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Market Valuations and Expectations During Volatile Times

The first few months of 2022 have certainly been a time of cultural, political, and economic challenge. We have witnessed the invasion of the sovereign nation of Ukraine by Russia and Vladimir Putin, throwing the entire world into geopolitical chaos. We have experienced levels of inflation not seen in four decades. We have watched as the Federal Reserve has begun the process of raising short-term interest rates and other strategies to fight inflation. We have been reminded that Covid is not yet in our rear-view window and watched as China has locked down their entire economy in response to widespread covid infections. All of these factors have deeply impacted both the stock and bond markets, creating significant market volatility that has negatively affected portfolio valuations in the short term. As a result of all these issues, I felt that a special update letter might be helpful to share a sense of our perspectives and expectations over the next several months. One of my most important responsibilities is to help each of you navigate through uncertain times. Market fluctuations are an unfortunate reality for all of us. My ongoing commitment to you is to use my 38 years of experience to help each of you get through these difficult times to a brighter future. At the end of 2021, we set out our projections for the stock market in 2022. We targeted 5,250 for the S&P 500 and 40,000 for the Dow Jones Industrial Average. Those projections were based upon our expectations for both profit growth in 2022 and the yield on the 10-year Treasury note. At that time, given interest rates, the US stock market was still under our estimate of fair value. This is no longer true. Given the surge in long-term interest rates this year, the U.S. stock market is now fairly valued for the first time in over a dozen years, dating back to the Financial Crisis of 2008. During many of these past 12 years, with the U.S. stock market well under fair value year after year, we often lifted our year-end forecast during the year. We have developed a model to assess fair value on the stock market. This model incorporates the government’s measure of economy-wide corporate profits and uses the yield on the 10-year Treasury Note to discount those profits. The yield on the 10-year Treasury finished last year at about 1.5%, which made the stock market look extremely attractive and undervalued. But to be cautious – and because we knew the 10-year Treasury yield was being held back by excessively accommodative Federal Reserve policy – we used a 2.5% yield to discount profits, instead. Using a 2.5% yield suggested fair value for the S&P 500 was 5,250, which became our forecast for the market at the end of 2022. But here we are in the middle of May and a vicious sell-off in the bond market has pushed the 10-year yield to 3.1%, substantially higher than the end of last year and above our 2.5% estimate. This higher yield makes a world of difference in how our model sees the stock market. Using a yield of 3.13% and projected fourth-quarter profits suggests that we were already at fair value as of May 8, with the S&P 500 closing Friday near 4,100. This would be a good point to pause and provide you with an explanation of our model. Our capitalized profits model IS NOT A TRADING TOOL. It is a valuation tool. Just because the model says we are over-valued does not mean that the stock market or stocks will automatically fall. Nor if the model says the markets are undervalued, does it mean that stocks and the markets automatically rise. I repeat this is not a tool to predict short-term market movements or the immediate direction of stock prices. It does indicate a change in probabilities. For example, from 1996 to 2000, the model showed that U.S. stocks grew increasingly over-valued, but the markets did not peak until early 2000. At the time of the peak on April 1, 2000, the over-valuation was over 60% and the subsequent crash was significant. When we say the stock market is fairly valued – as it is today – that means there is an equal chance that the market goes up or down from here. And the prime factor determining the outcome is whether the economy experiences a recession or not. A stock market at fair value should be expected to rise over time as long as profits tend to rise. Recessions typically drag down profits, and with that the stock market as well. We think the outlook through year-end suggests a larger gain than normal when stocks are at fair value. FIRST, some investors are already pricing in a recession for this year or early 2023. While a recession may be a possibility down the road, our research leads us to believe that it is highly unlikely for a recession to begin that early. As the most pessimistic investors begin to realize that they were wrong, we would expect to see a corresponding adjustment that should drive stock prices higher. It’s the classic “wall of worry” that should help boost stocks, as the anticipations of bad news that had already been priced into the markets have to be corrected. One way to think about this is to look at the yield curve. When the Federal Reserve gets too tight, the bond market starts to signal that the Fed will need to reverse course. When this occurs, short-term rates rise above long-term rates, creating an inverted yield curve. That is not happening today! Long-term rates have been rising faster than short-term rates, and thus the yield curve has steepened. Furthermore, the reopening of the economy following the pandemic is still underway, and we still expect profits to rise this year. SECOND, some investors are concerned about a wider war in Eastern Europe, perhaps triggering NATO’s call for mutual defense, which could lead to World War III. We think the conflict is more likely to be contained to Ukraine and as the weeks and months pass without a widening of the conflict, that’s another wall of worry for stocks to climb. THIRD, we think the stars are aligned for large Republican gains in the House and Senate, even after factoring in what appears to be an overturning of Roe vs. Wade. Our best guess is that the GOP ends up with a solid House majority near the post-World War II high-water mark of 247 seats (out of 435 total seats) set in the 2014 mid-term election. In addition, it looks like the GOP could be heading toward about 53 Senate seats. This is not to say Republican wins are always good for stocks; they’re not, far from it. It is to say that in the current political situation, a Republican Congress creates a divided government. In a divided government, the odds of tax hikes would be dead at the same time that the Judicial Branch is taking a tougher line on federal regulations. Put it all together, and we think there’s a recipe here for a stock-market rally into year-end with our model projecting the S&P 500 ending the year at 4,900 and the Dow at 39,000. However, we must remain vigilant. If we were to experience additional increases in interest rates beyond what is currently expected and priced into the markets, this type of stock market rally could potentially put the market into overvalued territory. While we would all enjoy this potential market rally, we could not become complacent. Based upon our best research information and opinions, our best guess would be that any potential recession would probably not happen until the Spring or Summer of 2024, if in fact we actually experience a recession. Fed Chair Jay Powell has publicly stated that he believes that we will NOT have a recession. We will be watching very closely. If we do begin to see signs that a recession is likely, we will be talking with each of you as to the best strategies to protect your portfolios, even if only as a temporary port in the storm. One issue making the current environment even more uncertain is that the Federal Reserve is trying to reverse course under a brand-new monetary regime. Quantitative easing/tightening, along with the payment of interest to banks on the reserves they hold at the Fed, has never faced a test like it does today. Under monetary policy before 2008 (Financial Crisis), interest rates and bank reserves were connected. The Fed operated with a “scarce reserve” model. If they pulled reserves down, the federal funds rate would go up. If they added reserves, the rate would fall. But today, interest rates and bank reserves are decoupled. In other words, the Fed can push rates up without changing the amount of money on its balance sheet. In fact, that is exactly what the Fed has done over the past few months. The Fed has lifted interest rates twice (by a total of just 75 basis points) but hasn’t done any quantitative tightening. In other words, the Fed has not become tight, just moderately less loose. We do not know, and neither does the Fed, whether the interest rates it pays banks on reserves will actually slow down the growth of the money supply. The bottom line is that recessions typically happen when the Fed tightens too much. With inflation well above current interest rate levels, the yield curve positively sloped, and money supply still expanding, the Fed is NOT TIGHT. It would take a recession for us to believe that a true bear market, not just a correction, would occur. At this point, economic projections do not support any reasonable expectation of a recession in 2022 or even reasonably beyond 2022. Thank you again for the honor and privilege of serving as your Advocate and Advisor. Together, we will help you navigate these periods of volatility as well as prepare you for any potential concerns going forward. May God be with each of you,

David A. Pickler President Pickler Wealth Advisors



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