Happy New Year! The end of one year and beginning of another provides the opportunity for many investors, economists, and prognosticators to provide their thoughts on the upcoming year, so I’ll jump in the mix and add my thoughts. Aggregate earnings for the S&P 500 are likely to grow in the 8% - 12% range this year. Indications from the Federal Reserve point to rate increases in 2022, which may mark the end of ultra-loose monetary conditions. Higher rates and tighter monetary conditions should decrease the multiple applied to earnings, leading to equity returns in the mid to high single-digit range. Consensus expectations generally settle around a similar framework, however it appears that the odds are against me and consensus. Over the last 94 years, the S&P 500 has gained between 5% and 10% only six times. During that period, the index has gone up approximately two out of three years with an average return of +18% during positive years. Conversely, the index has declined approximately one out of every three years with an average -14% return during the down years. An average return is fair to expect over a reasonable time horizon, but an average return is not common during any one calendar year.

The big risks on investors’ minds as we begin 2022 are inflation and Covid. The two are intertwined in that increasing spread of Covid decreases the availability of workers. The lack of available workers exacerbates supply chain issues and pushes up inflation. I found the following paragraph of a recent Wall Street Journal article interesting, “Every year the World Economic Forum asks business, political, and thought leaders to rank the biggest risks in the coming year or two. At the start of 2020, infectious disease didn’t make the list. Covid-19 became the most disruptive pandemic in a century. At the start of 2021, inflation didn’t make the list either. It is now the most vexing problem in the U.S. economy.” Inflation and Covid will undoubtedly have an impact on 2022, but some unexpected risk is also likely to surface.

So how do we manage portfolios when the return profile is likely volatile and unexpected risks will arise? We build portfolios of high-quality companies that we believe can navigate through a variety of economic backdrops and hold cash to allow us to invest opportunistically during difficult times.

Looking back to 2021, US equity markets provided a double-digit return for the third consecutive year, and 4^th out of the last five years. Bonds were slightly negative on the year due to an increase in interest rates. We decided to start 2022 with a slight tweak to our typical newsletter format. Below you will find background information on activity in each of our portfolios last year. We hope you find this look under the hood interesting and informative. 

The top performing stock in the Core Equity portfolio was Prologis, a real estate investment trust that leases distribution facilities. The position was originally purchased in November of 2020. Other top returning investments included Pfizer, Alphabet (Google), The Home Depot, Zebra Technologies, and Microsoft. Grocery Outlet was our worst performing holding. The stock traded down during the 2^nd and 3^rd quarters due to disappointing earnings guidance from the company. We added to the position during the 4^th quarter, and the stock has rebounded since that time. Other laggards during the year were Disney and Comcast. We hold cash in the portfolio to allow us to be opportunistic during inevitable times of turbulence. The cash weighting varies over time based on the market backdrop and the prevalence (or lack thereof) of investment opportunities. There were a few bumps in the market during the year, but no pullback exceeded 5%. Since 1980 the average market intra-year pullback has been about 14%, and the severity of the pullback has been higher than last year’s 5% in 38 of those 41 years. The lack of volatility last year combined with stretched valuations resulted in an average cash balance of 10.2% throughout the year. Trading activity was lower than usual, with turnover being about half of the level of the average turnover for the previous five years.   

Summary of trades in 2021:

Our Covered Call portfolio is designed to provide a higher level of income and a lower level of volatility than a typical equity portfolio. Income continued to be strong for the strategy with approximately 8.8% call premium plus approximately 2.0% dividends for an approximate 10.8% total income yield. This is the fourth consecutive year of income greater than 10%, and income has averaged 10.6% over the last six years. This strategy has higher turnover than our other portfolios, and typically averages five to six trades per month. 

Top performers in our Diversified Income portfolio included Pfizer, Broadcom, Chevron, Cisco Systems, Prudential Financial, and Old Republic. Laggards during the year were AT&T, Unilever, and Verizon. The goal of the portfolio is to provide a sustainable income stream, and the portfolio provided an approximate income yield of 4.5% for the year.

 

Summary of trades during 2021:

Bonds were generally down slightly on the year as interest rates increased. The US 10-year treasury yield increased from 0.92% to 1.51%, and bond prices move inversely with interest rates. Our bond portfolio has a relatively short average time until maturity, which decreases interest rate risk. At current interest rate levels, bonds primarily serve as a reduction in volatility to an overall investment portfolio.

The Fidelity Real Estate ETF was the best performing security in our ETF portfolio, followed by iShares S&P 500 ETF, iShares S&P Small Cap ETF, and iShares S&P Midcap ETF. The iShares MSCI Emerging Markets ETF was the largest laggard in the portfolio.

Summary of trades during 2021: