Our Thoughts on Fourth Quarter 2021
Matt Johnson, CFA® - Andy Nugent, CFA®
Market Recap, Portfolio Analysis, and Review
The 4th quarter continued to see Covid-19 as a top headline story. The variant has changed from Delta to Omicron, which is much more contagious than other variants, but thankfully, symptoms appear to be much less severe. Even so, many people had to call in sick to work causing staffing shortages which affects not only the service industry, but production too. Other headline topics for the quarter continue to include inflation and possible increases in the interest rates by the Fed in 2022. One story that isn’t getting the press it once did is the back log of ships outside the Long Beach port. Whether it is too many ships to unload or not enough trucks to carry containers, we still have an extreme backlog that impacts the supply of goods around the country. The market is looking through the distractions and hurdles and focusing on the most important thing to investors, earnings. Earnings continue to be strong and the stock market as a whole reflects it.
As it seems we say every quarter, it would be terrific if the market keeps it current momentum and moves higher every quarter and year. The stock market has had an incredible run of performance each of the last three years. Considering everything that is going on in the world, the increase is surprising. However, earnings rule the day and the market tends to look ahead. Earnings should continue to be strong and the market should move forward, but will undoubtedly have dips and bumps along the way.
Inflation
Inflation was a big topic of conversation in the fourth quarter. Is it here to stay? Some of it is and some of it isn’t. The current inflation rate as measured by the Consumer Price Index was about 7%. We do not think inflation will continue at this rate and will reduce to more normal levels. We believe the number is currently being skewed by the large price increase in both autos and oil.
It is going to cost more to go out to your local restaurant and we do not see these prices coming down. We have a very large employee shortage especially when it comes to lower paying service industry employment. As such, business have increased pay to attract new workers. These increases are passed on to the end customer sometimes just blatantly on the bill as a surcharge. The price of food products, such as meats, have risen significantly and restaurants in many cases pass that on too. Although, the food product costs for the restaurant may come down in the medium term, it is unlikely that discount will be reflected on the bill to the end consumer.
On the other hand, new cars are selling at thousands of dollars over the MSRP. This goes back to the microchip shortage, which in turn causes a new car shortage. Dealers only have a few cars on their lots, so they can charge high prices since the supply is very low and demand is high. This doesn’t just apply to automobiles, but refrigerators, washer/dryers, dishwashers, etc. It seems production for everything that has a chip in it is struggling to keep up with demand. And as such, prices zoom higher. This will not last forever. The supply of microchips will eventually increase allowing for the ramp up in automobile production (as well as other goods), which will lead to the prices of those item being reduced. More supply to meet demand will result in lower prices.
We are not hearing as much about the cargo ships off the port of Long Beach as much as we did, but they are still there. Many have been pushed further out to sea to reduce the likely hood of them bumping into each other when winter storms hit. Whether it is a problem with the ports being able to unload the ships in a timely manner or a lack of truck drivers, the problem persists. It is hard to believe that this issue will go unresolved, so our belief is that we should see a price decrease in products whose prices have risen due to shortages caused by the supply chain.
When it comes to the price of oil, due to the current political environment and stance which is limiting the ability to drill, we have seen a sharp increase in the price of oil which looks to remain at an elevated level for the foreseeable future.
Is inflation here to stay? In many areas it is. Will inflation continue at its high rate for an extended time? We don’t think so.
Interest Rates
Interest rates didn’t move much in the fourth quarter of 2021 and remain very low from a long-term perspective. The 10-year treasury note sits at 1.51% at the end of 2021. While this is low considering long-term numbers, it is up from a yield of just under 1% at the beginning of 2021 and down a tick from the 1.52% at the end of third quarter 2021. The rate remains 22 basis points lower than the 1.74% yield witnessed at the end of the first quarter of 2021. This may be about to change in 2022. There is a lot of talk about the likelihood of the Federal Reserve increasing rates in the new year. Some believe the Federal Reserve could raise rates as much as four times next year. We believe that the Fed will raise rates but no more than is necessary.
As mentioned last quarter, we continue to be very cautious on bond investments as new purchases will continue to have low yields, and if interest rates rise, the price of existing bonds will decline. As such, when we purchase a bond, we focus on short durations instruments with the hopes of rolling that money over into higher yields in the future. We are also utilizing preferred equities as bond proxies to increase yields as dividends received are higher than bond rates, and the prices are more stable than common equity.
Unemployment
The unemployment rate continued to decline as we ended 2021. The December unemployment rate was down to 3.9%. This was down from a 6.7% unemployment rate at the beginning of 2021. We continue to see many lower paying jobs going unfilled. Employers are giving sign on bonuses and paying higher wages to attract new employees.
Sector Analysis
Financials – After being the best performing sector in the third quarter, albeit up only modestly, Financials had mediocre returns in the fourth quarter, advancing 4%. On the year, Financials did better than the market, appreciating over 32%. As we mentioned last quarter, with interest rates on the move, this sector is attractive if you can find a company at the right price. We are very price conscious, especially when considering financials. During the fourth quarter, we were able to take advantage of one company’s price pull back and purchased Visa. Visa declined 20% from its end of July highs. This provided an opportunity to purchase this world class company with expected double-digit earnings growth over the next few years. Finding affordable companies in this sector has been a challenge, but we like the sector overall, and may invest more here if opportunities present themselves at the right price.
Industrials – Good old boring Industrials. They don’t get talked about often. They do not make news headlines often. They are typically old stodgy companies. There is one thing they do. They make money and are sometimes overlooked. They are typically less volatile than the rest of the market. And from time to time, they give you a chance to buy them at a discount. We did just that when the price dropped and allowed us to purchase Northrop Grumman in 2020. Just over a year later, Northrop’s price had recovered and appreciated to our sell target. We exited the stock in the fourth quarter. We then purchased Federal Express after its price declined over 30% from its June high. It trades at very reasonable multiples and we expect demand for its services to grow over the next few years.
Information Technology – After not doing much in the third quarter, Tech returned over 16% in the fourth quarter. We maintained our exposure in this area. We feel we could see bifurcated returns moving forward. We see a higher likelihood of growth tech companies that are trading on the promises of tomorrow, but not much in the way of earnings today, there could be a significant pullback. At the same time, we see big profitable tech companies who continue to grow their significant revenue and earnings to have strong returns in 2022. As earnings continue to grow, the higher multiples that had been previously applied will be validated. As such, we added Qualcomm during the quarter after the price pulled back about 15%. This afforded a strong entry point to establish a position in this very high-quality company whose products are very much in demand.
Consumer Staples – Consumer staples is an area we think has potential to increase in value in the coming year. Although it was up over 12.5% during the fourth quarter 2021, it lagged the market over the entire year returning 15.5%. This sector has more value investing opportunity as opposed to growth. The companies we hold have good value, low multiples, and above market dividend yields. We also believe they have some pricing elasticity in this inflationary environment. Companies held in this area will have the ability to raise prices with a minimal hit on demand. We held steady and did not make any changes to our portfolio over the quarter.
Healthcare – Healthcare is an area we continue to like at the right price. Many of the companies here pay above average dividends and are trading at reasonable multiples. The sector was up almost 11% in the quarter. We reshuffled our holdings bit during the fourth quarter. We sold CVS Health Corp as it had sharp appreciation and reached our estimate of its true value. We also increased our position in Bristol Myers as it was a performance lagger much of the year. The company has strong cash flows, a dividend yield of more than a 3.5% at the time of purchase and has very good upside stock price potential.
Summary
The fourth quarter saw robust returns in the stock market despite many headwinds and distractions. The Omicron variant, high inflation, and continued supply chain issues did not derail the stock market. The market tends to look to the future and earnings drove the day in the fourth quarter. We expect the equity market to see some bumps in 2022, but if earnings remain strong, we see no reason the market cannot advance.
We will continue to take advantage of market volatility when it presents opportunities to add value to the portfolio. The most important thing to remember is that investing is for the long term. The market will pull back at some point. That is not a time to panic, but a time to hunt for bargains. We are working for you to help you reach your long-term financial goals. We apply a disciplined investment strategy to get you there. Here is to a prosperous 2022.
If you would like to receive quarterly recaps, contact:
Andy Nugent, Director of Investments
anugent@sage-cap.com
844-279-7243
Sage Capital Advisors, LLC, an SEC Registered Investment Advisor. Sage Capital Advisors is headquartered in Sioux Falls, South Dakota. Advisory services are only offered to clients or prospective clients where representatives of Sage Capital Advisors are properly licensed or exempt from licensure. No advice may be rendered unless a client service agreement is in place.
