I hope you are managing to stay cool. For those of you that aren’t in Texas, I’m either getting older or it feels like Texas is sinking closer to Hades. My daughter that is in college in Wyoming came home for a few weeks and despite all the attention I gave her, said, “I’m going back home to cooler weather.” My advice, if you are planning a summer trip, follow the birds! (And have fun).
Today, I want to briefly point to some of what we have assembled in this packet. And give you a few of my thoughts on what are seeing in the market and how we are thinking about your investment today: (I’m going to try bullet point format to see if I can keep this shorter.)
Mills Weath Update
As you will see from the Quarter Market Review, Portfolios have had attractive returns this quarter and for the year. Large Technology companies (which were hardest hit in 2022) have rebounded riding the Artificial Intelligence Wave, led by the “Magnificent 7”: “Microsoft Corp., Apple Inc., Nvidia Corp., Amazon.com Inc., Meta Platforms Inc., Tesla Inc., and Google parent Alphabet Inc. (1) —collectively these 7 stocks have accounted for about 77% of the broader index’s advance this year. These 7 stocks have grown so large; it is sometimes hard to comprehend their size and economic power. For perspective, just Apple alone is now bigger than all the companies collectively valued in France. These 7 companies make up a large portion of indexes like the S&P 500 and the NASDAQ 100 because they are size weighted. As more money is invested in indexes, the bigger a company gets the more flows it gets from its weighting in the index and the bigger it gets, and so on, and so on. A few of these companies make up such a large part of the index that they are bumping into size caps and on the next rebalance date, will have their weighting lowered, which could add some short-term selling pressure to the index. If you study market history, in the past when a few very powerful companies made up a disproportional portion of the index, eventually these companies perceived value “maxed out” and their company size eventually plateaued until earnings could catch up or went the other direction (examples were ATT, Kodak, GE, Exxon/Standard Oil). Many of the Magnificent 7’s valuations have become rich; I would contend there is probably more downside risk than upside from here.
In Figure 1 above, the picture shows the earning yield of the S&P 500 (Earning Yield is a company’s earning divided by its price per share and gives a way to easily compare stock’s yield to a bond’s yield) compared to today’s corporate bond yields and 3-month Treasury Bond Yield. At today’s prices, investors in the S&P 500, are not receiving extra of margin of safety for owning stocks. Investors can basically earn the same expected returns in cash or bonds with much less risk, and this is one reason we think fund flows are likely to eventually move away from large US stocks.
Over the last 10+ years the US market has had stronger than average returns, as conditions in the US have been attractive coming out of the financial crisis compared to the rest of the world, however the main reason for this is not because the US companies have grown faster it is because the multiples that investors are willing to pay has expanded, and this has occurred in the face of higher interest rates (which usually makes stocks worth less not more). There are lots of ways to think about valuations, but I like to follow the master. Below is a simple tool Warren Buffet uses to help decide how expensive or cheap different markets are relative to their economic output now labeled the Buffet Indicator.
With higher rates and higher than normal starting valuations it is highly likely that future investment returns will eventually need to under-perform past returns as mean reversion is the strongest force in finance. To be fair, currency movements have exacerbated the performance divergence of US assets over international assets. From 2010 through 2022, the U.S. dollar appreciated a cumulative 33%—or 2.2%/year annualized—relative to a broad basket of foreign currencies, reducing non-U.S. asset returns denominated in U.S. dollars.
The spread in valuations between big and small is wider than normal and I think this continues to bode well for new money added to smaller companies in the US as managers rotate funds away the big tech like the Magnificent 7 towards less expensive areas of the market that may offer investors higher expected future returns. If you have outside money in the NASDAQ 100 or S&P 500 this might be a good time to revisit those weightings. Trees can’t grow to the sky forever.
Our thoughts on fixed income: The yield curve is still highly inverted. (An inverted yield curve means short-term interest rates are higher than long-term rates which is unusual and can signal a future slowdown in economic activity). Inflation has proven to be stickier that the FED projected (at least that they have publicly proclaimed).
• We recently placed our 1st recent trade re-extending fixed income duration because market participants once again began to worry about inflation sticking around, and longer the rates exceeded the 4% mark. As I have mentioned in the past, I think it will be a while before we see the FED’s target of 2% inflation. I think accepting it is going to be 3-3.5% range is probably a better policy plan unless the Fed wants to really hammer the economy. I think another 0.25 rate increase is most likely, but more rate increases could continue to hammer local banks and the commercial real estate markets.
• There is more pain to come in some areas like the real estate sectors as bridge loans will need additional equity to get refinanced and this will likely to cause some real estate defaults in the future. We still think prudent investors will remain invested, especially in less expensive areas, but continue to maintain exposure to some defensive assets like short and intermediate term debt.
• When I look around DFW, people are employed, and the labor market remains in short supply of qualified employees, so wages continue to rise. As long as this trend continues, people will spend a portion of their increased earnings (this has been most evident with travel this summer). If people spend, many companies will profit, and the economy will continue to grow albeit more slowly than a year ago. It is possible that current FED policy may be able to engineer a soft landing without causing a recession, but because of the long lag between policy changes and the impact of those changes it is difficult to get this exactly right. We think investors should continue to own both stocks and bonds and that this environment warrants some caution.
• 5.25% short-term yields will continue to pull some money away from the stock markets. We favor a barbell approach owning cash/debt combined with equity risk outside of large tech in the less expensive areas of the global markets where earnings yields are higher, and valuations are lower. As we leave the safety of treasuries, we can now get 5-8% on different types of debt depending on length and credit quality. As investors worry about inflation and longer-term rates exceed 4.25% we will continue to move our duration out of short-term fixed income which offers the highest short-term returns towards bonds that offers that offer us the highest capital gains if/when rates decline (which typically happens in a market sell off caused by an economic shock or panic).
• Why we still like Value overgrowth: Many managers we follow are finding lots of gems in non-0sexy businesses. According to GMO, meaningful upside remains, in undervalued securities, “at the end of May 2023 global value would need to outperform growth by the order of 50% to return to its median level of relative valuation.”(3)
• Commodities and material – Dirty businesses like oil and mining have had a dramatic amount of under investment over the past 10 years, which has caused lower supply and higher prices. As is typical of capitalistic system, capital has quickly returned to these cyclical areas of the market to cash in on higher prices and in several years we think supply be able to meet demand, but in the interim (while these projects are ramping up) prices will remain elevated and profits should be attractive in these areas. I think Buffet’s continued purchase of Occidental Petroleum is a prime example of the potential for attractive returns on capital in energy and materials. Our models have a significant exposure to this area because these stocks have lower valuations than big tech.
• Where institutional funds are flowing: Many of the talking heads on CNBC along with big bank allocations continue to talk up and favor value overgrowth and small over large and international over domestic for monies with 5+ year time horizon.
• Our portfolios should continue to capitalize on this trend. In Figure 3 above we compare how much cheaper a dollar of earnings is in the emerging markets compared to a dollar in the US by comparing the price to book ratios of the two asset classes. We have not lowered our allocations to this area.
We continue to believe the surest way to win in the long run is to keep cost low by aggressively minimizing implementation cost, reduce exposure to overvalued areas of the market by rebalancing through new savings or withdrawals, maintaining broad diversification across the global markets with greater weightings on factors that offer compelling future returns, and to maintain a disciplined process to help in avoiding emotional mistakes.
Our plan is to continue using both offensive and defensive investments inside your portfolio constrained by your goals and willingness to accept some risk. When markets eventually give us fear and dislocation and low bars to step over, we will then recommend considering moving some defense to offense. Until then, we hope you continue to sleep well at night knowing your money is slowly working day and night as it marches toward funding your goals.
If you have a big expense coming, an inflow of funds, or any changes that might impact your investments or if you just want to review your risk/expected investment returns, we think now is a great time to reevaluate your plan’s offense and defense. We would love to RE-confirm the allocation inside your plan still has the characteristics that will give you the most confidence.
Thanks for allowing our team to travel this journey with you.
Household items & FYI
On the last 2 pages of this quarterly report, we have included a great article on the power of compounding by David Booth where he explains the concept of compounding and the impact of a few years can have. This article also highlights a new tax strategy that has opened up with left over 529 funds.
Financial Planning Idea:
If anyone would like a high end no obligation property insurance review, we have partnered with an advisor who specializes in reviewing complex property issues like art, properties in multiple states and other issues that can arise as wealth increases. We just completed a review with another client and found several gaps. If you might find this service valuable, please let us know and we can set up an introduction as well as help get them the needed information to complete the review.
Upcoming Tax request:
You may have seen an email requesting your 2022 taxes in May and June. Any day now we will be following up with a phone call to request them. As many of you know we now have a CPA in our office who will look at them and see if there are any tax planning opportunities you may want to consider, along with a report with pictures for you to look at. Having your return helps us give you better financial advice. We are not trying to step on your CPA’s toes but given how busy most CPAs are we are trying to help better interface with your tax advisor by providing tax planning advice and better implementation of tax estimates, so no penalties accrue.
(1). “Worried About Nvidia, Apple and Meta? Nasdaq Has Your Back” by Jonathan Levin, 7/12/23
(2) Figure2: VettiFi.com website
(3) Source GMO website
PICTURES WORTH LOOKING AT: