Winter 2022 Letter to Clients

Please find below the investment letter recently sent to clients and friends of Lumen Capital Management, LLC.

 Certain Inconvenient Truths                                            Winter 2022

 

 

Markets had extraordinary returns in 2021.  The largest companies that treaded in trade in the US returned nearly 29%, most major US indices had returns in the low to mid-20% range.  Yet under the hood things were perhaps not as rosy as the indices appeared.  The majority of this return came from the largest of the large.  Something like 10 stocks were responsible for 35% of the S&P 500s~ return last year.  40% of all US stocks in fact fell nearly 50% from their highs around mid-year.   Overseas markets returns were paltry in comparison to US markets.  Emerging markets actually saw negative returns in 2021.  A balanced asset allocated portfolio returned 13.4% last year.*  As of this writing, 2022 has brought renewed selling to the markets with major US indices down 4-6%.  The market is dealing with certain inconvenient truths right now regarding valuations, interest rates and continued issues related to the pandemic and it’s having a bit of a digestion issue regarding these things at the moment.  I’m going to use the rest of this letter to argue that while I think these issues could impact investors in the next 4-6 months, they do nothing to impact the longer-term positive trend that both markets and the economy are currently on.  

 

Valuation of the stock market:  By any measure US equities are trading at extreme valuation levels.  Historically when this has occurred then stock prices have at best traded sideways.  It is very likely that we will see a decline closer to historic volatility in the markets in 2022.  We may be in the process of this occurring right now. Probability would therefore suggest that to mean we could see a decline at some point this year in the range of 10-15%.  That does not mean it must occur, just that it is more likely to happen.  The most likely culprits for this would be slowing economic growth, higher interest rates, higher inflation and supply chain disruptions related to Covid.  Corrections are a normal part of every market cycle.  For all the reasons I’ve outlined in previous letters to you I would welcome that kind of pullback as I like to buy assets cheap.  I also don’t think this kind of decline, were it to occur, is a precursor to a long-term bear market in stocks based on what we know today.  I think US economic growth will be higher than current consensus because I think the Covid crisis will largely be over by the spring.  More on that in a bit.  The loosening of restrictions and I believe some loosening of supply chain bottlenecks will mean greater not less economic activity by summer.  I think fixing the supply chain will go a long way towards easing some of the inflationary pressures in the economy.  For why I think that, go back and see what I’ve written in the past about what happened at the end of World War II.  Regarding interest rates, the Federal Reserve has been screaming for months now these are going higher.  The markets know this.  The adjustment we’ve seen since the beginning of 2022 are in response to this.  However, interest rates are at such historically low levels that even a 1% rise shouldn’t make money expensive enough to stifle economic activity.  On the contrary it starts to get rates up to levels where financial institutions might be willing to make loans again.  This would be healthy and expansionary for the economy. I believe at some point when stocks reach attractive levels, we’ll see a resumption of the upward trend we’ve been on since the spring of 2020.  That’s because I’m looking for higher than consensus economic growth this year, especially in the 2^nd half once we work through the Covid bottlenecks.

 

The Pandemic: I have finally cleared the Covid virus from my body.  It took me five weeks, but it’s gone.  It was basically like having a bad head cold.  I was able to continue working and exercising throughout.  I still get tired and have a cough I can’t seem to shake.  Other than that, I’m back to normal. All my kids also came down with Covid over the holidays as well.  Their symptoms weren’t much different than mine, though they recovered faster.  Omicron is more contagious than measles.  Once it gets into a place, it rips through there like gas and a match.  However, for the millions of Americans who’ve been vaccinated and boosted, it is likely less a life and death struggle than a bad case of the flu.  Millions of people that have it are also asymptomatic.  Throw out all statistics on how many of us have it because we’re undercounting millions of cases right now.  A person I know with some knowledge of these things thinks that by March everybody in this country will have been exposed to Omicron.  Simply put the virus in its bid to survive is becoming less lethal.  Probability suggests this could be the last extreme surge of the virus as a pandemic.  Regardless, Americans are increasingly voting with their feet and hearts.  They are done with the pandemic.  Thousands attended the national collegiate football championship recently.  Travel is restricted more by transportation issues than people’s unwillingness to get on an airplane.  It is not parents for the most part that do not want their children in school.  In many parts of the country people are going without masks with infection rates no different than in places like Chicago with more draconian rules.  People are ready to get on with their lives and it is governmental policies at all levels that are behind the curve.  The only thing that will change this mindset would be a variant much deadlier than what’s currently showing up.  I believe the dam is breaking in terms of what people are willing to tolerate regarding many of the pandemic related mandates we’ve lived under these past two years.  There will be other variants but again probability suggests Covid is rapidly becoming an endemic problem, something we’ll have to learn to live with like the flu.  This should also help economic growth, probably by spring as weather becomes milder in much of the country, allowing people easier ability to get out and about.

 

Things are getting back to normal:  I’ve got bad news if you think this is going to take place because there is no magic that takes us back to life as it was in January, 2020.  The world was knocked of its axis the same way we were after Pearl Harbor in 1941 and after the 9/11 terrorist attacks in 2001.  That is not necessarily a bad thing.  True, the world has been through wrenching change since then and the human toll is catastrophic.  Over 5 million people have died from Covid.  Here at home, we are approaching a death level equivalent to the entire city of San Francisco.  Yet, the pandemic has accelerated changes that were already happening and stepped up the pace of innovation and the adoption of new ways of doing business.  Telemedicine isn’t going away.  Neither will Zoom conference calls, working from home, the sharing of medical information, use of drone deliveries, home delivery services, streaming, contactless exchanges of payment, the use of a cellphone as a personal depository of key information, overall better sanitation and cleaner air quality in many buildings and public places in this country.  I could go on, but you get the drift.   Billions have been spent on new vaccine technologies, better hospital procedures, public policies to fight infectious disease.  There is also a better appreciation for the day-to-day struggles of the poorest amongst us and we are actively trying to come up with better policies to alleviate some of the issues in this regard.  Businesses are grappling with unprecedented supply chain issues and a persistent labor shortage.  Expect to see more jobs come back to the US and more money invested in automation technology.  What passes for normal in 2025, years after we’ve likely cleared this thing will no more resemble 2020 than 1946 resembled 1941 prior to Pearl Harbor.  I’d argue in many ways this will be a good thing and has the potential to be extremely beneficial to the economy as well.

 

While I believe the first half of 2022 could be challenging, I believe any declines in prices and any renewal in volatility would set the stage for the better potential for opportunity in the back half of the year.  

 

 

Christopher R. English

*Source:  Guide to the Markets, 12.31.2020.  JP Morgan and Co.}

~Currently long indices related to the S&P 500 in both clients and personal accounts.