The stock market was healthy, but the bond market got sick. Vaccines rolled out, undeterred by the chorus of grievances. The Constitution worked. We got to have the NCAA tournament. Brackets imploded. In the first quarter of 2021, the ascent out of the pandemic accelerated and we are all well served by ascent. Spring has sprung!
The Coming Balancing Act
The first quarter provided a window into what the next several years are likely to hold for investors. Our perspective is informed by two large themes that converge and blend in to influence the marketplace.
- Recovery and Expansion is a Constructive Factor.
Consensus earnings estimates for the S&P 500 Index for ’21, ’22 and ’23 are now $173, $200, and $219 respectively. In the first quarter, the best performing sectors were the more economically sensitive sectors: Financials, Energy, Industrials, and Materials. Both data points align with the message of recovery and expansion.
- The Inevitable End of Interest Rate Suppression and its Consequences. The second theme is the impact of rising interest rates and the resulting reset in equity valuations that accompany higher interest rates. In the first quarter we experienced modest increases in interest rates simultaneous with the Fed continuing to suppress interest rates. We believe interest rate suppression will taper, and interest rates are apt to rise as suppression is lifted. This is likely to unfold over several years, eventually resulting in a kind of regression to the mean from historically low interest rates to something on the low side of historical averages. As this happens, we expect to see premium valuations contract. For instance, a price-to-earnings ratio of 50 times earnings (or more) that was rationalized in an environment of suppressed and very low interest rates, will be subject to being repriced at a lower valuation. We saw the opening movements of this trend over the last 90 days.
So, what does the balancing act of rising earnings and contracting valuations beget? Probably a period of modest or underwhelming returns for the expensive glamour stocks that ran wild in 2019 and 2020. And probably a productive period for quality companies (with growing earnings) that trade at a reasonable price. We are confident our disciplined approach to quality investing will continue to provide constructive results in this environment.
Don’t be Distracted
The first quarter was filled with dramatic investment distractions. From the price of oil (+37%) to GameStop stampedes (both directions) to Bitcoin or SPAC speculations, it seemed like the brushfire of the week dominated the market narrative. The very big story of the rapid rollout of vaccines fell into the “taken for granted” category and was eclipsed by new drama. For a longer-term strategic business investor, these tactical events are unlikely to impart lasting consequence. Write the word GameStop on your April 2023 calendar and see if you can remember what it means or why you wrote it down two years ago. As for the price of oil, higher prices will result in more supply, and more supply will result in lower prices. At each end of that pricing spectrum, the oil business is a capital intensive, higher leveraged, lower free cash flow business. It is a tough sector to compound in. (Trailing 5 and 10 year returns for the Energy Sector are -17% and -34%).*
Our bias is to concentrate on the sustainable successes in the smaller and elite basket of companies that are capital light, low leverage, and subject to an embarrassment of free cash flow riches. (In Tealwood terms, these are Light, Free and Strong (“LFS”) businesses.) These companies turned in solid operating results in the first quarter and the past five years and ten years. These businesses are unlikely to be the hottest dot in any one quarter, and they are clear favorites to consistently offer better results in the long-distance race of your choice.
We hope to help with distraction management and to keep our focus on quality, as well as the reasonable prices that will get us through the slow drip torture of valuation corrections that will continue to impose their medicine upon the marketplace over the coming years.
*Energy Sector performance data derived from Fidelity E-research as of 3/26/21, using .gspe to track S&P 500 Energy Sector.