State of the Market Webinar – March 2023

Daniel Dusina: Thanks for joining everybody. Happy to bring you another part of our monthly webinar series here from Blue Chip Partners today. I'm Daniel Dusina, Director of Investments at Blue Chip, joined by Dan Seder, Managing Partner, and Matt Mondoux, Senior Financial Advisor here at the firm. We're taking a bit of a different approach for this month's session, relative to what we've done in past months.

Quite simply, we're just going to put forth some observations that we've found interesting over the last month. They don't necessarily have to be tied in some cohesive theme as we've done in the past, but instead we just wanted to point out some pertinent items that we think you all will enjoy. So as always, please do feel free to send in questions along the way using the question functionality in the GoTo Webinar app, or however you're viewing this webinar.

If you want to stay up to date on all of our current happenings and information flow, please do be a frequent visitor of our blog. Follow us on LinkedIn to receive directly our content. We hope that you'll continue to engage via the question function and consume our content along the way.

I'm going to kick things off here, and my observation from the last month or so is something that we've hit on in past webinars and past collateral that we've sent out to clients and other relations with the firm. It's regarding investor sentiment.

The American Association for Individual Investors every week collects data on investor sentiment, and the investors can either respond that they're bullish/optimistic, bearish/pessimistic, or neutral. What we've found is that when investor sentiment is incredibly negative, the forward returns tend to be a little bit better than when the investor sentiment is overly positive.

We've hit on this exact topic in the past and explained that in the past. What I thought was interesting is that since we've had persistent pessimism, I think now is a good time to dive a little bit deeper into the weeds and figure out how quantitatively are returns on a forward basis better when investor sentiment is increasingly negative.

What we're looking at here on the screen, you can see the chart has the full series of AAII Investor Sentiment Survey data going back to the 1980s, and certainly it moves and trends as you would expect. It generally follows the market. However, quantifying the data, what we see is that when respondents are overly negative, so below that beige middle line, that's the average.

Returns are quite frankly better than when investors are incredibly optimistic. So that first green line, that's one standard deviation below the average. That second green line, which is incredibly rare, is two standard deviations below the long-term average. And this is the bull-bear spread, so the difference between respondents that are optimistic and respondents that are pessimistic. As you can see in the box or the table on the right-hand side of the screen that kind of aligns with those various sections of the chart, the bottom half of that table is showing you the forward returns for the S&P 500. When the bull-bear spread is very negative, so pessimism greatly outnumbers optimism.

Furthermore, the percentage of times positive is generally greater when investor sentiment is increasingly negative for forward returns. I think this is really interesting because right now market participants have been more bearish over the last year than ever before.

So, this chart in blue, what you're seeing is the AAII Sentiment Survey data looking at the last 12 months instead of just one snippet in time, one piece in time. You can see that over the last 12 months, the average bearishness is 98%. We've never seen this level before, even at peak bearishness in past cycles. It's never reached this threshold.

What's very interesting about this, it lines up well with the previous slide, is that the forward returns from those kind of peak bearish points in a cycle, the forward returns are overly positive. So, you see that 71% peak bearishness around 1991. The forward returns for the S&P 500 were 23% as indicated by that green bubble.

When we talk about timing the market, that's not what we're in the business of doing. But I think it's important to note that a lot of the time, as evidenced by historical data, right when the night feels darkest, the horizon is among us. I think it's worth considering. I think quantifying this data instead of just speaking about it conceptually is incredibly powerful.

While we don't recommend trying to time the market or wait for periods as an entry point, I think it is worth noting, especially with all the negative sentiment we see and the headlines that have come out over the last month, after a stark January rally turning towards Fed concerns and economic concerns, it's worthwhile to keep in mind that it's not all doom and gloom, especially as it pertains to historical data.

So that's my interesting observation. Dan, I'm curious to hear if you have any interesting observations from the last month or so.

Dan Seder: I do, I do. Originally, I was going to talk about the Federal Reserve. There's been a lot of questions about Fed policy and the hikes and when the hikes are going to end, but Warren Buffett came out with his annual letter about a week ago, and so I thought I would touch on some highlights from Uncle Warren's letter.

One of the most popular letters out there, by the way, so it catches a ton of press. I'll quote Warren first: “Our satisfactory results have been the product of about a dozen truly good decisions. That would be about one good decision every five years.” What I thought was really interesting is his poster child analogy.

He walks through his story of Coca-Cola, which you see on the chart here on the screen. In white, you have a representation of price going back 30 years. And the green line, which looks like a stairstep, is the annual dividend that Coca-Cola pays.

Warren Buffet explains, Berkshire finished their purchases of about 400 million shares of Coca-Cola in August of 1994, and the investment that he made at that point was about $1.3 billion. At that time, that wasn't insignificant for Berkshire. It was a big investment. So, the dividend, the cash dividend that Koch yielded to Berkshire in 1994 was $74 million, so a lot of cash flow. If you follow this green line, what you can see is that the dividend has increased. If we fast forward to today, which is I guess the most recent calendar year of 2022, Coca-Cola was yielding in a cash dividend, $704 million to Berkshire.

So, in 1994, it went from 74 to 704 million in 2022. I think it's interesting that just the dividend alone represents over half of what Warren's initial investment was in the Coca-Cola stock. That investment of 1.3 billion grew to just shy of $14 billion today. Today it represents about 5% of Berkshire's holdings.

Now, I want to quote Warren again. He said, “assume for a moment, I had made a similarly sized investment mistake,” and I thought that was interesting. He called out an investment mistake being a 30-year high grade bond, that that investment would've flatlined and been worth 1.3 billion today, and it would only have yielded roughly $80 million in revenue in 2022.

It was a really interesting analogy that Uncle Warren made about Coca-Cola being a great investment, a 30-year high quality bond being a bad investment. We thought, okay, let's peel the onion back. Let's look at how great his investment in Coca-Cola actually was.

What you have on the screen here now is representation of not only Coca-Cola and Coke's total return over the last 30 years, which you can see in orange, went from 1,000,000,003 to roughly 14 billion and a return of about a thousand percent. We looked at a variety of other companies. You have Walmart total return over that period of roughly 1700%. We have Procter and Gamble, a total return of roughly 1900%.

And finally, Coke's competitor, which is Pepsi, a total return of over 2200%, and the total value today of being of roughly $31 billion. I find that really interesting. These are other companies in consumer staples that are high quality, dividend paying, dividend growing companies. Coca-Cola was actually at the bottom of the barrel, yet Warren Buffet highlights that as one of his best investments still in Berkshire.

I'm going to quote Warren one more time. He says, “the lesson for investors: the weeds wither away insignificance as the flowers bloom. Over time, it takes just a few winters to work wonders.” Even though Warren didn't pick the winner, he didn't pick Pepsi in this analogy, he still did really, really well.

I think that shows that participation matters. Our clients are invested in high quality dividend paying, dividend growing companies, and we do a lot of the same analysis that Warren might do on his companies. At the end of the day, if you buy those high-quality businesses they're going do great over time and they're going to produce an outstanding outcome.

So that was my interesting tidbit for the month. With that, I'll pass it over to Matt. Matt, what'd you find interesting?

Matt Mondoux: Thanks, Dan, great stuff there. So, for me, I think the most common question we get is, what do you think of the markets? Coming off of 2022 it's a pretty loaded question.

The markets meant very different things to different investors last year. Just even in the US large-cap sphere, the Dow was down just shy of 9%. The S&P 500 was down just shy at 20%, and the NASDAQ was actually down over 33% last year. Three fundamentally similar, but different markets had a wide range of investment outcomes for somebody.

We'd like to break that question down a little bit more and not just say, what do you think of the markets, particularly, what do you think of certain markets? They don't all row at the same pace or in the same direction every year. We often rely on inner market analysis to help us identify broader trends within different types of markets.

The whole idea of the concept of this chart that I'm going to discuss is putting two different investments in the ring together, one-on-one, and we see which one's going to outperform. When the numerator outperforms the denominator, this line will go up. When the denominator outperforms, this line will go down.

You can use this for broad investments, such as, in this case, growth versus value stocks. You can use it for commodities. It could be oil versus gold. It could be stocks versus gold, or it could be something even as granular as Coke versus Pepsi. We want to identify if there's a trend, which investment is trending versus the other.

What you'll see here is this is a pretty long-term chart of growth versus value of stocks in the United States. The most dominant investment theme, I would argue going back to just prior to the financial crisis, has been gross out relative outperformance to value. What you can see here is two main peaks on this chart.

The first peak here was in 2000 during the tech bubble. That was the last time that growth stocks had outperformed to the magnitude that they had in 2000, 2001. What we see here is the potential for a pretty clear reversal in that trend of growth versus value. As this chart, this trend that had been going up and to the right starts to go down and to the right, that is signs to us that that value may be changing the paradigm here in overall markets, and giving investors a different return profile than what they've been accustomed to the prior 10 years. Daniel, if you'll flip to my next slide here.

Reasons for that, this chart is pretty simple. We just took the two price-to-earnings ratios of growth versus value. We took the value P/E ratio, the forward P/E ratio, and subtracted the growth forward P/E ratio. The historical average of those two had been growth having about a five-point premium on price-to-earnings ratios relative to value.

At the end of ‘21, so heading into ‘22, that premium was close to 20. You can see that in the bottom right of this chart. Still today, growth is trading at a pretty substantial premium relative to its historical norm to value. That's something that we would expect to normalize over time. I think there's a lot of evidence here that value can do pretty well, relative to growth. Like I said, this is a big mindset shift from a market leadership standpoint over the intermediate to longer term.

Another market that's interesting, same type of analysis, has been US stocks relative to international stocks. There's been three primary trends over the past 30 years. In the late nineties, you can see here the US stocks did really, really well and outperformed international. The 2000s were really characterized by internationals outperformance, relative to US. Again, since the financial crisis, it's been all US, all the way.

Investors have been incentivized to have very little to no international holdings relative to their US portfolio, as US has just been the dominant player. Now in this chart, we don't see quite the turn yet that we saw with value stocks outperforming growth. But, if Daniel flips to my next chart, again the premium has far exceeded historical norms.

So again, US stocks are trading at a pretty substantial premium to where they had traded back, the prior 10 or 15 years. This does give some evidence. We think international stocks can do better than they have in the past. The chart or the intermarket analysis would say that's a little early. We haven't seen the trend break. But from a valuation standpoint, we think that there's a lot of potential for international to finally do pretty well and keep up with US stocks.

In a nutshell, these are pretty big themes. These themes tend to play out over years, not months. They think that there's something that we'll be talking about more on a secular basis going forward as the potential for higher rates, meaning lower growth stock premiums, plays out over coming years in the markets. So, with that, I'll wrap up. I'll turn over to Daniel.

Daniel, we could go through any questions or perhaps if you have any questions for us now would be a great time.

Daniel Dusina: Yeah, I thought that was great, Dan and Matt. We did get one question that came in and I would encourage anybody on the line, if you do have a question, please fire it in using the question functionality.

But the question that came in was: Given the negative results for stocks and bonds in 2022, do you think we are near realistic valuations in either or both? I'm happy to take a shot at this one, Matt, Dan, chime in if you have any observations and response as well. What I would say is it's a bit of a mixed bag.

Coming into this year, I'll remind everybody that we came out and said that we think that earnings expectations for 2023 across the US equity market, generally speaking, are too high and they have to come down. We've seen that happen along the way through the first two months of this year. There probably is more pain to come on earnings estimates. With that being said, we are in the belief that if we do get clarity on some major forces, major headwinds that had dragged stocks and bonds lower through 2022, we think there's actually room for valuation expansion, which would indicate that you're getting a fair value in equities today.

The problem with that is that we haven't really gotten any more clarity on those two major headwinds. One being inflation, the other being the Federal Reserve's response to inflation. We didn't get as much clarity on that thus far this year as we initially thought we would. So realistically for us to say we can get valuation expansion and investors are going to be willing to pay more for a share of a company's earnings going down the road, we really do need to get some clarity on those two major factors.

Although I would say there is still a bit of muddy water to come. The valuations that we've seen, I guess the valuation compression that we've seen, it would imply that you're getting an average multiple today on the equity side.

With regards to bonds, it's a bit of a different story because you actually are getting paid and I would say reasonable valuations now, to equate it to the equity conversation as well. We're pretty optimistic overall, if you look out over the next couple of years for bonds. Quite frankly, we haven't been able to collect such a nice coupon in really high-quality securities that are paying income on a monthly basis in any time in the last 15 years.

Kind of in line with that, bonds have gotten a lot more attractive relative to equities over the last year given fallen earnings and given rising interest rates. To say that we're near realistic valuations, I think that I could say yes. Whether or not we get continued compression on equity multiples really does relate back to whether or not we get clarity on the trajectory of interest rates from the Federal Reserve and their ability to continue to manage inflation, which we do tend to be a little bit more optimistic on at this point.

Matt, Dan, do you have any response to the question? Anything further to add?

Dan Seder: I do. I would just call the culprit or maybe talk about a different culprit, which is the recession. I think it's the same thing with regards to the Federal Reserve and monetary policy. It's kind of one and the same, but if you're in the recessionary camp, I think that we have to see lower prices in stocks.

So, there's an argument for lower stock prices, at least in the short term, if a recession is in fact ahead of us. And that's a big debate. There are some people now that are saying there's going to be no landing. But that seems to be more and more unlikely as time goes on.

What I think is interesting on the bond side, when you think about what happened to bonds since March of ‘22, when the Feds started hiking rates, they hiked extraordinarily quickly and bonds got crushed. It was a historically bad year for bonds. We're close to the pause phase.

The upper bound of the federal funds rate, I think is priced to be somewhere around 550 at some point. If the Fed pauses eventually in order to give the hike cycle a break, it's going to take some time for the economy and the economic data to roll in; but the economy's going to slow and if eventually they start cutting rates.

I want to point out for bonds, in a pause phase and a cut phase, bonds do really, really well. I'm not sure if you would call it valuations for bonds being attractive, but I think the point in time that we are in the Fed cycle, which is nearing a pause and a potential cut in rates down the road, bonds do really, really well. So, I would say that there's further to go for stocks and I think bonds have a great opportunity.

Daniel Dusina: Yeah. A couple other questions flowing in. So first that we'll cover here is related to municipal bonds. Either of you guys want to talk a little bit about a view on the municipal side of the bond market? Specifically, are we peaking there? Are we going to see even better coupon rates? Any thoughts? I'm happy to chime in as well if you guys want.

Matt Mondoux: I'll go ahead. Generally speaking, as new bonds get issued, you're certainly going to see better coupon rates on new issues just as the rate environment has gone up. From a valuation standpoint I don't know if they're going to be any more at attractively valued, kind of relative to a benchmark tenure treasury yield, but I would certainly expect coupon rates to go up. I don't know if they’re really going to get cheap, relative to treasuries though.

Daniel Dusina: Yeah, I mean this was in line with our Blue Chip debt conversation that we had last time. We hosted a live webinar and the last time I put out a quarterly outlook, you're getting a tax equivalent yield in the muni space today that you haven't been able to obtain at any point in the last 15 years.

The value proposition there is compelling from that perspective. It's also compelling from the perspective of, in tumultuous times, economically speaking, munis hold up among the best in the fixed income market. That in and of itself, I think is incredibly attractive. As Matt mentioned, certainly because of the fact that we have higher rates now than we did when some of the bonds were issued, we're certainly going to be able to, I guess if an investor wanted to take advantage of individual bonds, some of those that will be issued in the near future might be at higher rates.

Next question: Do you feel ESG-based investing will have an impact on the markets? If so, what?

This is a loaded question. I'll give my thoughts on this, but when I think about ESG investing I think there is a value additive way to do it, and there is a way that is ultimately, in my belief, detrimental to returns. The way that's detrimental to returns is what most people commonly think of when they think of ESG. They think of, here's a broad market, let me throw away all of these firms that don't check a certain box, and there's my market. Any level of historical data will show you that this exclusionary approach to ESG is not beneficial for the individual investor that's applying that approach.

However, I'm not gonna say that's going to have an overly large impact on the markets. I'll get to that in a minute. The more valuable approach, if there is someone that wanted to apply some sort of ESG framework, whether that is climate sensitive, pollution sensitive, faith-based, whatever it may be, there are a lot of ways that you can gauge a company's productivity and weight those companies hire, instead of just excluding companies that are not aligned because they are involved in oil and gas. ESG, realistically, you should be giving a very significant weight to companies like Exxon, Chevron, and BP because they have taken on such an active role in this green transition.

So that relative improvement, they're doing more now than they were ever before to do good or align with environmental values. In line with that, I don't think this has been as well publicized as the buzzy ESG, but impact investing is along the same lines as ESG, but it's more about companies that do good instead of looking good.

For example, Dan talked about Coca-Cola earlier. They're a good example on the impact side because what they have done in terms of recycling, that's an impact on worldwide, global environmental concerns, that very few companies have been able to match. So, long story short, I do think that the common perception of ESG is a little bit flawed, and I think you will start to see a little bit more pushback outside of some of the public plans that by mandate have to exclude certain items. But it's a bit of a loaded question, and I think the representation of ESG is a bit flawed as it pertains to the media today.  

Matt Mondoux: Daniel, I'll just jump in. You know one of my classic ESG examples: HSBC is in an ESG fund, an international ESG fund. And HSBC was literally laundering money for the cartel. I think of something that's very anti-ESG that should really prohibit your inclusion to a certain style of investing and that didn't do the case. I think there's a lot to unpack over what ESG really is and what these scores really mean, before it's some viable tried and true investment approach.

Daniel Dusina: Yeah, without a doubt. One last question: Do you think that the premium of growth versus value stocks over the last 10 years is a result of the very low interest rates and easing from 2010 to 2021? And if the Fed keeps going higher for longer, do you think this bodes well for value versus growth? Matt, do you want to chime in on that one?

Matt Mondoux: Yeah, I think that is part of what occurred. There was a large period back in the 2010s where that premium didn't really expand like that. I think the premium expansion was really a symptom of a lot of what happened with COVID. There's just a lot of trading, a lot of money kind of being pushed into the system, and I think momentum just really took over in those growth stocks at the expense of traditional value names and to the detriment, frankly, of the overall market.

I think it was just a tidal wave that occurred and looks like we had a blow off top and some of those valuations are coming online. It was a lot of things. Certainly, low interest rates were part of it, but I wouldn't discount what happened. The COVID response from the fiscal and monetary side as well.

Dan Seder: Nothing to add here. Great response.

Daniel Dusina: I was going to type a response to one of our question-askers here, but we're right on the dot just past 4:30, so I think we're going to wrap it up here. Thank you guys very much for joining as always. If you do have any follow up questions, you can feel free to reach out to any of us or your Blue Chip Partners contact.

Thanks again for joining. We're excited to keep bringing you guys fresh content that we think is timely and exciting and impactful for the broad majority of people. Stay up to date with us on LinkedIn and through our blog. As I mentioned before, we're always pushing out exciting items that we view as top of mind today. So once again, thanks for joining and we will speak to you soon.

Dan Seder: Thanks everyone.

Matt Mondoux: Thank you.