4th Quarter 2021 Investment Commentary

We are long-term, goal-oriented, plan-focused investors. We believe that the key to financial success is to continuously act on a specific plan. It has been our observation over the years that substandard returns, and even investment failure, inevitably occur from reacting to economic or market events. It is useful to think about the future and consider various possible outcomes under certain circumstances. But in the near term, we know the economy cannot be consistently forecasted, nor the markets consistently timed. We understand unpredictable things can happen at any time. With that in mind, the essential challenge to successful long-term investing is neither intellectual nor financial, but temperamental. The key determinant is how one reacts, or does not react, to market declines or uncertainty. These principles continue to govern the essential behavioral nature of our advice.

The U.S. stock market capped off another prosperous year rising 9.2% for the fourth quarter and 25.3% for 2021. Returns were solid across the board with small-cap value stocks (+32.3%) leading the way. Small cap value stocks are an area we have been favoring for a while and continue to be healthy weightings within equity portfolios. Foreign stocks rose 2.3% in the fourth quarter and 9.2% for 2021, a respectable return, but the real action remains within our borders.

The stock market’s rise continues to be met with a great deal of skepticism and disbelief regarding its sustainability. It is often said that the market climbs a wall of worry which is certainly the case today. Collectively, rising stock prices make sense considering how strong real economic growth has been. Retail sales are up 18% from a year ago. Corporate earnings are up 26% over the last two years and are projected to increase another 5% to 8% in 2022. Household balance sheets are in the best shape they have been in decades. Consumers have saved $2.2 trillion more than they’ve spent over the last two years and now have $18 trillion in zero-return bank deposit accounts. We would say the outlook for the economy is pretty good.

The U.S. bond market experienced its first annual decline in eight years with a total return of -1.5%. Because of the defensive nature of Watchman bond portfolios, our collective decline was just one-half of the market’s decline. The near-term outlook for bonds remains murky as the Federal Reserve shifts its policy away from emergency pandemic stimulus toward a more normal policy with an eye on fighting inflation. Interest rates have been rising but remain below current inflation levels. The path for future interest rates remains as unclear as ever. Consider that while the Fed is removing monetary accommodation, the U.S. government is removing its fiscal stimulus and the US Treasury is reducing the supply of new debt issuance by 70%. Both are strong forces working in opposition of each other.

People, and especially politicians, like to blame the Federal Reserve for the current spike in inflation. However, it is more the result of a combination of fiscal stimulus payments, restrictive government health policies, supply chain disruptions and the shift in consumer buying patterns (favoring tangible goods). There is simply too much money chasing too few goods. The Federal Reserve is optimistic that inflation will recede as supply congestions ease and consumer buying patterns normalize. This translates to a shift back toward services and away from durable goods like cars and appliances. How long the entire process will take is unknowable, but it will happen. An abrupt drop in prices paid by manufacturers during December could be the start of this trend and evidence that the inflation rate might be peaking. Changes in the producer price index have historically been a reliable leading indicator of consumer prices. However, China’s zero-covid policy is a wildcard that could prolong the supply issues. We do not expect consumer prices to decline per se, but the rate of change should retreat to more acceptable levels.

We are optimistic going into 2022, but we expect a year of greater market volatility and much more modest returns. There is still an incredible amount of innovation in the economy and capital willing to invest. This is not going to change regardless of the inflation situation. 2021 was a year of higher than usual capital gains for many clients and we anticipate 2022 could be another year of above-average realized capital gains as portfolios are rebalanced. Some may want to consider adjusting their estimated tax payments this year. Please reach out to us if you are interested in discussing more detailed tax planning.

Looking back on 2021, we’d like to share a few wins beyond the gains in our stock portfolios. As a firm we have grown and as such we expanded our office footprint. Some of you have been by and seen our new space, including the expanded lobby and conference room areas. We are very pleased with the new space, not only for its design but also its functionality in terms of the one-on-one work we do with each of you. We also added two new team members. Taylor Herzog CFA, CAIA joined us full time at the beginning of the year and is our Director of Portfolio Management. He contributes to all aspects of research, portfolio management and trading. He provides a great deal of leverage to the advisors in managing portfolios and his contribution to our investments has been meaningful. Jo Ann Barnett also joined us in December as a Client Service Associate, bringing decades of experience working with independent advisors and their clients. She has had an immediate impact on our services behind the scenes, and we expect many of you will get to know her very soon. Needless to say, we are fired up about the caliber of our team entering the new year.

We want to conclude by expressing our utmost appreciation for all of you and to say what a privilege it is to work for you and your families. We take our fiduciary responsibilities seriously and love coming to work every day to help make your life better. All of us at the Watchman Group wish you a healthy and fulfilling new year.

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