What is the number?
Dear Investors,
The end of September brings about the end of yet another quarter. At one point, the S&P 500 stock index was + 14.3% yet closed - 5.3%. Investors are closely watching the actions of the Federal Reserve and the Fed is closely watching the monthly report for inflation and signs the economy is slowing. Without a doubt, the most watched number is the inflation report, be it the CPI, PPI, or another economic indicator.
While inflation fell in September on a month-over-month basis, investors were hoping for a larger drop considering the large decline in energy prices. While inflation remains high, the Fed will likely continue to raise interest rates. Higher rates contribute to lower business valuations as it raises their costs to borrow and makes their future cash flows worth less. The farther in the future cash flows are, the greater the impact, thus the reason growth companies are more heavily impacted.
I have heard it said, the value of something is determined by the price someone is willing to pay for it. It has some merit. Such would be the case for collectables. Businesses, however, have an intrinsic value, determined by their future cash flows discounted to today at the appropriate rate. In the stock market, there exists a discrepancy between a business’s stock price and its value. Sometimes it is large and other times small. The psychology of the participants (investors) plays a crucial role.
In 1934, Security Analysis was published, authored by Benjamin Graham and David Dodd, it eventually became considered the bible for value investing. Graham, whom was one of Warren Buffett’s professors at Columbia Business School, introduced a fictitious character known as Mr. Market.
In his allegory, each day, your business partner, Mr. Market, offers to buy your share of the business or sell you his. The net worth of the business would not necessarily change day-to-day, yet the price offered would. This is how the stock market works.
Warren Buffett has used another example and I will paraphrase, “Let’s say you bought a farm. You were interested in the long-term productivity of the farm and knew that some years would be good and others bad. In some years corn and soybean prices will be high, in other years, low. Suppose a guy buys the farm next to you, with the same number of acres and soil quality. Every day that farmer offers to buy your farm or sell his farm to you. He is somewhat manic-depressive and the prices he offers all over the place.”
When you bought the farm, you looked at what it would produce, its potential. You do not really need continuous quotes on the value of the farm. If offered a silly price, high or low, you may sell to him or buy his farm. In stocks, like farms, no one is forcing you to buy or sell.
This is where investors often get twisted up. They feel that because prices are changing back and forth that they must do “something.” There is a lot of money available to so-called experts who claim to be able to tell you where the prices will be going. Over the last 50 years, if you had taken Mr. Buffett’s advice, you would have done well as an investor. You would not have done much buying or selling. Mr. Buffett’s business partner Charlie Munger has said, “The money is not in the buying and selling, it is in the waiting.” This is really a lesson in behavior and managing one’s behavior over time does not change much from decade to decade. The lesson is timeless.
Chances are you have realized the price of most stocks are lower this year than last year. Year-to-date, the S&P 500 stock index is - 25%. Does that mean the value of the businesses in which you own a part of have decreased? Not necessarily. It is possible for the company’s earnings to be increasing while the company’s stock price is falling? Absolutely!
Al Root recently wrote a column in Barron’s investment publication and selected twelve stocks which include O’Reilly Automotive, Dollar Tree and United Health Group. All have P/E (price to earnings) ratios which have declined about 21% (lower P/E ratio is indicative here of a cheaper stock) yet have earnings expected to grow 7% year-over-year. None of the companies lowered their earnings estimates during the past 6 months. Earnings have increased yet their respective prices have remained about the same. Therefore, we suggest value is increasing while the price is decreasing.
These types of disconnects between price and value lead us to believe the market is not efficient and that hard work and thorough analysis can produce favorable results.
Inflation
In August, the consumer price index (CPI) was + 8.3% year-over-year. According to the Bureau of Labor Statistics, “Increases in the shelter, food, and medical care indexes were the largest of many contributors to the broad-based monthly all items increase. These increases were mostly offset by a 10.6% decline in the gasoline index.” In July, CPI was + 8.5% and June was + 9.1%.
Investors were disappointed with this news as they seemed to have hoped the lower energy prices would have a greater effect on a declining inflation number.
What the average U.S. consumer who shops for their own food already knows, is showing up in the economic reports. The cost of eating at home has skyrocketed.
The food-at-home index rose to its largest 12-month increase since 1979. Cereals and baked goods + 15% year-over-year. Milk and dairy products + 14.9%, and fruits and vegetables + 9.3% year-over-year.
The Federal Reserve is continuing to raise interest rates in order to bring down inflation. Based on their latest information, interest rates will rise to about 4.6% in 2023. After the most recent increase, rates are now 3% to 3.25%. It is likely interest rates will rise to roughly 4.4% by the end of this year. In the long run, the Fed forecasts rates to decline back to around 2.5% to 3%.
Some fear the Federal Reserve will go too far, raising rates too far too quickly.
Even more challenging for investors, those investing in bonds have experienced the same type of volatility as stock investors. The Vanguard total market bond index is - 11% year-to-date and Gold, thought to be a safe haven, is - 5% for the year. Investors are finding difficultly looking for a safe place to hide.
Sincerely,
Brady Ritchey
Chief Investment Officer
The rest of the report includes housing news, economic news, business highlights, Warren Buffet’s new favorite stock, impulse buying, market highlights, and notable earnings.
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