the outcome of these races carrying significant implications.  The views articulated by Vice President Harris and former President Trump on tax, economic, social, and foreign policy issues are quite divergent.  The party in control of both houses, if any, will dictate the trajectory of legislation.  Otherwise they will be forced to “play” in the same sandbox. 

Several tax proposals are critical to our clients, particularly those impacting income tax and estate planning.  The changes to individual income tax rates and estate tax exemptions that were part of the Tax Cuts and Jobs Act of 2017 enacted by former President Trump are set to expire at the end of 2025, which will affect both tax and estate planning.  Clarity is needed to reduce confusion and allow taxpayers to plan for the future.  

Vice President Harris has proposed increasing taxes on certain tax payers (both corporate and individual) on income, estates, capital gains, and corporate earnings.  She has also floated the concept of tax on “unrealized capital gains.”  We view these proposals as potentially negative to long-term investors.

Former President Trump, on the other hand, has proposed a series of tax reductions.  While they sound appealing (no federal income tax on tips or social security, liberalization of the SALT deduction, and reduced corporate tax), implementing all of them could lead to large federal deficits and increase our already high national debt.  

All of these proposals are speculative and contingent on the outcomes of the Presidential, House, and Senate elections.  These elections are extremely consequential given the divergence in economic ideology.  Long-term investors should pay close attention, and we will keep you apprised. 

Adding to this complexity is the expected increase in liquidity coming from both fiscal and monetary policy in early 2025.  This could be positive for equity markets and the economy in general.  The Fed may stop its quantitative tapering, and funds in the government’s general account may be released.  We will continue to monitor these developments and their potential impact on our investment strategies.

What to do?

As stated, we delivered very good results in the third quarter, and year-to-date performance is quite solid.  We have almost made up all the loss from 2022 and then some, depending on the strategy.  Being patient and focusing on long-term investing has paid off.  Our continued guidance to maintain diversification still makes sense.  The recent outperformance by value stocks and small-cap stocks, while the Magnificent Seven have slowed, has brought happiness to a larger segment of investors.  This recent appreciation in value stocks has helped our Dividend Growth strategy, while the improvement in smaller-capitalization stocks and international strategies have helped other strategies, which have meaningful allocations to both value and smaller-caps along with allocations to more growth-oriented strategies.  

We continue to advise clients to maintain allocations to our “bookend” strategy of rapidly growing companies on one hand and dividend growing companies on the other hand, as well as exposure to small and mid-cap companies.  At the same time, our allocation to high-quality, slightly longer duration fixed income, implemented over the last year, is also appropriate for clients.  We also continue to recommend select alternative strategies where appropriate.

Given the world we live in as investors, some volatility should be expected.  The potential for a lengthy longshoreman strike at major ports in 2025 could be consequential and disruptive, following a short strike the first few days of October.  Ongoing foreign wars and the acrimony surrounding the upcoming election (where roughly 51% will be happy and 49% unhappy) could cause investor angst as we wait to see what this all means for the future.  

At FLI, our approach is to examine each investment through the lens of earnings growth, dividend growth, valuation, and for our alternative investments, economic opportunity.  This disciplined course will help us navigate any twists and turns the economy, geopolitics, and domestic politics may throw at us!  This approach has served us well for 41 years and is reflected in the opening quote. 

Of course, despite our cautious optimism, we encourage you to call upon any of the members of our investment and wealth management committees should you have questions or concerns. 

Finally, please join us at our next Thought Leadership Breakfast seminar on Wednesday, October 30th.  Our keynote speaker is Meena Bose, a renowned political science professor at Hofstra University, who will provide an insightful assessment of the 2024 U.S. Presidential election. 

Also, be on the lookout for our revamped website later this year, and please come visit us to see our newly renovated offices.

Have a great fall and holiday season,

Robert D. Rosenthal

Chairman, Chief Executive Officer and

Chief Investment Officer