Hall Capital “Market Views” Newsletter October 2022
This is the 50th edition of Market Views from HALL CAPITAL. Our aim is to provide concise views of where we see risk and opportunity for investors.
People Believe What They Want to Believe
- regardless of evidence to the contrary
The Shroud of Turin is well known for its faint image that resembles what people think of as Jesus. For centuries it was believed that the universe revolved around Earth, notwithstanding the challenge by astronomers. News events are reported by competing networks with a spin in opposite directions with the viewing constituents each believing incompatible "truths". A man meets a pretty woman and sees only perfection. You get the picture.
Believing what you want to believe is not always a bad thing. A patient with only a short time to live can actually benefit from believing an experimental drug could provide a cure. However, when it comes to the capital markets, faith alone is very dangerous. The danger can manifest itself in many ways, from faulty stock selection, chasing speculative new instruments, e.g., bitcoin and NFTs, to whipsaws in asset allocation.
Related to the "belief" bias is the "recency" bias. After a few strong days in the stock market, or even a single one, investors feel like they should "Buy Buy Buy". The market corrects and turns sharply down and the feeling is "What was I thinking? I need to Sell, Sell, Sell." These are natural emotional responses because we are humans, not Vulcans.
The stock market was oversold in June and rallied nicely in July. Yes, there was some good news on commodity inflation, but the main driver of investor psychology was the market action itself. Just as it was with the market going the other direction in late over the last month or so.
It takes a great deal of discipline to question your "feelings" about the market and challenge what you want to believe. It makes more sense to seek out information that refutes your beliefs than confirms them. This is because we are already biased to look for confirming evidence. If, through self-awareness, you discern your feelings about the market are mainly driven by short term market action, then they are probably not feelings you should act upon.
Higher Interest Rates
- can be good news
Inflation remains public enemy number one and our view has not changed: inflation has peaked and will subside - if more slowly than it ramped up. The Fed can only impact certain elements of inflation but the determination is there, even at the risk of recession. The determination is the consistent campaign toward higher interest rates.
We noted 18 months ago when the 10 year UST was near 1.5% that the tide has turned for interest rates - that rates are headed up, perhaps for years. Interest rates have soared this year to near 4% on the 10 year UST. US bond prices have declined more than any year since 1926!
Higher interest rates are a challenge for all long term asset classes as we have seen this year with the swoon in stock and bond prices. Even housing is finally feeling the impact.
So how is this good news?
Higher interest rates can help reduce inflation before it gets out of hand.
Savers and investors will enjoy a return on reserves for a change. While we have shunned bonds, the 4% yield on 2-year risk free US Treasury Notes is starting to look interesting for our reserves.
Having interest rates at a level well above zero gives the Fed some ammunition to stimulate the economy when needed by bringing rates back down.
Downside scenarios include unmitigated inflation, a deep recession, war escalation and a financial crisis brought on by a soaring US dollar, not to mention scenarios I can't imagine. However, our base case does not include those ~20% probability outcomes, but does include a mild recession eased next year by a Fed pivot. While the taming of inflation would set us up for mid to high single digit returns for stocks longer term, another 10% downside is certainly possible over the next couple of quarters - even in our base case, since unemployment will rise and earnings estimates will have to come in.
Overall, our asset allocation strategy is unchanged except for willingness to extend some reserves into riskless 2-year USTs, thanks to the 4% yield, the highest we have seen in over 15 years.
Focus List Slumps -11.3% Year to Date
- vs - 23.9% for S&P 500
Our FL is made up of mostly "Stalwarts", which are companies with strong competitive positions and good balance sheets selling at reasonable prices. Sprinkled in are a handful of "Fallen Angels". These may be smaller companies which have sold off sharply in a short period of time for reasons we think are temporary. (And we also add some hedges from time to time.)
The sell-off in Q3 was broad with even Stalwarts taking a hit. Making a positive difference in the FL was the continued recovery of Fallen Angel Unum, up 15%.
For Q3 the FL was off by -4.2 vs -4.9% for the S&P 500. The 5 year annualized return of the FL was 11.0% vs. 9.2% for the S&P 500. Since inception over 10 years ago, the Focus List has outperformed on an annual basis 14.9% vs.12.9% for the S&P 500.
The only change we are making to the Focus List is adding back some gold exposure as a hedge against the downside scenarios noted above.
For individual stocks as well as selection strategies, past performance is not necessarily indicative of the future.
Hall Capital Focus List
Allstate - strong brand. Strong balance sheet. Hedge against higher interest rates. Steadily higher dividends.
Verizon - largest cell phone service provider in the US. Some debt but safe 6.7% dividend yield.
Shell - lowest multiple of the global energy giants. Leader in LNG. 4% secure dividend yield.
NovoNordisk - Danish company has 50% of the global market for insulin. Strong balance sheet.
Alphabet - Google is the "oxygen of the internet". Leader in AI and many other forward technologies. Cash on hand >$125 billion.
CVS Health - with Aetna insurance and growing in store clinics, the chance to become the most integrated health care company.
Apple - brand with 1.4 billion users providing new growth opportunities in service revenue and wearables.
Corning - technological leader in glass for fiber optics and displays.
Goldman Sachs - Wall Street's premier investment banking firm. Stock trading near book value.
Medtronic - world's largest medical device company. Sales should recover when hospitals inevitably return to normal.
Unum - established life and disability insurance provider whose depressed stock price should benefit from higher interest rates.
Meta Platforms - controversial dominant social platform which 60% of US use daily. Trades now at less than a market multiple due to sharp decline in stock price.
Micron - a leader in memory chips with strong balance able to withstand a cyclical downturn.
Energy Select SPDR - hedge against energy driven inflation.
Lennar - a leading home builder facing near term slump in sales but long term opportunity as affordability eventually improves. Strong balance sheet.
iShares Gold Trust - hedge against uncertainties.
Follow Up – from our letter one year ago
"...one (factor) is impacting our long term investment strategy: the potential for higher interest rates."
- This potential was realized in spades with the expected impact.
"As you know Congress has to raise the debt ceiling from time to time . . .we are counting on this "groin kicking" process(arguments over the debt ceiling), which has been put off until December, to blow over before our next letter."
- Blow over it did.
"Sometimes we can take advantage of two attributes at once: a bargain priced stock which offers a hedge against a key uncertainty. We are adding Allstate to the FL."
- The S&P 500 is down -12% over the past year; ALL is UP 4%
NOTE: Now in addition to ALL our quarterly letters, on our website is a tab with just the Follow Ups.
About HALL CAPITAL
HALL CAPITAL, LLC is a registered investment advisor and was formed by Principals from Arcturus Capital in 2010.
For more information, contact Donald Hall 626 578 5700 x101 dhall@hallcapitalmanagement.com
HALL CAPITAL | 199 S. Los Robles Ave | Suite 535 | Pasadena | CA | 91101