So Long 60/40: How Circumstances Can Get In The Way Of Recipe Investing

So Long 60/40: How Circumstances Can Get in the Way Of Recipe Investing For at least 60 years, it has been an article of faith to invest one’s assets along the lines of 60 percent stocks, 40 percent bonds.  This formula was originally coined by the Ford Foundation; they advocated the allocation to endowments and large charities who previously had invested only in bonds.  The idea was that the stocks would provide rising dividends, which would preserve the purchasing power of the portfolio, while the bond portion would provide stability to the values of the total investments.  In effect, the two categories were to offset each other.  The performance of financial markets, both in this country and abroad, so far this year points to an unsettling uniformity of performance.  Bonds have gone down in value with the talk of increasing interest rates by the US Federal Reserve and their equivalent in other nations. Bonds with the longest duration (i.e., longest time to maturity) have declined the most in value. At the same time, stock indexes have declined with the indexes representing the longest duration stocks (i.e., highest price/earnings ratios) going down the most.  Since these two categories are supposed to offset each other in order to reduce the portfolio’s fluctuation (technically known as reducing volatility by holding non-correlated assets), their declining in unison is not a good thing. Ditto for the declines occurring world-wide, which blows a hole in the risk reduction that is supposed to come about from international investing.    The reason for the uniformity of the declines is that low interest rates helped support both asset classes.  Reversing low rates has caused both categories to take on water.  As interest rates are expected to increase for some time to a level far higher than now, stocks and bonds as asset classes are both expected to be under pressure.  There is not much bonds can do to escape the carnage that awaits them.  All bonds are essentially contracts to pay money, usually every six months, then the principal at maturity. It is hard to distinguish between debt.  One bond does not pay in greener dollars than another. Bonds are sometimes categorized by default risk, with riskier bonds paying relatively more in interest than less risky issues.  With years of low interest rates, the return between more- and less- risky bonds have compressed to the point where almost no bond issue pays more than inflation at any level of risk. Most bonds pay a lot less.  This is in contrast to 1980, when government agency bonds paid interest in the range of 16 percent, while inflation was trending down from 13 percent.  So if stocks and bonds as a group are slated for less than projected returns for the next decade, where are the assets that, as asset allocators like to say, do not correlate in terms of their returns? Enter the rabbit hole of alternative asset classes. To salvage asset allocation, enter alternative assets.  As the name would suggest, “alterative assets” covers a broad spectrum, including commodities, real estate, collectibles, hedge funds, and private equity (to name a few).  The common thread is that all these investments are not very liquid; this means that they are not bought and sold with the regularity of stocks or bonds, and thus the cost of buying and selling is far higher in terms of transaction costs, assuming a transaction can be arranged. If not traded often, how are such assets valued?  Usually by appraisal.  The accuracy of such appraisals varies, and they are usually no match for an actual transaction.  Then there is the matter of selling to raise funds should such be necessary.  It can take a long time to find a buyer for an illiquid asset at a price quoted by appraisal. What is the solution? For income, conservative value stocks with strong and rising dividends to offset inflation can address the need for cash flow.  Smaller companies that can grow and be taken over can assist in preserving the purchasing power of one’s holdings.  Both categories are volatile, but volatility is not necessarily risk.  Sufficient cash should be set aside for funds needed in the short term with this approach.  For smaller portfolios, there are ETFs that can represent these areas.  Investors with larger asset positions can purchase the same investments directly and avoid the expense of packaged financial products.  Investors with very large sums of money, like endowments and foundations, can best invest a portion in alternatives directly because they can, through their sheer size, acquire assets whole at lower cost as well as have the staff to oversee the investments.  Either way, it is important to acknowledge that the past is not prologue for the future.  As Dorothy once said, “…we’re not in Kansas anymore.”  An asset allocation formula that was adopted 60 years ago when inflation was trending down will not work when inflation and interest rates are trending up.  Choosing investment assets is a different matter than choosing asset categories.  Categories is the role of an asset allocator.  Investing is the matter for portfolio management.  Woe to the person who confuses the two.  The Economy The economy, while strong, continues to gear down from last year as the stimulus funds make their way through the financial system.  Economic growth in 2021 was 5.7 percent after inflation.  This year it is expected to be about three percent, and down to two percent in 2023. The greatest economic variable is Ukraine.   If Russia chooses to invade, the economic upheaval in Europe, Russia, and the US will be material.  The price of oil and other commodities will likely go through the roof given the supply disruption expected from such a conflict.  Much of Europe is dependent on Russia for natural gas.  For the last twenty years, Germany has been dismantling its nuclear program with no strategic alternative power source.  On the other hand, Russia will become insolvent quickly without the sale of oil and gas and the foreign exchange it provides.  The Russian people are not enamored of fighting in Ukraine, but Russia is not a democracy.  It will be interesting to see how this plays out.  Interest Rates Interest rates are rising.  The question is how much. The projected time rates officially rise seems to be in March, when the Federal Reserve meets.  As usual, there is a parlor game of how much interest rates will be increased.  Right now, the betting is between three and five quarter-point increases.  Much will depend on the economy and its ability to absorb such increases without sliding into a recession.  Of less focus but perhaps greater impact is the decision to begin reducing the government’s bond portfolio.  Such a reduction would serve to take money out of circulation, in theory reducing inflationary pressure in the process.  As the amount of bonds held is about $9 trillion, a reduction of $200 billion per quarter for about ten years would be enough to eliminate this prior source of stimulus.  As many of the bonds are made up of mortgages, the government may be able to reach this target by simply letting the bonds mature and not purchase new bonds with the proceeds. Inflation Everyone seems to have a story of higher prices.  Such pricing pressure, brought about by demand for goods, seems to be a world-wide phenomenon.  Like the economy, the course of inflation in the short-term hinges largely on Ukraine and the Russian decision whether or not to invade.  If a decision is made to invade, the disruption of supplies of energy and commodities will be felt all over the world.  On the other hand, a reduction in tensions between Russia and Ukraine would lead to some reduction in European energy prices and the price of other materials as well.  Labor shortages are also international in scope.  Demographics are changing in most parts of the world as populations get older and fewer children are raised.  This is expected to become a more embedded source of inflation going forward. The Stock Market While overall indexes have declined, there are companies and industries that excel in this environment.  Firms that pay dividends, cater to the general public, and are not overvalued are the drivers of the current market.  Stocks of those who are richly valued, pay no dividends, and need years of earnings growth as far as the eye can see to justify their current prices are at best going to tread water going forward. Warren M. Barnett, CFA February 1, 2022 Barnett & Company is a fee-only registered investment advisory firm registered with the U.S. Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations.  For a brochure on the company and its available services, please contact Elizabeth at 423-756-0125 or This email address is being protected from spambots. You need JavaScript enabled to view it.. 
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Forecasting 2022: The Road Steepens

The New Year will bring all sorts of changes.  A stock market floating on cheap money and excess funds will learn to float with less or capsize in the process.  Many speculative enterprises like cryptocurrencies, electric vehicles and the like will face a time of testing.  Not all will survive.  Inflation will become both more entrenched and more of a source of concern.  Interest rates are slated to rise but will need to rise more than forecast to rein in inflation. The Economy At this time, the American economy is slated to rise around 4 percent in 2022, net of inflation.  This will be down from an estimated 6 percent for 2021, but ahead of the 2-3 percent rate the economy is expected to fall back to in 2023.  2-3 percent is considered “normal” economic growth for an economy of the size and maturity of the United States. Most forecasts for 2022 are front-loaded, meaning the bulk of the growth will occur in the first two quarters.  This is due to the waning effects of the various stimulus programs launched by the Federal Government to shore up the economy during the Covid-19 pandemic.  If the pending round of stimulus is rejected by Congress, expect the economic deceleration to occur sooner than would otherwise be the case.  Even if passed, the economy will slow down in 2023 as the effects of no population growth impacts domestic demand.  The sectors most likely to expand in 2022 are those related to health care and infrastructure.  Health care is driven by demographics, while infrastructure benefits from the government programs already passed as well as potential future programs. The most vulnerable sectors are those who find themselves left out of the current economic environment.  Office-based firms are grappling with surplus space, given the number of workers who continue to ply their trade from home.  Passenger transportation is struggling as people become fickle and price-sensitive about travel and up to half of business trips are probably gone for good.  While movie theaters are falling behind, even their streaming replacements are having a problem as more outlets compete for the same audience. Ancillary leisure businesses like hotels and restaurants will also feel the pinch.  Restaurants on the surface have bounced back, but higher menu prices may translate into fewer customers.  Staffing is a major issue, with many who once worked in food service the most personally knowledgeable about the fatal nature of Covid-19. Inflation A tight labor market is the surest precursor of inflation.  While logistical bottlenecks will get better in 2022, supply chains are not the biggest inflation worry.  Finding qualified workers at a cost that still provides a profit is an ongoing battle.  Unless matters like childcare are addressed, there is little reason to believe things will get better. In this regard, larger companies who can spread the cost of labor, including benefits, over a larger volume of business have an edge over smaller firms.  Smaller firms can often offer a better work environment and sense of affiliation.  With inflation so much of an issue, these advantages may become less enhancing. The biggest driver of inflation currently is the cost of housing.  Those with houses have benefitted from the appreciation of real estate.  Those who do not own a house have not.  This accounts for why more turnover is evident in the lower end of the job market than the higher end.  In some cases, the cost of housing is close to 50 percent of a lower wage family’s income.  This is not sustainable. There is another aspect of inflation that most do not yet talk about: this is the expectation of more inflation in the future.  Inflation expectations are important.  They serve to make workers demand a certain rate of pay increase for inflation that does not yet exist.  By doing so, future inflation becomes more manifest. The Federal Reserve has done a dismal job of convincing the public that the current inflation is “transitory” as they once put it.  As inflation stays at the current level, the Fed’s credibility will be further reduced.  Their signaling of three interest rate hikes in 2022, along with tapering bond purchases, may be inadequate to the task.  The key question is whether the Fed has it in them to get ahead of inflation or if, by lagging, they will make it worse.  Already businesses are moving away from just-in-time inventory, where inputs are minimized, to keeping more inventory in stock.  While this was done originally to address the effects of supply chain disruptions, businesses are earning inventory profits on what they are holding.  This is being passed on the form of higher prices.  When holding assets earn more than holding cash, all bets are off for price increases.  Interest Rates Interest rates and the availability of funds are the two most obvious ways the Federal Reserve directs the economy.  Back in the days of Alan Greenspan, the Fed would cut interest rates to counter declines in stock market levels.  This strategy took on an additional impetus in 2008 when Ben Bernanke was Fed Chair.  He believed that prodigious quantities of cash pumped into the economy was the best way to avoid another Great Depression.  Jerome Powell has continued this approach with interest rates now below the rate of inflation and cash being pumped into the economy by way of bond purchases that now total some $8 trillion.  More recently, Powell has indicated he will begin to taper off the bond purchases which will have the effect of taking about $300 billion in cash out of the economy.  He has also signaled a desire to raise interest rates, although a timeframe is not yet known.  In this regard, Powell is trying to avoid the mistake of the last taper in 2018.  At that time, the stock market fell 20 percent in two months, until the Fed reversed itself in January of 2019.  More recently, the economic trauma of the Covid-19 epidemic again caused the Fed to provide abundant funds and close to zero interest rates.  The issue is how to raise rates to combat inflation without killing off the economy.  In a less complicated time, the chief job of the Federal Reserve was to control inflation.  More recently, the Fed has been tasked with the job of providing full employment.  In some ways, the additional mandate conflicts with the original one.  Full employment is usually inflationary.  Less than full employment is not.  Only during the Trump administration were the two goals met in tandem.  This is attributed to an abundance of imports, which kept domestic inflation down as other countries wanted US dollars.  Currently, inflation is world-wide, as those same exporting countries grapple with the effects of labor shortages of their own, and Covid-19 compromises the output of many areas lacking adequate vaccination supplies.  Add to the mix supply chain stresses and what was a steady source of non-inflationary goods disappears.  For 2022, look for the Fed to tighten in an effort to reduce inflation and regain its credibility.  If inflation is not contained, a Paul Volcker approach of rapid increases above the inflation rate to tame not just inflation but inflation expectations will be warranted.  Look for inflation to be around four percent officially, perhaps more for those who rent. The Stock Market Higher interest rates and more restricted lending are the enemies of inflated equity prices.  However, even the overall market can contain elements of appreciation if one knows where to look. The most vulnerable sectors of the stock market are those that are the most overvalued.  Large technology firms that may have good prospects but have gotten ahead of themselves in terms of price is an obvious example.  Some of these companies have aided the appreciation of index funds in years past.  As an index is carried by fewer names, it becomes less of an index and more of a potential trap, at least in terms of appreciation. Most people forget that index funds came into prominence around the time of the last market upturn in 2009.  They have not experienced a full market cycle in terms of a decline of any duration.  The investment issue is this: if index funds decline and stay down for a period of time, will investors sell them to go on to other things, or will they stay the course until the next upturn? Market strength should be found in health care, some home builders, infrastructure, and other special situations.  Markets that move sideways or decline are more the province of individual issues rather than packaged investment products.  For those who have sufficient funds to construct a portfolio, the results can be gratifying over time.  We at Barnett & Company wish a safe, happy, and prosperous New Year to you and yours! Warren M. Barnett, CFA December 30, 2021 Barnett & Company is a fee-only registered investment advisory firm registered with the Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations.  For a brochure on the company and its available services, please contact Elizabeth at 423-756-0125 or This email address is being protected from spambots. You need JavaScript enabled to view it.. 
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Can Crypto Go To Zero? You Betcha!

Can Crypto Go to Zero? You Betcha! Of all the asset classes traded today, none has the need for a collective set of beliefs as much as cryptocurrencies.  These virtual assets fluctuate widely in value, which is set supposedly by supply and demand.  The problem is that, with no central place to trade, transactions are taken on faith. There is no validation of the volume of trades, much less the trades themselves. Crypto is a marriage of technology with the utopian ideals of libertarianism. With cryptocurrency, there is no way for a government to trace a transaction, making it ideal for those who want to evade government oversight and taxation.  It also attracts the criminal element, who find the lack of tracing appealing for different reasons.  Cryptocurrency such as Bitcoin is a standard tender for ransomware attacks, as payments cannot be traced in the manner of bank transfers or wires.  While there is no central location for cryptocurrency, there has to be a way to transfer title from one party to another.  There also needs to be someone who controls the issuance of the currency so that the market is not flooded with so much currency it loses its value. This assumed restraint on currency creation is the heart of crypto appreciation.  Bitcoins that sold for $800 a few years ago now go for $50-60,000.  Naturally, this rapid appreciation has attracted others who believe that crypto coins can only go up. It also attracts those who may have otherwise invested in gold.  Some people believe gold is a store of value, especially during inflationary times.  Since the amount of new gold produced is small relative to the amount of gold outstanding, gold is assumed to be an excellent barometer for inflation.  The idea behind tying the growth of gold back to currency creation is to prevent materially more currency from being created and a rise in prices along with it. The key difference is that gold production is tangible and traceable.  Cryptocurrency is neither. The US Government is very interested in who invests in cryptocurrency.  It is assumed by the IRS that such purchases, if unreported, are to avoid taxes by trying to make financial assets untraceable in an effort to spirit them out of the country undetected.  Buying Bitcoins are thus, in theory, a way to ensure IRS audits for the rest of your life. The IRS has categorized crypto investments as subject to capital gains taxes, which is to say they want to know if you have them, and what you gain on trading them if you do. All of this is to say that regulation of crypto investments is coming. While some investors may consider such compliance with reporting requirements voluntary, the IRS will take a very dim view on unreported assets.  With this requirement, the crypto world will be fenced in much as was the American West in the late 19th century. There have been reports of criminal elements hacking into crypto vaults to try to seize the coins for themselves.  In spite of this, the attitude of some investors towards crypto is to party on.  Such invasions of crypto exchanges are often not reported, as such would be bad for business.  As for the fleeced crypto owners, how can you report the theft of an asset you never acknowledged owning? Significantly, no one seems to ask how a currency became an item of speculation.  Usually, a currency represents a stable value.  The purchase of Bitcoin by the young and naïve for speculation represents perhaps one of the later chapters in their existence.   So how does this end?  Badly.  Like Dutch tulip bulbs, the value of Bitcoin and other cryptocurrencies exists at the pleasure of supply and demand.  Should value decline, more coins would be required to make the same dollar transaction.  Should faith in their soundness be successfully challenged, then the game will be up.  With no government or other body standing behind the coins, their value could fall to zero.  The idea of a currency, independent of a government and readily tradable, is as old as gold.  However, to the extent its use acts as a competitor to legal fiat, do not be surprised when no central bank will come to the aid of the crypto investors. With nothing more than perhaps a variant of the Wizard of Oz standing behind it, the ability of cryptocurrency to survive having its legitimacy questioned is problematic.  Like the tulip bulbs in Holland, the aftermath will be both painful and sobering.  The scale of the losses could measure in the billions of dollars, assuming people are willing to admit to them.  The Economy Coming out of Covid, the economy is doing well. Supply chain disruptions are still making manufacturing and retail less than optimal.  We are perhaps one to two quarters away from a more normal supply.  Next year will likely see, for most businesses, the first expansion of revenues since the pandemic.  2022 will finally outperform 2019.  The infrastructure spending should help ensure that business and employment are good. Interest Rates Interest rates are widely expected to increase in 2022 – the question is how much.  The end of the government bond-buying program will be a de facto interest rate increase, as there will be fewer dollars in circulation.  The taper program, supposedly started last month, has already seen interest rates on home mortgages go over three percent.  Some people are calling for aggressive interest rate hikes to stem inflation.  Inflation will, in some ways, take care of itself.  While we will likely see positive interest rates in 2022, a decline in inflation will make that more easily attainable than otherwise the case. Inflation Inflation, so much on people’s minds now, will partly recede in 2022.  Oil prices should decline next spring, as rising domestic supply along with OPEC’s gradual increases counters prevailing prices.  Shipping should hopefully be sorted out by then, with the off months after December giving ports time to rationalize how they do things. The semiconductor chip shortage should also resolve itself, at least for the less sophisticated chips.  Coming out of this will be better coordination between product designers and chip suppliers.  This industry, which has principally been driven by price, may see more in the way of long-term contracts for a fixed amount of chips, at least by its larger buyers. The Stock Market Rising interest rates will bring down the curtain on an era of investing.  It need not bring down the overall stock market. Normally, low-interest rates favor high-growth companies.  If both interest rates and inflation are low, growing companies are often seen as being the only firms that generate excess returns.  With low-interest rates, the cost of attracting capital to grow is minimal. As interest rates increase, growth firms are saddled with higher costs and stiffer terms for incremental capital to fund their expansions, while more established firms get a higher return on their cash flows.  Also, even private equity and hedge funds have to pay more for investment funds, making their ventures less profitable. More established companies with the ability to grow cash flow will begin to share the floor with the less seasoned upstarts.  Also, should there be a crash in something like Bitcoin, there will be a lesson that not all market disruptions are positive.  The staff at Barnett & Company wish you and yours a safe and happy Thanksgiving! We are so grateful for you. Warren M. Barnett, CFA November 23, 2021 Barnett & Company is a fee-only registered investment advisory firm registered with the Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations.  For a brochure on the company and its available services, please contact Elizabeth at 423-756-0125 or This email address is being protected from spambots. You need JavaScript enabled to view it.. 
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Maximum Gain, Minimum Pain: The Current Approaches To Tax

Back in the day when Russell Long of Louisiana was chair of the Senate Ways and Means Committee, he used to tell a ditty to his colleagues: “Don’t tax you, don’t tax me, go tax that fella yonder under the tree.”  Long was in effect telling the other senators that the easiest taxes to pass are those that affect the fewest constituents.  In this spirit, communities have escalated hotel/motel taxes on guests, and some communities have a higher property tax structure for those who do not live in the same state.  Neither group can vote against those increasing the levies.  With the $1.5 trillion (give or take) Build Back Better Plan of the Biden administration, trying to find someone to pay gets trickier.  Right now, there are two focuses:  billionaire families, and corporations. Press reports tell us there are about 800 domestic families with a net worth in excess of $1 billion.  As currently devised, such families will need to pay a capital gains tax on unrealized gains of up to 23.8 percent, spread over some time frame.  There are already questions raised as to the tax’s constitutionally.  The Sixteenth Amendment of the Constitution permits the government to tax income and estates but is silent as to assets accumulated by living members.  The second tax proposed is to raise corporate taxes to 26.5 percent from the current level of 21 percent.  Only corporations that have over $1 Billion in annual profits would be affected.  About 200 companies in the US currently qualify.  For companies that generate enough tax deductions and credits to pay no taxes at this level of profits, the 26 percent would be a minimum tax, with any disallowed deductions eligible for future years, should they then qualify.  What has not been discussed is the expiration of many of the tax cuts passed by Donald Trump in 2017.   If left unchanged, personal taxes will all snap back to pre-2017 levels by 2026.  Only the corporate tax rate was permanently reduced.  This reduction/restoration of tax rates and deductions came about because the Trump White House could not show enough revenue increase from the tax cuts to make them permanent. Politically it was a gamble to see if the tax cuts were so popular, they would be maintained by future politicians. By portraying the needed tax increases as spread over such a small number of people and businesses, the idea is to shine a light on the fact that the 2017 tax cuts actually benefited a very small group of people and businesses at a cost to a far larger group of voters. The form of the proposed tax structure is not finalized, nor are the final expenditures included in the bill.  The progressive liberal wing of the Democratic Party is threatening to withhold support for the bill if their own goals are not met.  If carried out, such an act would be devastating to not only the chances of the Democrats to maintain control legislatively in 2022 but would also display the lack of influence of the President over his own party. At present, there is a $1 Trillion infrastructure bill that has been passed by the Senate with Republican support.  The Build Back Better bill of some unknown amount is being pushed by progressives.  This second bill includes such items as free junior college tuition, enhanced Medicare benefits, family leave, higher minimum wage, child-care, and the like.  This is the bill that divides the Democrats and has virtually no Republican support.  Liberals refuse to consider the bills separately, knowing that if they did so, they would lack support for the latter.  Thus, the current impasse. President Biden is in the center of this.  While most of the goals of the second Build Back Better bill were Biden political promises made while running for office, he did not commit to having them passed all at once.  The political calculus is whether passing some version of the second bill will help the Democrats expand their representation in 2022, or will it contribute to them losing one or both congressional houses to the Republicans.  If the latter occurs, expect no legislative progress until 2024. The economic impact of the passage of either or both bills is diluted by the fact that the programs span five to ten years; thus while still in the billions, it must be looked at relative to a $24 Trillion economy.  Items like junior college tuition payments and child-care would seem to be on target for enhancing the workforce and growing the economy.  For some, the idea of the government providing for free what they had to pay for themselves is a bit difficult to accept.  If in fact it encourages higher labor force participation and higher tax collections to boot, it may be worth it. The Economy Economic activity continues apace.  Many argue that the economy could do better if there were more workers/goods/supplies/etc., but this could be said of almost all advancing economies.  An example of economic distortion is the bromide that we are constrained by supply chains.  In reality, more containers have been unloaded in domestic ports now than in 2019, the year before the pandemic.  The problem is not so much the supply chain as the sheer volume of goods being imported.  When Americans were locked down, those who still had incomes shifted from services (restaurants, vacations, air travel) to goods.  Because so few goods are still made in this country, the shift triggered an avalanche of containers.  With the economic stimulus ending and forecasts of higher heating costs this winter, expect consumer spending to slow.  Whether the economy slows with it may depend on the infrastructure bills now pending. Interest Rates Just in time for Halloween, interest rate increases are back.  While up fractionally domestically, signs of higher rates are popping up in other countries.    As for how high is higher:  probably in the range of 2-2.5 percent on the ten-year US Government bond in the next 12 months.   Not enough to derail the economy, but enough to call into question some investments being made at current levels.  Perhaps the most sensitive industry for interest rates is housing.  While higher rates shrink the market for first-time homebuyers, it also reduces the pool of potential demand for those in appreciated properties thinking of downsizing.  There is some regional arbitrage going on, with retirees leaving higher cost of living areas and buying homes in lower-cost areas.  Higher interest rates may reduce the ability of such homeowners to freely move. Inflation While currently not as scary as interest rates, inflation is growing stronger in the area where it is hardest to dislodge: wages.  Higher wages, unless offset with productivity, are very difficult to deal with. The endless discussions about what happened to the five million workers who seem to have evaporated since the pandemic started fail to confront the fact that they are not returning.  Over three million consider themselves retired.  Another two million have not returned for reasons ranging from lack of child care to the need to upgrade skills. These are issues the government can address if given the resources. The Stock Market Stocks seem to grind higher, aided by the sharp appreciation in the price of oil and gas.   With the backdrop of higher interest rates, it would seem some growth stocks may come under pressure due to valuations that previously did not need to compete with income alternatives.  Much of 2022 forecasting will depend on the chip shortage being resolved, as well as the lifting of limitations imposed by COVID.  Recall that even when the US is vaccinated, much of the world is not.  The ability to travel outside our borders may take longer than most people realize. Warren M. Barnett, CFA November 01, 2021 Barnett & Company is a fee-only registered investment advisory firm registered with the Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations.  For a brochure on the company and its available services, please contact Elizabeth at 423-756-0125 or This email address is being protected from spambots. You need JavaScript enabled to view it.. 
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Watching Sausage Being Made: The $3.5 Trillion Budget Reconciliation Package

Otto Von Bismarck, the man credited with uniting various fiefdoms into what is today Germany, once said there are two things the public must never see: one is sausage being made; the other is how legislation is passed into law. The $3.5 trillion reconciliation spending bill before Congress this week is already known for its size and breadth of recipients.  Programs as diverse as building veterans hospitals and providing hearing aids and dental care for seniors are on the agenda. Interestedly, the American Dental Association is against the proposal since Medicare pays relatively little.  Community colleges would become free to all who attend, while pre-school programs accommodating students as young as three and four years old would be offered, assuming matching state funds.  A program of this size will require significant funding.  While the plans are not yet finalized, below is a partial list of what to possibly expect. There is a pledge not to raise taxes on individuals making less than $400,000 per year or families earning less than $450,000.  Above that level, things get interesting. Incomes in excess of those amounts would see the marginal tax rate increase to 39.6% from the current 37%.  Families or individuals making over $5 million per year will be subject to an additional 3% surtax on the excess. The top corporate tax rate will be increased to 26.5% from 21% for companies making over $5 million under the proposal.  The top capital gains tax rate for individuals goes to 25% from 20%. There is a provision for taxing net investment income in excess of $400,000 ($500,000 joint).  This pertains to hedge fund operators, private equity organizers, and the like.  Previously they have used various tax avoidance strategies to pay no more than 15 percent tax on their investment income.  All these increases are to bring in a net $1 Trillion per year.  Add increasing the budget for IRS enforcement, taxing foreign earnings at 16.5% (up from the current 10.5%), and additional levies on those earning more than $5 million per year, and the estimated total income is $2.9 Trillion.  After estimating that the increase in economic activity will kick in another $600 Billion, the $3.5 Trillion funding package is financed. Two caveats:  the package has not been voted on, so anything can happen, both on the spending and tax side.  Second, getting spending of this magnitude off the ground will take more than a year.  It may take more than two.  Given the tightness of the current labor market, the programs will be collectively quite inflationary. It could be that the biggest impact on the economy will not be the taxes themselves but the competition for workers.  2022 was previously shaping up to be a year of decelerating revenues and higher input costs.  In other words, narrower profit margins.  Higher corporate income taxes will have an adverse effect on corporate profits, perhaps causing what was projected to be flat aggregate earnings year over year to go negative. If this is the case, companies will have even more incentive to raise prices sooner rather than later, and the Fed’s mantra about “transitory inflation” will go out the window. Most of the discussion thus far has less to do with the merits of the various proposed programs and more to do with whether we as a country can afford it.  There may be some pushback on parts of the tax proposals due to their costs.    Republicans would like to see the measure fail so as not to give the Democrats credit for the enactment.  They would also like to avoid the tax increases, which even some moderate Democrats see as a bit much. We will have to wait to see what happens.  In the meantime, talk of victory or defeat here is more one of the percentages.  Probably neither side will get all it wants.  The trick will be to see how much is signed into law and how it is financed. The Economy Economic activity is moderating. A combination of higher labor costs and transportation expenses has made advancing revenues and profits problematic.  An effort afoot to create more output in the US has run into problems of finding domestic expertise for products that have been almost exclusively imported for years.  The pending spending package will greatly increase the demand for labor. Whether it will provide a second wind to the economy could depend on how, for example, increasing funds for child care frees up women to re-enter the workforce in greater numbers than previously. Inflation Inflation is rising.  Import disruption, semiconductor chip shortages, and changing demographics are all working to push prices higher.  The party line at the Fed has been that the increase in prices is transitory, although no forecast sees a decline in labor costs this year or next. The Fed has not incorporated the spending bill before Congress on the rationale that it is not foreseeable until passed.  Look for forecast revisions once the dust settles on the size and shape of the spending packed adopted. Interest Rates Every time the Fed meets, the date for increasing interest rates seems to be pushed forward.  Three months ago, it was 2023.  Now it is early 2022.  Depending on the size of the spending bill to be passed this week, it may be late 2021. There is a school of thought that the stock market cannot afford an interest rate increase given its rich valuation.  While that may be true of some of the more generously valued shares, it does not appear to be true of the market overall.  The Stock Market Stocks overall seem to be a bit rich in terms of price.  Possible downward revisions in earnings estimates, a lack of clarity on what is going on in China, and the lingering effects of COVID have all made the estimation of revenues and profits for next year and beyond especially fraught.  Some retailers are talking of selling out their holiday inventory in November due to supply-chain complications.  They frankly cannot predict how and when they can stock their shelves for Christmas. Some industries are doing better than others.  Energy seems to be a bright spot for those who will still invest in the same.  Financial firms as a group are expected to benefit as interest rates rise.  Freight transportation is booming, passenger transportation less so.  The fourth calendar quarter is usually when research firms turn the page and focus on the subsequent year, in this case, 2022.  It will be interesting to see how estimates come out given all the cross-currents at the moment. Warren M. Barnett, CFA September 28, 2021 Barnett & Company is a fee-only registered investment advisory firm registered with the Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations.  For a brochure on the company and its available services, please contact Elizabeth at 423-756-0125 or This email address is being protected from spambots. You need JavaScript enabled to view it.. 
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Bernie Madoff Redux: The Case Of Southport Capital

By now, most of the public has at least heard of the Ponzi scheme of John Woods, majority owner of Southport Capital, a Chattanooga, TN brokerage firm which has, in a complaint filed with the SEC, received $110 million from some 400 investors over the last ten years. These investors were told that their monies were invested in government debt and real estate projects that would produce a return of 6-7 percent per annum. Instead, the funds coming in were in part paying the interest to the earlier investors. Less than 20 percent of the monies raised went into any sort of investment, and the investments were not those which paid 6-7 percent right out of the gate, if ever. While the accounting is a bit murky at this point, it is assumed that John Woods and his co-conspirators were the principal beneficiaries of the fraud while it lasted. The vehicle for the fraud was a private equity fund called Horizon Investments. It was managed by Mr. Woods and a few close associates. The investment was sold through the brokers at Southport as a private placement. Southport is a “dual-listed” company that has both a brokerage arm and an advisor branch called Livingston Group Asset Management Company. The advisor part charges a fee for managing the Horizon Fund. The brokerage arm executes the trades for the advisor side and sells the packaged financial products assembled by the advisor (Livingston) for a commission. The conflicts should have been apparent instantly. Because it was an unregistered “private placement” and promoted as a non-marketable security, the conflicts were either not disclosed or not made obvious to the investor in the venture. This investment falls under the rubric “Alternative Investing.” As interest rates have fallen, investors needing income have become increasingly desperate for investments that have a steady return on the level of 12-15 years ago. Such investors were receptive to the blandishments of Southport brokers, some of whom may have been in the dark themselves and who touted the Horizon investments as ones that investors could retrieve their principal back in 30-90 days. This is the same promise made by Bernie Madoff, from whom Woods might have obtained his operating concept. Many will fault the Securities and Exchange Commission for this occurrence. However, Woods never registered Horizon Fund with the SEC, making it impossible for them to oversee until someone brought it to the SEC’s attention. Also, the SEC’s enforcement budget is a fraction of what it was a decade ago, thanks to Congress, while the proliferation of financial products has risen exponentially. Finally, investors of private placement products are usually required to sign a statement called a “big boy” letter saying that they are an “accredited investor.” Such a statement states that the investor has a net worth of at least $1 million (home excluded) or income of at least $200,000 per year in each of the two most recent years, the SEC-mandated minimum standards for purchasing a risky financial product. These amounts have not been changed in 39 years. The idea is that if an investment is risky, the investor must demonstrate that they can afford to lose the amount invested. The SEC spends more time going after those who are trying to fleece unsophisticated investors than in providing needed assistance to the investors themselves. Aside from a lack of inflation adjustment in the threshold amounts, the problem is that the investor’s financial information operates on a self-policing honor system. This data is notarized but never verified. It is assumed that the investor providing the information is presenting truthfully his or her financial status. Some people overstate their wealth in order to invest in a product that is supposedly only offered to those of means. They sometimes do this in order to obtain status since investing in such products is a subtle way to tell others of your presumed income or net worth. Some investors hope that investing like the “big shots” will enhance their own investment return. What people do not realize is that falsification of such information can impair their ability to sue for recovery. If you are this well off, you are more likely to be able to afford to lose your investment. At this time, it is not clear if the investors in the Horizon Private Placement were ever asked to sign such a statement validating their income or net worth. If not, the situation becomes even more criminal for the organizers. How can an investor protect himself or herself from situations such as this? The first thing is to demand a separation of functions. Those profiting from selling the investment should be different from those managing the same. In this case, the separation superficially existed, given the Livingston Group Asset Management Company appeared to be a separate entity from Southport Capital. The problem was that both were part of the same organization and shared common ownership. What looked like a separation, in fact, did not exist. An SEC database search would have revealed this. The sales brochures probably did not. The second thing is to insist on investments that can be converted to cash quickly and are valued by a third party. The lack of transparency of the Horizon Private investment gave the manipulators the ability to carry on a charade as to its worth for years. Many investors get vertigo following the stock market up and down. What they do not appreciate is that the fluctuation in prices is not the same thing as risk. Not all non-marketable investments have the soundness of a certificate of deposit, which is often the first experience most investors have with something that does not fluctuate in price. Third, submit a proposed investment to a reality test. A return of 6-7 percent a year on a US government investment does not currently exist. The return for a 30-year Treasury bond is less than 2 percent. If someone is promoting something too good to be true, it usually is. Finally, support more financial resources for the SEC. A tax of 0.1 cents per share transacted would greatly add to the budget of those who are mandated to protect the well-being of the investing public. States are hamstrung as well, for the same reasons. It is time to give those whom we entrust to safeguard our financial system the means to do so. The Economy The economy is getting ready to downshift due to the end of the federal stimulus program. While the program has been blamed for disincentivizing workers for low-wage jobs, the reality is that those states who had previously eliminated federal unemployment support are seeing a deceleration in economic activity relative to the states that have not, with no material uptick in numbers employed. Nationwide, the number of those not working roughly equals the number of jobs being listed as available. The problem is in the details. Many jobs are in areas where people do not want to move to due to family or community ties, the cost of living in the new locality (especially housing), a lack of complementary job skills, the cost and availability of daycare, a lack of social skills to secure service-type jobs, age of the jobless and the like. Interest Rates Internationally, interest rates have been slowly going up. Governments in other parts of the world (South Korea, Chile, Hungary) have already started raising rates. The question is how fast this trend will accelerate. The aggressiveness of interest rate increases will be a function of the ending of the Federal Reserve’s program of buying bonds. This provides liquidity and lowers interest rates by increasing the amount of currency in circulation. At present, the portfolio of bonds and other debt securities owned by the Federal Reserve is between $8 and $9 trillion. If the Fed were to simply stop buying bonds and let their portfolio mature, about $200 billion would be taken out of the money supply each quarter. Inflation The favorite word that is attached to inflation these days is “transitory”. People are trying to convince themselves that whatever inflation occurred this year will not be around going forward. This is being done because the alternative is perhaps too alarming to contemplate. Still, with labor shortages as prevalent as they are currently, it is somewhat wishful thinking to assume that inflation will go back to the level of pre-COVID. Expect inflation to be a more prominent topic of conversation going forward. The Stock Market Stocks seem to be grinding higher, supported by post-COVID profit increases that seem dramatic compared to 2020, less so when compared to 2019. The liquidity provided by the stimulus has helped greatly to keep the market on an upwards trajectory. Watch China. The current conduct of the country hardly reflects its self-interest. Its economy is slowing down. The issue is whether it will take other economies with it. Mark Hulbert recently quoted one of the fathers of contrarian investing, Humphrey O’Neill, saying “When everyone thinks alike, everyone is likely to be wrong.” There are still attractive stocks. The issue is whether there is an attractive stock market. Especially for those who invest in packaged products, the slope will soon get steeper. Index investing works when the broad sweep of the market propels it. Valuations would suggest that such tailwinds are going to slow down if not reverse. Warren M. Barnett, CFAAugust 30, 2021
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Riding The Chinese Tiger: How Changes In Chinese Securities Laws Will Impact US Investing

There is an old maxim in China: “He who chooses to ride the tiger goes wherever the tiger goes.” This has gained relevance for investors after China decreed over the past weekend that private schools set up to tutor Chinese students will have to become non-profit in order to continue operating. One entrepreneur saw his firm’s $15 billion valuation shrink by 98 percent in a day. The attack on tutoring, which the Chinese government described as “injecting capitalism into education,” will probably not be the last effort to rein in entrepreneurs in China. It follows a pattern of attacking Chinese companies that have listed securities abroad to raise capital, such as Alibaba, Tencent, Didi Global, and others. The common thread is that these firms are innovative, collect data on their customers, and have created great wealth outside the Communist Party. Just as it is the nail that sticks up from the board that gets hammered back down, so it is the innovators that fall into the gun sights of the Chinese government. To better understand the dynamics at play, understand that the Chinese military and the Chinese Communist Party are one and the same. For years China followed the Soviet Union’s example of total government ownership. They also suffered from inefficient production due to overstaffing of government-owned factories due to cronyism. This was reversed under the tenure of Deng Xiaoping (1977-89), who understood that China could not move forward unless the entrepreneurial nature of its people was harnessed. During his term, factories were transferred to private ownership through public stock sales. Industries became more efficient, and living conditions were greatly improved. With economic opportunities so abundant in the cities, people flocked from the rural areas much in the same manner as Americans did a century earlier. Because economic advancement was shared more by the urban areas than the rural, tension began to mount between the two. Rural areas began to grumble about the lack of government focus and funding afforded them compared to the cities. Children visited their parents and discovered they had less and less in common. Of great interest to the military, there were fewer rural people to recruit into the armed forces. This was especially alarming because most of the soldiers come from the countryside, where local avenues for improvement are limited, education is more primitive, and enthusiasm for the government is less questioned. Finally, as the current leader Xi Jinping (2012-present) knows, revolutions are started in the countryside. They then spread to the cities. There were incidents of uprisings in the provinces. The military took note. With less of a surveillance system on its people in the country compared to the urban areas, the party decided to err on the side of conformity, this option being the first choice of totalitarian regimes everywhere. Things like private tutoring struck a chord among the rural populace. Most could not afford such things, nor was it accessible without the internet service, which many lack. As the party began to see a deepening divide between rural and urban populations, it opted to defer to the rural to keep solidarity within the party. In the same fashion, those who were perceived as ostentatious in their success were reminded of where they came from and where they live. In the west, with its emphasis on the individual, displays of wealth are considered optional. Sometimes such displays are considered distasteful by those who critique the nouveau riche, but this is usually as far as it goes. In China, such displays invite harsh rebukes from party officials who feel that those who choose to stand out due to their success must be made examples for others not to emulate. In some cases, rebukes can take the form of prison sentences for charges that would not hold up anywhere else. Occasionally wealthy people disappear from public view for weeks at a time to return far less extroverted. To the extent that this crackdown on private companies shares anything in common with the west, it is in the area of data. Both western and eastern governments are growing increasingly alarmed about the volume of information collected on people and its private use. It looks increasingly likely that antitrust laws will be used against large tech companies by US and European regulators. China, with no concept of antitrust, prefers to cut to the chase. The implication of this change in attitude towards both large technology firms and foreign investment is sobering. China has been the fastest-growing securities market in the world. For this reason, it has been a magnet for US investment funds. There may come a time when extracting one’s investments from China may be impossible. This is a cautionary tale of international investing. It will be interesting to see where the tiger chooses to go. The Economy After all the stimulus pumped into the economy during the COVID pandemic, it has now come time to see what the economy can do on its own. This is a topic of great interest. Growth rates for the second half of 2021 range from 2-6%. While this is still a positive number, it is a definite deceleration from earlier in the year. Employment continues to vex the expansion. While returning to work takes time, it may also take higher wages for entry-level jobs. Interest Rates Interest rates have declined in the past quarter against most forecasts that they would increase. This decline can best be explained by the almost $900 billion that has flowed into the US from foreign investors since the first of the year. As China and other areas look less stable, investing in the US becomes more attractive. The inflows have affected both bond yields and stock prices. How long the funds will stay in the US is anyone’s guess, but they provide yet another source of market elevation so long as they remain. Most bond forecasts call for increasing interest rates. Even $900 billion cannot offset a deficit of $3 trillion and counting. Inflation Inflation spiked in July to over five percent. While the rate is expected to moderate, there is no forecast of decline. As inflation stays elevated and is acknowledged by more of the investment public, there will be an insistence that investments earn a return in excess of inflation. By category, bonds are the most vulnerable in this scenario. The Stock Market Stocks appear to be setting records for overall price and valuations. The issue is whether this can go on. If it can’t, what will rein it in? With the concentration of large tech stocks in the conventional indexes, the owners of the associated funds may find their appreciation of 17.5 percent year to date to be illusory if congress does go after the companies on antitrust grounds. So too will a declining level of economic growth make valuations questionable, although such a declining level of growth will affect everyone, although not equally. With valuations not seen since the dot com era of 2000, it may be a good time to know what one owns. History may not repeat, but it can display facets of commonality. Warren M. Barnett, CFAJuly 27, 2021
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The Zombies Among Us: How COVID Has Affected Some Companies

A grim milestone was reached this week as this country recorded 600,000 deaths from COVID-19 and its offshoots. Still, the trend is decelerating rapidly, vaccinations are being accepted no matter how unevenly, and there is an air of, if not victory, at least hope in dealing with the pandemic. The effect of COVID on companies is less obvious. Firms show, for the most part, no outward strains from the pandemic save for those in the hospitality and retail industries. However, data shows that companies borrowed around $11 trillion to stay afloat during the time that revenues declined or disappeared. The repayment of this sum, along with the interest it generates, will impact profits and cash flows for years. Take Norwegian Cruise Lines Holdings as a case study. During 2020 and 2021 year-to-date the company has taken on $7.1 billion in financing. This figure includes a recent $1.6 billion from the issuance of 53 million in new shares. The number of shares outstanding has increased by 73 percent since December 2019. Pre-COVID, Norwegian earned about $1.2 billion pretax per year. Norwegian had and still has several ships on order. In assessing the company’s ability to deliver future earnings, it has a good deal of debt to work through. Norwegian also now has more shares and thus more dilution of future earnings. This hollowing out of balance sheets and potential dilution of future earnings due to COVID is, in fact, more common than is generally observed. Transportation and retail seemed to have been the most often hit by this erosion of financial health. Outside transportation, a key attribute seems to have been whether an industry or company was considered “essential” during the pandemic. If so, the firm may not have done badly. In some cases, the results were stellar. For firms that were not essential, there was a lot of downtime, lost revenues, and lost profits to absorb. Companies that carried large dollar amounts of assets per dollar of revenue were the most at risk for material declines in operating leverage. Some demand will be recaptured in the post-COVID era that in some ways seems upon us. Some demand is lost forever. The current stock market, at least prior to this past week, seemed not to make the distinction between companies that were on the cusp of earning money and those that would be able to keep it. Many investors are fixated on projected earnings per share. Their reason: if earnings are to go up, it must be good for shareholders. While eventually true, if earnings are to pay down the principal of debt, it helps shareholders only indirectly and over time. Additional shares are equally problematic. Once profits are restored, they must be divided by a greater number of shares outstanding. This last fact impedes earnings per share growth. What about share buybacks? Do they not increase share prices? Yes and no. Buybacks do shrink the number of shares outstanding, but do not help the balance sheet if funds financing the buyback are borrowed. Then there is the issue of whether the funds should be used to reduce debt instead. Debt reduction strengthens the company but does not goose the increase in earnings per share like buybacks do. Management has been lobbied by investment bankers to reduce shares outstanding by buying them back. This aids the industry analyst in making stock forecasts and makes the investment banker look good in the process. A second reason is it makes the stock options issued to management more valuable so long as no one complains about the debt remaining. This act of self-interest, along with the ego trip of not splitting stock to make its rise easier to compute, would seem to indicate that not always is management’s interest aligned with the owners – the shareholders. Europe takes the concept of stock as a proportionate interest in the business far more seriously than the US does. Here stock is acquired by a company through public transactions. In Europe, stock cannot be bought back unless there is an auction that all shareholders can participate in. Conversely, a company cannot be acquired for stock unless the shareholders vote to authorize the additional shares. Issuing stock to management on the scale allowed in this country is unheard of. The European tax treatment of stock options is more transparent as well. European stocks, in general, pay higher dividends than the typical American share. Such is their way to distribute surpluses to shareholders. Correcting these mindsets will take more reform than currently exists in terms of political will. The issue here is one of ownership and governance. In the long list of grievances, these matters are not at the forefront, as most do not understand the implications of reforming them. The EconomyBy most measures, the economy is off the charts. The charts themselves are distorted by the lockdown of the economy last year. Most economists are looking for economic growth in the neighborhood of 6 plus percent for this year and the early part of next year as well. After that, the pandemic will be gone from yearly comparisons, and it will be up to the long-term growth of the economy going forward. One statistic of interest is the so-called quit rate, which is how often employees voluntarily leave their jobs. It is usually related to the number of jobs available compared to the number being pursued. Employees are leaving in record numbers (about 2.7 percent) for other opportunities. The reasons range from demographic (more people retiring than entering the workforce) to opportunistic (better pay and benefits elsewhere). All this portends to a tighter labor market and higher inflation going forward, especially in service industries that are less prone to automation. The fastest way to take pressure off the labor pool is through some form of immigration, perhaps in the form of worker visas for a specific amount of time. This has been done in Europe for years. The usual form is for a five-year visa followed by another five-year visa if employed at the end of the first five years. After that, citizenship may be applied for, but oftentimes the immigrant is simply saving to go back to his or her home country. InflationInflation is gathering momentum, as the forced savings of the past year meets the limited supply of goods as well as supply chain snafus that drive up prices. Housing seems to be of special attention. Years of building fewer homes than supply required coupled with the shut down during the pandemic has created a demand that possibly will not be satisfied for years. Lumber prices are coming down relatively, but shortages of workers and zoned land for building are keeping demand from being satisfied. Starter homes are especially rare to build, as higher profits are delivered by building more expensive homes. Interest RatesHow long the Federal Reserve can keep its thumb on the scales of interest rates is anyone’s guess. Some predict 2 percent ten-year Treasury bonds by year-end, up from under 1.5 percent now. Savers in banks and money market funds will have to suffer a while longer. There is so much money flowing through the system it seems that it will have a judgment day, but there is as of now no financial John the Baptist to say when. Until then, investing in assets that have some return beats no return, so long as there is substance behind them and hopefully the potential to raise their dividend. The Stock MarketThe declines of this past week seem to be a harbinger of something, although what is up for debate. The greatest declines were by the stocks that have gone up the most, which would seem to indicate profit-taking by short-term traders. However, the larger theme of value over growth, and substance over lack of the same, seems to be intact. Of special note: Tesla’s former President Jerome Guillen, who left the company earlier this month after over ten years there, just sold all his stock in Tesla, pocketing proceeds of $274 million after cashing in his stock options. Also, the Chinese government is cracking down on the production of cryptocurrency in that country due to the amount of electricity required for its creation. Bitcoin prices are down almost 44 percent since the peak this year. Party on. Warren M. Barnett, CFAJune 21, 2021
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Inflation is Coming: Are You Ready? Are You Sure?

As of last Friday, the Standard & Poors Index, the basis for index funds under the same banner, had recorded a year-to-date appreciation of 11.29 percent. While this is a commendable number, it was attained entirely (and then some) on Price/Earnings multiple expansion. A year ago, the index had an average P/E ratio of 20.34. It is now 44.41. In a nutshell, stock prices went up while earnings went south. Covid played a huge part in this earnings decline, and the vaccination is expected to play an equally huge role in causing earnings to return. This begs the question: what are earnings expected to be going forward post-Covid? According to published pronouncements from Standards & Poors, earnings for 2021 are expected to be $178.08 for the 500 stock index. If this forecast is accurate, it would imply a P/E ratio based on 2021 estimated earnings of 23.22. In 2022, assuming we can see out that far, earnings are predicted to rise to $202.75, which puts the P/E ratio at that point (assuming no change in the overall value of the 500-stock index) at 20.39. Historically the P/E ratio has been about 16, although it has been subject to a great deal of fluctuation. As the name implies, the Standard & Poors 500 is a composite of 500 stocks of the largest firms in the country. The stocks are weighted by market capitalization, so a large firm like Amazon has more impact on the index than a smaller firm. Six firms make up 22.13 percent of the weight of the index: Apple, Amazon, Facebook, Netflix, Alphabet (parent of Google), and Microsoft. The Standard & Poors also maintains an index of the next 400 firms in terms of size. This index, called the Midcap 400, is up 19.04 percent year to date. A third index of the smallest 600 stocks is up 20.66 percent in this same time frame. Both these indexes are doing almost twice as well as the largest index. What does this imply? First, the S&P 500 index is having some issues relative to the larger market. It included the most favored stocks for so long that their valuations may now be called into question. Last week, Netflix disappointed in terms of subscriber growth, and this led to the stock correcting over ten percent. If companies like Netflix, Amazon, and the like were the chief beneficiaries of the lockdown associated with the pandemic, does it not follow they would be hurt relatively speaking when the economy recovered? In a similar vein, could it be that smaller firms, who bore the brunt of the lockdown, are now ready to take back the business lost to the larger firms? Time will tell as to how much consumers’ shopping habits have been altered by the pandemic. Initial reports are that consumers just want to get out and take their lives back. That could take the form of more socializing and less binge-watching television. It could also take the form of travel, at least within the US this year. Restaurants are scrambling to find staff, which may mean higher prices and slower service. In fact, with a high savings rate, it would seem that higher rates of inflation will be a foregone conclusion. A second advantage the mid-cap and small-cap indexes have over the flagship S&P 500 is a more reasonable valuation. A third advantage is that smaller companies are more likely to already be paying corporate taxes, as smaller firms lack the know-how to avoid paying taxes in the manner of larger enterprises. This means that smaller firms will not feel the impact of the proposed minimum corporate tax rate as much as larger firms, should it be enacted. While the rate at this point is largely undefined, it will be a jolt to the profits of large companies like Amazon, who have never paid taxes due to their heavy investment spending. Companies who play games with keeping their profits abroad to avoid US taxation will also be targeted. Putting all of this together, we may yet have a correction, or we may already have had one. The term to describe leaders falling back and being replaced by other firms is “sector rotation”. A historical example is 1974-82: in this time frame, the Standard & Poors index essentially went nowhere, while the smaller capitalization index tripled. We may be witnessing the same now, as the environment for large companies becomes increasingly hostile. Pressure on large-cap names comes from not just valuations and taxes but also from antitrust, foreign governments’ desire to tax earnings at a higher rate, political and social issues, and privacy concerns. In 2017, the S&P 500 went up 19.4 percent. The chief reason earnings went up that year was the decline in corporate taxes from 35 percent maximum to 21 percent. While we are entering a very strong and recovering economy, should the tax increase be enacted into law, it will impact valuations to the downside. The chief questions are whether the increases will be enacted and when, as well as in what form. The Economy With pent-up demand and a high savings rate, it would seem logical to assume the economy will do well as the lockdown becomes history. Estimates are all over the map, but all are positive. The chief concern at this point is the adequacy of labor relative to demand. Demographically the country has more people dying than being born, even before Covid put its thumb on the scales. Without some sort of controlled immigration, there is no easy way to fix this. European countries have addressed this with worker visas of three to five years. If there is no work, the foreign workers are sent home. Critics say the process is easy to circumvent. In Europe, stiff fines and jail time await an employer who tries to hire a worker with an expired visa or below the legal wage. In the US, the onus has been on the employee rather than the employer. Inflation It looks like America’s efforts to avoid inflation are about to run out of string. The record prices for housing are pressing the inflation rate, as is the shortage of semiconductor chips to build everything from appliances to automobiles. It is predicted that there will be fewer sales when supply is constrained. Right now, there are about thirty container ships outside the port of Los Angles and Long Beach waiting to unload. It is estimated that they hold collectively 45,000 containers of goods for everything from clothes to washing machine parts. Until the logjam is resolved, look for bare spaces on store shelves as a result. Interest Rates Efforts by the Federal Reserve to hold down interest rates may also be running out of options. The Fed continues to champion full employment. However, the combination of jobs being in areas where people cannot or will not commute or move to coupled with a denial by employers as to what is required in terms of compensation to hire, is leading to an impasse in stronger job growth. If wages rise faster than interest rates, the effect will be to cause people to acquire things that they think will appreciate in value faster than inflation overall. Should this mindset take hold, the Fed’s job will be greatlycomplicated. The Stock Market Floating on the liquidity furnished by the Federal Reserve, stocks continue to rise on the backs of higher earnings, low-interest rates, and high demand. Reports of higher taxes under consideration are spooking the market, although nothing has been proposed or voted on. Given the reaction to what has been proposed thus far, the passing of tax legislation may provide a buying opportunity for those that do not hold some of the highflyers which have more compelling valuations. Addition to the Firm Barnett & Company welcomes the addition of Katie Stuart to our staff. Katie comes to us from the banking industry, where she excelled at customer service. Katie is a native of Newport, Tennessee, and an MBA graduate of Carson-Newman University. Katie will be assisting Yvonne Hobbs with client needs as well as serving as the office manager. She has embarked on the CFP program and will be the resident expert on financial and retirement planning. We at Barnett & Company welcome her aboard. Warren M. Barnett, CFAApril 27, 2021
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