Quarterly Market Perspective for 4Q21
Summary
The stock market shrugged off several attempts at a broad sell-off last quarter to eventually end up about 11% higher. Both November and December saw drawdowns of more than three percent before sharp reversals led to new all-time highs. Of course, this is only true if we consider the largest U.S. companies as “the stock market”. If I were describing last quarter’s performance by small and mid-size companies, I could have written the following: “the stock market ran up sharply in October only to decline even faster in November. A modest early December rebound quickly failed as did a late December bounce. The Russell 2000 small cap stock index gained only 2.1%[i] on the quarter”. Likewise, discussion of international stocks would have looked strikingly similar; a lot of choppiness and a modest gain (up 2.7%). The utterly massive performance of just a few stocks has distorted everything. Semiconductor chip-making powerhouse Nvidia was up 42%[ii] last quarter, while Tesla soared 36%, Apple 26%, and Microsoft just under 20%. Mega-cap health juggernaut UnitedHealth Group rose 29% and Home Depot climbed 27%. More on this below.
Bonds continued to struggle in the face of rising interest rates. The Bloomberg Aggregate Bond Index gained exactly 0.01%, which lifted its return for the full year from -1.55% to -1.54%[iii]. Ouch. By reducing interest sensitivity, either through buying shorter maturity bond or lower credit debt, it was possible to reduce or eliminate losses in a bond portfolio, but even the very best bond category still paled in comparison to most stocks. The positive in terms of bond ownership is that as yields rise, newly issued bonds have higher coupons. That means future bond market returns should improve.
European stocks were the next best performers last quarter, gaining 5.1%[iv]. China continued to drag Asia lower. China lost a little over 6% as investors continued to question Chinese economic policies and the real estate sector was reeling from the Evergrande crisis. Japan also fell almost 4%, but international analysts tend to regard that country as very cheap. It is easy to write off non-U.S. markets because of their poor relative performance over the past decade, but investors cannot invest in past returns. Going forward, the vast valuation discrepancies in foreign based stocks versus U.S. stocks make foreign markets attractive – if not immediately then at least on a 5-10 year basis.
Activity
We have been more active lately as financial markets show signs of succumbing to the pressure of rising interest rates. When interest rates rise, several things happen:
- Existing bonds decline because their coupons become less attractive relative to new bonds with higher coupons;
- Stocks decline, because the value of their future dividends and/or future cash flows are worth less when discounted to the present; and
- Gold may also worth less if interest rates increase faster than underlying inflation, such that they (interest rates) more fairly compensate investors from inflation.
As investors, we really don’t want to see inflation. It is almost never helpful. The problem is, if interest rates are kept artificially low, inflation eventually results. For years the Fed has kept inflation largely confined to the stock and real estate markets. The Covid crisis ended this, because the pandemic forced production shutdowns because of the unavailability of labor and/or materials. The obvious consequence of scarcity of materials and labor is higher prices and wages.
In bond portfolios we have been reducing interest rate sensitivity by exchanging into shorter duration bonds with higher yields. In some instances, we have substituted alternatives such as convertible or merger arbitrage for some of our bond exposure. In stock portfolios we have reduced exposure to the highest volatility stock positions. For the most part these were funds that focused on disruptive technologies which, while promising, will generate most of their profits in the distant future and as such cannot be valued as highly when interest rates are rising.
Outlook
What we’ve seen so far in January is either a needed correction that will set the stage for the next leg of rally once interest rates stabilize, or evidence that the speculative post-covid liquidity bubble has popped in which case stocks will not stop falling until all the speculative excess has been wrung out. Corrections caused by excessive valuation running into more restrictive monetary policy are not rare – we saw two in 2018 and one in each of the preceding eight years (except 2013 and 2017). Full fledged paradigm shifts tied to a crisis in one or multiple sectors of the economy are far more rare, and indeed, not what we expect this time either. Still, it can be unpleasant to go through these periodic downturns.
We are seeing some very strong companies starting to be sold off lately. We didn’t take it as a general warning when some of the highest post-Covid flyers like Zoom and Roku and Zillow ran into trouble last year because they are not very representative of the market as a whole. If a correction would come along that impacted Apple, Microsoft, Nvidia, Adobe, and the like – then you’d know investors were finally starting to care about inflation. That is where we stand today. Again, I believe this dip will be bought much like the others in this long bull market. The economy isn’t slowing at this point and interest rates are still low (the 10-year bond still yields less than 2%). Again, I believe this decade we will see a paradigm shift that causes U.S. interest rates to move to a higher range and makes non-U.S. assets more attractive, but this will take years to evolve.
Commentary
One good thing about analyzing very large companies like Apple, Microsoft, and Nvidia with hindsight is that you can say conclusively that none of them deserved their huge stock price surge. Their size is such that their profits could not possibly have grown fast enough to justify a 20% quarterly gain on top of their gains of the first three quarters of 2021. If we know, therefore, that the prices of U.S. mega-caps are not justified by their economic performance, why are they so high? Because they have pulled in capital from all over the globe seeking growth and safety in a world where growth has largely (but not exclusively) been confined to American companies and safety has meant that the earnings yields on blue chip U.S. companies (even with price-to-earnings ratios above 35) exceed what one could earn from the bond market, many regarded them as being bond substitutes. Years ago we even coined an acronym – TINA – for the idea that as far as U.S. stocks are concerned, There Is No Alternative.
Chart 1
Over the past decade or so, U.S. investors have been rewarded for behaving as if there was no alternative to U.S. stocks. It is my belief, however, that the “TINA Era” is in the process of ending. Imagine the Pacific Ocean at rest. Waves aren’t cresting in Japan, nor are they high in Oregon, Peru, or Australia. Now imagine the strongest hurricane force winds ever recorded blowing due northeast. The entire Pacific Ocean is being pushed toward the U.S. west coast, hard. The hurricane in this allegory is the combined forces of U.S. economic and taxation policy (a 40-year shift in tax policy away from corporations and toward individuals, chart 2), the U.S. dollar’s global reserve currency status, and the global oil payment system. All of this combines to drive money into the U.S. stock market and especially to biggest and the most liquid companies therein. The winds may fluctuate in intensity, but they never completely let up, so the world gets used to what would normally be regarded as very unusual circumstances. The U.S. dollar is expensive relative to all other currencies because everyone needs it to buy oil and U.S. equities (which have been at multi-decade highs, at least until recently).
Chart 2
Americans are disproportionally enriched by this system, which allows them to consume more and more, which makes their trade deficit with the rest of the world larger and larger (see Chart 1). The catch is this – the benefits to Americans are not evenly distributed. For the most part they are realized by stockholders, so the wealthiest get ever wealthier. Over time, the U.S. has developed a wealth gap that is more befitting a third world country (see Chart 3). At least somewhat as a result of this, our political system is as fragmented and contentious as it has been since the Civil War. This decade cannot, and I believe will not, just be more of the same, because a rising percentage of younger (and statistically poorer) people don’t believe the systems works for them. As economist Herbert Stein once said, “If something cannot go on forever, it will stop”.
Chart 3
Change is always difficult to forecast. On any given day, odds are that politically, economically, socially, and geologically things will change very little from the previous day. Then there are those days where something snaps and everything changes. In light of the extreme level of imbalances, it seems prudent to begin to invest as though there are alternatives and to use them more actively, rather that wait for market conditions to force this upon us. No one is going to ring a bell to tell investors that the great TINA era is over, but at some point in the future we will all know that it is. As I said in the Outlook, I expect a near term rally off last Friday’s (1/21/22) lows, but I also expect a more difficult decade for investors than the 2010s were.
[i] U.S. Index performance courtesy of S&P 500 via Morningstar Workstation
[ii] U.S. individual stock performance courtesy of Morningstar Workstation
[iii] Bond index performance courtesy of Bloomberg via Morningstar Workstation
[iv] International Index performance courtesy of MSCI Global via Morningstar Workstation
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