Capital 19 Catch-Up

Weekly Index Movement

S&P500-4.0%
Nasdaq-4.8%
Aussie All Ords-0.2%

The major U.S. stock indexes started and ended the week with steep daily declines, sending the S&P 500, the NASDAQ, and the Dow down around 4% overall. It was the second weekly setback in a row for the S&P 500, interrupting the positive momentum that had lifted the index more than 17% from mid-June to mid-August.

U.S. stock indexes fell more than 3% on Friday after U.S. Federal Reserve Chair Jerome Powell said the Fed remains committed to extending its policy of aggressively raising interest rates, even at the risk of fueling a potential recession. Speaking in Jackson Hole, Wyoming, Powell said recent data showing a cooling of inflation “falls far short” of what the Fed “will need to see before we are confident that inflation is moving down.”

So why did the market react so violently to his words on Friday?

To understand that we need to think about why the market rallied 17% since mid-June.

In mid-June Powell gave us a 75Bps interest rate hike but said words to the effect of “future rate rises will depend on economic data”.

Then inflation came in at 8.5% verses 9.1% the month before and traders decided the Fed would front load all the increases in 2022, getting to 3%-3.5% by the end of the year……..but then stop.

The 10yr Treasury Yield got up to 3.5% on June 14th but had fallen to 2.57% by August 1st. The 2 year yield was at 3.4% on June 14th, fell to 2.9% and this month has increased back to 3.49%.

The fact stocks have held up so well while these rates have moved back towards their recent highs is impressive.

On July 27th, Powell said “at some point, it would be appropriate to slow the pace of rate tightening”

The market read that as confirmation the Fed will soon be done with the interest rate rises.

We couldn’t quite understand why the market thought all the rate rises would be done in 2022. The market even started to price in interest rate cuts in Q1 of 2023, but there is no way that is going to happen.

On Friday, Powell spoke about lessons learned from Paul Volcker, who was Fed Chair from 1979 to 1987.

The oil price in 1979 doubled following industrial action in Iran and a 4% drop in global oil production. That sent inflation up over 14%. In response, Volcker increased interest rates to 17.5%.

But inflation fell in the summer of 1980 and Volcker reduced interest rates to under 9%.

That meant inflation did not fall significantly and remained stubbornly at 12%.

Volcker was forced to increase rates again and they were at 14% again in 1982.

It wasn’t until 1985 that the Fed Funds rate fell below 8%.

Powell thinks the mistake made by Volcker was not persisting long enough with high-interest rates to truly break inflation. On Friday he said:

“The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years,” Powell said. “A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year. Our aim is to avoid that outcome by acting with resolve now.”

“Without price stability, the economy does not work for anyone,” Powell said Friday. “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions.”

‌To bring down inflation, in other words, the Fed expects the economy to slow down. People will lose jobs.

“These are the unfortunate costs of reducing inflation,” Powell said. “But a failure to restore price stability would mean far greater pain.

‌The Fed has two goals

  • Maximum employment
  • Price of goods stability (inflation)

Unemployment is at an all-time low of 3.6%. Powell knows his actions will increase this and people will lose jobs, but it is the only way to bring down inflation.

Interest rates are going higher this year. We all know this. What others don’t seem to accept is there is a fairly long lag between interest rate rises and those rises bringing down inflation.

For example, as you know, here in Australia the RBA has increased interest rates. But the letter from my bank says the interest rate on my home loan will go up from September 1st. Even today, the rises from the RBA are not hitting me. (they will by the end of the week though)

But it will take a while for consumers, like me, to reduce spending patterns enough to see a reduction in demand and then even longer for companies to react and reduce prices.

All of which means – interest rates will remain higher for a long time. Certainly a lot longer than just the end of this year. I would be surprised if we saw a cut at all next year.

The market needs to adjust to this and it came up too fast in the last 6 weeks. It is now just normalising back to where it should be.

But normalising back to where it should be, does not mean collapsing to new lows.

We still have companies making record profits and record unemployment. GDP growth for Q2 was just revised higher also, so whilst the economy is contracting it is not contracting as fast as previously thought – yet another positive for stocks.

At this stage you probably need to decide to sit in one of two camps.

Camp 1 says the Fed will induce a recession, economies will contract and company profits will fall, and along with it stock prices. If company earnings fall, say 15%, that would put them at $192. If we give stocks an 18 multiple for recession lows then the S&P500 would be at 3,457 or about 15% lower than where they are today.

Camp 2 says the Fed will deliver a soft landing, where inflation reduces in an orderly fashion and company earnings remain robust. Under this scenario, we could say earnings remain flat at $226 and we give stocks a 17 multiple as the long-run average, and the S&P500 is at 3,842 or 5% lower than where they are now.

I am not in either camp. I recognise the market is not the index. My market is only what I invest in.

25% of the S&P500 is just 5 stocks – Apple, Microsoft, Amazon, Tesla and Google. Whatever happens to these 5 makes a big impact on the index. And these 5 are sensitive to interest rates.

My market does include Apple. But my market is weighted much differently to the index with a lot greater exposure to energy and commodities – sectors which are not affected greatly by interest rates and which benefit from higher inflation.

Consistent with that approach, let’s add an energy stock to our growing Capital Catch-up portfolio. Buffet agrees with us. He started buying Occidental Petroleum last quarter. In Buffet style, he bought 20% of the company and has recently been granted approval to buy up to 50% of it. You can bet he will be doing just that.

CatchUp Stock Tips

Our technology stocks fell last week because of the change in future interest rates and is normal in this volatile environment. You can pick them up at nice prices now if you do not have them yet.

Buy DateBuy PriceCurrent PriceGain / LossStop Loss
MSFT1 Aug 22277.82268.09-3.5%240.00
TXN1 Aug 22177.94169.49-4.7%145.00
ASC8 Aug 228.529.70+13.8%6.40
CDNS15 Aug 22188.83177.83-5.8%130.00
UNH22 Aug 22541.39529.25-2.2%450.00

Buy Williams Companies (WMB) with a stop at $29.50

We are borrowing this idea from our Dividend Growth Strategy which has been our best performing strategy of the past two years and has held up very well in 2022 despite falling markets.

The Williams Companies, Inc. (NYSE:WMB) is one of the largest natural gas-focused midstream companies in the United States. This is a very good place to be as natural gas has incredibly strong forward growth potential, which sets up the company for powerful prospects

WMB is a midstream gas transporter with a massive network of pipelines.

By far its most important asset is the Transco pipeline system that stretches across much of the East Coast, going from Texas to New York City. This system by itself carries approximately 15% of all natural gas consumed in the United States. The system is also likely to be the focal point of the company’s growth going forward.

One of the dominant trends in the energy industry right now is electric utilities retiring their old coal-fired power plants in favor of natural gas-fired ones. This is because natural gas burns much cleaner than coal and is actually reliable enough to support the needs of a modern economy, which separates it from renewables. A number of these new gas plants are being constructed along the East Coast and The Williams Companies is in a prime position to satisfy the need that these plants will have for natural gas due to the presence and scale of the Transco system. The company is indeed moving to take advantage of these opportunities. The company has six projects in development that are intended to provide approximately three billion cubic feet of natural gas per day to these powerplants.

The nice thing about these projects is that we know that this cash flow growth will actually occur. This is because The Williams Companies has already secured contracts from its customers for the use of this new capacity.

The Williams Companies enjoys remarkably stable cash flows regardless of the conditions in the broader economy. This is mostly because of its business model that revolves around entering into long-term contracts with its customers under which the fee paid by the customer is independent of energy prices. As these contracts are typically five to ten years in length, they should outlast any economic problems such as what we saw in 2020. In fact, The Williams Companies has consistently increased its cash flows over the 2018 to 2022 period, including in 2020:

One of the biggest reasons why investors purchase shares of The Williams Companies is because of the dividend that it pays out. Indeed, as of the time of writing, the company yields 4.78%. Perhaps more importantly, (and the reason it makes it into the Dividend Growth Strategy) the company has a long history of increasing its payout to investors every year:

In conclusion, The Williams Companies continues to look like a very solid investment for anyone that is looking to earn an attractive yield while the natural gas story continues to play out. The company has a number of opportunities to transport gas to various utilities along the East Coast and even get involved in supplying the substance to the rapidly emerging liquefied natural gas market. This provides it with a strong growth pipeline over the next decade and should allow it to provide investors with a safe and growing income stream to meet their needs.

Warning

Stock values can go down as well as up. It is possible to lose 100% of your investment in a stock. Any advice given by Capital 19 is general advice only and does not take your personal circumstances into account.