BFA Weekly Newsletter

March was a good month for us on both the stock and income sides and we're off to a strong start for the year.  In fact, the S&P hasn’t started a year as strong as this one since 2019.  Why?  In part it's due to optimism about interest rates, a belief that the Fed's rate-raising routine has ended and at some point soon rates might be cut.  Growth and AI are factors, too.  

Energy, the best sector this year, is up 16 percent and financial stocks are ahead 10 percent.  The energy sector was the only one rising during yesterday's sell-off.  Tech stocks have returned 7.5 percent.  Improving prospects for earnings growth in an expanding economy are enough to excite some cash-heavy investors no matter the outlook for interest rates.  They are buying.  

One can make a compelling case for the demand for oil, which is holding well despite weak economies overseas.  Energy demand will come from industrial companies and utilities that need to produce more electricity to power AI data centers and GDP growth.  Solar and wind projects will (and should) continue, but oil will remain our best option.  Never has a less efficient energy source replaced a more efficient one.   

Prospects for global supplies are a different matter.  They are vulnerable to well-armed groups in the Middle East, especially Iran and its proxies across the region.  Crude prices need to reflect the rising political risks, a fact that I stressed before and after October 7, but they haven't for months while the Middle East boils.  Exxon, which is up 18 percent year to date, is our best bet for energy. 

Financial services stocks are doing well, too, and out of the dog house where they have been for a few years.  The larger banks are leading despite a challenging interest rate environment.  Bank of America is 37 today, up from 27 five months ago.  The S & P Financial SPDR (XLF), which is up 10 percent year to date, holds a lot more than bank stocks and it reached a new high this week.  Berkshire Hathaway is the largest holding, but XLF holds insurance underwriters and brokers, Visa, Mastercard, and American Express. There is more upside for the financials, banks included.

On the income side, investors are nailing down some income before rates fall.  True, yields are not all that exciting, but they are likely to become less so if the Fed cuts rates three times, as they still insist, and even if they don't as many believe.  The market dictates to the Fed, not the other way around, and the futures market shows that many investors are not on board with Powell's plans for cuts. Some say cuts are not needed at all because the economy is doing okay, and rising commodity prices are reflecting a growing concern about inflation.  Inflation is very much a threat and will be if fiscal policy leads to deficits in the trillions (read forever). 

Among economists, the consensus still expects a cut in June.  If true money-market funds will continue to yield more than five percent.  That's okay, but investors happy to earn five percent are taking duration risk, which is why I still recommend nailing down yields on bonds that mature further out.  The two-year Treasury yields 4.7 percent. 

Note: The March employment report just announced showed 303,000 new private sector jobs, far more than the expected 200,000.  Unless reports for April and May show weakness, a rate cut in June will be unlikely.

Last week Fed governor Christopher Waller said he's in no rush to cut rates given the "sticky" inflation data, and his colleague Loretta Mester of the Cleveland Fed said the same on Tuesday.  On Wednesday it was Bostic, the Atlanta Fed's chief, then Jay Powell spoke.  Investors took their comments to mean that rates might be cut in June but probably not after that.  That wasn't music to their ears.  What did the Fed brass mean by sticky?  If they meant that underlying inflation data are even more troubling than the headline number, I agree.  So do consumers who are spending more on three areas -- shelter, food, and energy.  Prices are up across the board.  Never mind core this and core that and data that exclude the prices that matter most.   People know better.  The price of gasoline is most important around election time.  People blame the president for rising gas prices, no matter his party.   

Speaking of spending last week, the Biden administration unveiled its budget for the next fiscal year.  A $7.3 trillion monstrosity that will spend almost 25 percent of GDP and take 20 percent in taxes, almost war-time levels.  Maybe they are assuming that Americans will tune out budgets because the numbers are so staggering.  Probably.  And no one can relate to such large numbers anyway.  Are there a trillion grains of sand on the beach across the street?  Two trillion?  Ten?  Who could even guess?  

One of my favorite sectors has been missing the rally.  That is healthcare.  Except for Merck and the two companies with weight-loss treatments (Lilly and Novo Nordisk), drug stocks have been absent.  The same is true of medical device companies including Becton Dickinson.  For years drug and healthcare stocks were the best growth issues, then they were replaced by tech stocks.  They will have their day again.  

Everyone loves a winner.  Call it piling on, or chasing strength, or call it something else.  Whatever.  A bull market creates enthusiasm as it rolls along until it pushes prices to heights far above realistic and credible expectations for earnings and other metrics.  We are seeing that now with Bitcoin and some commodities, including gold.  People just want to own them, the cost notwithstanding.  We have seen such behavior again and again.  The enthusiasm always ends, usually not well.  When?  Maybe as the pool of cash in money-market funds is drained to free up funds to buy stocks.  No sign of much draining yet.  There are still trillions available.  That fuel will sustain the bull market.

Bottom line:   Allow for volatile days as the market is buffeted primarily by the changing outlook for interest rates or in yesterday's sell-off war in the Middle East.  And expect surprises, both positive and negative.  My base case is for modest earnings growth and declining interest rates with inflation staying down in the 2.5 to 3.0 percent range.  That will be above the Fed's 2 percent target, which it will raise to 2.5 percent or higher and say that's close enough. The Fed's comments this week set the stage for that.  What I have described is a favorable environment for stocks in a bull market.  And that is what we will have.

More later.

Best regards, JB