Date: February 1, 2022

***Q4 Client Report***

And just like that, 2021 is over. A year that began with so much hope and positivity with COVID vaccines and therapeutics ends with more of a whimper than a bang on the health front. However, the exact opposite happened on the financial market front where equities and other “risk on” assets closed at or near all-time highs.

The fourth quarter of 2021 was relatively quiet, or as quiet as anyone could expect with a global pandemic nearing the beginning of its third year. As has been the case since Q1 2020, the virus dominated the headlines. Can you quickly recall who won the World Series? The world became aware of yet another new strain of COVID-19 called Omicron which has thankfully been on the mild side compared to the other strains. As I wrote about repeatedly during Q4, the markets were looking well past COVID, regardless of what the media’s headline of the day said and didn’t even flinch. By the way, it was the Atlanta Braves who won the World Series.

A commonly asked question, regardless of the big topic du jour, has been what I mean when I say the markets are looking past something, or how can markets not worry about what’s clear and present today. Remember when the stock market plunged 33% in 5 weeks in Q1 2020? The worst of the news hadn’t even started. The novel coronavirus had supposedly just reached our shores. Yet, the stock market fell 10 out of 13 days in March.

In Q2 2020 the “risk on” markets soared, followed by more strength in Q3 as Covid cases surged and quickly spread throughout the country with hospitals bursting at the seams and the death toll skyrocketing. Q2 economic data and earnings reports crashed at a pace never before seen. It wasn’t just dark; it was pitch black. It didn’t make sense to many people and more than a few hunkered down, both personally and financially. However, the markets already knew in March 2020 that the next quarter or so would see awful health, economic and earnings news. That wasn’t a secret. Uncertainty, always the markets’ biggest enemy, was leaving. It was certainly going to be bad, but the mortality rate would be better than expected. The markets were pricing in an unprecedented and unfathomable response from the White House, Congress and Federal Reserve. And they got it.

So, when I write about markets looking past something or already pricing something in, it’s about things already known and the varying degrees of uncertainty diminishing. With Omicron, the markets already knew we had vaccines and the majority of Americans were getting them. The markets already knew there would be no more lockdowns. The markets already knew that therapeutics were available. The markets knew that PPE was widely available and that hospitals were better prepared. And finally, markets knew that Omicron wasn’t going to be a highly deadly strain like the Spanish Flu or Black Plague.

As I often write, financial markets discount future events 3-9 months ahead of time. In other words, today’s stock prices reflect what the market sees in the future and not the here and now. That is one of the most important things to accept in investing. Far too many people react to the latest headline and then scratch their head when the markets do not cooperate. And please remember one of my favorite sayings. It’s not what the actual news is, but rather, how markets react.

Getting back to the events of Q4, there were two notable political events. In early November, we had two very atypically high-profile gubernatorial races in Virginia and New Jersey. The few important elections the November following a big election is often seen as a harbinger of things to come when the incumbent party nationally does not do well as was the case in Q4. The media’s focus becomes acute and way too much is extrapolated.

The other political event was the seeming end of President Biden’s Build Back Better (BBB) non-traditional infrastructure plan after his traditional infrastructure bill received bipartisan support and easily passed in November. From an initial cost for BBB of well over $3 trillion, the Democrats could not get 100% of their caucus on board, even when the price tag was lowered to somewhere between $1.5 and $2 trillion. While Republicans took victory laps for this, let’s not forget that President Biden got two major initiatives passed in less than a year with the addition of The American Rescue Plan in Q1.

Regarding the relevance of the political events of Q4, I rate them very low as to their impact on the financial markets. The $1 trillion bipartisan, traditional infrastructure package was being bandied about all year and markets already priced it in by the time it passed. BBB was always a challenge and the markets never thought it would become reality in the first place.

Naturally segueing to the economy, I thought we would see much stronger growth in Q4 than it likely was. Of course, Omicron impacted it, but not enough to make up for my shortfall. Q3 earnings, released in October came in better than expected. Wages grew strongly, continuing a trend that began in mid-2020. Ideally, we want to see Goldilocks, not too hot and not too cold. However, wages were definitely red hot as 2021 ended and that helped lead to white hot inflation in Q4.

Inflation has been an ongoing theme since the summer of 2020 leading to its year-ending print of levels not seen since 1981. That’s certainly saying something and some of you may recall the W.I.N buttons from the early 80s. Whip Inflation Now. Legendary Fed Chair, Paul Volcker intentionally put the U.S. into two recessions during Ronald Reagan’s first term to tame inflation. I can’t even imagine the whining and crying, let alone the complete lack of political will, that would go on today if the Fed had a courageous leader and resolute FOMC.

Everyone has a reason why inflation is essentially out of control. To me, it is a confluence of factors. First, you have the Fed’s insanely easy money policy, or as some like to politely say, their accommodative stance. This isn’t new but should have been tamed starting in the summer of 2020 on a gentle glidepath instead of what looks to be a firm landing. Second, the government flooded America with more money than it has ever had. From stimulus checks to expanding the child tax credit to extended and increased unemployment to massive municipal aid and COVID relief to juiced financial markets, most people have money. It is so much money that excess savings in the U.S. now exceeds $2.5 trillion, a record by the widest of wide margins.

Couple that with soaring commodity prices, surging rents and housing costs and the worst supply chain crisis in history and it’s no wonder that inflation is at 40-year highs. However, and this is a big one, with inflation running rampant, why did the stock market make new all-time high after new all-time high throughout 2021? And how did the bond market only show low single digit losses?

If you want a silver lining from all this, inflation tends to run in 40-year super cycles and 2021 is 40 years from the last major peak. As such, the cycle is supposed to top out sooner than later. Finally, and fascinatingly, the U.S. dollar also rallied, going to show you how challenged economies in Europe and Japan have been because soaring inflation should not lead to a strong greenback unless the Fed was proactively well ahead of the curve

Going back to the Federal Reserve, their long-await plan to taper the purchase or mortgage-backed securities and treasury bonds was finally announced, albeit at least a year late in my humble opinion. Chair Jay Powell and friends are speeding up that taper as they finally realized that inflation was more than just a passing fancy. By the end of Q1, the Fed will be out of the ballooning balance sheet business with roughly $9 trillion worth of securities to handle. They have already started floating trial balloons that outright asset sales may be in the cards either before or concurrently with interest rates hikes in 2022.

Here’s the bottom line and something I get asked a lot. If the Fed’s actions since April 2020 have been a primary driver of the stock market and other “risk on” gains then why am I so critical and why do I think the Fed should have taken away the party punchbowl before all the guests were drunk. Isn’t it in my clients’ best interests for the Fed to never raise rates and never taper?

On the surface, those people are correct. The Fed’s action, not just since April 2020, but almost all accommodative cycles benefit most “risk on” assets which is what we manage. I never understood people who rooted for recession and bear markets. After all, it is so much easier to make money in bull markets when the rising tide usually lifts most ships.

Here’s the rub. If the Fed just kept the pedal to medal and never let up, the stock market would go to 100,000, 1,000,000 and much higher. At the same time, the world would lose confidence in our currency which is about the worst possible outcome for any nation. For the U.S. it would be catastrophic as the world does business in dollars. We are the world’s reserve currency, something we often take for granted. The world trusts our markets and our currency more than any other market and currency on earth. And the Federal Reserve is the most important bank on earth. Although not in their mandate of maximum employment and stable prices, they and the Treasury are certainly responsible for doing what they believe is in the best interest of the U.S. economy and markets, including confidence in the currency.

While I would love for the “risk on” markets to maintain their upward trajectories, that would be short-term and short-sighted thinking. Jay Powell and the Fed had the perfect window of opportunity to gradually taper 18 months ago, pause and then begin a rate hike cycle. However, they stuck with their accommodative stance way too long and now are forced to play catch up. And that can sometimes hurt as we saw in Q4 2018 with a 20% decline in the stock market.

Q4 was generally kind to the financial markets with stocks bottoming, pretty much on schedule as the quarter began. The first half of Q4 saw strong gains with two modest pullbacks in late November and again in mid-December. Both bouts of weakness did some damage to the over bullish case, but that impact won’t be felt until 2022. Almost on cue as the media and pundits declared that the traditional year-end would not appear, stocks found a low and closed stronger than I expected and extremely well for the full year. Commodities saw a full-fledged 10%+ correction in Q4 with more downside to come in 2022 while bond yields had higher volatility and big swings without much movement overall.

In Q4 we started transitioning back to in person meetings for those who preferred only to have Omicron cause yet another about face. In the end, it does not matter to me how we meet as long as we do, in fact, meet for retirement projection updates, portfolio reviews and social security analysis’. Please continue to know that I am always interested in meeting, whether it is to create or update retirement projections on your financial situation, review the strategies in your portfolio, run social security analysis’ on when and how to file for the best benefit, discuss your estate or even smaller transactional-type issues like securing a mortgage or weighing insurance.

I want to thank everyone who completed the client survey emailed last month. We conduct these every few years to make sure we continue to meet your needs and expectations as well as give you a forum to offer constructive criticism whether by name or anonymously.

At this point in the report, I usually write about my barbell strategy to investing. If you picture a barbell from the gym, there is a long, thin bar with big weights on both ends. Think of those weights as our conservative strategies and aggressive ones, the exact proportions do not matter yet. In theory, your money would have higher weights to conservative and aggressive strategies, especially if you are in or very close to retirement, and lower allocations to the middle of the road strategies. This barbell approach has also worked very well with monies being transferred in from 401K and 403b plans as those pre-packaged plans rely heavily on bonds for the more conservative approach and do not account for interest rates rising. Additionally, their aggressive choices do not usually reward the risk taken. If you would like to learn more about the barbell approach, we can set up a meeting, call, Skype or Zoom.

The stock market finally achieved our last target of 36,000. Interestingly, it did not create another upside target as of year-end. That is a bit unusual and can indicate choppy waters ahead. Three months ago, I forecast a strong and enjoyable final quarter of 2021. I am not so sanguine for the first three months of 2022. As you know, my 2022 Fearless Forecast did not see another double-digit growth year for the stock market. Instead, I wrote about a year of patience and frustration with a focus on quality.

I see a single digit stock market pullback in Q1 that will likely feel a lot worse than it is because there have been diminished levels of volatility for almost two years. I do believe the decline in Q1 can be bought for a rally in Q2. On the fixed income side, I see bond yields reaching a high in Q1 which means investors can buy bonds at some point in the new quarter, preferably above 2% on the 10-year treasury and hold for the intermediate-term.

Q4 earnings which are released in January and February are unlikely to be as strong as Q3 and I expect companies to hide behind the wall of Omicron, supply chains woes and higher input costs. However, I do not believe Q4 will be an outlier, but rather a theme for 2022. The Federal Reserve will end their tapering of asset purchases in Q1 with some pointing to the first of several interest rate hikes in March. I am not sold on this as the markets will likely dictate Fed action.

On October 28, 2021, I boldly wrote and stated on TV that inflation will peak by the end of Q1. That was a high conviction call and I am not wavering one bit. Part of that just boils down to math and the numbers that will drop off from the one-year inflation calculations. Everyone knows that gas and food prices rose dramatically. Less know that rents soared. In order for inflation to remain high, oil, food and rents will need accelerate higher from here. Remember, high prices do not equal high inflation. Accelerating prices do.

I would like to think that Omicron will fade away in Q1 and we will get back to seeing as many people as possible in the office who want to come in. Regardless, we will continue to offer all methods of meeting to suit our diverse client family. Again, I don’t care how we communicate or meet as long as we do. I am so thankful for such a trusting, loyal and supportive client base.

Please continue to share your feedback, positive and negative. Investing is a marathon not a sprint and the long-term future continues to look very, very bright. We look forward to sharing that with you over the coming years. Again, here is the link to my calendar to schedule a meeting in the office, call, Zoom meeting or Skype.

Thank you for the privilege of serving as your investment adviser!


Heritage Capital, LLC


Paul Schatz

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Paul Schatz, President, Heritage Capital