Sometimes a quarter passes and nothing much happens. Other times, so much happens in a quarter that it seems like a full year. The first quarter of 2022 falls into the latter category. Supply bottlenecks and then, of course, the inflationary implications of the war in Ukraine brought large price changes to bonds (negative) and commodities (positive). Energy and resource-related stocks were the biggest beneficiaries because supply disruption translates to higher selling prices. Other sectors could not as easily pass on their higher costs. Technology and consumer discretionary stocks were the biggest losers in the latter category, dropping around nine percent.
The S&P 500 large company stock index, down more than -10% on March 14th, managed to recover over half of that by quarter end to finish off -4.6%.[i] The late quarter bounce was driven by the desire for safer, larger, dividend paying stocks, thus small caps had a much smaller bounce and finished -7.5%. The technology-driven NASDAQ Composite Index was off -8.9%. As we shall see below, there was no help from foreign stocks or bonds last quarter; only utilities and commodity-oriented funds managed to post a gain. Energy was far and away the best sector last quarter, but as it represented less than 4% of the S&P 500 at the start of the quarter, it could hardly offset the negative impact of technology (almost 25% of that index).
As a whole, international stocks were down -5.9% last quarter.[ii] Again, there were bright spots. Latin America, on the strength of soaring demand for Brazilian oil, Argentinian agricultural products and Chilean copper (among other things) roared ahead 27.3% last quarter. That said, Latin America accounts for less than 2.5% of the total international index, so the drag from Europe (-9.6%), China (-14.5%) and Japan (-6.6%) was just too strong. Most international markets were not helped by ongoing strength in the U.S. dollar.
Bond investors experienced their worst quarter in more than 40 years. The benchmark Bloomberg Aggregate Bond Index fell a staggering 5.9%. Considering that the index yields around 2%, roughly three years’ worth of coupon payments were lost last quarter. The bond market had been telegraphing weakness for quite some time, so we were able to substantially reduce interest rate sensitivity before bond yields had their big post-invasion spike. Other than short term floating rate treasuries (+0.2%), one could not have made money in bonds this past quarter. Municipal bonds performed especially poorly (-6.2%) as very low yields and overbuying in 2021 made them particularly vulnerable to rising interest rates and investor flight. High yield corporate bonds lost -4.8%.
Since this was a very eventful quarter, there was much more activity than usual. As interest rates rise, future earnings become less and less valuable relative to current earnings. If the rise in interest rates is gradual, the stock market tends to take it in stride. If rates rise sharply, as they did this past quarter, the stock market gets alarmed. In fact, the whole valuation paradigm of the market can be thrown into question. Specifically, if the prevailing environment is low and generally declining interest rates, as it had been the great majority of the time between 2009 and 2021, it makes sense to pay up for rapidly growing companies even if that rapid growth is still in the revenue stage and had not progressed to actual net profits. If, however, interest rates begin to soar and funding costs climb, investors quickly tire of rapidly growing, unprofitable, companies that need to spend every dollar of revenue to fund growth. Not when they can buy a company that is already profitable and seeing demand for its products grow such that it is able to raise prices faster than its input and labors costs are rising. This is how natural gas and coal investors make 35% in a quarter while biotechnology and software-as-a-service investors lose 35%. Growth is out, value is in. Small caps, especially if they are growth-oriented and outside the U.S., are especially vulnerable when the paradigm changes back to “bird-in-the-hand” companies and away from “two-in-the-bush”.
The number of changes necessary for most portfolios required a complete re-balance. Because we had already reduced the duration (interest rate sensitivity) of the bond portion of portfolios in 2021, the biggest change on the bond side last quarter was the outright substitution of alternatives like commodities, real estate, or merger arbitrage for coupon paying bond funds.
In my investing career I have never seen a wider range of possible market and economic outcomes than exist today – Doug Kass, President, Seabreeze Partners
First of all, bond yields have moved up a considerable amount in a very short period of time, so I expect yields to stabilize in the short run. That should be a positive. I am concerned that the Federal Reserve has, because it was overly accommodative in 2019 and again in 2021, put itself in a position where it probably needs to err in the other direction over the next few months. The resulting contraction in liquidity is probably not going to do markets much good. With an ongoing crisis in Ukraine and the midterm election coming up, it just feels like the headwinds exceed the tailwinds this year. Allocating a higher percentage to hard assets like industrial and agricultural commodities, precious metals, and energy seems like a prudent way to get through what promises to be a prolonged period of above average inflation.
Looking farther out, the recent correction in growth stock prices has made this sector of the market much cheaper. Strong companies that sported eye-watering P/E multiples last year such as Adobe, Chipotle, Nvidia, and Intuitive Surgical are down 20%-40%, so while not cheap per se, they are at least much more reasonable. They have a good chance of rallying once investors believe that the end of the Federal Reserve rate hiking cycle is in sight.
Commentary– of Trends, Wolves, Torches and Lebron James
It’s a tough quarter when somewhere around 96% of one’s investable universe declines in price, but that happens sometimes. I’ve certainly gone through many quarters when 96% or more of everything we track went up in price. When the interest rate and liquidity trends are at your back, investing is fairly easy. On the other hand, if those trends are working against you, investing is much harder – with the only reward sometimes being that one loses less. That doesn’t have to be a bad thing. Investing is cyclical. Bad periods set up good periods, and vice versa. You cannot survive as a money manager projecting current trends into infinity.
I remember when the yield on the 10-year bond fell to less than 0.6% back in August 2020. That was great if one had been a bond buyer in any of the previous 40 years, but where do you go from there? Inflation was running at about 2%, so buyers at 0.6% were getting no inflation protection. The only chance of a positive real return was that interest rates went even lower. You didn’t need to know that interest rates were going to soar in the first quarter of 2022 to know that buying the 10-year at that point was a terrible bet. It was like watching Lebron James score 55 points in a basketball game and betting that he will score 60 points in the next game. It’s not impossible, but the odds are not in your favor. The odds were also not in your favor if you paid $500 per share for Zoom Video in October 2020 or $160 for Zillow in February 2021. You were betting that an explosive trend (in this case, shop from home) would continue to grow at exponential rates.
The nature of trends is that the longer they last the more powerful they tend to be, but that all trends eventually end. Stocks with a high and consistent rate of annual earnings growth (growth stocks in the parlance) performed extremely well in the low interest rate environment of the past decade. On one hand it was a mistake to assume their outperformance would end simply because they had become expensive (in some cases very expensive), because bull markets are generally not killed off by valuation. On the other hand, it was a mistake to assume the growth stock run would never end. Rising rates and tight credit are like kryptonite for growth stocks. There were two periods – late 2015 into 2016 and late 2018 – where worsening credit conditions led to 15-20% drops in growth stock prices. In each case, the economy slowed, the Fed reversed itself, and these stocks were off to the races again. Therefore, an experienced manager doesn’t panic when growth stocks hit an 8-10% skid as they did in February and again in October of 2021.
The decline that began on December 28th of last year was not a concern until the rally attempt at the end of January quickly failed and lower lows were made – even before the Russian invasion of Ukraine. This was new. As the market began to digest the impact of wage inflation driven by the difficulty finding qualified available workers and of goods inflation driven by raw materials shortages and shipping bottlenecks, it was suddenly confronted with a regional war. A significant amount of energy and agricultural commodities were effectively taken “off-line” through a lack of available workers (Ukraine) or embargo (Russia) – which only makes the goods inflation situation worse. At this point we had not just a sell-off but a change in the narrative driving the market – that rising inflation wasn’t a transitory event but in fact a structural change that would usher a new group of companies into market leadership.
The point here is that the first perhaps 5-8% stock market decline is noise. Markets fluctuate. If you aren’t conformable with that, you should probably buy a CD or a fixed annuity instead. Most declines of this magnitude don’t last very long. The proper course of action in most cases is to do very little. Every so often, however, the market will cry wolf and there will actually be a wolf. Those are the times where you have to be prepared to act. As a manager, I really don’t expect to add value in a 5% decline. I’m not going to radically change a portfolio for a decline that small or else I’d constantly be buying and selling. I also know that it is hard to add value in a crisis decline like March 2020 because that situation was completely emotional and nearly impossible to model[iii]. Where managers can add the most value is in a prolonged decline. The more the market loses, the less I expect to participate in that decline because I can discern what the new narrative is and I can re-position portfolios away from the most vulnerable areas. The bear market that ran from March of 2000 through October 2002 was much easier to outperform after the Autumn of 2000 because it had become clear that the growth narrative had been broken and the technology sector no longer carried the torch of market leadership.
Periods of strong performance almost always lead to periods of low performance, because as asset prices rise in excess of the increases in their intrinsic value, valuation deteriorates. Happily, that process also works in reverse. If we have to endure a multi-year period of poor bond returns while bond yields rise to a level that better compensates us for taking inflation risk, that’s fine. We’ll get through it by underweighting bonds and overweighting hard asset alternatives. After a decade of fairly poor-to-terrible returns, most commodity producers are undervalued despite having done very well this year. The conditions they required in order to thrive have finally come to pass. Energy stocks are about 4% of the S&P 500 and Basic Materials stocks are less than 2.5% today – less than half of where they were at their peaks in 1980. That’s kind of like betting on Lebron the game after he’s just had a 15 point game; not a guarantee but attractive from a probability standpoint. At the end of the day, as investment managers, that (putting the odds in your favor and watching carefully to see that they remain there) is one of the most impactful things we can do.
Updated Statement Benchmarks
Please note that we updated the benchmarks on our quarterly statement to be in greater alignment with industry standards. We believe the updated benchmarks better highlight the broad array of investment possibilities as they more clearly delineate the asset classes in which we invest. A brief explanation of our new benchmarks is below. Please don’t hesitate to reach out with questions.
The S&P 500 is used to track the performance of the United States stock market. The index covers the 500 largest companies by market capitalization. This represents a little over 80% of the total capitalization of the U.S. stock market. These companies vary widely across the sector spectrum, covering both manufacturing and service companies.
The Russell 2000 is used to track the performance of smaller companies in the United States. It tracks the roughly 2000 securities considered to be among the smallest US companies. It is a capitalization-weighted index made up of the smallest 2,000 U.S. common stocks as measured by market capitalization included in the Russell 3000 Index, which consists of the largest 3,000 U.S. common stocks based on market capitalization. There are between 3700 and 3800 listed companies on U.S. exchanges right now, so the Russell 3000 covers more than 99% of total U.S. market capitalization. This gives you some idea o1f how small the smallest 700-800 companies must be.
MSCI ACWI Ex-US
The MSCI All Country World Index Ex-US is used to track the performance of stock markets around the world, excluding the United States. It captures large and mid-cap representation across 22 or 23 Developed Markets (DM) countries (excluding the US) and 25 Emerging Market (EM) countries. With 2,300 constituents, the index covers approximately 85% of the global equity opportunity set outside the US.
Bloomberg US Aggregate Bond Index
The Bloomberg US Aggregate Bond Index is used to track the performance of the United States investment grade (BBB-rated or higher) bond market. It is a broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency). In May 2019, 72% of all U.S. bonds were investment grade. This number fluctuates due to economic conditions and investor preferences.
[i] Source: Morningstar Advisor Workstation
[ii] Source: MSCI ACWI-EX US, Morningstar Advisor Workstation
[iii] Over the course of 17 days (March 6th to March 23) the market discounted the absolute worst-case scenario and then began to walk it back, slowly at first and then rapidly by June.
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