A punch in the face - it’s largely about speed and magnitude

July 11, 2021 by Martin L. Yokosawa

The first half of 2021 was a pleasant surprise for many considering all the obstacles COVID-19 threw at the general public, corporate management, and investors. Despite the shortages of material and labor, the markets in the second quarter continued to climb, but not without a few dips.

During the second quarter of 2021, the S&P 500 Index gained 8.2%, the NASDAQ Index gained 9.5%, the Russell 2000 Growth Index gained 3.8%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) gained 2.3%.^[1]

In my opinion, the takeaway news of the second quarter was the increased discussion about inflation.

Inflation is the rate at which the general price level of goods and services rise. This, in turn, causes a drop in purchasing power.

Purchasing Power is the key and what I work to stay ahead of as I think about investments since it is the metric by which you and I compete against each other in buying things. Purchasing power is the value of a currency, or your savings, expressed in terms of the number of goods or services that one unit of money can buy. Inflation invisibly robs you as each dollar held buys less and less in the future.

Milton Friedman, an economics professor at The University of Chicago, my alma mater, was given the Nobel Prize for his work. In relation to our discussion, Professor Friedman had two concise quotes.

1. Inflation is caused by too much money chasing after too few goods.

2. Rapid increases in the quantity of money produce inflation. Sharp decreases produce depression.

The relevance of both points is that a sharp decrease in money stock could produce a depression, since the Federal Reserve has a track record of missing the mark in speed and magnitude when addressing key issues. If the Fed gets this wrong, it could be like a punch to the face.

Around mid-June, many pieces of the inflation puzzle were presented as the Federal Reserve commentary following their June meeting revealed a change in posture with a less accommodating tone. The Fed raised its inflation outlook by a full percentage point and penciled in two rate hikes a year earlier than previously indicated.

The following chart directly addresses the issue of Milton Friedman’s idea that inflation is caused by too much money. It clearly indicates the increase in M2 Money Stock which is and has been worrisome to me.

Beginning May 2020, M2 consists of M1 plus (1) small-denomination time deposits (time deposits in amounts of less than $100,000) less IRA and Keogh balances at depository institutions; and (2) balances in retail MMFs less IRA and Keogh balances at MMFs.

The second chart represents the percentage increase of the money supply. What is worrisome in this chart is that the recent magnitude of increase is far greater than the increases of the inflationary 1970’s. During this period the financial system was awash in excess credit, too much money, until the then Fed Chairman, Paul Volker, announced that, instead of directly targeting interest rates, the Fed would target the volume of bank reserves in the system. And it would allow the federal funds rate to go as high as needed to reduce reserves.

When Volcker took over, the Fed funds rate was just under 11 percent. By June 1981, it was over 19 percent. Every scenario is different, but themes are many times very similar. If it took a 72% increase in rates to address the inflation produced by the money supply increases of the 1970’s, today’s increases should be concerning.

What we know:

Fed Chair Jerome Powell yesterday did acknowledge higher inflation in some areas
Fed will not raise rates on inflation fears alone, Powell says
Investors seem to have begun readjusting their thinking and positioning for inflation, even though the timing of probable sustained inflation is not certain.

I believe there is a high probability that sustained inflation is setting in.

As with any market or economic directional change, it is only obvious after the fact and it is impossible to predetermine an outcome since so many interrelated variables are involved. Compounding the issue is human participants with differing degrees of sophistication and investable resources. Don’t let a few negative data points or sensational headlines skew your thinking.

In times of change I like to look at smaller nimble companies which have the ability to pass on inflationary costs and quickly adapt to a changing environment. Very large companies which have fixed long-term contracts and lead times are vulnerable since they contractually have to absorb the higher costs. Since a stock’s price is generally a reflection of its future earnings stream, high growth companies with high PE ratios are particularly vulnerable when interest rates rise since the effect of future earnings discounting is greater. Think of it as the reduction of a company’s future purchasing power, which in turn negatively reflects its stock price.

Also of interest are commodity-related investments since they generally move in the same direction as interest rates.

Fixed income or bond investors should be particularly wary of a speedy and material increase in rates as their investment values will be negatively impacted. As of 7/7/21 the 5-year US Treasury real yield was -1.64%, as quoted by the U.S. Department of the Treasury. Real yield subtracts inflation from how much a bond pays.

The economy is growing and should continue barring any black swan event, but it will undoubtedly be a bumpy ride. The stock market is ripe for a temporary setback, but I believe it will recover and continue its upward trajectory.

When making investment decisions, I attempt to discount the daily state of the market since it contains only a snapshot of market forces which includes the collective buys, sells, positioning and thoughts of all participants in the market at one particular point in time. Due to the high number of inputs which determines the level of a market average, it is difficult to determine if the overall market is truly overvalued or undervalued and why.

I believe I can add value by being able to seek out smaller growth companies, which large institutions and computer models may miss, leaving me room to beat them to the punch.

To our existing clients, I extend my sincere thanks for your business. You have our continued commitment to your success. To prospective clients, I invite you to come and grow with us.

Very truly yours,

Martin L. Yokosawa

Torii^® Asset Management, Inc. Landolt Securities, Inc.

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[1] These returns are priced based and exclusive of dividend reinvestment.