November 2021 | Victoria Bogner, CFP®, CFA, AIF®
It seems like a dog year, but 2021 is already in the final innings and what a year it’s been. I’d like to walk through some of the themes from the past year and what we think is important moving forward as we wrap up the year and head into 2022.
First of all, let’s talk about what hasn’t been talked about enough: COVID. We’ve had various spikes in cases with the latest this last summer. Fortunately, we are seeing cases and deaths beginning to decrease again. Immunity as measured by how many people are vaccinated and how many have been infected already is now above 80%. That means that the affects of COVID on the overall economy are waning and will likely be completely gone heading into 2022. Companies have adapted the way they do business, in many ways actually increasing profits as a result. The flip side of this is that government stimulus will also start to wane, which has been the biggest driver of market gains.
Speaking of government stimulus, let’s talk about the federal budget. I know that when you woke up this morning, this is exactly what you wanted to learn about.
In response to COVID, Congress created new 20-year 0% interest bonds. Then the Federal Reserve magically printed a bunch of money out of thin air. They then used that money to purchase these 20 year bonds. That gave Congress all the money they needed to do all of their stimulus. What that also means is that the government can kick this can down the road a really long time. This money is not due for 20 years, long after many of the people who put these policies in place will be dead. So, what does that mean for us? What that means is if you hear fear mongering in the media about how much money the government is spending, remember that governments don’t work like households. It’s not like the government’s racking up its credit card and can’t make the payments. For all the money we printed, there are no payments for two decades.
Let’s move on to Gross Domestic Product. It’s basically all of the stuff that we’re building in its final state, and how much money we’re spending not only as consumers, but also as the government. It includes how much money is being invested in housing and how much we all put into investments. The biggest by far is how much money you and I are spending day in and day out. Consumer spending accounts for approximately 70% of our GDP.
Of course, during COVID, GDP went negative because we were locked away in our houses, businesses were closed, and no one was spending money. Then, of course, things started open back up and GDP came roaring back because of pent up demand and gigantic government stimulus. However, that’s going to start slowing down because stimulus is likely over and consumer demand will begin to normalize.
Next let’s talk about unemployment. The unemployment rate before COVID was about 3.5%. Then it spiked to levels not seen since WWII. Now it’s at 5.2%, still higher than the pre-COVID number. That’s not due to lack of jobs but a huge labor shortage. There are a ton of job openings but there aren’t enough people that are interested in taking those jobs. As a result, wage growth has come up significantly. We haven’t seen this level of wage growth since the mid-80s. Employers are willing to pay more and more for labor to try to entice people to come back to work. As boosted unemployment benefits end, we’ll see unemployment come down. That’s one of the key metrics that the Federal Reserve is looking at to determine when to back off the gas pedal and when to begin raising rates. The other metric is inflation.
This is one of the big debates going on in the economic sphere. We have seen a huge jump in inflation which was, in part, a large offset of the negative inflation from last year during the pandemic. The debate is whether or not this higher inflation is temporary. What we’re seeing currently is a mixed bag. Much of inflation is due to high demand and supply shortages, which should be temporary. But some of it is due to wage growth and consumers having more money to spend. Inflation generated from consumer spending is stickier. Our opinion is that long term inflation will likely stick around the 3% to 3.5% level, which is 1-1.5% higher than we’ve experienced over the past 10 years. This will factor into financial plans and future spending costs, so it’s important to keep that in mind when doing income and retirement planning.
The Federal Reserve controls a specific rate that banks lend to one another overnight. All other interest rates are then loosely based on this rate. And they’ve cut that rate down to historically low levels. That is a huge stimulant to the economy because loans are incredibly cheap. Coupled with money being plentiful, loans are also easier to acquire. However, the lower those interest rates are, the more that they might be running the economy too hot. People may begin spending enough to drive inflation much higher, and one of the Federal Reserve’s main mandates is to keep inflation in check.
There are two tools that the Federal Reserve has to deal with high inflation: interest rates and liquidity. These are known as fiscal and monetary policy. To curb inflation, they can begin to raise interest rates. They can also begin to taper bond buying. Here’s what that means. In the open market, Treasury bonds go to auction for all of the globe to buy. In order to add additional money into the US economy, the Federal Reserve can buy billions of dollars of treasury bonds each month, which has the added benefit of keeping interest rates that they can’t directly control lower. This is because bond prices and interest rates are inversely related. As bond prices rise due to higher demand, rates go down.
If they need to take money out of the system, they can begin to sell back the bonds they purchased in the open market, therefore sucking those billions of dollars back out of the system. This would also have the effect of raising interest rates depending on the magnitude they used.
Right now, the Fed has the money spigot turned all the way on, but beginning in November, they’ve hinted that they’ll begin tapering, or decreasing, the amount of bonds they buy in the open market. What will this do to the stock and bond market? If history is any guide, we may see a short-term shock but long term, it has very little effect. So news of bond tapering by the Federal Reserve shouldn’t be a reason to fundamentally change your investment risk tolerance or strategy.
Finally, let’s talk about the stock market. You may hear financial talking heads saying the stock market is overvalued. What does that mean exactly? There are ways to fundamentally value companies by looking at their financial statements, which is what my Chartered Financial Analyst designation taught me. You can compare that by how much the company is being valued in the marketplace by taking their issued shares times their share price. If that number is higher than the intrinsic value of the company, you could say they’re overpriced.
A lazy shortcut that investors use to measure whether a stock or index is overvalued is to take their price and simply divide it by their earnings. That’s what the PE ratio is. If the PE ratio is higher than normal, that means something is overvalued. And if it’s lower than normal, it means it’s undervalued. But that is too simplistic because a company might have a very high PE because their earnings are growing at 50% per year. In that case, a high PE ratio would be justified. Similarly, a company might have a terrible PE ratio because it’s a terrible company and they have negative earnings growth. For that reason, you should never buy or sell something based purely on its PE ratio.
When looking at the S&P 500 as a whole, the PE ratio is as high as it was in the tech bubble. But we’re in totally different circumstances than we were in the early 2000s. We have record high liquidity and record low interest rates. Therefore, you can’t value a company the same way as before. The lower the rates are, the higher the earnings growth of a company and the higher PE they can command.
Here’s an example. Let’s say that you have a mortgage for an interest rate of 10% and you want to buy $100,000 house. Your payment on a 30 year loan would be $877/month. Now let’s say that you can get a mortgage for 0%. You can borrow money for free. Well, now you can afford way more house because you’re not paying $10,000 a year in interest. An $877/month payment will get you a $315,000 mortgage! That’s an over 3X difference. Your purchasing power when interest rates are low is so much greater because you’re not forking over all of your money to pay interest. It’s the exact same idea with PE ratios. When interest rates are so low, the PE ratio being higher is justified. Don’t be scared of high PE ratios.
What is all of this telling us? In our view, we think that the fourth quarter of 2021 and the beginning of 2022 are shaping up to be overall positive. There are headwinds, such as inflation, waning stimulus, and the unpredictability of COVID. But there are tailwinds, such as liquidity, low interest rates, and high consumer demand. We’re positive about the future of the stock market for now, but we’ll see what 2022 has in store for us.
The takeaway is moving into the fourth quarter and into 2022. We have a lot of tailwinds. We have record low interest rates, record high liquidity. When we look at p.e. ratios, they aren’t too high when we’re factoring in interest rates. However, that doesn’t mean we aren’t going to have some challenges. those challenges are going to be inflation, if that continues to be really sticky and really high. The tapering of the Federal Reserve’s support for the economy. They’re gonna have to do that the right way. So, there are some challenges moving forward. But I believe that there are more tailwinds than headwinds, we might see more volatility, we might see lower returns. But I do think from what we know at this point in time, that the fourth quarter I would anticipate will be overall positive, and 2022 is looking overall positive. So, in my opinion, I think this market has room to run. But it’s more important to be intentional about where you invest, as opposed to just throwing darts at a board and investing what in whatever sticks. So, if you have any questions or you want your portfolio to have a second set of eyes on it, contact us contact our advisors. It’s what we’re here for. It’s what we love to do, and I will see you on the flip side of 2022.