First Long Island Investors is proud to share that on September 15, 2022, First Long Island Investors (FLI) Senior Vice President Brian Gamble was presented with the Blank Slate Media 40 Under 40 Award for his dedication and commitment to both his profession and community. The ceremony was held at the Crest Hollow Country Club, where Mr. Gamble was joined by 39 other honorees from various industries who also received this honor.
“People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game.”
-Peter Lynch (renowned investor)
Equity, bond, and some commodity markets suffered sharp declines adding to woes from the first quarter. The Dow Jones Industrial Average, S&P 500 Index, and NASDAQ Composite declined 11.3%, 16.1%, and 22.3% for the second quarter, respectively, and for the first half, declined 15.3%, 20.0%, and 29.2%, respectively. This marked the biggest drawdown for equity markets since 1970 (also a midterm election year). There was little shelter in bond markets where intermediate term U.S. Treasuries declined 11%. Surprisingly, with inflation running at 9%, even lumber and copper declined 42% and 17%, respectively. Bitcoin dropped a precipitous 58%. (We have not invested in cryptocurrencies nor are we inclined to.)
These market results seem exaggerated and unexpected when one considers that we are experiencing strong domestic employment, projected S&P 500 earnings growth of 10% for 2022, robust consumer balance sheets (see Chart 1 below), and a strong banking system evidenced by all major commercial banks just having passed their federal stress tests. Add to this list a residential housing shortage, which should help support home values.
However, fears of rising interest rates, inflation at levels not seen in 41 years, a continuing brutal war in Ukraine, depressed consumer confidence, and divisive Supreme Court decisions make virtually all investors and non-investors trepidatious of what lies ahead, including a possible recession, especially when there is little confidence in our elected officials in Washington, D.C. crafting any solutions to these issues. Let us not forget the continued, diminished, but still prevalent COVID-19 pandemic while scattered lockdowns in China continue to impact both the Chinese and global economies.
Perhaps the most troublesome issue facing American consumers and businesses is the pervasive inflation (not transitory as suggested by the Fed and Treasury officials last year) including rising food and energy prices along with housing costs. The shock of gasoline averaging $5 per gallon, representing a 59% increase from a year ago, and food prices rising 12% over the past year has impacted consumer spending and consumer sentiment. This inflation, in major part occurred due to supply/demand shocks caused by the COVID-19 pandemic and the new Administration’s policy changes regarding the promotion of green energy. A barrel of oil had actually increased by 74% from Biden’s inauguration to just prior to the Russian invasion of Ukraine, which led to a greater increase in energy costs. Thus, the perils of rising inflation have now been with us for more than a year.
The Federal Reserve’s belated response to rising inflation was to commence an aggressive series of rate increases as well as the onset of the shrinking of its bloated balance sheet, which in turn has led to a reduction of price-earnings multiples and thus a significant decline in the price of most equities, especially growth company shares. Fed “speak” has led to fears of continued aggressive interest rate increases, decreased liquidity, and demand destruction designed to quell economic activity in an attempt to reduce inflation. Both Fed monetary policy of continued historically low interest rates and government fiscal policy of printing money to buffer the economy from the effects of COVID-19 have led to too much loose and cheap money that the Fed is trying to purge from our economy without inducing a recession.
The traditional barometers that historically predict with decent precision impending recessions, however, are NOT flashing a warning at this point. A brief, modest inversion of the spread between the 2-year and 10-year U.S. Treasuries occurred in the beginning of the quarter while a slightly wider inversion occurred shortly after the end of the quarter. However, the Fed’s preferred spread is between the three-month and ten-year U.S. Treasuries, which is not inverted (see Chart 2). At the same time employment remains strong as seen in Chart 3 (although jobless claims have recently ticked up and hiring freezes have been announced by the likes of Meta Platforms, formerly Facebook).
However, in our opinion, fear of impending interest rate increases, reduced demand/economic activity from inflation, worries about COVID-19, and concerns of a nuclear or other escalation by Russia in its war in Ukraine has pummeled consumer and investor sentiment to extremely low levels (see Charts 4, 5, and 6 below). This in turn has led to retail sales that have been impacted by the rate of inflation. While retail sales continue to be up in dollar terms, net of inflation, they are down slightly.
All of the above has resulted in caution in our consumer-driven economy and poor equity market performance in the first half of the year. Where does this leave us? In 1970, also a midterm election year, equity markets declined in the first half of the year by 21% while dramatically increasing in the second half of the year to end the year essentially flat, but that is not always the case. Meanwhile from a historical perspective, midterm election years have typically been impacted by significant market declines, followed by robust performance (see Chart 7).
We have always relied on earnings growth, dividend increases, and reasonable interest rates to generate returns from our investments. If earnings for the balance of the year (starting with second quarter results and guidance to be announced starting in mid-July) continue to grow in a fairly broad way, not just for energy companies (currently enjoying robust oil prices), we hope to enjoy a second half rebound even as the Fed increases interest rates to stifle inflation. If President Biden is successful in motivating the Saudis to increase oil output (so much for carbon and climate concerns), oil prices might drop enough to temper the Fed’s aggressive interest rate hikes. This could return investor focus to fundamentals, earnings, and dividend increases. Our Dividend Growth strategy continued to put up robust dividend growth in the first half (13.7% on average) as all of those companies expected to raise dividends during the first half of the year did so. This strategy outpaced the S&P 500 for the second quarter and year-to-date by several hundred basis points.
In our view, much depends on achieving projected earnings, reasonable guidance, and continued dividend growth to reverse the dire negative trend we have endured during the first six months of the year. In addition, any cessation of hostilities in Ukraine would remove a cloud that now exists and has added to the decline in market multiples experienced thus far this year. It is our view that price-earnings ratios suffer during periods of war or severe global crisis. However, our current view of this conflict is one of grave concern as Russia takes Ukrainian territory in the eastern part of the country, while the chances of a near-term negotiated cease fire appear remote. Couple this with poor relations with China and efforts to de-globalize parts of our economy and there is more to worry about for investors.
What to Do?
As our quote suggests, periodic stock market losses are part of the investment process, especially if one wants to achieve better returns over the longer term than those available from cash or bonds. Please keep in mind that equity returns over the last three and five years despite this serious downturn have been meaningful:
We would be remiss in suggesting we have reached a bottom in equity markets. If earnings do not continue to materialize or price-earnings multiples continue to contract further downside is possible. As of now however, with the S&P 500 Index trading at 15.4 times 2023 projected earnings and the 10-year U.S. Treasury yielding 3.0%, overall market valuations feel reasonable to attractive. This is especially the case when one looks at the number of fine companies that are down more than 20% year-to-date including Microsoft, Amazon.com, Walt Disney, Meta Platforms, Qualcomm, Abbott Laboratories, Home Depot, JPMorgan Chase, etc. These are profitable and dominant companies, not those that were trading at excessive multiples of sales with no profitability such as Peloton Interactive or Vroom, which are off at least 90% from their highs within the last year.
We believe that staying the course in our defensive and traditional equity strategies comprised of high-quality, financially strong, market dominant companies, other than having an appropriate cash buffer (which we have urged for quarter after quarter), continues to make sense for long-term investors. For those with excess cash above one’s necessary cash buffer, a program of dollar cost averaging to take advantage of what we believe are long-term opportunities would be prudent, even despite when we face a recession, now or later, which we believe would be shallow but could last a while.
Our paper losses to date from market highs have been painful for all of us. (Please remember we invest side by side with you.) Even though we have made significant investment gains over the last five years, these are troubling and uncertain times. Yet we are invested in companies that we believe have excellent futures and the current ugliness of investor sentiment does not impact the business models of these companies, many of which continue to ride secular growth trends such as cloud computing, the internet of things, conversion to electronic payments, medical breakthroughs, and the rise of e-commerce or are just great consumer companies like Starbucks and McDonald’s, which are durable, long-term franchises.
Heed what the great investor Peter Lynch said. To make decent gains over time, we must be willing to endure periodic losses, even those caused by unexpected events, whether a pandemic or a Russian war (both at the same time feels like a high wall of worry to climb). To some extent, this ugly downturn in equity markets in part has been caused by excessive cheap money in response to the COVID-19 pandemic. Call it long-term financial COVID. The global economy must digest the dramatic shut downs of economies, the horror of so many lives lost, the reopening causing both demand shocks and supply disruptions as well as the government’s loose and plentiful monetary medicine to address the pandemic. This has led in part to high inflation, fear, and declines in equity markets.
The Patient Investors
It is hard to recall an investing environment where one has to scale such a “wall of worry” encompassing both domestic and global economic, governmental, and social challenges (wealth disparities may be part of the cause for rampant crime). Despite these many challenges we remain cautiously optimistic that long-term investing in quality companies at reasonable valuations (for public and private companies’ equities and debt) as well as quality real estate will reward the long-term investor on an after-inflation basis. We believe those select opportunities (not all investments will qualify) still exist at what are far more attractive prices today than last year, but one must endure volatility along the way. As Warren Buffett said, “Never bet against America.” America remains resilient, innovative, and a leader, but with much work to be done to reunite us.
Please do not hesitate to call upon us with any questions or for any of your wealth management needs.
Best regards and have an enjoyable summer!
Robert D. Rosenthal
Chairman, Chief Executive Officer,
and Chief Investment Officer
PS: It is with regret that we announce Ebonie Hazle, our Vice President and Deputy General Counsel, and Karen Weiskopf, our Vice President of Marketing, have been poached away based on their fine work at FLI. We wish them much success in their new endeavors. A search is in progress for high-quality replacements while their responsibilities are currently absorbed by our organization. On a positive note, we would like to share that Alexia Yaziciyan has been added to the Investment Committee and we have hired a new Junior Investment Analyst, Joseph Libretti. We are excited by what both bring to the table and look forward to their contributions.
*The forecast provided above is based on the reasonable beliefs of First Long Island Investors, LLC and is not a guarantee of future performance. Actual results may differ materially. Past performance statistics may not be indicative of future results. Partnership returns are estimated and are subject to change without notice. Performance information for Dividend Growth, FLI Core and AB Concentrated US Growth strategies represent the performance of their respective composites. FLI average performance figures are dollar weighted based on assets.
The views expressed are the views of Robert D. Rosenthal through the period ending July 27, 2022, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such.
References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Content may not be reproduced, distributed, or transmitted, in whole or in portion, by any means, without written permission from First Long Island Investors, LLC.
On Thursday June 16, 2022 First Long Island Investors held an online web seminar with Robert F. DeLucia, CFA. Bob was formerly Senior Economist and Portfolio Manager for Prudential Retirement. Prior to that role, he spent 25 years at CIGNA Investment Management and 15 years with Prudential Retirement most recently serving as Chief Economist and Senior Portfolio Manager. He currently serves as a Consulting Economist for Empower. Bob has 50 years of investment experience. He shared with us his latest economic forecast and the implications for global financial markets. He also provided guidance on how the various indicators should be taken into consideration when making investment decisions.
“The most important quality for an investor is temperament, not intellect.”
-Warren Buffett
All major indices were negative for the quarter (including bond indices), ending the string of seven quarters of consecutive gains and leaving investors facing a complex environment to navigate Challenges, both economic and geopolitical, which were cited in our 2022 Market Outlook (published in January), abruptly confronted investors during the course of the quarter.
The Fed, recognizing the highest inflation rate in 40 years, finally started a course of increasing the short-term borrowing rate that will be implemented in 2022 and 2023 in addition to ending its asset purchase program. The pace and magnitude of the increases will be data dependent, but it appears at this point to suggest short term rates approximating 2.5%-3.0% by the middle of 2023. The first increase, announced in March, was 25 basis points. At least six more increases are forecasted between now and the end of 2022 given the current level of inflation (8.5% as of March 2022), which the Fed now realizes may only be in part transitory. Americans are facing significantly higher fuel and food costs which in and of itself represents a major tax on the average family. Although we believe certain supply shortages will abate by year end, they are no longer what constitutes the root cause of inflation, as once thought by many.
Short-term borrowing rate increases could lead to long-term rates increasing reflected in the 10-Year U.S. Treasury that will impact mortgage rates and consumers in general; and possibly reduce price earnings multiples on equities if the 10-Year U.S. Treasury rises to above 3.5% in our opinion (as of March 31, 2022, the 10-Year U.S. Treasury was 2.3%). Later in this report we will address the possibility of a recession in 2023, but for right now we do not see a recession in the near term.
Long desired wage increases have finally made their way into our economy with increases approximating 5.6% most recently. This tracks a lower unemployment rate where labor is becoming scarce making wage increases for many a necessity to do business. Chart 1 shows average wage growth tracking the improvement in the unemployment rate. Of course, these trends follow the abatement of COVID-19 or perhaps our improved ability to navigate COVID-19 given vaccines, boosters, monoclonal antibody treatments, and the new drugs from both Pfizer and Merck. These provide relief for people contracting the virus and helps keep them out of the hospital. However, based on scientific opinion, variants of the coronavirus appear here to stay and boosters seem to be a preventive measure that we will all be receiving for quite a while.
Besides wage increases, which we do not believe are transitory, fuel costs have soared. The increase in fuel costs (oil) seem to have been parallel to the Administration’s focus on alternative energy sources and a deemphasis on fossil fuels. Chart 2 shows the increase in the price of oil over the last several years. The initial surge began with the election of President Biden. The second surge has occurred with the Russian invasion of Ukraine and our government’s decision to stop importing some of our energy needs from Russia. At this time, the President has decided for the second time in the last six months to release oil from our Strategic Petroleum Reserve (a reserve that was created in 1975 to provide emergency protection given geopolitical strife in the Middle East). In our opinion, releasing oil from our Strategic Petroleum Reserve will not have a long-term positive impact on oil prices (the release of reserves is currently slated from now until the fall).
The current causes of the rising price of oil and natural gas are complex. Certain regulatory guidelines imposed by the new Administration limited the ability of U.S. production to meet the rising demand in 2021, driving oil and fuel prices higher. Add to that, the outrageous invasion of Ukraine has led to significant economic sanctions against Russia including scaling back energy purchases. This is forcing the U.S. and European nations to seek supplies elsewhere. An obvious partial solution would be to attempt to more aggressively increase oil production domestically, but the Biden administration is trying to balance the needs of domestic oil production and combating climate change. Middle Eastern countries have been urged to increase their production, but thus far this has not resulted in much success. Increased oil from such disreputable countries as Iran and Venezuela are also under consideration but bring geopolitical issues.
Another significant area of inflation is food prices (as depicted in Chart 3). Here wage growth as well as supply constraints have helped usher in a wave of inflation. However, this situation could get worse as Russia/Ukraine represent about 30% of the wheat (grains) produced globally. Given the ongoing war, we believe that supply will be constrained and this will further impact the price of certain foods going forward. Some countries are seeking to plant on government acreage as a way to increase supply, but this will take time.
Several key areas including wages, oil, and food are stoking the rise of inflation confronting America. This could at some point lead consumers to reduce their purchases and contract economic growth. However, the consumer still appears very strong from a balance sheet standpoint, as you can see in Chart 4.
Our Complex Investment Environment
Despite starting from record lows, we are still facing higher interest rates for the first time in many years. These rate increases are designed to curtail the highest inflation in 40 years. Rising interest rates and higher inflation at the same time that we have a war raging in Ukraine makes for a pretty high wall of worry for investors. Profits for S&P 500 companies for this year are still projected to rise by 9% despite global concerns while the S&P 500 Index declined by 4.6% during the first quarter. This represents a modest reduction from the beginning of the year probably reflecting slower projected global GDP growth given the war in Ukraine as well as continued pockets of COVID-19 impacting various economies, including that of China. But a down market of 4.6% while still forecasting growth in earnings would seem to suggest some happiness by the end of the year. We believe this is a possibility and seems plausible to us as bond investors must digest negative real returns (absolute return minus the rate of inflation) that makes quality equity investing a better long-term option than investing in bonds (at this time, in our opinion).
Adding to this complex picture is the history of the equity markets appreciating after the first rate increase by the Fed as shown in Chart 5.
It appears that in times past the equity markets have been able to absorb Fed rate increases especially when earnings and GDP growth were still intact. Also, we must ponder the meaning of potential rate inversion where short-term rates exceed longer-term rates and the ensuing probability and timing of a possible recession. The spread between the 2-year and 10-year U.S. Treasuries slightly inverted for a brief period of time (less than one day) in the first quarter but is not currently inverted. The following charts show that meaningful inversion of the spread between the 2-year and 10-year U.S. Treasuries or that of the 3-month and 10-year U.S. Treasuries have typically been followed by a recession. As you can see in Charts 6A and 6B, recession has typically followed the inversion of the 2-year/10-year spread in the next twelve to eighteen months and of the 3-month/10-year by six to twelve months. We believe the spread between the 3-month and 10-year is more indicative of future economic growth and at this point it does not indicate an imminent recession.
This complex picture shows challenges to investors in the form of Fed rate hikes and possible recession; inflation and the potential impact on consumers and businesses; geopolitical strife with a war in Ukraine; and we still have to navigate the COVID-19 landscape but with many more tools (vaccines, boosters, and novel drugs).
Outlook for 2022
We believe that the complexity of investing right now is daunting, but the challenges are offset to a large extent by the strength of the consumer, our robust banking system, growing corporate profits, companies with pricing power, somewhat more reasonable valuations given the first quarter drop in stock prices, and growing dividends from many of the companies we invest in.
The current confluence of economic and geopolitical factors makes for investor anxiety and market volatility. From a contrarian standpoint, this negativity might be a positive. Our view remains that we should look over the valley of these factors with the expectation that over time, we as investors will continue to make gains. Proper temperament is now required so that we do not act emotionally to the first negative full quarter in two years. Whether one invests in public or private companies or real estate related opportunities quality, growth in cash flow, increasing dividends, and solid financial fundamentals will again be the keys to investment success. This, along with a prudent asset allocation among risk assets and a buffer of cash, is our prescription for weathering the complexity of the current investment environment. Over the longer term, never bet against America!
Please call upon any of us on our investment committee or wealth management team to discuss your asset allocations and/or wealth management needs.
Best regards,
Robert D. Rosenthal
Chairman, Chief Executive Officer,
and Chief Investment Officer
P.S. President Biden recently proposed a federal budget. It includes an increase in spending as well as a host of tax increases similar to those proposed last year, but not enacted. It is premature to discuss any aspect of it at this time. We will include discussion on it when warranted.
*The forecast provided above is based on the reasonable beliefs of First Long Island Investors, LLC and is not a guarantee of future performance. Actual results may differ materially. Past performance statistics may not be indicative of future results. Partnership returns are estimated and are subject to change without notice. Performance information for Dividend Growth, FLI Core and AB Concentrated US Growth strategies represent the performance of their respective composites. FLI average performance figures are dollar weighted based on assets.
The views expressed are the views of Robert D. Rosenthal through the period ending April 22, 2022, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such.
References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Content may not be reproduced, distributed, or transmitted, in whole or in portion, by any means, without written permission from First Long Island Investors, LLC.
Barron’s recently asked financial advisors, including Philip Malakoff of First Long Island Investors, how they are navigating 2022’s volatile first quarter.
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