What’s Up With The Market?
The S&P 500 peaked on January 4th and it has been a volatile ride down since that date. The prospect of rising inflation, the Federal Reserve increasing interest rates and reducing its balance sheet caught up with the major index even though the growth stocks in the index fell along with the NASDAQ beginning in November.
The NASDAQ peaked prior to that, in early November coincident with the Federal Reserve announcing that they would begin to tighten monetary policy in 2022 in response to rising inflation. The NASDAQ pulled back on that news but rallied to test the November high in early December, but ultimately that failed and its also been a volatile ride down since then.
At this point, over three quarters of the stocks in the NASDAQ are trading below their 200 day moving average, and are in a bear market. Similarly, though not quite as severe, over half the stocks in the S&P 500 Index, S&P Mid Cap Index and S&P Small Cal Index are trading below their 200 day moving average, and are in a bear market.
Why Do Inflation and Tighter Monetary Policy Impact Investments?
I have lived through nearly 40 years of stock and bond market investing for clients, and the two economic issues that seem to have the greatest impact on the value of investments are inflation and liquidity. At the present time, we have the highest level of inflation in over 40 years and we have the prospect for reduced liquidity in the stock and bond markets – a double whammy on stocks and bonds.
So why is this becoming a problem now? The inflation issue stems from bad monetary policy by the Federal Reserve, keeping interest rates too low for too long coming out of the 2009 stock market crash and from a demand/supply imbalance caused by global supply chain problems stemming from COVID-19. In order to fulfill their low-inflation mandate, the Federal Reserve made the decision to0 increase short term interest rates and end their purchasing of Government Bonds. This resulted in two impacts:
- Increasing interest rates increases the magnitude of the discount rate that investors use to value the future earnings of companies. Basically, the value of a stock is really the present value of its perceived earning power in the future. Higher interest rates lead to higher discount rates which means that investors are discounting the value of that future earning power more than they did previously, leading to lower valuations and ultimately lower stock prices.
- Ending their purchases of Government Bonds reduces the available pool of buyers for those bonds which means there is less liquidity in the market that can absorb the funding of our government’s budget deficit. This means that interest rates on bonds will have to go up to attract buyers and that leads to less liquidity in the stock market as investors shift money that was available to buy stocks over to buying bonds that have become more attractive with higher interest rates.
When this happens, it has a disproportionately bigger impact on Growth Stocks than on Value Stocks. Why? Buyers of Growth Stocks are willing to pay more for future earnings in a low interest rate environment because the growth rate on those earnings leads to significantly higher in the future earnings. Higher future earnings means that the discounted value of those earnings are higher than the discounted value of the lower growth rate Value Stocks when the discount rate is low. When interest rates go up and discount rates go up, investors put a higher value on current earnings than future earnings, so Growth Stocks are more negatively impacted than Value Stocks by higher interest rates – its the old “bird in the hand” saying in practice.
How Has This Impacted Investment Strategy?
Two of our three primary investment strategies, Blue Chip and Dividend Income, thrive in the current environment on both a relative and absolute basis. Their objectives fit very well with an increasing interest rate scenario as they have a greater allocation to Value Stocks than our third primary investment strategy, Growth.
The Blue Chip strategy focuses on a balance between Growth and Value, with an emphasis on large cap growth stocks that are purchased at a discount and companies with a strong shareholder-friendly record of dividend payments. The Dividend Income strategy focuses on companies, both Growth and Value, who belong to the group of companies known as Dividend Aristocrats – companies with long track records (some over 100 years) of paying and increasing dividends through all economic and stock market cycles, boom and bust.
No material changes have been required in these two strategies as they are positioned for whatever the market throws at us.
The Growth strategy is different. It focuses on Growth Stocks whose value is determined by the combination of high earnings growth and low or falling rates at which those future earnings are discounted. Since the Federal Reserve has told us for many months that they would eventually tighten monetary policy if inflation got out of control, and since we have written on this blog for nearly a year that inflation was moving higher, we knew that a tweaking of strategy was needed to ensure our Growth strategy clients were protected from the Fed’s inflation response.
Growth Strategy Updates
In the last few months of 2021, we began to shift the focus of the Growth strategy to a larger capitalization and more current earnings focused. This led to establishing several Focus Areas are are emphasized in the revised strategy that have strong catalysts for earnings growth and that investors are willing to pay for in spite of increasing discount rates. Here is a summary of those Focus Areas:
- Energy: for the past year, it was growing increasingly clear that there was a supply/demand imbalance in the energy market, which was growing over time. Because of this, early last year we began to increase our allocation to energy companies in client portfolios from underweight to overweight the S&P 500 sector weight. Results: energy prices have moved steadily higher with the major investment banks increasing their target for the high in oil prices as demand has not increased to meet supply and geopolitical tensions have made supply sources questionable.
- Agriculture: last Fall, the two largest producers of agricultural nitrogen announced that there would not be enough supply to meet global demand in 2022 and 2023. Because of this, we began to increase allocation to the agriculture industry – chemicals and machinery. Results: earnings reports from companies in this industry have surprised to the upside and valuations have increased accordingly.
- Gold: we have traditionally always kept a small allocation to gold and/or gold miners in client portfolios as an insurance policy against unforeseen events happening. Fortunately, gold also acts as a hedge against inflation. Results: gold prices have risen along with inflation and geopolitical tensions, resulting in our gold and gold miners moving higher in price.
- Banks: as discussed above, higher interest rates have a dampening effect on valuations of most companies. However, it is the opposite situation for banks. Banks can increase their net interest margins as interest rates go up, increasing there bottom line net income. Because of this, we started increasing our allocation to banks in the Fall as a hedge against rising rates in the rest of the portfolios Results: as an industry, bank valuations are up 20% since October.
- Defense: in early 2021, China began to fly warplanes into Taiwanese airspace and in November, Russia began to build up troops on the border with Ukraine. We were monitoring the China situation but began to increase our exposure to the defense industry in December. Results: the stock prices on defense companies moved steadily higher until last week when Russia invaded Ukraine and they exploded upward 10%+ on the news.
- Specialty Metals: this is really an offshoot of the Energy focus because supply constraints in energy mean that there is increased interest in alternatives to carbon-based energy. We initiated an allocation to Uranium miners when China announced they were building 150 new Nuclear Power Plants. We initiated an allocation to alternative energy production with solar and biofuels companies. We initiated an allocation to electronic vehicles with a major car company, a principal parts producer, a cobalt miner and a lithium miner. Results: We also established positions in electric vehicle charging companies but our stop losses hit on these high beta companies in the market downdraft – look for us to re-establish those positions when the market recovers as they should be long-term winners.
- CyberSecurity: in May 2021, there was a cyber attack on a US oil pipeline which piqued my interest in cybersecurity companies. Initially, we just added to an existing position. However with the Ukraine War showing that Russia use cyber warfare with abandon – no to mention the Chinese, North Koreans and Iranians who are repeat offenders – prevention of cyber attacks seems to be a growing and critical need. Results: our upsizing our initial investment proved very profitable; increasing exposure further is too recent for any results, but given the increasing level of such attacks its reasonable to assume we will see similarly profitable returns.
In addition to concentrating investments in the Focus Areas and in higher capitalization companies, as well as above average levels of cash on hand for opportunistic investments, the strategy has focused on materially undervalued Growth and Value Stocks in the primary portfolio. This means companies undervalued on a Price-to-Fair-Value ratio basis, companies undervalued on a Price/Earnings-to-Growth ratio basis, companies trading for less than 10 times Pre-Tax Profit, and companies trading for less than 10 times Growth-Adjusted-Free-Cash-Flow.
Overall Results: January was a very bad month in the market – worst January on record to be exact – with the S&P 500 Index down about 10% year-to-date, the Growth strategy is down half of that.
Since most Growth stocks more closely track the NASDAQ Composite Index, and with it down 14% year-to-date, I am even more pleased with the Growth Strategy’s performance being down a bit more than one-third of that.
What To Watch For In Coming Months
No one has a crystal ball, but at times like this I like to look at cycles. Past cycles would indicate that the market will be under pressure until Mid-March then recover with volatility through the balance of the year. The forecasts for GDP growth have steadily been reduced for 2022 due to inflationary impact on corporate earnings and consumer spending, plus the War in Ukraine putting further pressure on economic growth globally. If GDP growth is stagnant and inflation continues to grow, watch for lots of talk in the news about a return to Stagflation (it was the dominant economic force in the 1970’s). If the Federal Reserve makes a policy mistake and tightens monetary policy too much, watch for talk in the news of an inverted yield curve (it is historically a precursor to a Recession).
Neither of these is a certainty – it is unknown how much of the current inflation is due to the supply chain issues and how much is due to bad monetary policy. Time will tell whether it is transitory as the Fed initially told us or systemic as their current narrative goes. Either way, we will be managing client portfolios to balance risk and reward and believe we will continue to see results that are better than our benchmarks.
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