Category: Stock Investing

In October 1968, with the United States fighting wars against poverty at home and perceived communist threats abroad, the S&P 500 Index climbed on the back of an overheated economy to record highs in both real and nominal terms. The boom times were not to last. Adjusted for inflation, stocks would not return to their late 1968 levels until mid-1992 (chart data). In nominal terms, full recovery took about seven years from a January 1973 peak.

I offer this cautionary tale by way of explaining why recent decades have differed so dramatically for equity market investors from those generally unprofitable years a generation or two ago. Unlike current conditions, what characterized the period beginning in the late 1960’s were cost of living increases that compelled President Richard Nixon to impose wage and price controls and the Federal Reserve to raise interest rates to levels that today would seem unfathomable.

At the vanguard of the Fed’s anti-inflation effort was the late Paul Volcker, the central bank’s chairman from 1979-1987. Volcker allowed benchmark rates to reach nearly 20%, but his tough love approach to price stability is widely credited with subduing inflationary expectations and thus sowing the seeds for the long economic expansions and bull markets to follow.

So, while recessions are the most obvious and direct causes of severe market declines, it’s rising inflation that triggers economic downturns by motivating the Fed to take away the monetary punchbowl. Of course, recessions cause corporate profits to fall as well, but earnings are only half the story. The other half concerns the impact of rates on valuations.

Historically, the equity market’s price-earnings ratio has moved inversely to bond yields as money flowed out of stocks and into higher-yielding assets. Viewed another way, the equity market’s earnings yield – its P/E ratio expressed as a percent – closely tracked the yield on Treasury bonds. (A P/E ratio of 20 equals an earning yield of 5%, or 1.00/20=0.05)

Which brings our story to the outlook for stocks in the months ahead.

Among the enduring mysteries of what’s become the longest expansion on record is the breakdown in the relationship between unemployment and inflation, also known as the Phillips Curve. In the past, tight labor markets have fueled fast-rising wages and benefits, which in turn fed through to consumer prices and finally to higher interest rates. This time, not so much. Despite the lowest jobless rate since the boom days of the late 1960’s, inflation has consistently undershot the Fed’s 2% target, as measured by the central bank’s preferred metric, the Core Personal Consumption Expenditures Price Index. That’s allowed rates to stay low by historical standards, thus extending the bull market in stocks.

Some economists believe the recent failure of the Phillips Curve to explain inflation can be attributed to a changed definition of full employment while others think a myriad of complex global factors are at work.

Conclusion

What matters most for investors, however, is that inflation expectations remain anchored and that core inflation stays at or below the Fed’s 2% target. Until that changes, we aren’t likely to find the Fed’s fingerprints on whatever weapon eventually brings about the demise of the longest bull market in U.S. history.

Still interested in understanding more when it comes to inflation? If so, contact our firm at 843-999-1570 and someone will be able to explain more in depth of what you need to know when it comes to what’s ahead for stocks and inflation! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries

Bonus websites of interest…

• Effective Federal Funds Rate, Federal Reserve Bank of St. Louis
• Paul Volcker, Fed Chairman Who Waged War on Inflation…
• Contra Shiller: Stock P/E Ratio Depends on Bond Yields…
• Business Sector: Unit Labor Costs, Federal Reserve Bank of St. Louis
• Personal Consumption Expenditures Excluding Food and Energy, Federal Reserve Bank of St. Louis
• Yes, There Is a Trade-Off Between Inflation and Unemployment…
• Why Is Inflation Low Globally…
• Consumers optimistic about economic prospects…

I figured it seems fitting to write this article in the market environment in which we find ourselves today.

“If the job has been correctly done when a common stock is purchased, the time to sell it is — almost never.” — Philip A. Fisher, Common Stocks and Uncommon Profits, 1958

With the major market indices continuing to reach new highs, some investors are wondering if they should sell their stocks. After all, if prices are high & the holdings have been profitable, why not sell & take the gains?

On Wall Street, the preference to sell can be especially popular. Many brokerage & research firms publish price targets for stocks & recommend selling them once the target has been reached. Other firms routinely recommend moving to all-cash positions based on market, macroeconomic or geopolitical forecasts. Still others view stocks as little more than trading vehicles & move in/out many times over the course of a month, week, day or microsecond, as in the case of high-frequency traders.

At the other end of the spectrum are investors who never sell at all. In an article published in 1984, author Robert Kirby described a situation where his purchase recommendations were followed, but his sell recommendations were ignored. After many years, the result was an odd assortment of small holdings, several large holdings, & one huge holding of Haloid which later turned into a zillion shares of Xerox. Kirby, of course, had recommended that Haloid be sold.

In our investment club, our analytical work focuses on the underlying businesses of the stocks. We think of our club as part-owners of those businesses &, as long-term investors, our club owns the shares for as long as the company’s management team is doing its job to increase shareholder value. Given enough time, a company’s share price is likely to increase along with growth in its revenues, earnings, & dividends.

However, companies can change & industries evolve, & management teams can lose their way. Sometimes better opportunities develop elsewhere.

“If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.” — Benjamin Graham, The Intelligent Investor, 1949

Conclusion

At the end of the day, investors are well-served if the job of analyzing a company includes a thorough review of its underlying business & fundamental characteristics — this holds true for selling & buying. If the company selected for purchase passes criteria on all counts, it could be a long time before it needs to be sold. And selling a high-quality, adeptly managed company just to take profits rarely is a viable long-term investment strategy.

Still interested in understanding more when it comes to selling a stock investment? If so, contact our Firm at 843-945-0051 and someone will be able to explain more in depth of what you need to know when it comes to stock market investing! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries