Last fall we advised you that we were expecting an adjustment period for the capital markets [see blog here]. An adjustment to slowing economic growth, decelerating corporate earnings, higher inflation, and new Federal Reserve policy measures. Market valuation models are adjusting to these new circumstances. Ultra-low interest rates, massive fiscal and monetary initiatives elevated valuations beyond actual long-term earnings potential. Under the Fed’s efforts to contain inflation, valuations will now align to actual long term economic growth expectations which remain attractive. The economy is still expanding at historical trend line GDP growth of 3% and corporate earnings are more representative of expectations at 8%.

Now capital valuations must adjust to this new level of growth. Irrational liquidity provided by the Fed’s actions to rescue the post-pandemic recovery distorted valuations. As the Fed withdraws this excess liquidity by raising rates and reducing their balance sheet, economic demand will slow, and inflation should abate. As usual, the Fed is behind the curve and should have been raising rates during the recent exuberant growth expansionary phase – not when economic growth is slowing. Inflation levels are at their highest in forty years, by some calculations the Fed Funds rate should be 5.4% - not the 0.25% to 0.50% rate we are currently at. While the talking heads claim the Fed will orchestrate a soft landing it has never been accomplished. I think we will go through a disruptive time as valuations adjust with elevated volatility. During market cycles like this it is important to maintain your asset allocation investment models. There are always reasons to sell but in order to be successful, investors need to be exposed to trend line growth.

It takes courage, patience, and fortitude to remain invested during volatile times. Remaining invested while adhering to our asset allocation strategies over market cycles produces the long-term investment returns we desire. It’s important to be aware that during market corrections companies often buy back their outstanding shares when market prices are below their intrinsic value which improves shareholder value while also adhering to and growing their dividend payouts. The US economy remains the most innovative, most diversified, and largest economy in the world. We are a self-sustaining economy. As globalization has waned, our investment strategy of avoiding the international markets has served our clients well. Investing primarily in large capitalized multi-regional domestic companies that pay growing dividends has been rewarding to our clients in up and down economic cycles.

So, what will you do given the elevated volatility? Our strategy remains to be fully invested in proven enterprises that have weathered through multiple economic and business cycles. These are companies that have healthy balance sheets that are not overleveraged and that pay us an attractive dividend that grows overtime or are buying back shares. Also, it’s important that you stick to your long-term financial plan and avoid the temptation to make drastic changes to your asset allocation. Equities, while expensive by historical valuation measures, is the best place for earning positive real returns. For some clients, bonds and cash play a role in stabilizing the portfolio during volatile periods in the equity market. Lastly, it’s important to establish an emergency fund so we are not liquidating investments during market down cycles.

 

 

Commentary Disclosures: Covington Investment Advisors, Inc. prepared this material for informational purposes only and is not an offer or solicitation to buy or sell. The information provided is for general guidance and is not a personal recommendation for any particular investor or client and does not take into account the financial, investment or other objectives or needs of a particular investor or client. Clients and investors should consider other factors in making their investment decision while taking into account the current market environment.

Covington Investment Advisors, Inc. uses reasonable efforts to obtain information from sources which it believes to be reliable. Any comments and opinions made in this correspondence are subject to change without notice. Past performance is no indication of future results.