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The ValueAligned Model Portfolio (“VAP”) is up +11.4% for 2021 as of Thursday May 20, 2021. The S&P 500 Index is +11.4%.
The broader market bounced back nicely yesterday following the past week’s selling.  Tech stocks were particularly strong, with the S&P Technology Select exchange traded fund (ETF) up more than +1.9%%.

 

Our top three stocks were Broadcom (AVGO, +3.0%), NXP Semiconductor (NXPI,+2.4%) and Markel (MKL, +2.4%). MKL, our specialty insurance stock that made a new high today.
This action is especially encouraging as it signifies signs of buying pressure in many of our stocks and that the rally is more broad-based than it has been.

Inflation: The Magic Number is Four

Last week we found out that inflation measured by the Consumer Price Index (CPI) soared at its fastest 12-month pace in 13 years. The CPI rose +4.2% year-over-year and +0.8% month-to-month in April. Both exceeded economists’ estimates for a +3.6% year-over-year increase and a 0.2% month-to-month increase. Core CPI, which strips out food and energy costs, jumped +3.0% year-over-year.

The Producer Price Index (PPI) also surged in April, rising +6.2% year-over-year. On a month-to-month basis, the PPI climbed +0.6% in April. To put this into perspective, economists were only looking for a +3.8% year-over-year increase and a +0.3% month-to-month increase. Core PPI, which also excludes food and energy costs, jumped +4.6% year-over-year.

Inflation rising above 4% last week proved a shock for inflation-sensitive assets, with bond yields jumping and stocks falling, growth stocks most of all.

And in the chart above you can see that the University of Michigan Survey of Consumers shows that consumers expect inflation to exceed +4.0%.
Just look around us. The +17% year over year gain in existing home prices is the highest ever. Lumber, until a small decline this week, and other building material prices have skyrocketed. Lumber’s price is up 3x since last November; The price of a deck has also tripled in many parts of the country. Food prices are up and climbing. Gasoline prices are up +75% since November as I’m sure you noticed. And Labor costs appear more inflationary than at anytime since the early 1980s.

Wall Street does not like inflation because interest rates head up, and fears are now spreading that inflation could negatively impact companies’ bottom lines. These fears aren’t completely unfounded, but during times of booming economic growth, inflation’s negative impact on earnings is often muted as profits are higher too. Stocks are an inflation hedge if the rise in prices is accompanied with strong economic growth.

And right now, U.S. economic growth is accelerating – the Atlanta Fed expects +10.5% GDP growth in the second quarter and earnings momentum is showing no signs of tapping the brakes either. FactSet anticipates that S&P 500 companies will achieve +60.0% average earnings growth and +18.7% average sales growth in the current second quarter. That’s up from +49.4% average earnings growth and +10% average sales growth in the first quarter.
But don’t worry our Treasury Secretary does not think inflation is a problem because it is “transitory”. And for now the Fed and the Administration are probably correct.

The economy is going from 0-60 in a blink as vaccines give people confidence to buy stuff. The government has supplied so much extra money in the form of extended unemployment insurance and checks from the treasury that supplies of everything are tight and demand is accelerating, therefore, prices go up. But as their argument goes, as supply chains catch up to demand and we lap last year’s bottom in the recession, inflation will settle back near the Fed’s 2.0% target.

A Warning from the Supply Side, On the Verge of Real Inflation.

Scott Grannis at his Calafia Beach Pundit blog has for years argued that Quantitative Easing (“QE”; where the Federal Reserve buys securities from banks in exchange for bank reserves) was not “money printing”. He saw QE as a response by the Fed to the economy’s demand for zero risk additional cash and cash equivalents.

This desire of the public to hoard cash, even when it pays nothing or close to nothing, was created by the extraordinary bouts of fear and uncertainty present since the Great Recession of 2008-09.

By engaging in QE, the Fed was simply responding to an increase in money demand by buying longer term US Treasury notes and bonds from banks with bank reserves (which pay a floating rate of interest and are default-free, just like short term T-bills). The huge increases in the money supply that we saw in the late 2000s and early 2010s were not inflationary because the Fed was essentially converting notes and bonds into cash equivalents, which in turn was necessary to avoid a shortage of money (cash). Grannis has maintained that when the Fed adds to the money supply to match an increase in the demand by the public to hold cash, it is not inflationary; inflation only happens when the supply of money exceeds the demand for it.

But just this week he now worries that the public’s demand for cash is waning and, therefore, the Fed is making a monumental policy mistake by not withdrawing QE now. He says:

I am now arguing that we are in the early stages of a monetary policy mistake that the Fed is committing. Last year the Fed boosted M2 by over $4 trillion in response to the unprecedented, catastrophic and extremely costly shutdown of the US economy. That was fine then, but it’s not fine now. The economy is rebounding, confidence is returning, fears have eased, and the demand for money is consequently no longer increasing and in fact is decreasing. But the Fed is not reversing its QE in response, and so unwanted money is accumulating. That shows up in dollar weakness, rising commodity prices, rising housing prices, and rising inflation expectations. Lots of unwanted money is likely helping stock prices to rise as well.

 
If monetary policy is too easy or too tight, that affects the current and future value of the dollar, and the future thus becomes less certain. Uncertainty is the enemy of investment, and investment is the source of growth and prosperity. An uncertain future inhibits growth by encouraging investors to choose safety over risky ventures which promise to enhance productivity and living standards. As my mentor John Rutledge used to say, inflation is like a thick fog that settles on the highway, forcing everyone to slow down. Deflation is just as bad. A strong and stable dollar is nirvana. Huge increases in the money supply coupled with massive deficit-fueled government spending is most definitely not nirvana. It’s time to get very worried that policymakers are going to be too slow to respond to the huge improvement in the economic outlook.

So the Fed may be too loose especially with a federal government hell bent on reversing the business friendly supply side policies of the last four years. We need to increase supply, not restrict it. But that discussion is for another day. In case you wonder what I mean, look at the evidence below: Small business have NEVER found it harder to get jobs filled.

Summary

Nevertheless, earnings continue to rapidly rise relieving some pressure on valuations. With earnings beating analysts expectations at rates far above the historical norm, add in strong guidance by management for the year ahead, and we have analyst estimates surging and are likely to keep rising.

The global economy led by the United States may have reached its peak growth rate but strong growth is expected through at least the end of the year. While commodity prices are rising rapidly thanks to extremely tight commodity markets, inflation pricing does not seem to reflect out-of-control pressure yet, and the Fed remains accommodative. But policymakers may be making a big mistake.

Low interest rates and a Federal Reserve willing to accept what it calls “transitory” inflation means we are in a sort of sweet spot for stocks. The only place to make a return is in the rising income businesses of great companies.

All bets are off if the current macro policy turns into a monumental mistake. We’re watching so you don’t have to.

I trust you’ve found this review to be educational and informative.

Thank you for being our clients. It is a privilege to serve you and your families.

I’m at david@valuealigned.com or 732-800-2375. Feel free to call me direct on my cell phone at 732-284-1267 (or text me too).

Best regards,


David