Finding Good Quality Investments

Last Month’s Winners and LosersLast month favored the fanciful, with a strong performance in crypto, theme stocks, growth, and momentum. Stodgy stocks were stuck in the mud, with weak performance turned in by value, regional banks, and utilities. Long-term bonds also lagged as rates rose for the month.
 StocksThe market continued to be led by big tech stocks, theme stocks, and other risky assets. It feels a bit frothy in those areas and I am starting to be concerned about a bubble in certain sectors. Keep in mind, however, that the high valuations and strong performance have been limited to a very narrow part of the market.

Looking more broadly at the characteristics of different equity markets, they seem appealing to long-term investors. Earnings yields average around 5-6%, depending on which segment of the market you’re looking at, and earnings growth expectations range from 7% to 13%, depending on the segment. When I look at individual stocks, I am not having a problem finding ones I think are appealing from a value perspective.

I believe a good balance for equity investors is to be wary of the expensive part of the market, but open to finding value in the parts of the market left behind.
 * “Earnings yield” is an investor’s share of earnings for every dollar invested (i.e., earnings per share / price per share). It’s the same as the more famous Price / Earnings (P/E) ratio, but expressed as a yield rather than as a multiple. I use it to compare stocks more clearly with bonds and other asset classes.“Equity Risk Premium” equals the Earnings Yield minus the 10-year Treasury Inflation Protected Securities yield.
 Income InvestingCore inflation has not improved recently. If anything, it’s gotten a little worse. Given that, along with the strength in the economy, the Federal Reserve has little incentive to cut rates anytime soon. My guess would be that rates will not fall until the second half of the year, at the earliest. And that’s only if core inflation numbers come in better than they have recently.

I continue to believe that long-term interest rates are not particularly attractive given persistent inflation. For that reason, I am keeping my eye on short term instruments of less than one year maturity and dividend stocks that have the potential to increase dividends faster than inflation over time.

* Implied inflation expectations are derived from taking the 10-Year Treasury rate and subtracting the 10-Year Treasury Inflation Protected Securities (TIPS) rate. For example, if the yield on 10-year treasuries is 2.8% and the yield on 10-year TIPS is 0.4%, they are roughly equivalent investments if inflation comes in at the difference (2.8% – 0.4% = 2.4%).
 The Long ViewFor the last 20, 30, and 100 years, stocks have averaged around an 8-10% return, driven by dividend yield, reinvestment of earnings, and earnings growth. Long-term bonds have yielded about 5% on average over the last century while inflation has been about 3%.
Throughout this period, there have been major upheavals, such as the Great Depression, World War II, The Korean War, The Vietnam War, dropping the gold standard, 1970s high inflation, 1987’s Black Monday Crash, the Dot.com bust, the 9/11 terror attacks, the Global Financial Crisis, and the Covid Crash, among others.
These events led to severe market downturns about once every decade, with a median price decline of 33% and a median time to recover back to the previous high of 3.5 years. If we were to include dividends, the recovery to previous highs is actually a little faster. *
Meanwhile, a 3% inflation rate results in a 59% decline in the value of a dollar over 30 years. Meaning that people who retire at 60 years old on a fixed income face a high risk of a lower quality of life as they get further into retirement. ** Source: Morningstar Direct via cfainstitute.org, FactSet. Past performance is not necessarily indicative of future performance. Depreciation of the dollar: $1 / (1 + 3%)^30 = $0.41 real value 30 years later.
 Market OutlookNow I’ll put on my “Nostradamus Hat” and make some predictions, for whatever they’re worth:

From the standpoint of where you and your family will be in 30 years, none of this matters. What matters is finding good quality investments that are likely to grow over the decades. For this reason, I largely ignore my own general market forecast and invest whenever I find a business that I am confident in and that trades at an attractive valuation.More By This Author:Opportunities In Stocks And Bonds
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