The U.S. stock market closed the second quarter at a record high, as measured by the S&P 500, which enjoyed a total return of approximately 15% for the first half of the year, marking the best first half of a year since the tech boom of the late nineties. However, very much unlike the late nineties, this year’s gains have been led by previously out-of-favor sectors like energy, financials, real estate, and industrials, while the mega-cap technology stocks have taken a bit of a breather. As a result, value has outperformed growth so far this year, and small-caps have done better than large. Indeed, several of our value and small-cap funds have delivered returns well in excess of the S&P 500. International stocks have delivered solidly positive, respectable returns but continue to lag the U.S. Bonds, on the other hand, have been slightly negative so far this year.
As for stocks, we confess to being a little perplexed by the strength in the market. Admittedly, our economy is enjoying a robust recovery as vaccinations roll out, the pandemic recedes, the world returns to some sense of normalcy, and demand is surging for, well, seemingly everything. On the other hand, though, the market seems to be dismissing the potential impact of the new administration’s tax and economic policy, not to mention the unintended consequences of unprecedented stimulus, the most worrisome of which is inflation.
Regular readers of our commentary will recall that we have long believed that inflation presented the most likely threat to the current level of stock valuations. Earlier in the year, we might have called it a clear danger, if not a present one. But in recent months, it has become present as well, with prices of most things rising, and some, like lumber, rising sharply enough to alarm inflation hawks. As inflation concerns have increased, longer-term (5+ year) bond yields have risen, resulting in the negative returns for the year. Our position on bonds continues to be one of shorter maturities and higher credit quality, recognizing that their role in a portfolio is to provide downside protection during major stock market declines. Stocks sold off a bit as inflation fears became more tangible. But in the most recent weeks, the Fed signaled that inflationary pressures are “transitory,” lumber prices dropped 40% from their recent peak, and headlines claiming “Inflation fears may be starting to pass” scrolled across our news feeds; and just like that, stocks resumed their climb.
We still think inflation is a credible threat, and at some point, we believe the Fed will engineer enough inflation to justify higher interest rates, which is now among their stated goals. And higher interest rates, all else being equal, means lower prices for both bonds and stocks.
So what do we recommend? Well, first of all, we strive to prepare, not predict. Rather than bet the farm on a specific outcome, we prefer to acknowledge uncertainty and be well-positioned for a wide range of possible outcomes. And while there are several “inflation trades” that could be incorporated into portfolios, we agree with Dr. Michael Burry (made famous by The Big Short) who said, “[M]y firm opinion is that the best hedge is buying an appropriately safe and cheap stock.” We would add that we believe one of the best hedges against inflation, in particular, is to own companies that are “best of breed,” competitively advantaged, and have pricing power. Combine our take with Dr. Burry’s and you have the formula employed, in one form or another, by our fund managers: find the best companies and buy them when they are undervalued.
Over the last decade, the S&P 500 has earned an average annual return of nearly 15%, well above the longer-term historical average closer to 9%. Also consider that in the previous decade, the return was near zero. Going back nearly 100 years, the S&P 500 has achieved its long-term record with prolonged periods of both above-average and below-average returns. Given where we are in that cycle, coupled with a historically high level of valuation, it does not take an oracle to conclude that we may be in for a stretch of below-average returns, at least for the index.
We emphasize that final point because our caution about the level of the index does not imply that we don’t want to own stocks. To the contrary, a period of above-average index valuation and below-average index return is an environment well-suited to our style of active management and good, old-fashioned stock picking. While a lofty market and uncertain future might make some want to sit on the sidelines, we are reminded of famed investor Howard Marks’ warning that “When taken too far, ‘risk avoidance’ condemns you to ‘return avoidance.’”