Greetings from the Northwest!

With the new year beginning, it’s our usual practice to give a nod to the year past and an opinion or two about what’s to come. Underlying that habit is the concept that “what is done is done.” While this may be true, it’s also true that we are living in a continuous and unceasing flow of connected events that don’t always match up well with a year’s ending or beginning. Much is in play at the moment, and I find myself reluctant to express any firm predictions at this point. 

I enter this year with a simultaneous sense of optimism and caution. So much is happening so fast in the world and some of it might not work out the way we wish. I’m hopeful that Syria will begin to heal and that the larger conflicts around the globe will resolve into a peace that can last more than a few years, but each has the potential to become something worse than we imagined. Europe is in the throes of major political, economic and demographic shifts, and it feels like an inflection point is near; fingers crossed that they work this out sooner than later. It’s hard to imagine the Germans, specifically, not solving their energy and industrial policy difficulties, but they haven’t yet.

Here in the United States, we’re so fortunate in our geography, our political legacy, and our amazingly creative private sector, that I cannot but help to feel a sense of optimism when considering the next year and those to follow. Our future is truly ours to create, and we have at hand the best tools on earth to make it happen. Sure, there are speed bumps and obstacles at every turn, but that’s the way it’s always been and always will be. We’ll continue to be challenged by the unequal exchange of technology and information with nations that don’t subscribe to our notions of freedom and openness, and we’ll self-impose limitations on our use of our natural and human resources, unlike some of our competitors. 

My optimism is not blind to the stock market risks, as we do need to work our way out of the extraordinarily high stock market valuations that we are seeing, and the highly priced and stagnant housing market, among many less obvious challenges, but that’s what we do, and it keeps us moving forward.

Truly, with a sense of optimism, I wish a Happy New Year to you all! Let’s see what Patrick has to offer on your investments, Patrick’s part:

Capital markets had a mixed finish to the year, with most indices, outside of the tech heavy S&P 500 and Nasdaq, flat or down. Even bonds showed weakness after the Fed cut rates in September, which might be counterintuitive since generally lower interest rates lead to higher bond prices (more on this later).

In our July letter, I wrote at length about a US equity market being characterized by high valuations and poor market participation. Market participation improved during the Q3, and I mentioned that was a silver lining for US stocks given the valuation backdrop we are working through. Well, that quickly reversed in November and we are now at levels we haven’t seen since 2008 when looking at the S&P 500 equal weight versus cap weight price performance.

Also, as the chart below shows, starting in October of 2022, there has been a widening disparity regarding valuations between the cap weighted S&P 500 and the equal weight version of the same index.

The same can be seen when looking at the performance and valuations of large cap growth versus large cap value stocks.

While we have no issue buying a company that is “classified” as a growth company (META in 2022, Booking in 2020, Alphabet in 2019) if the price it is being offered at reflects a margin of safety based on the fair value of the company. As the valuation chart below shows, that is hardly the case currently.

The lack of market participation outside of a handful of large-cap tech disruptors triggered a condition on 12/18 that we don’t witness very often. The chart below shows the S&P 500 with highlights of instances where the index was trading more than 5% above its 200-day moving average (positive trend), while less than 60% of its constituents trading above their own 200-day moving average (negative trend). Outside of 2000, 2007, and 2021 instances, severe market losses were avoided, but volatility increased.

Market participation can improve in one of two ways, either the majority of the index participants catch up to the few stocks that have been outperforming, or the concentrated winners catch down to the rest, dragging the rest of the index with it. While he would prefer the prior to happen, we must be prepared for either outcome with valuations sitting at such high levels.
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I have heard recently from pundits arguing that solid economic activity based on the boom in AI growth and more accommodative Fed policy justify high valuations. My observation is, yes, AI growth could shift valuation expectations if we reach a permanent higher level of economic activity based on technological advancements and productivity growth from those advancements. But looking at the chart below which measures the value of US stocks to our Gross Domestic Product, I think that is more than represented in current prices.

Most investors have already erased from their memory how 2022 was characterized by falling equity and bond prices as high valuations driven by the story of Covid, stay-at-home and disruptor stocks would escort a new era of growth, collided with a shifting narrative around the sustainability of the work-from-home transition combined with rising inflation. In fact, US small cap and international stocks have underperformed a simple money market fund since 12/31/2021, with the S&P 500 Equal Weight and Cap Weight indices taking until early 2024 to surpass it.

This euphoric environment has left retail investors the most exposed to risk assets that we have seen in the last 25 years. The chart below is a combination of investors’ allocations to stocks and their expectation for positive returns this year.

Not to say that equity investors will not experience positive returns in 2025, but historically, “above average” returns are born from environments of pessimism where valuations are low, allocations to stocks are low, and expectations for returns are dismal. We are nowhere near that type of environment.

On September 18th the Fed started its shift in monetary policy to be more accommodative by lowering the fed funds rate by 0.50%. Since then, lowered the rate two more times by 0.50% to a target rate of 4.50%. One might believe that lowering short term rates would shift all maturities of the treasury yield curve lower since historically lower rates are a byproduct of lower growth and inflation expectations. As the chart below shows, the exact opposite happened with the yield curve. Short term rates did in fact shift downwards, but in contrast to what many pundits anticipated, long term rates (10+ years) have moved upward in dramatic fashion signaling that the bond market is not convinced inflation has been tamed enough to warrant cutting interest rates and we can’t say we disagree. As I wrote about last quarter, the shift upward in long-term rates potentially poses a large risk to US government spending as over $7 trillion in bonds mature over the next three years. The benefit of higher long-term rates for investors is you can now earn a more competitive return for taking on the risk of holding longer dated bonds then you were just a few short months ago.

As we start the new year, portfolios still have a conservative bias for the reasons we have written about above and in other letters throughout the last 12 months. That is not to say we are not taking on risk in equity markets, we are just not fully invested. We still view international markets offer more compelling valuations than US markets, however, the US dollar strength has weighed on that opportunity over the last year. Also, high quality, value stocks offer good long-term returns when compared to other pockets of equity markets in the US. Our data driven process relies on understanding the price we are paying for a company or asset class and then buying those investments with enough margin of safety in case we are early or flat out wrong, so that downside risk can be managed. When the facts change, we change our mind and with the allocation to cash and money markets, we can get more aggressive or more conservative based on what the data and market environment dictates. Risk management is a high priority right now which seems in conflict with what you read in headlines and see in the news. Unfortunately, most investors only buy insurance (i.e. get more conservative) after they have been in an accident, not before when it is needed the most. We are here to grow your wealth over time in a thoughtful risk-managed approach and will continue to do so. Thank you for your continued support and trust and please do not hesitate to reach out to me with any questions or comments. —Patrick Mason

Thanks Patrick, lots to consider as we move into the new year. Normally, I’d invite you down for a cup of coffee if you’re in the area, but that may need to wait a few months as we purge our decades-old furniture, remodel the office, and get everything redecorated. Hopefully, we’re done with all that by June, at which point we’ll be excited to have visitors.

Happy Trails,
​Tim Mosier, President
​Cairn Investment Group, Inc.

Greetings from the Northwest!

Well, the calendar says it’s Fall and I’m seeing some signs that it’s true with some colorful trees, greener lawns, cool morning mists, and an occasional rain drop. If you don’t live in the Pacific Northwest, you might be surprised by how dry it gets here in the late summer. The lawns are a dull yellow and the evergreens sag like they’re begging for help. The shorter days and dewy mornings bring some relief, and then the rains arrive to finish the job. I know many of you share with me the sentiment that Fall is your favorite season. I’m not quite sure why it’s better than spring, but it is. Maybe it’s the anticipation of the Holidays or the excuse to cuddle up with a hot drink that’s missing in the spring. 

This will be a momentous fall season, with a high-stakes election and global unrest like we’ve not seen in a long time. We’ll watch with interest, but as we’ve said before, we don’t try to predict these outcomes or try to outsmart the hedge fund crowd by placing bets on such things. We have our data-driven process, and it will guide us through whatever these times present. 

Speaking of data, you may have heard the witty and insightful quote attributed to Mark Twain, that “there are 3 kinds of lies: lies, damn lies, and statistics.” Sometimes analysts are looking for an answer and they find it; other times they don’t understand the nature of the data and present “findings” that are flawed. These are mistakes that we work hard not to make. In his part, Patrick will point out a situation or two where the answer being presented by the financial media may be the result of poor use of the available data.

On the home front, we have committed to a new lease for our Vancouver Headquarters, and with it comes a refresh of the office space and furnishings. We’re not quite sure of the timing, but it should be in the early winter. While the construction is active, we’ll be working much more out of the office than in and won’t be having onsite meetings until it is completed. We’re very excited for this next step in our evolution, and I hope that many of you will be able to come in and see the results next year.

One last thing before I hand it over. I have heard time and again how much you appreciate having a live person picking up the phone, and how having our Cairn staff available to answer your questions is so unusual and helpful. We are committed to continuing this level of service, as it’s something that you deserve, and is increasingly rare nowadays. We’re here to help you to navigate life’s financial dilemmas, so please, call and ask to speak with any of our advisors when you’re looking for a little help. It’ll cost you nothing and you won’t be disappointed.
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With that, on to Patrick:

The third quarter continued to see strong returns across capital markets, as both stock and bond prices were supported by the belief that monetary policy was going to shift to be more accommodative. US stocks, measured by the S&P 500, returned 5.89%, and bonds returned 5.20%. International stocks had a nice tailwind during the quarter with the US Dollar weakening, returning 7.26%. Unlike the first half of the year, equity performance was quite broad, which is the one silver lining despite record high equity valuations.

Last quarter, I did a deep dive into valuations across the broad market and different asset classes so I won’t spend too much time on the topic today besides saying that valuations remain extremely elevated.

The biggest event of the quarter was the change of monetary policy in the US, with the Fed cutting interest rates for the first time since 2020, on September 18th. The media and market participants immediately cheered the Fed’s new policy stance, citing instances of previous interest rate cuts and subsequent market returns. As you know by now, we spend countless hours looking at data, and with any major shift in market behavior it’s useful to look underneath the hood instead of relying on the media’s constant cheerleading. Below is a table of previous interest rate cut cycles and subsequent one year returns for stocks. I’ve also included starting valuations when the Fed embarked on a rate cut cycle.

When pundits and media personalities site the average return of stocks being strong after the Fed embarks on an interest rate cut cycle, they are not wrong, but looking at the data more closely paints a different picture. The starting level of valuation was a big driver of whether stocks did well or not after a shift in monetary policy. We do not know for certain what the next year brings, but we can say that outside of 2001, the S&P 500 has never been more expensive to start a rate cut cycle.
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With all the talk about equity market performance after the Fed’s policy change, the reaction in the bond market was equally interesting. Intuitively, one would think that interest rates across all maturities of US treasuries would drop after an interest rate cut. The chart below shows how interest rates have moved since September 17th.

As you can see in the bottom part of the chart, short maturity treasury bonds did see a drop in interest rates following the Fed’s 0.50% interest rate cut. But when you look at the longer maturity bonds, interest rates increased in response to looser monetary policy. This seems to indicate that the bond market is not convinced the fight against inflation is finished, and looser monetary policy could reignite inflationary forces. The chart below shows the maturity schedule of the over $19 trillion in US government debt. Between 2025-2027 there is over $7 trillion maturing that will need to be refinanced. Suffice it to say, the US government does not want to see longer dated US treasury bond rates moving higher with the interest expense on US debt taking up over 30% of tax receipts 2023. I would imagine that number will increase when it is reported for 2024.

Longer maturity treasuries yields are sensitive to inflation and growth expectations in the economy. Currently, the data is still mixed on both fronts, with headline inflation numbers showing improvement, but survey inflation metrics and expectations still elevated. Economic activity data has started to show some weakness, so time will tell if a clear trend in either direction materializes.
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Portfolio positioning has not shifted drastically over the last few months because opportunities are still scarce. We are still holding high levels of cash in money markets, as we view risks to be quite elevated and interest rates on cash are sufficient while we wait for a better risk / reward environment. When there have been opportunities to put some cash to work, we have taken advantage of them. We will let the data guide us on when a larger shift in portfolio allocation is warranted, but in the meantime, we still view risk management as being the largest priority, considering high valuations and euphoric sentiment.

We thank you for your continued trust and welcome any questions or comments you have on the economy, markets, or your portfolio. —Patrick Mason

Greetings from the Northwest!

July is upon us, and the forecast here is for some very Summery days ahead with temps in the mid-nineties. With that, we’re coming into what has traditionally been a slower season for security markets and many businesses, with folks nationwide taking advantage of the good weather to travel or enjoy their homes and families. At Cairn, the incoming calls have dropped off quite a bit, and are most likely to be about pulling a little cash for home improvements or travel. As usual, we’re cycling through a few staff vacations here, but will always have someone available to take your call and move funds or make a trade if the markets and banks are open.

Despite the predictable lull in business activity, this year has some underlying circumstances that make it unique and interesting. For one, it’s an election year. I hardly go for an hour without someone pointing this out. With each passing week the intensity of the media storm on this topic is increasing, with no respite likely until late in the year. Many people worry about the possible election outcomes and how their lives, finances, investments and the future health of the nation could be affected. Our job is to see to it that no matter what happens in November, our clients’ investments survive the experience, and, if possible, thrive. On our side is the fact that election years tend to be good for the stock market; this is not intuitive, but historically the markets have advanced, regardless of who wins. Since 1960, only 3 of 16 elections have coincided with a down market.
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We’ve also got a bit of a tailwind with our positions in fixed income and cash, both of which are paying much higher rates than just a couple of years ago; and the fixed income is better positioned to act in its traditional role as a counterbalance to stocks and is less subject to interest rate shocks going forward.

Every year, and every election year, is different, and many other realities are in play. Inflation has subsided but is not yet back where the Fed, and most of us, want it to be; mortgage rates are high relative to the past decade or so, and with house prices as high as they are, this has put the market for existing homes in quite a bind. People simply cannot afford to buy an equivalent house if they choose to sell the one that they’re in. This chart (below) illustrates the difference between the average rate of existing mortgages (loans outstanding) and the current rates. This has resulted in fewer existing homes for sale and has greatly benefited new home builders, who can offer homes at just the right price point, along with preferential financing.

A possible longer-term outcome will be a sideways or down market for several years as folks just stay put, and when they do move, they can afford less of a home.

Other things in play include massive public debt at much higher interest costs, a thinly supported stock market and generally high valuations. On the bright side, people seem to be going about their lives and spending money, and the US economy still shines above all others.

One last thing before I hand this to Patrick for an in-depth discussion: Please remember that we have your back when it comes to financial planning of pretty much any sort, with broad expertise, multiple certifications, and best in class tools; we can work with you, at no additional cost, to develop and implement a plan for your future needs. Contact anyone at Cairn to get started.

Equity markets had a mixed 2nd quarter as US stocks continue to be led by just a few select large technology companies. The table below summarizes the returns of the major indices for the quarter.

As you can observe from the table above, outside of the S&P 500 and Nasdaq, most major indices were negative, which might not be intuitive given the media’s regular mentioning that stocks are hitting all-time highs. The previous few quarters, I have written about inflation, Fed rate cut decisions, investor sentiment, and equity valuations. I am not going to touch on the economic backdrop, which remains mixed, but focus this letter solely on what is driving equity market returns, what that could mean moving forward, and how we are navigating this challenging environment. As we go through the charts below, the major takeaway will be waning market participation (breadth) being masked by a few large tech companies despite lofty or extreme valuations.

The chart above takes the equal weight version of the S&P 500 and divides that into the traditional (market cap weighted) version of the S&P 500. When the line is moving down, fewer stocks are driving the returns of the S&P 500 which is generally not a healthy market environment. Historically, sustained bull markets are accompanied by broad participation across sectors and asset classes. The current level of this ratio is at a 16-year low, and as you can also see from the chart, prolonged downturns in this ratio have preceded some nasty bear markets in the past in 2000, 2007 and 2020.

As the market continues to make new highs, fewer companies are trading above their respective 200 day moving averages, which signals more companies’ prices are entering a downtrend than an uptrend. As we have witnessed in other reflection points in the market.

With the tech sector growing to over 30% of the S&P 500’s weighting, similar to 1999, it is even more glaring when you compare the price performance of the S&P 500 Equal Weight Index versus the S&P 500 Information Technology Sector Index.

Year-to-date performance of the different S&P 500 sectors confirms that most sectors are showing mid-single digit gains.
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The same can be said when looking at asset class performance.

Investors piling into mutual funds or passive ETFs that follow or overweight these popular sectors are taking on much more risk than they probably realize. I think of it as momentum chasing with little regard to the price being paid for the underlying fundamentals.
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Recently in the Wall Street Journal, a chief investment officer of a well-known brokerage firm was quoted as saying, “Tech allows you to play defense and offense at the same time.” I find this difficult to believe. Tech has a trailing p/e ratio of 43x, a forward p/e of 34x, a combined price to sales ratio of over 13x, and we are late in a cycle with euphoria at very high levels for that given sector.

Valuations in the US are also reaching extremes when you compare them to the rest of the world. The chart above shows the S&P 500 price / sales ratio divided into the rest of the world’s price / sales ratio. There have only been a few times over the last 27 years when we have reached this level of relative overvaluation. 

Equity market returns have been largely positive this year and over the last twelve months; but the outsized returns that are being shown in select indices are being driven by just a handful of names that are trading at historically high valuations. We feel this brings a high amount of risk to chasing those names as well as to the broader market. Speculators seem to believe that no price is too high and that they will be able to time the exit from the party before everyone else rushes for the door. This is almost impossible to accomplish on a consistent basis. As investors, we believe in understanding the price we are paying for the underlying fundamentals of the business and asset class, then paying a price we believe is below the value of what the market is offering it for. This does two things: It provides more downside protection than buying overpriced assets if the market falters, or we end up being wrong (which happens occasionally), and it produces a long-term return sufficient to meet your goals. Ignoring the noise and focusing on process is essential for navigating expensive equity markets. Currently, we are still invested below our long-term equity targets across all asset allocation strategies. We are still finding some limited opportunities, but the data guides us to still have a higher-than-normal cash balance. When the facts change, rest assured, we will change our mind and will have the flexibility to deploy cash without having to sell other assets that have declined in value.
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Thank you again for your continued support and trust. I intend my section of the newsletter to be informative and to give you a glimpse into what we are looking at daily. Please feel free to reach out to me if you want to discuss any topic in more detail. —Patrick Mason

Thanks, Patrick! As always, a well thought out analysis of some important factors affecting our markets.

I hope everyone has a safe and fun summer. If you’d like to come in to review your accounts or your long-term plans, please give Stefanie a call, and she’ll get you scheduled with your advisor.
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​Tim Mosier, President
​Cairn Investment Group, Inc.

Greetings from the Northwest!

Well, it’s been quite a first quarter for 2024! Against a backdrop of multi-faceted turmoil, the US economy has been strong enough to avoid a recession, despite last year’s spike in interest rates and enduring inflation. Apparently, consumers are still spending, even if it means getting deeper into debt, which may indicate a sense of optimism about their prospects, or it could be a house of cards ready to fall. We’ll see. Stock market indexes outperformed most expectations, but still, we saw that the broader market was not as enthusiastic as the few market leaders, although this last month saw that broader market catch up a bit; a healthy move. The “Magnificent Seven” is now the “Fab Four,” with Apple and Tesla in particular underperforming of late. 

A much-desired outcome for the Fed and most investors is the elusive “soft landing” whereby a major economic shift occurs (in this case, raising the Fed rates), without driving the economy into recession. I think it’s arguable that they’ve achieved that goal, recognizing that we never actually land anywhere; the merry-go-round never stops, and someday, due to some set of circumstances, we will experience a recession. Inflation is not yet in the bag either. We can’t yet predict the combined effect of having the Suez Canal route compromised and the upper Chesapeake out of service at the same time.

I’ve heard it argued that we’ve been experiencing a “rolling” recession, with economic sectors taking their turn getting hit, then recovering, with the net result that overall, we never dip below the line. I can believe that. 

We’ve moved past the bank scare we were talking about last year at this time, but it may not all be over, especially for regional banks that have lent heavily into the commercial real estate market. I probably don’t have to tell you much about the state of that market for you to understand the risk presented. We have little to no exposure there, so hopefully whatever transpires won’t spread much beyond that sector. 
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We’re happy to welcome Spring, and with the better weather, more of you are wanting to come in for an in-person meeting! I highly encourage it. Just give us a week or two’s notice and we can be prepared.

Before moving on to Patrick’s well thought out dissection of the financial world, I’ll mention that we now have the ability to actively manage your 401(k)s and similar assets that cannot be brought into Schwab at this time. We’re utilizing a software service by Pontera that allows us access to almost any employer retirement plan. The advantages to you are our ability to coordinate those investments with your overall strategy and relieve you of the need to stay on top of rebalancing and allocation changes. Dan, Mark, or Patrick can explain how to set this up if it makes sense for you.

With that, here’s Patrick:

Equity markets continued the upward trend that started in November last year, with most stock indexes posting mid to upper single digit gains for the quarter. The combination of better than anticipated economic data and the continued hope that the Fed will lower interest rates at some point this year added fuel to already overheated equity market prices. Last quarter, I wrote at length about the expensiveness of most US stocks and the effects on future returns. Suffice to say, with the performance of most markets being positive so far this year, our concerns surrounding high valuations have not changed.

The current rally we are witnessing in the S&P 500 has created the following conditions: the price is more than 13% above its 200-day moving average, with more than 85% of members trading about their own 200-day moving average, the Price / Sales ratio (valuation) to the VIX (complacency) at multi-year highs (h/t John Hussman), and household allocations to stocks and their feelings about future prospects at extreme levels. The charts on the right show these conditions going back to 1998. As you can see, this does not always signal a market correction, but it has been a precursor to some of the larger drawdowns we have seen over the last 25 years.

So, if there is one word I could use to describe the environment in the short term it would be “Exhausted.” One silver lining during the quarter is that participation improved in February and March, meaning that the market was not being driven by just a small group of stocks, as we witnessed over much of 2023. It is too early to tell if this is a change in trend, but it would be a much healthier environment in which to take more risk if participation wasn’t as ragged, even when considering current high valuations.

The current trend in inflation data being released might make even three cuts overly optimistic. The trend in CPI, Core PCE (Personal Consumption), and the prices paid component of the ISM manufacturing survey, all point to inflation being stickier and more permanent than what the market was anticipating starting the year.

If inflation does become more embedded in the economy, the effects would be widespread across capital markets. Operating margins for the S&P 500 have maintained a high level, despite higher inflation, on the belief that inflation would moderate, and input costs and end prices would come back down. Inflation remaining sticky is going to test companies’ ability to continue to suppress wages and push higher prices down to the consumer. If the consumer is unable or unwilling to absorb continuously higher prices, margins will compress to more normal levels.

Our job is to navigate this challenging environment and build portfolios that protect against the risks we observe, while earning a return to meet long term goals. To help protect our portfolios against margin compression and inflation risk, our analysis of companies looks at the ability of a company to maintain pricing power and the ability to adjust cost structures based on changing market dynamics.
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We also run scenario analysis on the operating performance of a company to make sure the price we are paying has a wide margin of safety built in. When looking at other asset classes to complement the portfolio companies we own, our understanding of market history and valuations provides the framework to take advantage of opportunities and avoid unnecessary risks when prices do not reflect economic reality. I look forward to the day when we talk about the breadth of opportunities and how the cash positions in the portfolio are being deployed to take advantage of them. In the meantime, we continue to have a neutral stance, and hold more cash than normal due to high valuations, euphoric sentiment, and ragged market participation. When the data changes, we will change our mind. Thank you for your continued trust and please do not hesitate to reach out to me to discuss any topic in greater detail. —Patrick Mason

Thanks, Patrick!

Have a safe and happy spring!

Tim Mosier, President
​Cairn Investment Group, Inc.