Greetings from the Northwest!
It’s a new year, and, I hope, a happy one! I had to check the calendar to believe that it’s been three years now since I took the helm from Jim and began writing the opening lines of these newsletters, and what a three years it’s been! It’s a matter of fact that none of us truly knows what the future holds, but I must say, “How could I have known” that Covid would shut down the economy in just a matter of weeks, tanking the stock market with it, and that massive government aid and a taste for speculation would propel markets to new highs while the pandemic still raged?
In that first newsletter we were already expressing concern that markets were pricey and that risk-taking behavior was higher than warranted. Patrick shared the CNN Money Fear & Greed Index, with the indicator firmly planted in the “Extreme Greed” quadrant. I did not track that meter much over the next year, but it must have been quite dynamic as the events unfolded. As I write this, it is firmly in the “Fear” quadrant.
We know now, that in fact, many assets were overpriced, and some hard lessons were learned by those who chased performance or went all in on the “highflyers.” I’m glad that I never participated in the Crypto Craze and both Patrick and I gave consistent advice against it. That’s just a foundational part of who we are and how we think, rather than some precognition or other talent. Our beliefs and our processes have served us well as the market has deflated off its highs this year and will continue to provide a buffer against what may come.
Speaking of which, I see 2023 as a year of reckoning with number of issues, not all financial in nature. A new burst of economic growth is unlikely to happen until inflation is back to reasonable levels. We’ll all have to live with new higher interest rates and adapt our personal economic decisions around them. So too, our political leaders will need to grapple with this, as the cost of funding their unprecedented spending is no longer free. The war in Ukraine needs to get resolved in favor of Ukraine for many reasons; one is that the adoption of Ukraine into the European community and the rebuilding that will follow may well be “the thing” that launches our next recovery. The opposite outcome is too bleak to consider.
With that I’ll hand things over to Patrick for a more specific and detailed examination of your investment prospects.
What a difference a year makes. As Tim mentioned, at the start of 2022 investors were trumpeting the strong stock market returns and accommodative fiscal and monetary policy that 2021 witnessed. Although 2021 had ended well, we discussed in our 4th quarter letter that inflation pressures were starting to alter consumer sentiment, which could have a profound impact on corporate profits and valuations. Well, here we are a year later, and valuations have slightly improved, with the S&P 500 having fallen over 18%, whereas international stocks measured by the MSCI EAFE fared slightly better, declining by over 14%. Negative performance in the bond market is what caught most investors by surprise, with the Bloomberg US Aggregate declining more than 13%. Seeing both stocks and bonds decline at the same time is not something most investors are used to experiencing, leaving the unprepared asking, “Where can I hide?”
Thankfully, we at Cairn were prepared for what had transpired and were able to avoid many of the large drawdowns in stocks and bonds. Our disciplined process is built around finding unrecognized value in companies and asset classes, and then making sure we are compensated enough for the risks that could unfold. If we are not finding opportunities, we are more than willing to hold cash, which was one of the best performing asset classes in 2022! Many of you have expressed concerns in the past about holding cash, since interest rates were at very low levels. My response was always two-pronged: First, cash gives you instant optionality to do something different without having to sell something in your portfolio that you might not want to sell. Second, cash is the BEST short-term inflation hedge. As inflation and short-term rates start to rise, your cash rate adjusts and the nominal value of your cash does not go down, unlike stocks and bonds.
Many of the Covid darlings that rewarded investors in 2020 and 2021 saw their share prices drop by 50-80% in the last year as interest rates increased and concerns about future growth took center stage. We have discussed this many times in the past, that the price paid for an asset is the largest determiner of your future return. Growth investors learned this lesson in real time. The chart below shows the one-year price performance of four of the Covid darlings; Tesla, Netflix, Zoom Video, and Peloton Interactive.
Equal weight ownership of these companies would have produced a return of -64% in 2022. I have nothing against any of these four companies (I love my Peloton); I just use them as an example that large losses can be realized by paying too high a price for even disruptive and innovative companies. In fact, of these four companies, only Tesla has had a positive price performance over the last 3 years. Large losses destroy compounding much faster than the benefit of a large unrealized gain.
Our disciplined value philosophy also served us relatively well during 2022. I must admit, my patience was put to the test from 2014-2021 as value underperformed growth by a wide margin, prompting many headlines stating that value was dead. Though one year does not signal a complete shift in trend, I am happy to hear that argument going silent. As the chart below shows, value stocks have outperformed growth stocks by over 30% from their lows of November 2021. If history is any guide, we are still in the early stages of this outperformance, especially given the current inflation and interest rate backdrop.
Concerning inflation and interest rates, as we have said many times, we are not in the business of predicting the direction of inflation and interest rates but will observe where we are now to make decisions. Our view based on the current data is that inflation will continue to come down from its peak levels witnessed in the fall. Many pressures that caused the spike in inflation will inevitably roll off as the months go on. The Fed has stated that they intend to keep short-term rates higher than inflation for longer than what capital markets might expect. We will see. Historically, the Fed has changed their tune as soon as financial stress gets too painful. The strong performance of stocks during the 4th quarter seems to point to the “hope” that the Fed will have to reverse course sooner than later. But as a reminder, the Fed has never cut rates when inflation is above the Fed Funds Rate. And looking at the chart below, we still have a way to go.
As we enter a new year, our portfolio positioning remains defensive as risks are still tilted towards the downside. If we get a more material retreat in valuations or price behavior improves, we will be more than happy to put some of our excess cash to work. From an asset class perspective, we still have a positive intermediate term view on international stocks, though that was not materially helpful during 2022. With the strength in the US Dollar starting to subside, international equities could provide a nice tailwind in the future as valuations are much more attractive than broad US stocks. Thank you again for your continued trust and support. I’m always happy to discuss any of these topics in more detail, so drop me a line anytime. —Patrick Mason
Thank you, Patrick. You may have noticed that a smiling new face has been added to our team in the form of Stefanie Schneider. Hopefully, more of you will make it into the office as the season turns, and have a chance to introduce yourself. Remember, the coffee is always hot and free.
Tim Mosier, President
Cairn Investment Group, Inc.
Greetings from the Northwest.
I can hardly believe that it’s been a year since I wrote of frosty mornings and fall colors! This year it’s summerlike temperatures, sunglasses, and tinder dry vegetation. I’m afraid that the eventual but certain surrender to Autumn may be more abrupt than usual.
It’s been a rough investing season so far. I’m not sure I know why the stock market likes to pick the fall to make its most dramatic downside moves, but if September is a gauge, we’re probably in for some more pain before the bargain shopping kicks into gear to turn things around. We’ve done much to protect your assets from the most painful moves, as Patrick will point out, and we’ll continue to look for opportunities to reduce risk or pick up a bargain when we can. For most of you, staying the course will yield the best result, but if your needs and circumstances have changed, please let us know so that we can re-evaluate our plan.
Here’s a topic that we’ve never really touched on before, and it has nothing to do with making you more money: In times like this it’s common to allow negative sentiment to seep into our decision making and knock us out of our normal patterns in many unexpected ways. While we’re all experiencing what’s likely a temporary reduction in our wealth, many of the organizations that provide for those in need, protect the environment, or otherwise do the hard work that most of us cannot do ourselves, still need our help, and they often find that getting the funds to do so is a bit tougher in times like this. I suggest that we continue to remember the causes that are dear to us, even when our own fortunes may be somewhat less.
With that, I’ll hand things over to Patrick, who will again school us on the numerical realities of investing.
It is understandable to hear investors’ comments about never having seen a market environment like the one we are living through now, having never witnessed both US stocks and bonds decline for 3 quarters in a row (h/t Liz Ann Sonders). High inflation, and the Fed’s response by raising interest rates at an unprecedented pace, have caused a shift in investor sentiment and risk-taking behavior across numerous asset classes. We have observed a quick reversal in how households and investors are feeling about their future, with the consumer expectations index hovering in recessionary territory.
Though households are feeling pessimistic about the future, it seems like most investors have been conditioned over the years to expect that the Fed will always have their back, so even though pessimism is high, it seems like a fake pessimism. Although we are still in a bear market, and households are as pessimistic about the current economic environment as they have been in 30 years, very few are acting like it. The chart below shows household allocations to stocks still sitting at close to 65%, which is much higher than previous bear market lows where consumer confidence currently sits.
So even though valuations have come down from their extremes (though still not cheap) and sentiment is low, the fact is that household allocations to stocks remain elevated, and we haven’t seen the signs of capitulation that signal that this bear market is over.
In our first quarter letter we suggested that TINA (There is No Alternative) might be a thing of the past, as interest rates were starting to move higher. I think market pundits are going to have to come up with a new acronym, now that interest rates have risen substantially this year. The chart below shows US treasury bond rates at the start of the year and what the corresponding rates are now. Needless to say, there are now compelling opportunities to earn interest in more conservative assets, which we have not seen since 2007. Another observation looking at this chart that has been caused by aggressive Fed policy is this: I don’t know how something doesn’t break with rates rising as quickly as they have across the entire yield curve. Treasury rates are the starting place for the pricing of many other financial products across capital markets (just look at the current 30-year mortgage rate of 6.70%). Time will tell if the Fed will/can remain so vigilant in fighting inflation if higher rates start to have more broad consequences across the economy and capital markets.
We have spoken many times over the years about the risks that have been present in markets due to high valuation combined with overly optimistic sentiment. We are not seeing those risks become a reality. We have preached risk management and protecting against the full brunt of market losses when bull market cycles inevitably turn. Though portfolios are down this year, holding extra cash and focusing on attractively valued companies and asset classes have helped us not participate in the full brunt of equity market losses. In our fixed income portfolios, we have focused on high quality, shorter maturity bonds which have also held up well compared to the broader fixed income market. Even though we are still cautious in thinking that the worst is behind us, we are now finding opportunities in companies and asset classes that were not present a year ago. Having extra cash in portfolios accomplishes two important goals during this period. First, it helps protect the portfolio when both stocks and bonds are not performing well. Second, it allows us to take advantage of opportunities without having to sell other assets that might be at depressed prices. So even though we still view risk as being elevated, we have the flexibility to shift gears when the time comes. We appreciate your continued trust and are always open to discuss any topic or concern in more detail if needed. —Patrick Mason
Thanks, Patrick. If any of this feels like it needs a better explanation, please give us a call.
Tim Mosier, President
Cairn Investment Group, Inc.
Greetings from the Northwest.
It looks like this year’s take on summer has arrived, and we’re seeing a noticeable surge in the number of people mingling, dining out, shopping, and pursuing their outdoor passions, despite the higher costs that have been lightening wallets. The basic human need to live our lives and move beyond the virus is driving this burst of social activity. We’ll see how long this can survive in the face of the higher prices we’re experiencing. I’m sure glad I don’t have air travel planned any time soon, as that appears to be an unpredictable and expensive mess.
So here we are, officially in a bear market, having just completed the worst first half experienced in our stock markets since the 1970s, with more clouds in the distance, as historically, the second half is the rougher. We’re probably in a recession, but a strange one. The economy is trying to burst forth from our COVID-induced lull, while at the same time the Fed is dousing the flames of the stimulus bonfire; and there’s a war and a lingering virus. The stock market has been overpriced for some time, so it’s not surprising to see a pull back, and Patrick will point out that overall, it’s still not cheap, despite some huge drawdowns in the more speculative asset classes. Housing is due for a correction of sorts, and it’s probably in the early stages of one.
Depending on who you talk to and where you get your news, you could get the impression that the sky is falling and that we’re in a complete and total market meltdown. To be sure, it has been tough to find shelter in this storm, but I find comfort in our process, imperfect as it may be, believing that we’ll come out of this better than the broader markets, and well prepped for whatever’s next. Your actual experiences will vary, but I believe that what you have seen so far with your investments is distinctly less frightening than the shrill alarms being heard on many media outlets.
On another, somewhat related note, I’m proud and excited to share with you that Cairn Investment Group was honored this last month as one of Oregon’s fastest growing private companies by the Portland Business Journal, the result of much hard work by the entire team.
With that, on to Patrick and some specific and useful thoughts:
Equity and fixed income markets continued their march lower during the 2nd quarter, as investors continued to absorb rising inflation, tighter monetary policy, corporate profit margin pressures, and still high equity valuations. There were very few places for investors to hide during the first half of the year as large cap stocks, measured by the S&P 500, are down -19.96% and the Bloomberg US Aggregate Bond Index down -10.35%. I pointed to this as a risk in our Q1 2021 letter:
As we’ve discussed with many of you during meetings and reviews, stocks are not a very good inflation hedge when they are combined with high valuations. It’s only after valuations return to a more reasonable level that stocks offer a good hedge against inflation. The actual best hedge (short-term) against inflation is cash, which is why we have been holding a higher-than-normal cash allocation in portfolios for the last 18 months. The chart below shows inflation (vertical scale) and valuations (horizontal scale). As it illustrates, generally when you have 8.5% inflation, valuations are much lower than where they currently stand. So even though valuations have fallen from their historical extremes that investors were witnessing to start the year, they are still well above normal given the current inflationary backdrop.
To combat the steady rise in inflationary pressures the economy has been experiencing, the Fed has become more aggressive in raising interest rates and tightening financial conditions. During their June meeting they raised the fed funds rate by 0.75% and have been hinting that another 0.75% hike might take place in July. As the chart below indicates, historically, when inflation is over 8% the fed funds rate is higher, not lower, than the inflation rate. So, if inflation stays high, then the fed has a way to go in raising rates.
The biggest argument that we hear about why the Fed should slow their pace of interest rate hikes is the problem with the toolkit the Fed has to cool inflation. The options available are useful in decreasing the demand side of the inflation, not the supply side. Lyn Alden, of Alden Investment Strategy, said it best in her most recent monthly newsletter:
By raising interest rates, the Fed is in essence trying to raise unemployment and cool consumer demand. These actions could slow inflation for a period of time but, unfortunately, the price paid might be an economy that goes into recession. We are not in the business of predicting recessions, but we do have to be aware of the environment we are in and manage through it appropriately. With that said, we have a hard time believing that if the Fed continues down its current path, a soft landing they are hoping for is the most likely outcome.
Through all the negativity there are some silver linings. Though the S&P 500 is down over 20% from its highs, many companies and asset classes have fared far worse. Many of the high-flying growth stocks that helped fuel the market bubble we were in, are now trading like beaten up value stocks. Overall, portfolios continue to hold higher than normal cash positions and are defensively positioned based on what the data is showing us. This provides us plenty of flexibility to change course when opportunities present themselves across the investment landscape. Combined with our cash allocation, we continue to hold a portfolio consisting of high quality, value-oriented stocks and bonds across asset classes that can weather market turbulence and provide the ability for capital appreciation, once the market environment eventually changes course. Thank you again for your continued trust and feel free to reach out to me to discuss any topics in greater detail. —Patrick Mason
Here’s a reminder that the office is open, the coffee is fresh and hot, so please, don’t be shy about requesting an appointment or giving us a ring.
Tim Mosier, President
Cairn Investment Group, Inc.
To say that there have been a lot of moving parts, in capital markets and economy, would be an understatement. Though equity and fixed income markets both finished down for the quarter, March provided some reprieve. Having both stocks and treasury bonds decline at the same time is a rare phenomenon. Over the last 100 years, it has happened four times during a calendar year. I guess we will see how the next nine months go. Many of the headlines being written, and market pundits’ comments, have been blaming the volatility that we have been witnessing in stocks on geopolitical concerns. While we are appalled at the conflict in Ukraine, we continue to believe the main drivers of equity and fixed income price movements are inflation, interest rates, and monetary policy. We have written about these topics many times over the last couple of years, and our opinion, based on data, has not changed. Inflation is here, and it is not going away anytime soon. Interest rates, and the Fed’s reaction to inflation, have been behind the curve; so now monetary policy makers are forced to play catch-up by raising rates into a slowing economy. A term that you might start to hear more over the next few quarters will most likely be “Stagflation.” Stagflation is the ugly combination of high inflation and declining economic activity, which the US has not witnessed since the 1970s. As I spoke about last quarter, rising inflation has affected consumer expectations about their future and that continues to show up in the data. The bond market has also started to take notice as the US treasury bond yield curve is the most inverted since the financial crisis.
The yield curve has a strong track record of predicting a slowdown in economic activity. There will be plenty of talk about how “this time is different.” We would take those arguments with a huge grain of salt. We are not predicting, just observing the conditions and responding appropriately. If the environment changes, we will change our mind.
On a positive note, there have been arguments over the last couple of years justifying the strong performance in equity markets as being driven by having no other alternative (TINA) due to interest rates being at historic lows. With the recent jump in treasury bond yields, this is no longer the case.
Investors now have some options to earn income in relatively safe investments, which should impact decision-making at some point. This positive development will allow investors options for investing and provide competition for capital, which is beneficial to determine fair prices for many different asset classes.
Overall, we have been pleased how portfolios have reacted during this shift in market behavior. Having a value bias during this rising interest rate environment has been helpful, as we have talked about previously. We continue to focus our equity allocation on companies and asset classes that generate consistent free cash flow, have resilient operating performance, and returns on capital that trade at attractive valuations. The main detractor to performance has been our allocation to international stocks. We continue to view international equities to be much more attractively valued than US stocks, so we are willing to be patient. Bonds have not been spared the volatility in capital markets. We manage your fixed income to be short-term in maturity and with lower credit risk than the broader bond market. Our focus on risk management, the willingness to hold cash, and be patient provides your portfolio flexibilities that are well positioned to navigate this challenging market environment.
Thank you again for your continued trust. I have had many great talks with you over the last few months and continue to invite a conversation on anything you find needs further discussion.
Greetings from the Northwest.
Wasn’t that a nice bonus, getting a fresh blanket of snow between Christmas and New Year’s? I hope the kids all enjoyed it during their time off, as you never know around here if you’ll see any more snow this winter. I’d be just as happy if it stayed in the mountains.
So, we have a new year, and we say farewell to 2021; it was quite the ride! How best should we remember it? I’m sure each of us has our own, unique take on it, but we all dealt with the same long parade of often painful global, national, and local events. Heck, we didn’t even get through the first week of the year before it started!
So, again, how should we remember you, 2021? I’ll remember a year when the US equity markets provided one of the best ways on earth that one could grow their wealth, a year that saw real-estate values leap, even in areas experiencing net outflows, and one in which consumer prices rose undeniably higher. The supply of money was high, the cost of it low, and the desire of people to do something besides sit quietly in quarantine created a potent brew. The people reading this newsletter assuredly had their net worth increase this last year, providing welcome contrast to the other frustrations they may have experienced.
We also got a welcome, if only temporary, reprieve from the virus in time for some early summer fun, and apparently it was easy to find a job if you wanted one. So, thank you, 2021, for what you did provide.
Looking forward is both a necessary and imperfect part of our job here at Cairn. For over a year, Patrick has provided a consistent message highlighting the coming inflation and its possible effects, many of which have already been realized. This changing landscape, combined with the continued high stock valuations, is a formula for volatility. Let’s hear what Patrick has to say about this.
Thanks, Tim. Over the last few quarters, we have discussed inflation and equity valuations from many different angles, so I apologize if I’m starting to sound like a broken record (Q2.2021 and Q3.2021). However, the changing market dynamic, moving from a long-term deflationary environment to a rising inflationary environment, will continue to have profound effects on capital markets. Prior to last quarter, we discussed that inflation might be on its way, but it was too soon to have a strong conviction one way or another. As the data continued to evolve, so did our opinion, when last quarter we echoed that inflation is here and will most likely be something we are going to have to live with for the foreseeable future. Nothing has changed over the subsequent three months to alter our opinion. In fact, more data points are emerging confirming inflation is here to stay, and that consumers are starting to believe in the same narrative. The chart below shows the year-over-year change in the Consumer Price Index with corresponding survey data on consumer sentiment. As you can see, the continued rise in inflation is starting to put a dent in consumer sentiment and their feelings about current economic conditions.
Combined with survey data taken from business leaders (below) pointing to higher prices paid along with higher wage expectations, it paints an interesting picture of where future profit growth and margins could be heading
Again, our concerns about inflationary pressures and the effects on capital markets would not be so strong if profit margins and valuations were more reasonable than they are today. But with profit margins and U.S. equity valuations close to record highs (below), the coming inflationary dynamic poses greater risk of loss.
As we have spoken about previously, we do have a playbook and process for managing through these difficult market environments. The good news is that excessive valuations are not broadly based. Currently we are finding opportunities in international equities, and US value stocks. We were rewarded by having a value bias in 2021 as US value stocks performed well. However, international equities lagged as investors continue to blindly pile money into what “has” worked instead of what is “most likely” to work going forward. For reasons we have spoken about before, we continue to view international equities attractively, due to more compelling valuations combined with greater inflationary pressures in the US than abroad. Even as we are finding pockets of opportunity, risks are higher than normal, so our focus on risk management and capital preservation remains paramount. Thank you again for your continued trust, and please feel free to reach out to me to discuss this topic or any other concern. —Patrick Mason
Thank you, Patrick, and wishing everyone a successful and happy 2022.
Tim Mosier, President
Cairn Investment Group, Inc
Greetings from the Northwest.
I love this time of the year, and I know many of you do too. The welcome relief from the heat, with a cool fresh breeze, soaking rain and magical, mystical fog coming to the rescue of flora baked and broiled through this hot dry summer. Trees turn brilliant colors, salmon leap at the falls, waterfowl get ready for their annual migrations; here and there someone lights a fire in their hearth and shares a warm drink with a friend. All is wonderful, and for now, new and exciting. It’s fall.
On many counts it’s another normal fall. Kids are in school, the stock market is getting choppy, and politicians are back at work doing whatever politicians do. I do hope they choose to continue funding the government. There is that COVID thing, though. I don’t think that last year I thought I’d still be asked to wear a mask at this point, but unfortunately here we are. Whether it’s exhaustion or unwillingness to continue with extreme shutdown measures, or wisdom gained through hard-won experience, we do seem to be weathering this better economically than we did last year, despite the surging infection rates.
There are some economic oddities that we can blame on the pandemic, and one that many of you are experiencing is related to a damaged global supply chain. Try buying new furniture or finding a replacement part for your car. You might be waiting weeks if not months. Aside from the obvious inconvenience and irritation this may cause, it’s also a symptom of supply and demand that are out of sync; probably and hopefully temporarily, since this was caused by a shock event. However, we all know that more demand than supply leads to higher prices. Patrick will again dice and slice this in his section, with some new and intriguing angles.
Another, not unrelated, economic oddity we’re experiencing is the surge in home prices, not just in the predictable core urban areas, but in the far suburbs or “exurbs” as people seek a bit more space between themselves and others or flee urban crime and blight. Freed for now from commuting constraints, high-paid professionals are even driving up prices in cities far from their employers; Bozeman, Montana comes to mind.
With that I’ll hand things over to Patrick:
Financial markets showed more volatility during the third quarter. Large cap stocks were the best performers, rising a modest 0.58%, driven by the biggest cap stocks. Peeling back the skin, performance of equities showed mixed results with large value stocks declining -0.78%, small cap stocks returning -4.36%, and international stocks returning –0.45%. Bonds did their job, showing low volatility and modest returns of 0.05%. In the past two quarters we have written about the effects of inflation on equity markets, the current high valuations of large cap stocks, and how we would manage through a period of higher inflation. In recent months the hard data surrounding inflation, and the commentary from company management, have made it clear that inflation is here, and how quickly it will subside is anyone’s guess. Though The Fed has been adamant that inflation will be transitory due to the pandemic, in their September policy meeting they admitted that inflation has lasted longer at a higher rate than anticipated. I indicated last quarter that the bond market has not been a believer in the inflation narrative. However, the bond market can only turn a blind eye for so long. The prolonged inflation picture could have effects on the following: consumer behavior, how profitable companies will be going forward, and how the equity markets will behave.
First, on the effects of consumer behavior. Here is just one example of the headlines investors and consumers were reading from the Wall Street Journal on September 26th:
I have discussed the inflation topic with many of you over the last 12 months, and one thing I have said is that inflation can take hold because people believe it will take hold, like a self-fulfilling prophecy. As demand for goods continues to be high, while supply of goods is low due to supply chain issues, consumer behavior could change based on the expectation of higher prices, causing the very thing that everyone fears the most, inflation. The chart below is a survey measuring inflation expectations from consumers. As you can see, it is the highest since 2011.
Inflation’s effect on corporate profit margins will be highly dependent on a company’s ability to pass higher input costs to the end consumers. In our analysis of each company we own, we stress test their cash flows, considering negative effects of inflation and profitability when we determine a fair value. One thing is for sure: company executives are talking about inflation. Below is a chart showing the number of S&P 500 companies that are mentioning inflation in their earnings calls.
With nearly 50% of companies mentioning inflation in earnings calls, there seems to be a real concern about inflation amongst companies. Executives are going to have to make some tough decisions about how to allocate capital going forward if costs continue to rise and profits start to come under pressure. This is one of the many reasons why being disciplined in the price you are willing to pay for a company is so important. Paying too high a price during a period of eroding profits is a dangerous recipe.
Over the last few quarters, we have talked about what the effects of inflation would be on equity markets, so I will be brief. The chart below shows corporate profit margins at a national level. As you can see, profit margins are at an all-time high.
The combination of record high equity valuations with record high profit margins could prove to be a challenge for equity market performance if inflation starts to erode profits.
Though we view many large cap stocks as being expensive, we are still finding opportunities in select individual companies and certain asset classes. Over the last year, portfolios have been rewarded by having a value and small cap bias. The main detractor to performance has been our allocation to emerging market equities. Though the underperformance of emerging market equities has been disappointing, we believe we will be rewarded in the long term as valuations are much more attractive compared to the United States. Our portfolios continue to have a conservative bias and hold slightly more cash than normal, due to the risks that are present in equities combined with the low opportunity set available. Thank you for your continued trust and support. The topic of inflation and the effects it will have on capital markets is complex, so feel free to reach out to me with any question. —Patrick Mason
Thank you, Patrick. We’re all curious to see how this plays out.
Goodbye for now and Happy Trails,
Tim Mosier, President
Cairn Investment Group, Inc.
Greetings from the Northwest.
Wasn’t that hot spell unpleasant! Who needs temps in the 110s? We’ve already had our first local wildfire prior to the heat kicking in, getting a good whiff of smoke in our neighborhood from a blaze just over the mountains. I’m hoping we don’t have a repeat of that thick, unpleasant smoke last September. Please, be careful out there!
Now and then a new word seeps into our daily discourse; not new in the sense of its creation, but new in the sense of its prevalence and meaning. Often it’s a way to get our attention and describe something that was previously vaguely understood. Remember the word sustainable becoming part of our common language some years ago? It was novel at first, and eventually over-used, but we all came to terms with it in our own way. It now has a certain shared meaning that allows us to better communicate an important concept that’s used for a broad swath of topics.
The word that I want to talk about today is narrative. You know what I mean… it seems that everybody, and every cause, has a narrative. The word “spin” may have been used in the past for some things meant by narrative, but spin sounds too negative to use in most cases. Narrative can be used for topics without sounding negative or dishonest. But let’s be clear: A narrative is a story, and these stories are all told to create reactions to the benefit of the storyteller. Because of this, they cannot be the whole truth, just a subset of the truth that works for the storyteller. In its ugliest form a narrative includes untruths as well. Unfortunately, today, narratives are even masquerading as news in our hyper-informed world.
So why am I bringing up this potentially over-broad and serious topic? Well, first of all, we are being engulfed by narratives daily. Pick a topic and there are competing narratives, and our investing world is not immune. We need to remain alert to this and not let ourselves be too quickly or easily swayed before we have a chance to weigh the facts and draw our own conclusions. Our job here at Cairn is to parse through a barrage of narratives, real news, raw data, and opinion to come up with reasonable actions and advice for our investors. We can’t let ourselves get swept up in a narrative that presents a distorted view of the future and entices us to act in a way that is out of step with reality. These are momentous times as we come out from under the shadow of the virus; it’s equally possible to miss the opportunities that this presents, or to fall into a trap of our own creation.
I want to emphasize that at Cairn we are working hard to remain rational and pragmatic in our vision and actions. Please read carefully though Patrick’s part as he again explains our beliefs and processes to care for your money.
Last quarter we wrote at length regarding the potential for higher inflation, how equities might react to it, and how our disciplined process would manage through it. As Tim correctly points out, we are being bombarded by narratives surrounding the investment and economic landscape on a daily basis. The dominant narrative to start the second quarter said something along the lines of, “inflation is coming, and you better get prepared for it!” While we still see many headlines regarding the topic, financial markets do not seem to be overly concerned. The chart below shows the year-over-year change in Core CPI (Inflation) and the yield on the US 10-year treasury bond.
What is interesting is that the data shows a spike in inflation (partly due to lower-than-normal levels a year ago), but the bond market does not seem to be worried about it. If there was a large concern about persistently higher inflation, the yield on long-dated treasury bonds would be moving HIGHER, not lower as we are witnessing now. This speaks to what Tim discussed; our job is to parse through the noise being created by these numerous narratives to see what the data is actually suggesting. Currently, many data points indicate that inflation is moving higher but could be temporary. We will take the evidence as it comes and act appropriately.
Another popular narrative that we hear these days revolves around valuation. With equity markets continuing to outpace underlying fundamentals, many pundits have started to whisper opinions that valuations are not as important and that elevated valuations are justified, due to higher economic growth, combined with the larger representation of disruptive technology companies. As with any good story, there are some partial truths that make these arguments sound compelling. Yes, technology companies have become more dominant in equity markets and trade at higher valuations due to their disruptive qualities. But the skeptics in us always like to take a look at the actual data to see what that tells us. Below is a chart of the S&P 500 index Price to Sales Ratio.
A couple of thoughts enter my mind when I look at this chart. First, current valuations are roughly 20% higher than they were during the height of the technology bubble when the same arguments were being made about disruptive tech companies. Second, with S&P 500 revenues growing on average in the mid single digits over the last couple of decades and valuations trading at 2x long-term averages, the disconnect between price and underlying fundamentals is not solely explained by disruptive stocks trading at high valuations. So, while the financial media try to spin the narrative that today’s high valuations are justified by the dominance of select companies, when you look underneath the hood at the actual data, high valuations are present in many different sizes of companies, which is how you get valuations so much higher than average.
Our process is built around understanding the price we are paying for an asset and then paying a price we believe is below what the asset is worth, whether that be a specific company, or asset class. We feel that is the best way to deliver consistent long-term results while avoiding the overvaluation we are witnessing in many areas of the equity markets. The last chart below shows the return of value vs. growth during the late 90s and what we are witnessing today.
Just as in the late 90s, value just went through a period of underperformance versus its growth counterpart up until the fall of last year. Since then, value has been staging a comeback, and if history is any guide (it usually is), then this short period of value outperformance since the fall is just getting started. With relative valuations being much more attractive for value companies versus growth, we feel our investment philosophy acts as another layer of safety if market volatility rises, and opportunity if markets continue their march higher in the months ahead.
Thank you for your continued trust and support. Please reach out to me if you want to discuss any of the above topics in greater detail.
Wishing you all a wonderful summer with lots of freedom to gather and travel.
Tim Mosier, President
Cairn Investment Group, Inc
Greetings from the Northwest.
Can you believe that it’s been over a year living with this pandemic, and no clear end in sight? And yet, here we are with financial markets and home prices at all-time highs, leading to a large divergence in fortunes between those who own assets, and those who don’t. We all know that it’s been particularly hard on those whose livelihood depends upon up-close and personal interactions with other humans. Let’s all hope that the stimulus and a well-managed re-opening of the economy relieve much of this burden for them. I believe that almost everyone reading this falls into the category of “those who own assets,” and have seen their personal worth increase during one of the most disruptive events in modern history.
What has happened and what is happening globally should be considered as seminal, an inflection point in history heading towards something new and unknown. One can sense that big changes are afoot, and on many fronts. Indications are that after decades hiding in his bottle, the inflation genie is likely to reappear, fueled by massive government spending, and rising wealth from gains on many types of assets. Interest rates, on a downward path for the better part of 40 years and an entire career for most financial professionals, are very likely to rise in concert with inflation. Both of these have direct implications for asset prices and your investments. In his part, Patrick will give you our thoughts on this and what we plan to do about it.
On the positive side are the emergence of medical and vaccine technologies that promise to improve our response to future outbreaks. One hopes that governments, too, will have learned and adapted to better handle them. Companies globally are adapting to the idea of more worker autonomy and a more dispersed and mobile workforce. What implications can we imagine for urban centers and commercial real estate?
How far will or can this administration go in changing the direction of U.S. policy and practice on a broad array of American interests? It’s working with a clear mandate to pull us through the current crisis, but without such a clear mandate on many of the other issues that we face. How much further in debt will we go, and what will be the impact on our taxes? Will the world see a separation of supply chains and economies divided between the U.S. and China? How far will China’s economic and political rise take it? Will Russia’s global meddling (while its home economy is in shambles) lead to something worse or get checked in the future? Will the European Union come out of the crisis stronger or weaker after its chaotic response to COVID? The way that these and many other issues play out will have lasting effects on our investments and our personal lives. They don’t come with a playbook or a probable outcome, so we’ll adapt as we see them evolve.
With that, here’s Patrick with some practical, measurable observations and what we are doing about them.
Through small bouts of volatility, equity markets continued their forward march during the first quarter. Stocks, measured by the S&P 500, returned 6.17%, while the real drag on capital markets during the quarter took place in fixed income, with Long Dated Treasury bonds dropping 13.92%. The recent negative returns generated in bonds due to rising interest rates have caused a lot of chatter across the investment community. This is a topic we find of high importance as we manage your wealth moving forward. Some might say, “Wait, Patrick; interest rates rose a couple years ago, and bonds did okay.” Or “I don’t own many bonds in my portfolio, so what will this have to do with equity markets?” My simple response: “A lot!” The source of rising rates will have a profound effect on equity markets and returns realized across different investment styles over the coming market cycle. The source is very important, because, unlike 2018 when rates were rising due to the Fed reversing QE, the current narrative and concern of rising rates are not being driven by the Fed tightening monetary policy. Fed officials have been clear that they have no intention of reversing their current course for at least a couple of years. As the two charts below indicate, we are seeing interest rates rise today because market participants, investors, and business managers are becoming concerned that inflation is starting to heat up. This could be for a myriad of reasons, but the most likely culprits are large government spending, combined with strong economic growth, and extremely accommodative monetary policy.
If inflationary pressures and concerns become a reality, the tool kit used over that last cycle (investing in high revenue growth, low current earnings U.S. companies, combined with long dated bonds), will not have the same level of success that investors have become accustomed to. The bullet points below explain the intuition:
As with most things in financial markets, not everything is black and white, so there will be certain areas of the marketplace we will continue to focus on, to find opportunities to combat the threat of higher inflation. First, as we have written about many times in the past, value stocks vs. growth stocks still trade at a large historical discount. The benefit of value stocks over their growth counterpart in a rising inflationary environment is that many of the cash flows and earnings of traditional value companies are realized in the present (think of Costco). So even if inflation is rising, the future value of earnings is not as impaired as in growth companies that realize their earnings many years into the future. Second, companies that have a strong competitive advantage with the ability to pass rising costs on to their customers and consumers should weather inflationary periods with less disruption to profits. Lastly, having exposure to equity markets outside the U.S. will be essential, as the relative value of international stocks is much more attractive, and higher inflation domestically generally comes with a lower value for the U.S. dollar. A lower value of the U.S. dollar versus other currencies is historically a positive to foreign equity markets.
The benefit of our process is that it is built around understanding the value of what we are paying for something, while comparing that to the risks that could be present. Our disciplined approach will only act as another layer of safety during this potentially changing investment landscape. When risks are high, and opportunity is low, we will remain flexible but defensive for when the pendulum eventually swings in the other direction. Currently, we view risks as being high but not so high that defense is the only strategy. This positions our portfolios to hold slightly more cash than normal, while we are actively taking advantage of investments we feel offer compelling return potential during this challenging market environment. As always, thank you for your continued trust, and please reach out if you would like to discuss any topic in greater detail.
In case you’ve missed the website and LinkedIn updates, Cairn has added a key member to the team in the last month. Mark Farrelly CFP®, CDFA® has joined us as Senior Advisor and Director of Financial Planning. It’s exciting to bring on someone as experienced and talented as Mark, who’s been in the business for almost 20 years, specializing in providing detailed and comprehensive financial advice. Mark and Patrick have worked together earlier in their careers, and already have a deep level of trust and respect for the other’s skill set and work ethic, setting up a promising integration of Mark and Cairn. Mark operates out of Northern California and will continue to work remotely. Over time Mark will help us in improving and codifying our financial planning practices, providing a better experience for all of our clients.
As restrictions ease, I hope to see many of you back in the office. In the meantime, we’re happy to provide help by any means that works for you, including Zoom or WebEx meetings.
Tim Mosier, President
Cairn Investment Group, Inc.
Greetings from the Northwest.
Was that a Mack Truck or a herd of reindeer that knocked us off our feet? I didn’t catch a glimpse of the perpetrator, but it sure was nice of him to pick us back up and dust off our coats before he left. I’m talking, of course, about last year. Done with that, let’s move on to better days, and I do believe that better days are ahead.
On a global scale, private enterprise has figured out how to operate while hampered by the confusing regulations and ever-present risks. Consumers are consuming, homebuyers are buying, etc. People and companies everywhere have pulled forward their use of technology for communicating, shopping, and more, by several years; yet it seems like we all still want to visit Costco and Fred Meyer between our Zoom meetings. As the health crisis eases with the coming vaccines, we’ll find out just how much pent-up demand exists. My sense is that it’s high. When we get the green light, we’ll be eating out, shopping, and traveling in vast numbers.
Continuing in a more positive vein, I am so impressed by the people iour community who have, throughout the crisis, kept on task, helping those in need, whether that be financially, emotionally, medically, or all the above. We’ve seen strong giving from our clients and can see the good this spreads in the community. Similarly, I’ve observed an unabated commitment to important environmental projects in our state and elsewhere, with people giving their time and money trying to make a positive impact. Thank you.
There will be challenges; we’ll all learn the tax impacts of the election in coming months, and we’ll all adapt. The stock market itself has already celebrated some of this success, so its performance may not be so rosy.
I’ll leave it to Patrick to explain our thoughts on that in more detail. Speaking of Patrick and a brighter future, I want you all to know that as of January 1, Patrick is officially on the ownership team at Cairn. This is an important step for him, for your relationship with Cairn, and our ongoing growth, health, and continuity. Welcome, Patrick!
Equities posted a strong finish to 2020 with most indices up low double digits for the quarter. Investors continued to focus primarily on positive vaccine news versus a still muddling economy with lofty equity valuations. Small-Cap stocks were the biggest winner, rising 31.37% during Q4, while bonds posted a modest 0.67% gain. During our Q3 letter and our mid-quarter update we discussed where we are finding opportunity based on the large mis-pricing in small cap and value stocks, and though the first quarter of the year did not meet our expectations, portfolios have benefited from the change in market participation we are currently witnessing. One of our favorite indicators to track market participation (breadth), is the S&P 500 Equal Weight Index over the S&P 500 Cap Weight Index. When this indicator is moving down, market participation is narrow and being driven by a few large companies (like FAANG stocks). When it is moving up, the smaller companies are carrying more of the load and participating in a meaningful way, which is the current trend as you can see in the chart below.
We have written quite a bit about high valuations and risk over the last few years. Though our concerns about valuation have not receded, observing more broad participation in the equity markets is a positive.
With the rebound in equities that took place in April, we are now witnessing sentiment indicators at optimistic levels. One of our favorite sentiment indicators is the Smart Money vs. Dumb Money Spread released by our friends at SentimenTrader.com. This indicator measures money flows based on large option trading versus small speculative option trading. This is a contrarian indicator based on the logic that large institutional hedgers and participants have more knowledge and therefore are the “Smart Money.” As you can see from the chart below, when “Dumb Money” is at extremes, this tends to be a warning sign for the coming months.
We are witnessing a tale of two markets summarized by: better participation across asset classes, and companies that will benefit from further economic improvement. Countered by equity markets that exhibit excessive valuation and frothy sentiment dampening future return potential. We have positioned portfolios accordingly, to take advantage of markets that are rewarding attractively valued companies and asset classes, while maintaining some extra cash and fixed income to act as a ballast in case more turbulent times arrive.
Thank you for your continued trust. I always enjoy conversations with clients regarding any of these notes or the data we analyze, so please drop me a line if you care to discuss in greater detail.
Here’s to a happier 2021.
Tim Mosier, President
Cairn Investment Group, Inc.
Greetings from the Northwest.
Well, it’s Fall at last and it’s beginning to cool off a bit, although more slowly than usual, as it’s still been in the 80s when the smoke’s not too thick. We did kick off October with the first foggy mornings of the season and that seems to make a cup of coffee just a little more enjoyable. I look forward to the wonderful, natural changes that happen this time of the year, in stark contrast to some of our human constructs. Below, I’ll dig into some of my thoughts about our man-made world, but first I’ll share a moving personal experience with you.
Some weeks ago, I woke up along the banks of the Madison River in Montana, having spent a few days fishing and revisiting one of the favorite memories from my youth. Wow, had it changed! Trophy homes are perched on every hill and a very active tourist/fishing racket drags paying customers down the river in small armadas, slapping the water continuously with their bright strands of fly line, all hoping to catch the same fish that had successfully ignored the prior dozens of presentations. Having had enough of that, I packed up camp early and headed east to Wyoming, through Yellowstone Park. I always enjoy Yellowstone, but unless one can stay awhile and explore, it’s just a slow drive through some pretty country, albeit a bit smoky this time.
Midway through the drive, along the banks of the Yellowstone River, I found myself coming to a halt behind a line of stopped cars and a scene straight out of an apocalyptic movie, with drivers abandoning cars mid-road, grabbing cameras and optics, while lunging towards the river with much excitement.
What I witnessed was one of nature’s greatest and most brutal spectacles. A very large grizzly had chased a mature bull elk into the river and was dispatching him as I arrived. Despite the elk’s long powerful legs and massive pointed antlers, he was no match for the bear’s practiced approach and agility. By entering the river, he had unwittingly sealed his fate. I watched as the bear finished this task, essential to his survival, and then slowly, working with the current, brought the elk to shore. Having assured survival for another week or so, he sat on his haunches, resting and considering his victory. This entire episode, from well before I arrived on the scene and for days thereafter, has been photographed and recorded by many, and you can easily find this on YouTube if you’re interested.
While this is a cool story and a great memory for me, I think it also has some instructional value when it comes to our lives, our decisions and our investing behavior.
The outcome of this event was not preordained. Why did the elk give up its advantage and play into the strengths of the bear? My theory is that in this case the bear was much more experienced at killing than the elk was at not getting killed. The elk lived in a predator-rich environment, being on guard at all times and occasionally experiencing the loss of a herd member, but it probably had not been in such close proximity to death and had an exaggerated sense of his ability to escape.
He was the amateur in this fight. Seeking safety was his undoing. By contrast, the bear, evidenced by his mere existence, was a professional. Each and every meal not scavenged, was preceded by a successful hunt. He is an expert at the end game.
I draw a parallel from this to our own behavior: what we think and do when we’re afraid, and again when we’re confident. Our current human environment is unprecedented. To some extent we are all amateurs today. Who could imagine a year when the impeachment of the President of the United States is page three news? I cannot claim that we here at Cairn have some special insight into the future, or that we’re even smarter than the average bear, but I can tell you that we have a process and that process works much better than running into the river for safety. Please take a moment and consider what Patrick has to say about what we do and what we plan to do to keep your money in a good place.
It was only a few short months ago that we were writing about the deep recession and corresponding market correction. Contrast that to today where we’re witnessing exuberance in parts of the equity markets that resembles the tech bubble that took place 20 years ago. The US stock market, not to mention Robinhood traders, must be fans of the late musician Prince because it is partying like it is 1999. My apologies if that song is now stuck in your head. The difference being, in 1999 you had stock tips on AOL message boards and discount brokerage firms that would take your trades 24 hours a day. Today, you have a slew of new traders with Twitter and a phone app that lets you trade stocks like a video game.
We have written in previous quarters on some of the reasons investor enthusiasm is at its peak (Fed intervention, low interest rates, etc.). This optimistic behavior has driven valuation metrics across the board to historic highs. One of our favorite valuation metrics is the Price to Revenues (P/S) ratio. It gives a clear picture of what investors are willing to pay for a stream of revenues before costs and other accounting factors. It has been observed that there are now more companies in the S&P 500 trading at 10 times revenues (37) than there were in March of 2000 (30). This data point reminds me of a quote from former Sun Microsystems Founder and CEO, Scott McNeely, when he discussed the investor euphoria that was taking place prior to the tech bubble bursting:
The recent price performance of Tesla showcases a current example of investor euphoria when their share rose 50% after the company announced a stock split on August 11th. A stock being split may sound like a good thing, but there is no economic value created with a stock split! The market value, earnings, revenues, and cash flows of the company remain the same. There are simply more shares outstanding being offset by a lower price. Tesla’s 50% increase in market cap in the two short weeks following their split announcement generated more wealth for investors during that period of time than any of their car designs have ever done.
Wonderful companies (many of which we own) that create essential products and services have seen their share prices shoot past the fair value of the underlying business. However, this means that the prospects of these companies have been accounted for in the high share price. This potentially leaves little room for growth and heightens risks if the prospects fail to materialize. Down the road many investors may be looking back on this period asking themselves, “What was I thinking?”
With the levitation in growth stocks, investors have ignored other well-run businesses and asset classes. This is where we are finding opportunities for new investments. As value investors, our primary focus is not looking for new investments based on what has previously done well, but rather we look for companies and markets that are under appreciated that will do well in the future. The current divergence in price returns has been shown to reward some companies too much while punishing others too harshly. Mean reversion is a powerful phenomenon and the evidence suggests that such anomalies tend to reverse.
Below are charts showing the relative valuation of value stocks vs growth stocks, and small company stocks vs large company stocks.
Looking at these charts together tells a strong message. While focusing on risk, the opportunity for investors to earn returns is found by looking at value over growth and smaller companies over larger companies. The companies and asset classes we are investing in fit this criterion as investor enthusiasm has swung the pendulum to extreme levels in both instances. Unfortunately, no one can predict precisely when the pendulum will lose momentum and swing back in the other direction. We continue to focus on what we can control: being disciplined, patient, having a historical perspective, and straying away from the herd when opportunities or excessive risks are present. Thank you for your continued trust and please reach out if you would like to discuss any topic in greater detail. Stay safe and healthy.
Wishing you all good health and dry feet as the Autumn soaks in.
Tim Mosier, President
Cairn Investment Group, Inc.