2021 Year-End Newsletter and Outlook

The Pandemic Investomania enabled many, but not all, risk takers to prosper in 2021. With some small
exceptions, I declined to risk your money in an environment that has ranged from supremely overconfident to
borderline insane.

For the full year 2021 (if MCS clients’ investments were treated as one large portfolio including their cash), on
average clients gained 2.8%, after fees. For comparison purposes, the S&P 500 Total Return Stock Index (S&P
500) gained 28.7%, and the Bloomberg Barclays Aggregate Bond Index lost 1.5%. The range of MCS individual
client returns was from a gain of 9.2% to a loss of 1.1%.1

The client with the lowest return took a 60% cash distribution, and an underperforming asset negatively
impacted her returns. The next lowest returns were for newer clients who have little equity exposure. Clients with the highest returns had higher US equity exposure or exposure to a legacy stock position that outperformed. MCS client returns were protected from the bond market underperformance by the focus on short term bonds, which did not decline in price.

“It’s Tough to Make Predictions, Especially About the Future.” —Yogi Berra

In December 2020, the FOMC (Federal Open Market Committee) predicted that 2021 inflation, as measured by
PCE (Personal Consumption Expenditure), would be 1.8%, but actual inflation came in at 5.3%, the highest it has
been in almost 40 years.

• Below are the December 2020 and December 2021 FOMC (Federal Open Market Committee) inflation
forecasts. Note bolded numbers are actual.

  • The 1.8% 2021 inflation estimate is so far off from the actual 5.3% that it begs the question: Is there some fundamental misunderstanding of the current situation? Note that inflation estimates for this year and beyond reassert the pre-pandemic assumptions of inflation gradually going back to 2%, with inflation projected to fall 50% this year. This means that the Fed is sticking to its transitory inflation viewpoint.

Here is another look at inflation using the more well-known CPI (Consumer Price Index).

Annual CPI inflation ended at 7.04% in 2021. It would not surprise me to see some deceleration in 2022. Nor
would it surprise me to see market pundits selling a ‘don’t worry about inflation because it’s declining’ story.
Frankly, most market participants are praying for much lower inflation because the consequences of persistently
higher inflation, even 4% inflation, would be ugly for asset values (more on this below).

The ginormous $5 trillion Pandemic stimulus, while well-intended and supported by Wall Street, was in part a
reaction to make-up for the lack of sufficient stimulus after the 2008 Great Recession. The Federal Reserve Bank
(Fed) and Federal government were determined not to under-capitalize the pandemic recovery in 2020! So, they
went all in to rescue the economy from the Pandemic-induced Recession.

One problem: a pandemic recession is a very different animal from a housing price collapse recession. House
prices, often one’s most valuable asset, have risen dramatically during the pandemic.

The Fed appears cognizant of what’s at stake (economic stability) and has said it will be vigilant regarding
inflation. Yet there is a “Don’t worry little ones, Daddy has it all under control” vibe to it.

Another problem is that the Fed’s two mandates, to maintain low inflation and full employment, require opposing solutions. Reigning in inflation requires raising rates (perhaps dramatically) to slow the economy – it may take a recession to do that. Slower economic growth, of course, would raise unemployment. Maintaining the full employment mandate means letting inflation run with the hope it will decline as the Fed has projected. There is also a question about how to measure when full employment is achieved. Many people have left the workforce and it’s not clear what a post-pandemic, full employment workforce looks like.

The Fed’s response to inflation is to reduce its inflation-inducing bond buying and then end it in March, rather
than ending it by mid-year as originally planned. After that, the Fed expects to raise the overnight Fed funds
interest rate by .25% three times this year.

I could be wrong, obviously, but the analogy that comes to mind is that in response to a forest fire, the fire
department keeps dumping more dry tinder on it (but less than before) and then it plans to stop adding fuel to
the fire after 3 months instead of 6 months. Next, it will heroically roll out the garden hose. All the time, assuring
folks the fire will go out anyway when the rains come.

Now, your house is in that forest, so what do you do?

If I’m in charge of protecting your house, I’m not waiting around to see if the fire department’s limp response
means it must be right about the weather. I’m going to buy insurance and spend money to protect your house
knowing that those expenses could be unnecessary.

Are We About to End the Pandemic?

Imbedded in expectations of inflation returning to 2.6% in 2022 is a belief that Covid induced economic
dislocations like supply chain problems and labor shortages will end soon, in part, because Covid will be under
control. The expectation is that Omicron, the ‘mild’ variant now clogging hospitals with Covid patients, will ebb
quickly and increase herd immunity. However, this doesn’t mean those infected by Omicron will be immune to a
future variant.

As long as COVID-19 is able to mutate, lasting immunity is likely off the table. If yet another mutation or variant of concern surges that more completely evades the antibodies people have built up, “we start all over,” Dr. Gregory Poland, head of Mayo Clinic’s Vaccine Research Group
Source: Fortune, 5 January 2022

“It’s an open question as to whether or not Omicron is going to be the live virus vaccination everyone is hoping for,” Fauci said Monday at the World Economic Forum’s Davos Agenda online conference.
Source: Fortune, 17 Jan 2022

Nearly 3 billion unvaccinated people, plus the vaccinated with breakthrough infections, can become a potential
reservoir for Covid mutations. Because Omicron is so infectious, the number of potential Covid evolution hosts
has gone up dramatically.

While I’m hopeful that Covid will soon become a manageable endemic disease, I recall shortly after the vaccine
was developed that the markets expected the pandemic end was near! It hasn’t worked out that way. As result,
Covid continues to impose significant hardships in health care, supply chains and labor.

The global economy is in an asynchronous state. Supply chain and labor demands are adjusting to
this asynchronous environment with rising prices. Economic models seem to assume a simultaneous
resynchronization of economic inputs once Covid is under control.

I have my doubts about this. For example, the demand for commercial real estate is dropping with every quarter
companies demonstrate they can function fine without so much office space. This has significant implications for major cities which are large islands of concentrated and often specialized economic activity.

What About Investments That ‘Do Well’ With Inflation? Hmmm.

Wall Street is now selling ‘inflation protection’ strategies to clients, yet, it’s anything but simple. Here’s a popular
example: Treasury Inflation-Protected Securities or TIPS. What could be simpler right? ‘Inflation Protection’ is in
the name and it’s from the US Treasury!

Here’s the track record of iShares TIPS Bond ETF, rated 4 stars out of 5 by Morningstar, symbol TIP. As you
can see, inflation protection securities can lose money just when an investor expects to make money. This is
because the price of TIPS bonds reflects investor expectations of future inflation rates. If those expectations are
too low, the investment doesn’t protect you. The TIPS price adjusts to the new inflation expectations which, so
far in 2022, translates to losses.

‘Stocks beat inflation’ is an often, but not always, true meme.
There are decades like the 1970’s and 2000’s when inflation beats up stocks. The real return is the actual return
minus inflation.

Interest rates went up to fight high inflation in the 1970’s, and this in turn reduced stock PE ratios and thus the
price of stocks. Low inflation / low interest rates mean a stock earning $1 dollar per share could sell for $20 (a PE
ratio of 20) whereas with higher inflation / interest rates the same stock might sell at $15 per share (a PE ratio of
15). Nothing else changed about the company, but the stock’s price fell due to changes in interest rates.

This may be easier to understand if we flip PE (price to earnings) ratios to EP (earnings to price) yields:

  • a 20 PE stock ($20 stock price /$1 per share earnings) is the same thing as a 5% yield EP stock ($1 per share earnings / $20 stock price)
  • a PE 15 stock when changed to EP (1/15) has an earnings yield of 6.67%

As interest rates go up, the earnings yield of stocks must go up as well to maintain their prices and remain
competitive with bond yields. This means that the stock price drops unless the stock’s earnings can grow fast
enough to offset higher interest rates.

Today the stocks that are getting whacked hardest are those with no earnings per share or very high PE’s (very
low earnings yields). As interest rates go higher, downside price pressure increases.

Stock prices are incredibly high, based on historical PE ratios adjusted for inflation. Or put another way, stocks
could fall dramatically if we were to return to average historical PE vs. inflation norms.

The table below is helpful in gauging where we are vs where we may be going from an inflation and a taxation
standpoint. We are very likely now moving between two extremes. The past ten plus years were a low inflation
(less than 2%) and low tax environment. We are now in a greater than 4% inflation environment and it’s
reasonable to expect a higher tax environment given the tremendous deficits.

Table 4 (below) suggests the potential of a large downward adjustment to stock prices. The 2021 PE ratio of
24.5x earnings is well above the average for a low inflation, low tax environment. Current inflation is above 4%
in a low tax environment, which implies an average PE of 14.4x earnings and a decline of 41% from current
levels. Of course, it’s never this simple, but we should interpret the current situation as mostly risk with little to
no reward.

Ashes, Ashes, Will Markets All Fall Down?

In 2018, inflation (CPI) rose to 2.44% from 2.13% the previous year. The Fed, concerned about inflation, stopped
its bond buying program and raised interest rates four times. The December 21, 2018 CNBC headline read,
“Nothing worked for investors this year- nearly every major asset class in in the red for 2018.” The exception was
that cash had a positive return, and so did MCS clients.

The CNBC article continued:

Low rates and other easing measures fueled a boom in stocks by enabling companies to borrow and aggressively buy back their own shares. Not to mention that the easy borrowing fueled their expansion. And a lot of the easy money injected into the system found its way into stocks because there was no alternative, lifting equity valuations to high levels.

Now that process is unwinding.

“All assets have underperformed in 2018 simply because the Fed accelerated the process of tightening monetary policy with a two-pronged approach of both hiking rates and reducing the balance sheet,” Ian Lyngen, head of U.S. rate strategy at BMO, said in an interview. “So it follows intuitively that it would be difficult to find pockets of outperformance when the Fed is actively trying to deflate asset bubbles.”

The same sentiments expressed in 2018 apply today, only CPI inflation ended 2021 at about 7.04%, not 2.44%
as it did in 2018.

MCS Strategy

The start of 2022 is a brutal one for risk takers. MCS clients are very well positioned to capitalize on the
downside volatility that is unfolding, but it is early in the cycle. We are living through an investment and political
mania of historic proportions. I would expect strong price reversals as “it’s ok, it’s not ok” investment memes
compete for mind space.

I’ve appreciated your patience during the past several years. We were well positioned as Covid crushed the
market, but the Fed’s response and financial market reaction was so massive and so quick, I felt the market had
run too quickly back to over-valuation. The Fed played its big hand, and now those chickens (or buzzards) are
coming home to roost. There is ample room for this situation to become much worse once mania psychology is
broken. This is not yet the case.

See the following GMO (Grantham, Mayo, Van Otterloo & Co LLC) link for a detailed mania overview.

It’s a well-done article on manias. One observation, however, is that lays the blame solely on the Fed. Wall Street
is just as complicit in these manic periods as the Fed, perhaps more so, in my opinion.


MCS Family Wealth Advisors (MCS) consolidated client returns are dollar-weighted, net of investment
management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent
all clients with fully discretionary Income/Growth accounts under management for at least one full month in 2021. These accounts represent 93% of MCS’s discretionary assets under management as of 12/31/2021
and were invested primarily in US stocks and bonds (8.8% of client assets on 12/31/2021 were invested in
tax-exempt municipal bonds). The Stock Index values are based on the S&P 500 Total Return Index, which
measures the large-capitalization US equity market. The Bond Index values are based on the Bloomberg
Barclays US Aggregate Bond Index, which measures the US investment-grade bond market. Index values are
for comparison purposes only. The report is for information purposes only and does not consider the specific
investment objective, financial situation, or particular needs of any recipient, nor is it to be construed as an
offer to sell or solicit investment management or any other services. Past performance is not indicative of
future results