Quarterly Letter Excerpt: Economy & Markets

What does it mean to have humility? Classically defined, it is “a feeling or attitude awarding no special standing that makes you better than others.” As we close out the year, there are many lessons 2023 can teach us. Perhaps most salient is the concept of humility, especially relating to financial markets. Sour moods festooned the investment landscape as the year began. Inflation was high, interest rates were rising, stocks (and bonds) had just closed out a tough year, and recession was expected by most. Fast forward twelve months, as the year closes inflation is lower, rates have peaked, stocks (and bonds) logged solid returns, and the US has so far avoided recession. On the latter, while our process is thorough, I got it wrong in 2023. But it’s fanciful to expect that we’ll get everything right. Rather the aim is simply to go to bed a little smarter than when we woke up. To be lifelong learners and compound our knowledge. Fortunately, our toil and tenets position us to do just that.

We lost the venerable Charlie Munger this year. For over six decades Charlie was Warren Buffett’s sage right-hand at Berkshire Hathaway. He used to say, “we try to arrange our affairs so that no matter what happens we’ll never be sent ‘back to go,’” [Monopoly board game reference]. At Albion, we manage money under a similar belief. We don’t speculate. We invest. We don’t bank on short run forecasts when building portfolios. We take a long-term view. Indeed, an investment strategy shouldn’t hang on getting macro and market calls correct, and any such projections must carry a sizable dollop of humility. In practice, this means portfolio execution is incremental as opposed to extensive. Again, avoiding ‘back to go.’ This conduct is core to our investment philosophy. Adhering to these principles, plus sound investment selection, work together to deliver laudable risk-adjusted returns over time. Knowing the future is impossible. Accepting this is the first step to becoming less fragile and more adaptable. Instead, we pursue strategies that can survive whatever may occur.

Now, let’s review the fourth quarter.

The October through December period saw a continuance of the post pandemic expansion. GDP was (very likely) somewhat higher, the labor market is healthy, and consumer demand endures. Meanwhile, as we’ve anticipated, inflation is now about 3% (sub-3% by some measures!) and the Fed has clearly communicated that they’re done hiking rates. On balance, economic and market conditions sit somewhere between favorable and improving. This sent equities bounding higher. Concurrently, business profits – the lifeblood of stock prices – have perhaps bottomed if we avoid recession. That last piece is critical; we’ll revisit in a moment. A
ding against the quarter was the awful Israel / Hamas war that broke out on October 7th. While markets, including energy, have taken the turmoil in stride, the human cost has been immense.

The overall good vibes sent valuations higher. The S&P 500 now goes for about 21.5x trailing earnings and 19.5x 2024 estimates. Not cheap, especially against yields that, despite the recent drop, are near multi-year highs. It’s also not wildly expensive. Profit growth for the whole of 2023 will settle in slightly better than flat (versus 2022) and growth expectations for 2024 infer an impressive +12% stride. And it’s here where the question of recession / no recession matters most. As for Wall Street’s big picture 2024 outlook? The consensus is now (unsurprisingly) cheerful. Economists and strategists expect a decent year for stocks (i.e., building on ’23 gains) and no recession. Our outlook? Unhappily we still see elevated risk of a mild recession. Yes, the economy has been resilient. But just because a slump hasn’t happened yet doesn’t mean it won’t. The business cycle always looks good just before it slides.

Generally, when you spike rates it has a negative impact that works with a lag. The idea that the Fed can take rates from 0% to nearly 5.5% with over a trillion in quantitative tightening (QT), over a short period of time, and that the economic pendulum will stop from strong growth to perfect growth without going negative doesn’t make sense to us. It would be ahistorical to expect that. There’s evidence of this in many of our preferred leading indicators, like LEI and the Treasury yield curve, as well as some early signs that strong employment and a robust consumer may be waning. Add to this those higher rates – plus the view that they may stay up here for a while (“higher for longer”) – and we still see heightened odds of recession near-term. We’re not out of the woods yet.

Despite this stance, with great humility and borrowing from Munger’s book of wisdom, we’re not betting the farm. Instead, the result of our uncharacteristically cautious macro outlook means we’ve added some “defense” to growth portfolios while, importantly, staying fully invested. We consider this approach to strike a functional balance between respecting short-term risks while staying true to our DNA as long-term investors. The big money is not in the buying and selling, but in the waiting. We will continue to manage your precious capital using a resolute investment philosophy, quality securities, and the best possible information. Many thanks for your trust in us. Happy New Year!

Albion Financial Group is an SEC registered investment advisor. The information provided is intended solely for educational purposes and should not be construed as an offer or solicitation for the purchase or sale of any particular securities product, service, or investment strategy. Past performance is not indicative of future performance.