2021 Winter Newsletter – Fourth Quarter Review

It ain’t what you don’t know that gets you in trouble, it’s what you know for sure that just ain’t so
— Mark Twain

Dear Valued Clients,

As we approach the beginning of the third year of the presence of COVID-19, I suspect that most have a balance between fatigue, caution regarding our health, and a desire for a more open way of living. Yes, this is getting old. Quite remarkably though, as much as we have felt an impact on how we live our lives, the vast programs of stimulus and support have kept people that were in harm’s way financially afloat financially during the crisis. Even more, while equity markets boomed in 2020 based primarily on ‘hope’ that economic growth would return, 2021 saw markets climb even higher. Central Banks pulled out all the stops to keep the economy moving forward, and broadly deserve credit. The US, once again, was the best-performing major equity market – returning almost 29% – capping the strongest three- and five-year periods since the Tech bubble of the late 1990s. The rebound in equities from the 2020 trough was the fastest in the last 50 years.1 With such a tremendous recovery, it is understandable to ponder what could be next. The purpose of our letter this quarter is to try and address this specific question.

Changes are upon us. US fiscal policy is no longer expected to be a net support to economic growth in 2022, and Central banks have moved notably more hawkish, or less accommodative. Recent minutes from the Federal Reserve’s Open Market Committee meeting highlighted the risk of “higher and more persistent and widespread” inflation and the “fast approaching” maximum employment, signaling the need for tighter monetary policy. Current consensus expectations are for four rate hikes in the US this year, a significant shift from as recently as last summer when the first-rate hike was not expected until 2023 at the earliest.

While policy support is fading, elevated equity valuations make the outlook more complicated relative to other recoveries from recession. Most secular bull markets of previous decades began with depressed margins, low valuations, and either strong economic expansions (like the 1950s and 1960s) or a sustained fall in interest rates (like the 1990s and 2000s). The starting point for this cycle is very different: interest rates are close to zero; margins are at record high levels and being pressured by rising input costs due to inflation; and valuations are high, particularly in the US. Similar dynamics exist in private markets, where several companies in the technology space, in particular, have grown into ‘unicorns’ without ever tapping the wider public markets.

Thus far, the rise in inflation has been positive for equities as anchored policy rates have meant negative real interest rates, incentivizing investors to move up the risk curve into equities. The markets have been further supported by companies buying back shares, as low rates made issuing debt historically inexpensive. But as market expectations shift and real interest rates rise, the notion of TINA (there is no alternative) starts to dissipate. Equity market returns will need to be increasingly driven by higher earnings growth as price to earnings multiples come under pressure from rising rates.

Current consensus calls for above-average economic growth in the US to continue, driven by strong capital expenditures, improving supply chains, and robust consumer balance sheets along with other normalizing forces post-pandemic. However, most analysts also expect the Fed to remain ‘behind the curve’ i.e., raise rates but not so much as to throttle growth. That, as one can imagine, is a delicate balancing act.

With such prevailing uncertainties, most market pundits are calling for lower returns across all asset classes going forward and higher likelihoods of market corrections; they however remain supportive of overweight allocations to equities.2 Indeed, retail investors continue to ‘buy into the dip’ as we start 20223. It is tempting at such moments to dramatically decrease risk and shift to the sidelines. But market timing is a perilous game. For instance, a JP Morgan Asset Management study from 2019 showed that in the 20-year period between 1999 and 2018, the annual return on the S&P 500 was 5.6%; however, the return dropped to 2.0% if one was not invested during the top 10 return days (roughly 0.4% of trading days), and close to zero if one had missed the top 20 days.

As long-term investors, our focus remains on capital preservation and accumulation by investing through the cycle. Practically, this equates to not chasing the trend of the day or getting spooked by short-term volatility; investing in companies that have sustainable, growing business models and strong balance sheets, and trade at valuations that provide appropriate risk-adjusted returns; and maintaining our philosophy of diversification, whether that be with regards to asset allocation, sector bias, or geographic exposure.

We will close with points about income taxes. First, it is common for investment companies, primarily mutual funds, to restate their annual fund accounting/tax results for the year, sometimes even more than once. Admittedly, this creates headaches. As required, Schwab will accurately report to you the tax implications of your account. This does mean, however, that as these changes occur, Schwab will need to amend your tax package. The best counsel we can provide is to give some time for the possibility of an amended tax package and file your tax return closer to the tax filing deadline, which falls on April 18 this year.

Second, it has become common amongst the people we work with to donate a portion of their Required Minimum Distribution to charity. We generally think IRAs make a very good source for charitable donations, allowing the donor to both avoid taxation on the amount of the IRA donation, and yet receive the full magnitude of the standard tax deduction. In fact, Schwab now offers ‘checkbooks for IRAs’ to help those so inclined to make such charitable donations. We have shared this alert before but wanted to provide a reminder for anyone making Qualified Charitable Contributions or QCDs, to remember that your 1099r tax form will only reflect the full amount of all of your IRA withdrawals. It is up to the taxpayer to differentiate between withdrawals that provided funds for you, versus what went to charity. If anyone needs help quantifying the magnitude of their QCDs, please call us and we can help you calculate the amount.

We wish you all, our clients and our friends, a very happy, healthy, and prosperous 2022. As always, we look forward to speaking with you soon.

Scott Upham, CIMA® CPWA®
Managing Partner

Contributions were made to this letter by Amyn Moolji, CIO & COO, & Jeffrey Burch, Director of Wealth Management.

1 Source: Goldman Sachs Research  
2 https://www.bloomberg.com/graphics/2022-investment-outlooks/
3 https://www.reuters.com/business/finance/time-buy-retail-investors-swoop-when-stocks-falter-2022-01-12/  

Cribstone Capital Management (“CCM”) is an SEC-registered investment advisor located in the State of Maine. The firm and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC-registered investment advisors. CCM may only transact business in those states in which it is notice filed or qualifies for an exemption from notice filing requirements. For information pertaining to the registration status of the firm, please contact the SEC on its website at www.adviserinfo.sec.gov. A copy of the firm’s current written disclosure brochure discussing the firm’s business operation and fees is available from CCM upon request.

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