Join our mailing list
April 17, 2023
To the friends and clients of the Harvey Investment Company:
The financial markets showed notable resilience in Q1 of 2023. The S&P 500 rose a stellar 7.5%, while bonds rallied sharply. The yield on the US Treasury 10 year bond has recently dropped back to 3.4% after reaching a high of over 4% during the persistent Fed tightening in 2022.
The rally in stocks was largely due to recovery in the technology sector which performed miserably in 2022. Specifically, three stocks--- Apple, Microsoft and Nvidia--- recovered dramatically from their poor showings last year. They alone added 3.6% to the S&P’s return. The average stock was up a mere 1% for the quarter.
Celebration focused on declining interest rates should be tempered. Recall that at the beginning of 2022 the ten-year Treasury yield clocked in at less than 2%. Despite a host of other serious concerns, Fed tightening is the paramount bugbear fueling investor anxiety. Notwithstanding the war in Ukraine, political parties at each other’s throats, environmental and meteorological extremes, wide scale domestic gun violence, and other important societal concerns, for the financial markets, interest rate worries are front and center.
The powerful effect Fed policy exerts on stock valuations is readily demonstrable. Consider this: in the 10 years beginning 12/31/2001 and ending 12/31/2011, the S&P generated a compounded annual return of 2.92%. In the ten years ending 12/31/2021, supercharged by near zero interest rates, the S&P returned an annualized 16.53%. During the latter 10 years, P/E ratios roughly doubled, meaning a dollar of corporate earnings was valued on 12/31/2021 at twice what it was ten years earlier. This added more than 7% per year to the index return. Then, in 2022, inflation reared its ugly head, the Fed responded, and markets tanked. Evidently what the Fed giveth, it can take away.
In addition to the simple math that lower interest rates work on earnings, low rates also feed into the gambling urge that, to varying degrees, is ever present in financial markets. As this speculative cycle ripened, J. M. Keynes classic depiction of markets in the late 1920’s and early 30’s comes to mind:
…professional investing might be likened to those newspaper contests in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of those which, to his judgement really are the prettiest, nor even those average opinion genuinely thinks is the prettiest. We have reached the third degree, where we devote our intelligences to anticipating what average opinion expects the average opinion to be…
If the Federal Reserve governors, forced into action by burgeoning inflation, have indeed ushered in a new era of investing, it is of paramount importance that advisors cease playing the game Keynes describes and pick the “the prettiest faces” that correspond with the objectives they hope to deliver to their clients. The first, and, indeed, the most important step, is to define those objectives precisely and to make sure that they concur with what their clients’ objectives are.
The Fed “pivot” to higher rates no doubt removes a powerful tail wind to stocks. Future successful investments are likely to depend less on just “being in the game” and more on long term factors that are obscure and unpredictable. Some years back we talked of a strategy of “getting in the way of good luck.” That strategy entailed only considering for investment high quality businesses that were extremely well financed. The strategy placed special emphasis on identifying diligent managements whose capital allocation skills were demonstrably excellent. Focusing on such long-term factors transcends the game that Keynes describes and, in our view, offers the best chance of escaping the downward pull of higher interest rates.As always, we are energized by your faith in our program. We thank you for your support.
Sincerely,Samuel C. Harvey