Markets Update | Phase II of The Recovery

In our latest Markets Update, the team covers Phase II of the Recovery: macro-economic outlook, end of year planning, fixed-income updates, sector analysis, and a look at how some of the stocks in your portfolio are positioned to hedge inflation. This update is available in video and an audio only format, a transcript is also available.

You can listen to the audio only version here:

Markets Update November 2021

James: Hi, everybody. Welcome to another. Fun edition of strategy update. We've got lots of great stuff to share with you. Some related to a year-end some things to think about as far as taxes and gifting. And our colleague, Natalie McMahon will share that.

And of course we want to dig into markets, equity markets, fixed income markets, all markets for the highest level business cycle stuff down to individual securities. uh, With that said, I think what we'll start with is Natalie sharing some really important year-end things you want to think about right before that January one date comes along.

So Natalie, I'll just go ahead and share my screen with you and let's talk about that.  

[00:00:37] Planning

Natalie: Sounds good! Thanks, James. Tis' the season to think about gifting and giving back. Everyone has the ability to give $15,000, that's $30,000, if you're married, filing, jointly to per individual. So always good to give cash.

But if you have appreciated stock with low cost basis, meaning you purchased the stock a very low price and it has now grown to a very high level, that would be a good option to gift as well. There's benefits to gifting appreciated stock. One is you can potentially chip away at a, a large position in your portfolio.

You can avoid capital gains taxes and you'll also get a charitable deduction up to 30% of your adjusted gross income. So it's a really good option to consider. If you do have a highly appreciated stock. You also have the ability to group your donations, either through donor advised funds or charitable trusts donor advised funds are great for uh, taking a big portion of of cash or stock and putting it into an account that's designated for charitable giving and charitable trusts are really great for potentially reducing your estate and thus avoiding the estate tax.

And then finally, we've got qualified charitable distributions. If you are a 70 and a half or older and have a qualified retirement account or IRA, you can give directly to qualified charities from this account up to a hundred thousand dollars. Speaking of IRAs we have a couple of year-end items.

If you haven't heard from us and you are 72 or older and have an IRA or another qualified retirement account. We will be reaching out to you to take your required minimum distribution by year end, and remember a great way to use your RMD is to make a QCD. But you do not need to have a required minimum distribution to make a QCD.

You just have to be 70 and a half or older. We also want to consider a Roth conversion, so taking IRA money, paying the taxes up front and converting those into Roth IRAs and letting them grow tax-free and never having to pay taxes on those accounts again. Those must be completed by year end by December 31st, 2021.

If you're thinking about doing a Roth conversion, reach out to your planning team here at Main Street Research, and then connect with your CPA or accountant and let's get some numbers that we can start to convert. Finally, I just wanted to make a little bit make a little note about changes. I feel like I've been talking about coming legislative tax changes for the whole year now.

And we still don't have any legislation that has passed. It's still being worked and reworked. Unfortunately, we're probably not going to see any of these changes enacted until closer, even closer to the end of the year. So if we recall the secure act of 2019, wasn't passed until December 20th, 2019.

So it's going to be cutting it close and should we see higher income tax brackets, higher capital gains rates, we're definitely going to be reaching out to you, our clients and making sure that we can take some tax savings strategies. This year before those take effect and the ink is dry, so to speak well. With that I'd like to pass it over to James, to talk a little bit about the stock market and what's to come.

[00:04:47] Macro-Economic Outlook

James: Thanks Natalie, the tax change in the laws are harder to predict in the stock market, right? It's just, we follow it closely for everyone that's on the call and we will be in touch with you in lots of different ways when we get more concrete evidence of which way some of this stuff goes, if it goes at all right.

So let's back up a bit. Let's talk about the big picture. Let's get into the market. Uh, you know, We're really excited and passionate about this stuff and I'm going to start off and then we're going to share some thoughts from each of my colleagues about different parts of the markets, but let's take a look and step back a bit and look at the economic cycle.

This is a great chart. Know, of course it's the chart of my career since I started in the early eighties and, boy equities are the way to build wealth as well as real estate. Um, But one of the things I think we can take from this picture, and we wanted to think about today, Is it, we just came out of recession.

I know it was a COVID recession, but we are recovering from a recession. And what does, what happens to the business cycle? What happens to markets when you leave a recession behind? And I think this picture is indicative of really what history has shown us. And I don't know that today will be any different.

Of course the world's different. So we're going to be ready and on our toes, one of the things you can see from this picture is after you come out of those yellow periods of time, where we saw the recession oftentimes the economy re-expand, we start a new business cycle and a new bull market. And I would suggest, as my teammates also support, that we are in the beginning, just the beginning stages of a new bull market.

And, you know, we've been saying this for awhile. And so far, the market has been very accommodating to our opinions. We think it will continue to be, the economy now growing at a whopping 6% growth. We have not seen that kind of growth in some time. The market's been extremely generous as you know, and I want to just use this chart to look back.

If you remember anybody, 2009 and 10, when the market started to recover, we had this crazy, very significant trajectory, upward in stocks, and then stocks started to level out and trade a little bit more of a normal pace. So if I have a couple of messages for you today is A we're in the beginning of a business cycle.

So let's be invested in equities. B, at the beginning of. The business cycle oftentimes brings very strong and consistent corporate profits. So again, equities are a great place to be. This is a different kind of cycle. So I want to share a different picture with you, and this will help us guide us into what my other colleagues would share with you about what I call the intermarket opportunities and the intermarket risks.

This next picture is really just a picture of the stock market globally, we always looking at global stocks, and the incredible path we've been on, to the left is the 40% decline with the COVID recession. Companies basically did what they normally do in recessions, just a whole lot faster.

Got rid of employees, got their inventory skinny, and then the U. S government came with all that liquidity. The difference between this recovery, and most, is that this recovery what it really needed was a vaccine. So when you take the vaccine, which now is becoming obviously much more obvious and more people having it pairing it with the tremendous amount of liquidity is powerful.

And that's why, instead of coming out of this, back to the old growth where we had pre pandemic, which is 2% we're coming out, boom, what does that mean? It means a strong economy, strong corporate profits. There's no wonder that stocks have gone up so much. The other thing was brought with, I bet.

You bet. You're wondering, we can talk about this word inflation. Yep, it's back. It's back with a vengeance. We don't think it's transitory. And we think the federal reserve is probably a little bit behind that. But we'll have Stephanie, I don't want to steal your thunder there Stephanie will have her chat about that.

With 6% growth. All the inflation is saying is it's confirming the economy strong, so strong that there just isn't enough supply versus the demand for goods and services and even workers. So you're gonna see some wage inflation here. The second and third thing I want to mention is really based on when you have strong economies that you have.

What really coincides with that as interest rates that go up. Again, I'm not going to step on Stephanie's toes cause she's got some really good info for you. But from a standpoint of stocks, let's think about a couple of things. Where do we go from here? That's what we all want to know. Where we go from here is not where we've been for the last 18 months.

This trajectory that you see here is unsustainable, but however stock could easily trade at eight to 12% annual returns over the next year, two and three annually. So consider stocks to continue to be very favorable relative to other asset classes, bonds, however will start to get competitive as rates move up.

A couple of the thoughts I wanted to share with you as well. The risks here, what is the risk in the overall market? I think two. One is economy slows down or decelerates in the face of rising inflation. That is called stagflation. It is not good for equities. It's not good for the markets. So we're going to be on the lookout for that.

We really want to see the economy continued to grow either at the 6% or even trending to five or four at what I would call the cruising space, cruising pace. That should allow corporate profits to grow quite nicely. If we decelerate significantly, maybe a variant, maybe the fed raises two rates too high what's going to happen is our Active Risk Management will have to be deployed.

What that means is if equities fall more than normal we're going to use those tools, that flexibility to reduce stock. That ability to hide in sectors that could potentially do okay. In that environment. And lastly uses carefully placed stop loss orders to mitigate catastrophic loss. And many of you have been through many cycles with us and that our process works quite well.

So in the face of an overall market decline, I think it would be based on a decelerating economy. We're ready. I don't think we're going to see that. The second thing I wanted to mention, and then we're going to push it over to Stephanie is there's intermarket risk here. What I mean by that in a bull market that continues upward from here, albeit at a slower pace, maybe a little bit more volatile because this hasn't been no volatility.

Keep in mind in certain sectors with higher rates are not going to do well. Utility stocks tend to do very poorly as opposed to banks. So if you see your portfolio being shifted in the last few quarters towards companies that benefit from higher rates, companies benefit from inflation it's on purposely because we're entering what I call phase two of this recovery, where stocks continue to do well.

Not quite as well as they have in the last 18 months, maybe a bit bumpier. And the stock market becomes more selective, great opportunity for us to really profit from these big changes in the overall economy. So we're excited. We're going to be continuing to use stop losses on individual securities, just in case one or two is mismanaged, but we're very optimistic and continue to be.

I don't think the market's overpriced. So with that, I'd like to share the screen and have Stephanie share some thoughts about fixed income, because she's got some great things to share.  

[00:11:57] Fixed Income

Stephanie: Thank you, James. It seems like rates have been the talk of the town lately. From my perspective, it is always wise to be keeping an eye on the bond market, regardless of whether or not you're an income investor as the direction's rates are moving.

And the shape of the yield curve can offer clues to where the economy may be heading. Over the past year, we have seen a pickup and rates among most maturities across the curve. And this chart, you can clearly see that this is the case as a solid line on top it's rates at the start of November. And this is compared to the end of last year, which is the dotted line below. Just to hone in on a few areas, in particular, we have seen a rise in the 10 year yield above 1.5 in recent weeks. We've also seen a pickup on rates, closer to the front end of the curve, notably the two year treasury. A rise in rates in this area of the curve is seen as the market pricing and a rate hike or hikes by the fed reserve in the future, which this leads us to the big news in the market, which is a change in fed policy announced today.

The fed has finally announced that it will begin unwinding its current asset purchase program known as tapering does not involve the outright sale of the feds holding. It just simply means that they will reduce their purchase. This will likely end by the middle of next year, but the fed could change the pace based on market and economic conditions.

Although this is not a tightening of monetary policy, it is still an important step. The key will now be for the fed to convince the market that this is not a direct signal for raising rates. We expect the fed to continue to be transparent about their next moves, which should ease, concerned about any unexpected policy changes.

Shocking. We expect volatility to continue as the market tries to make sense of the future. There has been some fears recently that a rise in rates will stifle economic growth. We feel the economy is in a much stronger foot in coming out of this crisis, than the last one. And we still feel that rights are still low when viewed from a historical standpoint and this chart, this has the ten-year treasury over the past 10.

As you can see we're off Lowe's, but we're still in a low range viewed from a historical perspective. If I would have this chart to include go back in time to include the seventies and eighties, we would see that the 10 year treasury yield average above 6% and peak at 15% in 1981. Some of you may remember those times. As you can see, it's pretty clear that we're in a much different interest rate environment in this past decade.

Our firm is positioned to take advantage of rising rates, as it will create more opportunities for us to add to your individual corporate and municipal bond holdings. However, we do have a warning for holders of bond funds. A rise in rates could cause them to decline in value during these rates cycles.

You may have heard my colleagues say, don't let your friends and family own a significant amount of bond funds or long maturity bonds. And with that, I think I'll turn things Aaron to with so he can get further into sector performance.  

James: Stephanie I just want to say that's, you're so right about so much of what you just said and the Feds, but they said today, You know, we're all Fed watchers really fascinating. It could be the one time the bond market really steals the stage from from the stock market. Really exciting, fascinating stuff going on. So Aaron, yeah let's talk about, within the stock market, some of the sectors, if you can share some of your wisdom on this.

[00:15:30] Sector Analysis

Aaron: Yeah, thanks, James. As you can see there's a whole bunch of green on this screen. Most major indices are up nearly 20% this year. And at the moment, every sector is currently in the green and participating. Uh, However, taking a deeper dive allows us to see that not every industry is doing quite as well.

As you know, we use individual securities here at main street, as opposed to sector ETFs or mutual. This really allows us to hone in on specific industries that are relevant and avoid those that are being ignored or sold off by investors. As you can see on the blowup there in the communication sector your positions contain investments in some of the better performing companies but we've stayed far away from, or removed positions in those industries like telecom and gaming that have significantly underperformed can see the, that group of red Verizon, AT&T, and T-Mobile.  

Thankfully we're far away from those stocks. As my colleagues previously mentioned, one topic that is forefront in many investors minds today is inflation. And while some of the sectors will face a strong headwinds in the face of rising rates and inflation others such as commodities, raw materials, banks, industrials, and even some technology companies will do just fine because of their ability to absorb these higher costs and pass them onto the end consumer.

Companies that have pricing power over their products and easily raise those prices to keep in pace with inflation. Historically the energy sector has been able to beat inflation as the revenue of energy companies is of course, closely tied to oil prices, which is, and there were a large component of inflation indices.

Uh, So investing in the energy sector is a great hedge against inflation. Conversely, when a company's revenue can't increase with the pace and inflation, they often struggle. Take consumer staples, for example, there's simply too much product already on shelves and too much competition for these companies to raise prices fast enough to keep pace.

Lastly while the final numbers are somewhat diminished in order to achieve bipartisan support there's still trillions of dollars of infrastructure spending on the table in Washington, DC. Uh, These dollars will be put to work, improving everything from roads and bridges to the grid and high-speed internet for everyone.

Next Benjamin and Lily are going to show you exactly where your investments are in these and some other spaces.  

James: Aaron, that's a really good point. You know, I think it's really important for investors to know now that this market it might become really bifurcated. You know what? You got rates going up, you got infrastructure bill and that can change the sector orientation.

We really want to be careful here about being weighted in the right sectors. I love what you just mentioned, how you're thinking about the sectors relative to the economy. Very important. And yeah let's switch it over to Benjamin.  

[00:18:13] Individual Securities

Benjamin Armellini: Great. I think you were alluding to this James, which is right. We're just coming out of a great period of corporate profitability. And so we've seen a number of companies objectively and very openly discuss inflation. And so what our teams consistently thinking about is what type of businesses that are selling these products and services and providing platforms for consumers all around the world.

What's one of these really dominate the ability to pass pricing pressures onto consumers and maybe Lily, do you want it to give a couple examples of that.  

Lily Taft: Yeah, thanks Ben. So Aaron already mentioned energy. I think that's a pretty obvious one for a lot of us going to the pump and feeling that right there, filling our cars up.

But some, you may not have noticed that we're keeping our eyes out for is lithium and cobalt. These are commodities, they're at the bottom of the supply chain, and they're really important for things like electric vehicles. Which have a ton of demand right now. Another theme that you can see here along the lines of inflation is there's a lot of international companies on the screen.

And this gives us exposure to different currencies, so there's a little bit of a currency hedge in the, built into the portfolio. And particularly no China left in the portfolio. We stayed away from that space. There's a lot of political volatility. And we've been able to capture growth elsewhere in places like Europe and even Japan.

Benjamin Armellini: It's such a good point, Lily, I think one that really resonated through it with this process that we're using around the stop-loss orders. And my gosh, you wouldn't want to be stuck in some of these Chinese companies that are just gone through some really difficult regulatory headwinds, as we're also thinking through this portfolio creatively, we spoke a little bit about interest rates and banks.

Those two tend to really move in lock step. And so again, we've really put a bit of a tilt on the portfolio to encompass some of these sectors and specific companies that really benefit from interest rates. And then Lily, I know also we were actually just speaking about this earlier today in our Investment Policy Committee meeting is market breadth.

It's not just the three or four stocks that really led that first move out of COVID recession, but we're really seeing this more broad based participation and particularly amongst smaller companies.  

Lily Taft: Yeah, it's great to see more companies participating in the beginning of the recovery. It was really just the Googles and the Microsofts, and now it's all across the board.

But what's interesting is it's mostly the really high quality company. Stocks that are not overly exposed to heavy debt loads on their balance sheets. We're focusing on companies that have strong cash flows, really solid valuations, or being really careful about the price we're paying for the.

That we're buying these days and participating across the board. So not just energy and banks, but, healthcare is a really interesting place that we've done more research on recently and even logistics right with the holiday seasons coming up. It even something as simple as that can have so much growth potential.

Benjamin Armellini: It's so true and it's really comes down to maybe in a single word, making a portfolio that's modern. And so that's really the theme that is trying to be consistent here. We want a lot of representation for inflationary factors, but also just businesses that are really modern today. Everything from the squares to companies helping produce enough supply for the excess amount of demand that we're seeing in the housing market. So we hope this very brief update on some of the individual holdings is helpful. And with that, James, I might pass it back to you for some closing comments.  

James: Thanks Ben um, and Lily, many of us in the team from the same securities you do we eat our own cooking.

We have a pride in some of these incredible companies and I love what you guys just mentioned, the word modern, right? Keep this portfolio of modern companies selling a product or service the world wants more of, are great ways to play this market and it's going to be a fascinating period of time over the next quarter or two as we consider a significant change in interest rates probably a continuation of inflation in a market, yeah, that continues to probably perform better than most asset classes, but probably a little bit bumpier. So put your seatbelt on get used to the way the markets used to trade. Big rally. And I think we're going to have a great few years ahead of us as we are in the early stages of the economic cycle.

With that said all of us on the team are honored to be the steward of your investment assets and doing your financial planning. And we look forward to chatting with you soon. We're always around. We love what we do for a living. So via email call, whatever way you want to contact us, please feel free to do.

And we look forward to sharing any information we can and and just thanks for watching and we'll see you again soon!

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