November 2023 Client Newsletter
It’s hard to believe that we are already in the fourth quarter. We often talk about how things move in cycles. After several years of drought, we had almost twice as much snow fall than an average winter resulting in higher rivers, mountain grasses stayed green longer and the fall leaves have been more brilliant. According to forecasts, we could be in for another high snow year. Investing also moves in cycles. Some are long and some are short. One of the most important cycles is the business cycle. After 13 years of growth, we have endured the low part of this cycle over the past two years. In spite of market declines in the third quarter, the stock market remained higher than expected for 2023. But, are we in a new business cycle or do we still have more economic problems ahead?
Based on low unemployment and higher than expected demand, it appears the Federal Reserve is poised to increase interest rates at least one more time. They will do whatever is necessary to lower inflation. Therefore, we don’t believe we are in a new business cycle yet. This could mean level or decreasing stock prices over the remainder of the year. This means two things; continue earning dividends on bonds and prepare for buying opportunities in stocks. What it doesn’t mean is sell stocks in the short term. As an investor, remaining invested over the long-run and taking advantage of stock volatility is a time proven strategy.
A Look Behind and Ahead
2023 3rd Quarter Review
After unexpected high growth in stocks over the first half of the year, the stock markets declined in the third quarter. This was not a surprise. Underlying economic conditions have not improved much as high interest rates continue to be a disincentive to purchasing large items such as homes and automobiles. Unemployment remains very low, indicating strong purchasing power that could keep inflation higher than the Federal Reserve would like.
Bond values also declined due to the threat of even higher interest rates by the Federal Reserve.
2023 4th Quarter Preview
As mentioned above, the Federal Reserve is likely to increase the Federal Lending rate by .25% in November. Bonds may lose a bit more value unless last month’s bond declines have already priced in higher rates.
Low unemployment is one of the most important metrics the Federal Reserve is using to determine rate increases. We don’t see any reason why unemployment would increase in
the fourth quarter. While low unemployment is good for individual households, it could mean additional artificial economic pain through higher interest rates.
US Stock Market
Stock market declines in the third quarter were not a surprise. As discussed above, stock price increases were unexpected. It will take real economic improvement to justify higher stock prices. This means higher net profits on a broad scale. Large cap stock prices are normal or a bit high, mid-cap stock prices are low and small-cap stocks are begging us to buy them. Once we see signs of increased profits in several sectors, we are likely to be more optimistic.
Small-cap stocks are low for a reason. They generally use bank loans for additional capitalization. Higher interest rates decrease profits and scare investors away. There should be a time when we recommend small cap stocks, but not yet.
In our view, this is not a time to sell existing stock or buy additional stocks. Simply stay put for now.
Bond Market
Last quarter, we discussed the probability of bond values decreasing. We were correct. The best way to view low bond prices at this point is to consider buying or holding them. Most sectors are selling under par and our long-term (12 month) view calls for lower rates in spite of short-term increases described earlier in this letter. This is no time to be afraid of buying and holding bonds at these low prices. This could be one of the best buying opportunities for a long time.
Historically, there has been a 97% correlation between the starting yield of a bond and its 7-year annualized return. Currently, yields are close to 5%. The last time yields were this high was in 2007. The ability to earn nearly 5% in the cash position of our portfolios is one of the few silver linings of higher interest rates.
International Stock Market
Our decision to reduce international stocks last November appears to be a good one. International stocks continue to under-perform. China seems to be stuck in a social and population quagmire, Europe has demand and energy problems and the US has not started an earnest recovery to lead the world out of remaining Covid caused economic problems. We remain pessimistic on international stocks.
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