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Ranking Stocks for Investment – Sixth in Series

Tuesday, July 20th, 2021

Our Ranking

Our proprietary investment analysis system is able to rank the 1200 companies I keep in our database according to several factors. These factors lead us to six ranks based upon traditional investment concepts: Earnings Growth, Financial Strength, Value, Momentum, Quality and Fundamentals. Each of the rankings combines several financial ratios that reflect each of the above investment concepts, and they are chosen based upon years of analysis that show that these specific ratios provide me with a clear picture of how the company fairs under each concept. They are ranked from 100 (best) to 1 (worst) on a relative basis to their industry and to the S&P 1500.

Companies Ranked as Candidates For Investment

In the first four entries in this series, we looked at Quality Ranked companies , Earnings Growth Ranked companies, Financial Strength Ranked companies, and Fundamental Ranked companies. Today, we are going to look at companies to see if they are Candidates For Investment based upon aggregating the four ranking systems.

Over the years, I have found that when a company ranks highly on all four of the ranking systems, they are a strong candidate for further due diligence to see if they make the cut to be included in client portfolios.

Below are a selection of companies from our database with a rank above 90 on each of the four ranking systems and a history of above average bear market performance plus those with a rank below 60 on each of the ranking systems and a history of very weak bear market performance.

Company NameQuality RankEarnings Growth RankFinancial Strength RankFundamental Rank10-yr Avg Return
Avery Dennison Corp98.496.393.892.319.55%
Cabot Oil & Gas Corp97.895.299.495.10.93%
Jazz Pharmaceuticals PLC98.695.191.195.618.91%
Mercury General Corp92.994.698.798.18.37%
NVR Inc99.998.297.793.621.08%
Rio Tinto PLC96.59594.199.94.98%
Southern Copper Corp91.598.393.695.69.39%
The Toro Co92.49392.694.722.59%
Werner Enterprises Inc90.296.194.3977.84%
Winnebago Industries Inc98.399.69894.222.40%
Altisource Portfolio Solutions SA314.713.127.2-6.74%
FuelCell Energy Inc24.725.621.127.2-26.28%
Fluor Corp49.230.449.159.9-9.00%
The Howard Hughes Corp40.837.820.943.84.53%
Ocean Power Technologies Inc5929.411.810.8-42.96%
Spirit AeroSystems Holdings Inc40.213.114.838.59.08%
Triumph Group Inc34.843.145.244.3-7.61%
Tata Motors Ltd2241.734.4460.93%
AgEagle Aerial Systems Inc9.430.111.515.3-32.32%
Wynn Resorts Ltd32.916.31333.21.64%

A review of the chart above will indicate that the companies highly ranked ranked performed better on average over the past ten years than those ranked low. So, lets look at the scatter graph for a visual analysis:

Looking at the graph, it is easy to conclude that the companies ranked highly on all four ranking systems have materially out-performed those with low ranks on all four ranking systems on average over the past ten years.

Why Is This Important Now?

In the first entry in this series, I mentioned that the Federal Reserve had begun to discuss tightening monetary policy, an event that has in the past led to stock market corrections and sometimes full bear markets. Given their recent statements, it is prudent to know how companies will perform when there is not a significant stimulus pushing their stock prices higher.

Investment Strategy

In the normal course of portfolio management during this period in time where we have been warned that monetary tightening is in the plans, we want to book the gains on the companies that show the least ability to withstand a bear market and focus on the companies that have the best ability to withstand a bear market. We do not want to see the gains we have made be lost by not monetizing them when the market tells us it is time.

Summary

In the six posts in this blog series, we looked at four of our Ranking Systems and compared them to the 3-year Average Return for companies ranked both high and low by the systems. We then looked at how the combining the systems compared to both 3-year and 10-year Average returns. The analysis showed that by relying on the results of the analytical ranking systems provides a start for further due diligence on those that appear to be strong candidates for investment to see if they should in fact be included in client portfolios.

–Mark

Ranking Stocks for Investment – Fifth in Series

Friday, July 16th, 2021

Our Ranking

Our proprietary investment analysis system is able to rank the 1200 companies I keep in our database according to several factors. These factors lead us to six ranks based upon traditional investment concepts: Earnings Growth, Financial Strength, Value, Momentum, Quality and Fundamentals. Each of the rankings combines several financial ratios that reflect each of the above investment concepts, and they are chosen based upon years of analysis that show that these specific ratios provide me with a clear picture of how the company fairs under each concept. They are ranked from 100 (best) to 1 (worst) on a relative basis to their industry and to the S&P 1500.

Companies Ranked as Candidates For Investment

In the first four entries in this series, we looked at Quality Ranked companies , Earnings Growth Ranked companies, Financial Strength Ranked companies, and Fundamental Ranked companies. Today, we are going to look at companies to see if they are Candidates For Investment based upon aggregating the four ranking systems.

Over the years, I have found that when a company ranks highly on all four of the ranking systems, they are a strong candidate for further due diligence to see if they make the cut to be included in client portfolios.

Below are a selection of companies from our database with a rank above 90 on each of the four ranking systems and a history of above average bear market performance plus those with a rank below 60 on each of the ranking systems and a history of very weak bear market performance.

Company NameQuality RankEarnings Growth RankFinancial Strength RankFundamental Rank3-yr Avg Return
Avery Dennison Corp98.496.393.892.329%
Cabot Oil & Gas Corp97.895.299.495.1-9%
Jazz Pharmaceuticals PLC98.695.191.195.61%
Mercury General Corp92.994.698.798.114%
NVR Inc99.998.297.793.617%
Rio Tinto PLC96.59594.199.923%
Southern Copper Corp91.598.393.695.616%
The Toro Co92.49392.694.725%
Werner Enterprises Inc90.296.194.39710%
Winnebago Industries Inc98.399.69894.228%
Aurora Cannabis Inc41.7109.622.3-50%
Altisource Portfolio Solutions SA314.713.127.2-38%
Coty Inc2050.232.132.8-9%
FuelCell Energy Inc24.725.621.127.2-24%
Fluor Corp49.230.449.159.9-25%
The Howard Hughes Corp40.837.820.943.8-6%
Norwegian Cruise Line Holdings Ltd010.23.117.1-15%
Ocean Power Technologies Inc5929.411.810.8-52%
PBF Energy Inc30.259.236.249.8-27%
Spirit AeroSystems Holdings Inc40.213.114.838.5-16%
Triumph Group Inc34.843.145.244.3-2%
Tata Motors Ltd2241.734.4461%
T2 Biosystems Inc2248356.8-46%
AgEagle Aerial Systems Inc9.430.111.515.331%
Alkaline Water Co Inc26.429.113.717-7%
Wynn Resorts Ltd32.916.31333.2-10%

A review of the chart above will indicate that the companies highly ranked performed better on average over the past three years than those ranked low. So, lets look at the scatter graph for a visual analysis:

Looking at the graph, it is easy to conclude that the companies ranked highly on all four ranking systems have materially out-performed those with low ranks on all four ranking systems on average over the past three years.

Why Is This Important Now?

In the first entry in this series, I mentioned that the Federal Reserve had begun to discuss tightening monetary policy, an event that has in the past led to stock market corrections and sometimes full bear markets. Given their recent statements, it is prudent to know how companies will perform when there is not a significant stimulus pushing their stock prices higher.

Investment Strategy

In the normal course of portfolio management during this period in time where we have been warned that monetary tightening is in the plans, we want to book the gains on the companies that show the least ability to withstand a bear market and focus on the companies that have the best ability to withstand a bear market. We do not want to see the gains we have made be lost by not monetizing them when the market tells us it is time.

What’s Next?

We have looked at the combined ranks on a 3-year average return comparison so lets look at it on a 10-year average return comparison to make sure the correlation between high ranks and high returns holds true.

–Mark

Ranking Stocks for Investment – Fourth in Series

Wednesday, July 14th, 2021

Our Ranking

Our proprietary investment analysis system is able to rank the 1200 companies I keep in our database according to several factors. These factors lead us to six ranks based upon traditional investment concepts: Earnings Growth, Financial Strength, Value, Momentum, Quality and Fundamentals. Each of the rankings combines several financial ratios that reflect each of the above investment concepts, and they are chosen based upon years of analysis that show that these specific ratios provide me with a clear picture of how the company fairs under each concept. They are ranked from 100 (best) to 1 (worst) on a relative basis to their industry and to the S&P 1500.

Fundamental Ranked Companies

In the first three entries in this series, we looked at Quality Ranked companies , Earnings Growth Ranked companies, and Financial Strength Ranked companies. Today, we are going to look at another of our concept-based ranks: Fundamental.

Our Fundamental Rank is the most complex of the ranking systems and encompasses 87 financial ratios related to the Balance Sheet, Income Statement, Statement of Cash Flows and the Effectiveness of Company Management. The ratios rank the companies against their industry as well as the S&P 1500.

Based upon this, below are a selection of companies from our database that are ranked Fundamentally Strong with a rank above 90 and a history of strong bear market performance plus those ranked Fundamentally Weak with a rank below 60 and a history of weak bear market performance.

FundamentalsCompany NameFundamental Rank3-yr Avg Return
Fundamentally StrongDollar General Corp99.332%
Fundamentally StrongIntel Corp96.82%
Fundamentally StrongKirkland Lake Gold Ltd92.433%
Fundamentally StrongEli Lilly and Co90.135%
Fundamentally StrongMercury General Corp98.714%
Fundamentally StrongProgressive Corp95.520%
Fundamentally StrongQuinStreet Inc91.810%
Fundamentally StrongRoss Stores Inc98.716%
Fundamentally StrongBoston Beer Co Inc94.761%
Fundamentally StrongUnitedHealth Group Inc98.920%
Fundamentally WeakApogee Enterprises Inc59.5-2%
Fundamentally WeakDevon Energy Corp58.6-8%
Fundamentally WeakGeneral Electric Co42.51%
Fundamentally WeakThe St. Joe Co36.339%
Fundamentally WeakLimoneira Co33.1-7%
Fundamentally WeakPhillips 6659.8-6%
Fundamentally WeakRaytheon Technologies Corp54.62%
Fundamentally WeakSplunk Inc48.92%
Fundamentally WeakValero Energy Corp53.2-9%

A review of the chart above will indicate that the companies ranked as Fundamentally Strong performed better on average over the past three years than those ranked as Fundamentally Weak. So, lets look at the scatter graph for a visual analysis:

Looking at the graph, it is easy to conclude that the companies ranked Fundamentally Strong have out-performed those ranked Fundamentally Weak on average over the past three years.

Why Is This Important Now?

In the first entry in this series, I mentioned that the Federal Reserve had begun to discuss tightening monetary policy, an event that has in the past led to stock market corrections and sometimes full bear markets. Given their recent statements, it is prudent to know how companies will perform when there is not a significant stimulus pushing their stock prices higher.

Investment Strategy

In the normal course of portfolio management during this period in time where we have been warned that monetary tightening is in the plans, we want to book the gains on the companies that show the least ability to withstand a bear market and focus on the companies that have the best ability to withstand a bear market. We do not want to see the gains we have made be lost by not monetizing them when the market tells us it is time.

What’s Next?

In Part Five of this series, we will look at what happens when we combine the ranks discussed in the first four parts of this series.

–Mark

Ranking Stocks for Investment – Third in Series

Friday, July 9th, 2021

Our Ranking

Our proprietary investment analysis system is able to rank the 1200 companies I keep in our database according to several factors. These factors lead us to six ranks based upon traditional investment concepts: Earnings Growth, Financial Strength, Value, Momentum, Quality and Fundamentals. Each of the rankings combines several financial ratios that reflect each of the above investment concepts, and they are chosen based upon years of analysis that show that these specific ratios provide me with a clear picture of how the company fairs under each concept. They are ranked from 100 (best) to 1 (worst) on a relative basis to their industry and to the S&P 1500.

Financial Strength Ranked Companies

In the first two entries in this series, we looked at Quality Ranked companies and Earnings Growth Ranked companies. Today, we are going to look at another of our concept-based ranks: Financial Strength.

Our Financial Strength Rank combines our Quality Rank with several Value related ratios that help rank the company based upon earnings valuation (e.g., Price/Earnings), sales valuation (e.g., Price/Sales), free cash flow (e.g., FCF/Enterprise Value), and asset valuation (e.g., Price/Book), among others.

Based upon this, below are a selection of companies from our database that are ranked Financially Strong with a rank above 90 and a history of strong bear market performance plus those ranked Financially Weak with a rank below 60 and a history of weak bear market performance.

FinancialsCompany NameFinancial Strength Rating3-yr Avg Return
Strong FinancialsDollar General Corp90.432%
Strong FinancialsBarrick Gold Corp98.524%
Strong FinancialsIntel Corp91.52%
Strong FinancialsKirkland Lake Gold Ltd97.633%
Strong FinancialsMercury General Corp98.114%
Strong FinancialsNewmont Corp98.226%
Strong FinancialsProgressive Corp95.920%
Strong FinancialsSouthern Copper Corp95.616%
Strong FinancialsUnitedHealth Group Inc93.520%
Weak FinancialsAlaska Air Group Inc48.26%
Weak FinancialsBank of America Corp42.315%
Weak FinancialsChevron Corp40.8-1%
Weak FinancialsGeneral Electric Co41.31%
Weak FinancialsIntuitive Surgical Inc54.820%
Weak FinancialsPalo Alto Networks Inc35.220%
Weak FinancialsPhillips 6658.2-6%
Weak FinancialsRaytheon Technologies Corp56.32%
Weak FinancialsSplunk Inc30.72%
Weak FinancialsTruist Financial Corp58.48%
Weak FinancialsWells Fargo & Co58.2-2%
Weak FinancialsExxon Mobil Corp58.3-5%

A review of the chart above will indicate that the companies ranked as having Strong Financials performed better on average over the past three years than those ranked as having Weak Financials. So, lets look at the scatter graph for a visual analysis:

Looking at the graph, it is easy to conclude that the companies ranked with Strong Financials have out-performed those with Weak Financials on average over the past three years.

Why Is This Important Now?

In the first entry in this series, I mentioned that the Federal Reserve had begun to discuss tightening monetary policy, an event that has in the past led to stock market corrections and sometimes full bear markets. Given their recent statements, it is prudent to know how companies will perform when there is not a significant stimulus pushing their stock prices higher.

Investment Strategy

In the normal course of portfolio management during this period in time where we have been warned that monetary tightening is in the plans, we want to book the gains on the companies that show the least ability to withstand a bear market and focus on the companies that have the best ability to withstand a bear market. We do not want to see the gains we have made be lost by not monetizing them when the market tells us it is time.

What’s Next?

In Part Four of this series, we will look at our Fundamental Rank to see what it tells us that will be useful in managing portfolios to prepare for a correction or bear market at some point in the future.

–Mark

Ranking Stocks for Investment – Second in Series

Tuesday, July 6th, 2021

Our Ranking

Our proprietary investment analysis system is able to rank the 1200 companies I keep in our database according to several factors. These factors lead us to six ranks based upon traditional investment concepts: Earnings Growth, Financial Strength, Value, Momentum, Quality and Fundamentals. Each of the rankings combines several financial ratios that reflect each of the above investment concepts, and they are chosen based upon years of analysis that show that these specific ratios provide me with a clear picture of how the company fairs under each concept. They are ranked from 100 (best) to 1 (worst) on a relative basis to their industry and to the S&P 1500.

Earnings Growth Ranked Companies

Our Earnings Growth Rank is the original analytical system whose nexus started with my Masters Thesis. The thesis set out to disprove the Efficient Market Hypothesis (yes, that is how long ago it was – it has graduated to a Theory and is no longer a Hypothesis). The synopsis of the thesis was that in spite of the strong support for the Hypothesis, there really are certain financial ratios in the public realm that when viewed as a whole can provide index beating returns over the long run. And given our track record of beating the index over the long run, the Earnings Growth Rank is a very important part of our investment process.

There are several financial ratios that comprise the Earnings Growth Rank, but they can categorized into four main groupings: Earnings Per Share Growth; Sales Growth; Operating Income Growth; and Cash Flow. There are nineteen ratios that are distributed between these four primary groupings, but when taken as a complete package, provide a good look into which companies are investable based upon their income statement.

Below is a non-exhaustive list of companies from our database that are designated either High Growth or Low Growth based upon, among other factors, their Earnings Growth Rank.

DesignationCompany NameEarnings Growth Rank3-yr Avg Return
High GrowthBroadcom Inc9825%
High GrowthBerkshire Hathaway Inc95.115%
High GrowthEtsy Inc94.173%
High GrowthGenmab A/S94.937%
High GrowthMercury General Corp94.614%
High GrowthNational Fuel Gas Co943%
High GrowthOracle Corp92.820%
High GrowthPayPal Holdings Inc95.746%
High GrowthQorvo Inc98.931%
High GrowthRoss Stores Inc97.816%
High GrowthSouthern Copper Corp98.316%
High GrowthSkyworks Solutions Inc98.620%
High GrowthTexas Instruments Inc95.420%
Low GrowthAlaska Air Group Inc42.96%
Low GrowthApogee Enterprises Inc49.7-2%
Low GrowthBank of America Corp57.515%
Low GrowthCompass Minerals International Inc59.86%
Low GrowthChevron Corp54.5-1%
Low GrowthGeneral Electric Co34.71%
Low GrowthLimoneira Co32.2-7%
Low GrowthPalo Alto Networks Inc54.720%
Low GrowthPhillips 6633.1-6%
Low GrowthRaytheon Technologies Corp47.32%
Low GrowthSplunk Inc11.92%
Low GrowthValero Energy Corp43.7-9%

A quick look at the table gives you a good feel for the fact that the High Growth companies have performed much better over the last three years than the Low Growth companies. This may not always be the case as their are certain times when companies with low earnings growth scores will out-perform those with high earnings growth scores.

Below is a scatter plot that shows you visually the results of the above analysis – it is pretty apparent that the high growth companies performed better over the past three years than the low growth companies., even when taking into consideration the impact of the significant covid correction:

However, I specifically chose the last three years average return because it included the covid correction in the spring of 2020 for the stock market. I wanted to specifically know which designation performed better during a major correction.

Why Is This Important Now?

In the first entry in this series, I mentioned that the Federal Reserve had begun to discuss tightening monetary policy, an event that has in the past led to stock market corrections and sometimes full bear markets. Given their recent statements, it is prudent to know how companies will perform when their is not a significant stimulus pushing their stock prices higher.

Investment Strategy

In the normal course of portfolio management during this period in time where we have been warned that monetary tightening is in the plans, we want to book the gains on the companies that show the least ability to withstand a bear market and focus on the companies that have the best ability to withstand a bear market. We do not want to see the gains we have made be lost by not monetizing them when the market tells us it is time.

What’s Next?

In Part Three of this series, we will look at our Financial Strength Rank to see what it tells us that will be useful in managing portfolios to prepare for a correction or bear market at some point in the future.

–Mark

Ranking Stocks for Investment – First in Series

Thursday, July 1st, 2021

Our Ranking

Our proprietary investment analysis system is able to rank the 1200 companies I keep in our database according to several factors. These factors lead us to six ranks based upon traditional investment concepts: Earnings Growth, Financial Strength, Value, Momentum, Quality and Fundamentals. Each of the rankings combines several financial ratios that reflect each of the above investment concepts, and they are chosen based upon years of analysis that show that these specific ratios provide me with a clear picture of how the company fairs under each concept. They are ranked from 100 (best) to 1 (worst) on a relative basis to their industry and to the S&P 1500.

Quality Ranked Companies

Today, I thought we would look at our Quality Rank – one of the factors that lead to their being designated as High Quality or Low Quality. The other factors include having 9 of past 10 years as profitable, a Return on Invested Capital > Weighted Average Cost of Capital, Growing Book Value, growing earnings, bear market stock price performance, etc.

However, being either high or low quality in and of itself is not a reason to buy or sell a company – there are times in the market that High Quality companies under-perform Low Quality companies,and visa versa. No one set of ratios can tell you everything you need to know to buy or sell a company, but it gives you a place to start due diligence that gets you to the buy or sell decision.

Starting with our Quality Rank, this set of ratios gives me a feel for the soundness of a company’s financial position. The ratios I use are centered around four major items that comprise quality: Gross and Operating Margins; Asset Turnover; ROE and ROI; and Debt Management.

Below is a non-exhaustive list of companies from our database that are categorized as either High Quality or Low Quality.

QualityCompany NameBCNA Quality Rank3yr Avg Return
Low QualityAlaska Air Group Inc50.66%
Low QualityBank of America Corp17.115%
Low QualityCornerstone Building Brand42.8-1%
Low QualityChevron Corp18.4-1%
Low QualityFord Motor Co22.211%
Low QualityFifth Third Bancorp61.514%
Low QualityGeneral Electric Co18.71%
Low QualityJPMorgan Chase & Co49.818%
Low QualityTruist Financial Corp51.48%
Low QualityValero Energy Corp63.3-9%
Low QualityWESCO International Inc44.122%
Low QualityWells Fargo & Co26-2%
Low QualityExxon Mobil Corp38.4-5%
High QualityDollar General Corp91.432%
High QualityGenmab A/S99.737%
High QualityBarrick Gold Corp98.624%
High QualityKirkland Lake Gold Ltd99.933%
High QualityMercury General Corp92.914%
High QualityBoston Beer Co Inc59.561%
High QualitySouthern Copper Corp91.516%
High QualitySkyworks Solutions Inc79.820%
High QualityTaiwan Semiconductor86.947%
High QualityUnitedHealth Group Inc95.220%
High QualityVeeva Systems Inc71.453%
High QualityVertex Pharmaceuticals Inc99.811%

To get a feel for whether High Quality companies are a better investment than Low Quality companies, we can scan the list above and see that, by and large, the 3-year Average Return for High Quality Companies is much better than Low Quality Companies. But I thought we should be a bit more rigorous and look at a linear regression of each quality designation to see the magnitude of the difference.

This scatter plot makes it easy to see that the Blue Dots representing the High Quality companies are well above (i.e., higher three year average return) the Red Dots representing Low Quality companies. Again, let me restate this: Low Quality does not mean they are bad, it just mean that in the three most recent years the ratios that define them as Low Quality were not as high as other companies in their industry or in the S&P 1500.

Why Is This Important Now?

At some point, we will have a market correction that exceeds a simple 10% 0r 20% move down in price. With the Federal Reserve now beginning to talk about tightening money supply due to above target inflation, that could be a catalyst for such a correction (or even a bear market). As such, we want to have the best companies in client portfolios that can withstand a major draw down when the inevitable happens down the road.

The Investment Strategy

In the normal course of portfolio management during this period in time where we have been warned that monetary tightening is in the plans, we want to book the gains on the companies that show the least ability to withstand a bear market and focus on the companies that have the best ability to withstand a bear market. We do not want to see the gains we have made be lost by not monetizing them when the market tells us it is time.

What’s Next?

Our next discussion will be on our Earnings Growth Rank – the original analytical system whose nexus started with my Masters Thesis that set out to disprove the Efficient Market Hypothesis (yes, that is how long ago it was – it has graduated to a Theory and is no longer a Hypothesis). The synopsis of the thesis was that in spite of the strong support for the Hypothesis, there really are certain financial ratios in the public realm that when viewed as a whole can provide index beating returns over the long run. And given our track record of beating the index over the long run, the Earnings Growth Rank is a very important part of our investment process.

–Mark

Is Inflation Transitory?

Thursday, June 3rd, 2021

What are the odds that the Fed is correct?

Below is a graph that I saw on an investment site I watch. It struck me that the current level of bond yields for the current level of inflation are so outside the norm and divergent from the mean that either the Federal Reserve is correct and the inflation we are seeing now is a temporary blip up OR we have investors betting on a big return based upon a low probability bet that could end very badly.

If you play the casino game craps, you know that it is all probability-based. You are betting that a number is or is not rolled before the number seven is rolled (seven being the number with the most combinations of the numbers on the dice – one and six, two and five, three and four, four and three, five and two, six and one – making it the highest probability of being rolled. The high probability bets are on the six and the eight since they have the second highest number of combinations. one less than seven. The odds are higher that you will win with a six and an eight, so your winnings are less when they hit. The big money is made betting on two, three, eleven and twelve as the combinations are limited so the odds that they are rolled before a seven are much smaller.

When I look at the chart above, the current plot point shown in red and labeled as such is so far from the mean (as represented by the red line) that its like betting on two or twelve, which are known as the sucker’s bets since the house’s odds of winning are so high that these are the numbers the house encourages you to bet on.

There is an economic concept called Yield Curve Control. Yield Curve Control is a process by which the Federal Reserve buys so many bonds with longer maturities that it keeps yields from rising – it’s simply our old friend supply and demand coming into play. The Fed provides more demand than the required supply so the treasury has no need to issue bonds at higher yields to fund the government. Since the 2008-2009 financial crisis, the Fed has been buying bonds as a way to increase the money supply and thereby stimulate the economy (we’ve written about this Quantitative Easing process on the blog in the past).

So what happens if the artificial demand from the Fed slows down? We can look back to 2013 because the Fed tried to do exactly that thing and it caused them a problem that has become known at the Taper Tantrum in the bond markets. The ten year treasury bond yield roughly double over a three month period in Spring 2013 when the Fed began to slow its purchases of bonds – ie., the demand dropped below the supply required to fund the government so the yield had to rise to entice people to buy the bonds. Before any major damage was done to the economy from the abrupt rise in yields, they resumed buying bonds at the previous level.

In recent statements from the Federal Reserve, certain members of its board have come out with statements saying that the Fed would need to start tapering in the future to ease up on the monetary stimulus that is helping to fuel the rise in inflation. This week, the Fed announced that they would begin to sell off the corporate bonds they purchased last year during the covid recession. Tapering seems to be real, even if it is beginning slowly with the sale of the small number of corporate bonds they own.

Going back to our craps analogy, in the world of economics and bond yields, it appears that the Federal Reserve is the house and they are encouraging you to buy bonds at low yields by saying that inflation is transitory. The big question is whether the bet to buy a ten-year treasury is betting on the six or betting on the twelve, and whether rolling a seven with inflation being higher for longer hits sooner rather than later.

—Mark

Investing During Inflation (Last In Series)

Friday, May 21st, 2021

Where We Are

This has been a rather exhaustive series on which asset types have a historically positive or negative correlation with inflationary periods in our economy.

Here Is What We Learned

  • Broad market investments: over the periods of time examined, the S&P 500 (Large Cap Stocks) and S&P 600 (Small Cap Stocks) were negatively correlated with inflation. This does not bode well for the people who have bought into the theory that investing in an index fund like the S&P 500 is a safe and good choice at all times
  • Value Stocks: over the periods of time examined, the Dow Jones Industrial Average was negatively correlated with inflation
  • Growth Stocks: over the periods of time examined, the NASDAQ was positively correlated with inflation – but we did note that the NASDAQ Index of the 70’s and 80’s is a materially different index than the one we have today, so this positive correlation should be viewed cautiously
  • Gold, Oil & Agricultural Commodities: we saw a positive historic correlation between inflation and these commodities – we did note that the rising price of oil due to supply/demand imbalances is a leading cause of inflation that drives prices higher across the board
  • Fixed Income and Fixed Income Alternatives: as expected, fixed income and its alternatives showed decisively negative correlation with inflation – however, we examined both Treasury Inflation Protected Securities and Floating Rate Loan ETF’s which showed positive correlation but cautioned that the data on the latter is too new and limited to really draw solid conclusions
  • Consumer Staples: given the pricing power that consumer staples companies have used to pass along their increased costs of production to consumers, we were surprised to find that there is a negative historic correlation between their returns and inflation – we noted that could be any number of mitigating factors that keep them from passing along all or even a material amount of their own cost increases, which might be the cause of the negative correlation
  • Financials: again we were surprised to find a negative correlation between the returns on bank stocks and inflation since inflation generally results in rising interest rates which have a positive impact on bank margins and net income – we noted that this may be a case where early in the rising inflation cycle, the rising rates would have a positive impact but that later in the cycle when rates are elevated credit quality issues might come into play and negatively impact net income
  • Health Care: a common perception is that Health Care companies can raise their prices to offset increased costs of production, making them a good investment during times of inflation, and that is exactly what we found with positive correlations between drug, supply and device company returns and inflation
  • Industrials: we found a mixed bag when we examined industrial companies, with some having positive correlations and some having negative correlations – our assumption is that there are industries in the Industrial Sector that have pricing power and others that don’t, and since many of the largest industrials are conglomerates that operate in multiple industries, their correlations are really dependent upon the mix of industries in which they operate
  • Consumer Discretionary: again we found a mixed bag with some companies showing a negative correlation and some a positive correlation – our assumption again that certain companies have competitive advantages that give them pricing power whereas others do not

Implications

In the April 30th post titled Prices On The Rise ( http://investmentblog.bankchampaign.com/2021/04/30/prices-on-the-rise/(opens in a new tab) ) I showed you a number of instances where corporations made statements about having to raise prices due to their costs of production increasing. Since then, we had reports of steeply increased consumer and producer inflation with the CPI and PPI reports last week. Also, at the most recent Berkshire Hathaway annual meeting, Warren Buffet noted that his companies were raising prices due to their own costs going up.

Inflation appears to be here and hitting all aspects of the economy, At the present time, the Federal Reserve is stating that the inflation is transitory and will be gone in a few months so they have no intention of tightening monetary policy. We also know that the government is planning on historic levels of fiscal policy spending. The combination of announced easy monetary and fiscal policy to me means inflation will likely not be transitory, but will lead to a permanently higher level of prices.

Before we plateau at that higher level, we will see inflation driving up those prices to that plateau and we need to have investment portfolios structured so that they perform as best as possible.

A winning investment strategy for stock portfolios would appear to be focusing on: (1) blue chips in the health care, energy, agriculture and materials sectors; (2) selectively on companies with pricing power in the industrials, discretionary and financial sector; (3) gold miners; (4) real estate (but not the fixed income alternative REITs); and (5) growth stocks with secular earnings growth fundamentals and perceived dominance for the future.

A defensive strategy for fixed income portfolios would appear to be: (1) a laddered portfolio of bonds and certificates of deposit that will have frequent and sequential maturities that allow for reinvestment at rising rates during an inflationary period; (2) an allocation to Treasury Inflation Protected Securities through a mutual fund or ETF; (3) short duration high quality fixed income mutual funds; and (4) an allocation to variable rate corporate fixed income ETF’s as long as credit quality is maintained.

What’s Next

I mentioned above the concept of prices rising until we plateau at a higher level. I hope to work on a blog post about that in the near future.

—Mark