Rising Yields Bring Valuation into Focus

February 26, 2021

If investors had any question about whether or not cheap money lies at the heart of today’s valuations, you didn’t have to look much further than this week’s market action to get your answer. The Dow Jones Industrial Average managed to notch another record close Wednesday following dovish comments from Federal Reserve Chairman Jerome Powell. In his testimony to Congress, Powell told lawmakers it may take more than three years for the central bank to reach its inflation and employment targets. Those comments were taken by equity markets as yet another confirmation that the Fed remains fully committed to keeping rates low far into the future, giving equity investors time to still enjoy the punch bowl. Meanwhile, bond investors were unconvinced with yields on the 10-year treasury continuing to increase on rising inflation expectations. The tension between equity and the bond market’s expectations spilled over to the S&P 500 on Thursday with the index suffering its worst daily sell-off since October as investors sold interest sensitive sectors, technology in particular. This week’s economic data fit the “rising inflation” theme as personal income rose 10% in January thanks to the most recent round of stimulus checks and durable goods orders increased 3.40%. Things still remain incredibly accommodative for equity markets, but cracks in the post-COVID, utopian model are beginning to be acknowledged, which resulted in the S&P 500 falling -2.50% for the week. 

Stimulus Checks Lift Personal Income and Spending

Another round of government stimulus checks and enhanced unemployment benefits helped lift personal income 10% in January. The double-digit increase follows December’s modest 0.60% gain – a period which saw stimulus end for millions as Congress grappled with the follow-on relief bill. As quickly as the checks came in, consumers were quick to turn around and spend, pushing consumer spending up 2.40% for the month. Despite the higher spending and the bond market’s inflation expectations, prices remain in check. Core PCE, which is the Fed’s preferred inflation gauge rose 0.30% in January. That translates to a modest 1.50% year-over-year rise which is still well below the Fed’s 2.00% inflation target. While the bond market is signaling longer term inflationary concerns, at present, there is still very little sign of price acceleration. 

Consumer Spending Lifts Durable Goods

Durable goods, or items meant to last at least three years, rose 3.40% in January to $256.6 billion. That was higher than December’s 1.20% increase. Excluding the volatile transportation sector, durable goods increased a more moderate 1.40%, which was slightly cooler than December’s 1.70% gain. Computers and related products continue to be popular with consumers as they have throughout the pandemic, rising 8.70% in January. Strong homebuying activity also helped the electrical equipment and appliance sales, up 4.20% for the month. Core capital goods orders, which is seen as a barometer of business investment, rose 0.50%. That was actually lower than December’s 1.50% gain. The latter suggests businesses still remain more guarded even as we approach the latter stages of the pandemic.     
On Saturday, Warren Buffet will release his letter to shareholders where he will reveal Berkshire Hathaway’s holdings and his thoughts on their investments, the economy and on investing in general. Warren Buffet and his long-time investment partner, Charlie Munger, are iconic value investors who – at 90 and 97 years of age – have at times been chided in the financial press for being out of touch with today’s market. It is typical that just at those moments markets will typically turn to favor value once again (as we are now experiencing), restoring the media’s respect for the “Oracle of Omaha”. We’re not much for idol worship, but it is hard to argue with Buffet’s success and much harder to not appreciate the succinctness with how Buffet is able to convey important investment principals to the everyday person. One of those lesson’s was revealed in a recent interview. Buffet was being pitched by a CEO of an artificial intelligence company and the CEO kept saying “what we’re trying to be smart about” and then the CEO would go on to describe what it was they were trying to be smarter at. Buffet interrupted the CEO and said, “I’ve gotta be honest, for years, Charlie and I have always asked, ‘What’s the dumbest thing we could do here?’” Truer words have probably never been spoken when it comes to investing.
Prior to the recent move in treasury prices, real yields on treasuries were negative and sitting at all-time lows. Treasury yields factor heavily into the discount rate applied to future earnings, which in essence means that the lower the treasury yield, the higher you can justify the valuations on equities. The sky is the limit for equities as you approach zero, or even negative rates, and this is exactly what we’ve seen with the acceleration in the market over the last several months. Earnings forecasts have improved on vaccine news, discount rates have declined due to the Fed and fundamentals have been thrown out the window – or worse gimmicked up in the context of the current interest rate environment.  Sure, the math works based on current interest rates, but back to our Buffet quote, “what’s the dumbest thing you could do?” We think it is pretty clear that the dumbest thing you could do is assume rates stay near zero forever, but that is what some otherwise smart investors have tried to justify.  This week we saw the market start to wake up to the fact that rates won’t stay at zero forever, and as State Street’s Head of Macro Strategy was quoted as saying, “what has happened in recent weeks is that the markets have had to reprice expectations of the Federal Reserve’s rate hikes.” Give that guy a dummy trophy – of course they were going to rise. We suspect rates will go higher but not become high, but for a market that is so tightly leveraged, even small changes in interest rates can cause a large movement in capital. We expect higher volatility in the near term as the market grapples with inflation expectations and then again later (2+ years) once the Fed actually starts tightening. None of this gives us a great deal of heartburn. We wish markets would have been more sober going into this recovery, but they never are, and to the degree we’ve been feeling valuations were getting stretched, rising interest rate concerns should help prick some of the bubbles that were starting to emerge.
The Week Ahead
We will have reports on jobs, manufacturing, and services data next week. In overseas news, China reports on global demand with figures on manufacturing.


Nature’s Rx

There is mounting evidence of the numerous benefits to humans of spending time in nature. This is something most of us intuitively know. Fresh air and natural surroundings seem to have calming and rejuvenating effects, and scientists have been studying the connection between nature and our physical and mental well-being. Spending time in nature to gain health benefits is an idea that the Japanese have promoted for ages. In fact, they have a name for it. They call it “forest bathing” which is translated from the Japanese shinrin-yoku. Japan today has more than 60 government-certified forest bathing sites. There are numerous books on the topic that aim to teach readers how to tap into the healing power of trees by spending mindful, intentional time outdoors.
Dr. Qing Li is a medical doctor and chairman of the Japanese Society for Forest Medicine. He authored a book on forest bathing in which he shares scientific evidence that the practice can lower blood pressure and stress, improve concentration and memory, lift depression, and boost the immune system. Li has been studying the effects of the environment on our health and immune function for thirty years. His research shows that when people walk through a forest, they inhale phytoncides that increase their number of natural killer (NK) cells, a type of white blood cell that supports the immune system and is associated with a lower risk of cancer. NK cells are also thought to have a role in combating infections and autoimmune disorders and reducing inflammation, which contributes to a range of ailments, including heart disease and diabetes. Li provides advice for how to practice forest bathing by using all five senses — sight, sound, smell, touch, and taste — and immersing oneself in the natural world.
Mounting research supports Li’s claims. A study published in 2019 found that 20,000 participants were significantly more likely to report good health and well-being when they spent 120 minutes or more in nature a week. A 2018 study in The Journal of Pediatrics showed that “increased exposure to residential greenspace” led to reduced anxiety, depression, and “problematic internal and external behaviors” among hundreds of children in Ohio. In a 2009 study in the Journal of Attention Disorders, researchers at the University of Illinois reported that 20 minutes spent walking in a park “substantially” increased the ability of children with attention deficits to concentrate.
Author Richard Louv coined the term “Nature-deficit disorder” to help identify problems associated with spending little or no time in nature. He makes a strong case for people, and particularly children, to get outside and experience nature. Louv argued that obesity, Attention Deficit Disorder (ADD), and depression are headed off or mitigated when children are exposed to nature in consistent doses. Medical providers are taking nature therapy seriously for both children and adults.  Sometimes referred to as ecotherapy or tree therapy, primary care physicians, nurse practitioners, and pediatricians are writing prescriptions for their patients to spend time outdoors. With people becoming more homebound due to COVID, the importance of getting to greener pastures has become amplified. 
A cardiologist in Ohio started meeting his patients for a walk in a park to help get them moving and reap the health and wellness benefits of being outside. There are now more than 500 “Walk with a Doc” chapters in 25 countries. ­­­­A pediatrician in Washington, D.C. created Park Rx America, which helps doctors prescribe parks and outdoor activities to both pediatric and adult patients. The stated mission of Park Rx America is to “decrease the burden of chronic disease, increase health and happiness, and foster environmental stewardship, by virtue of prescribing Nature during the routine delivery of healthcare.” A Parks Rx America application allows doctors to connect a patient’s electronic health record with parks near their home and prescribe activities. There are numerous other provider-based, nature-prescription programs that use digital tools to help patients find nature and remind them to go out in it. 
Those seeking this ecotherapy can find certified forest therapy guides in parks across the country. There are programs around the world for those wishing to become a certified guide. Mother Nature can have a positive impact on our health, and we hope you have an opportunity to get outside.





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