As we wrote earlier this month, that we anticipated volatility to pick up, the market has sold off almost daily as we start the new year. In dramatic fashion, seemingly daily 1-2% declines are sure to unnerve even the most optimistic investor.
We wanted to reach out to you today to provide our “take” on the current selloff and what we believe is causing the current correction in stocks, which is an update on talking point #5 that we touched on in our 2022 outlook.
During the first week of the year, the Fed released the minutes from its December policy meeting. In it contained a statement about expected future rate policy considerations: Reduction of the Fed’s balance sheet. What this means is that the Fed is signaling not only an end to their quantitative easing (buying bonds, which started during the COVID pandemic induced sell-off) but is now considering a 180 by selling bonds into the market or not rolling the proceeds of those maturing bonds to purchase new bonds. This mechanism serves to not only reduce the holdings on the Fed’s books, but inherently injects supply of treasuries and mortgage-backed securities into the market to absorb. With heightened supply, principles of economics suggest that there will upward pressure on bond yields, causing downward pressure on bond prices as Fed supplied liquidity is removed from the market. This was a big surprise to the market, which was already concerned about the Fed raising funds rate this year.
From the inception of the Fed’s announcement, the market began going through a revaluation of sorts, given that higher rates cause a higher discount factor to future earnings. Higher discounts have impacted higher multiple stocks more – those names whose valuation was already stretched by historical standards leading up to the end of the year. This announcement of QT, however, is perhaps causing the market to price in a Fed policy “mistake.” This mistake can be broadly summarized as doing too much too quickly in the Fed’s effort to address spiraling inflationary readings.
Which brings us back to the main culprit, or driver of the market movement – inflation. The Fed is now changing course from being accommodative and providing liquidity to a posture where it is focused on reeling in inflation. Therefore, the market is sorting out what impact both inflation and a hawkish Fed will have on future corporate earnings and their fair valuations against this backdrop.
However, corporate earnings as of late are at (or close to) historical highs. Corporations are more profitable now than they have been in some time. This is a positive indicator, but profit growth cannot stay at such lofty levels indefinitely. As we wrote the other week, inflation will certainly take a bite out of earnings, and thus profit. But to what extent is the market sell-off justified, or is it painting a more negative scenario than the underlying fundamentals justify? That is the million-dollar question. Even if forward earnings decline by double digits, the underlying profit margin is still respectable, which should support valuations at some level. Perhaps we are closer to that level than not. Furthermore, gross domestic product (GDP), is still trending around 4%, which is historically high. A 4% GDP also points to a fundamentally strong economic backdrop. Inflation will have the impact of eroding future earnings and rising rates will impact the discounting of future cash flows.
At the end of the day, the sell-off has been swift and deep, and we are likely closer to a bottom that you may think. An old investment adage is ringing true this year – markets go up like an escalator and go down like an elevator. This is the typical pattern of market dynamics, and the current decline is no different.
At the time of this writing (12:00PM 1/24/2022) the S&P has “corrected” by around 10%, which is not uncommon historically. Sure, the sell-off seems like the start of something worse, as it usually does. But at this juncture, it has not yet impacted corporate profitability to an extent that may signal an upcoming recessionary environment. No doubt, giving back a good chunk of last year’s gains is frustrating. However the economy is still on solid footing, and once the market drains out the speculative excesses from the prior year’s exuberant sentiment, excess (and over extended) liquidity measures, and weak hands, the market is likely to again focus on fundamentals, as it has time and time again. If so, participants may begin to realize that the sell-off was overdone, just as the prior year’s advance was more than what was fundamentally justified.
At the end of the day, valuations do matter. The past several years were odd –seemingly valuations did not matter. Speculation was elevated. Retail investors came rushing into the market in droves. Thank you zero commission trading platforms, meme stocks and Reddit boards rallying the novices. Now those novices are learning a painful lesson of bidding up companies that have no earnings, or very little earnings, to valuation levels that are historically ludicrous. Over time, the market will settle into a justified reality that quality companies that make what the world wants and needs are indeed making money. The market will ultimately find a level of valuation that no longer attracts speculative investing, but instead is supported on fundamentals and reasonable valuations.
The selling will come to an end, but it will likely continue to be painful until the market works this out.
Know that we are assessing the situation, but are not making emotionally laden decisions. Instead, we will continue to utilize our objective, price observation research tools to navigate these storms. For instance, last Monday 1/14 we sold our QQQ position (large cap tech) and rotated to RPV (large cap value). Since then, RPV has declined less than QQQ through 2PM on 1/25 (-3.9% vs -7.3%). Our risk mitigation process is getting closer to triggering a reduction in risk exposure, which it typically does AFTER the market sells off around 15%. QQQ had a trim recommendation on 1/21, but we had already evacuated that position a week prior. RPV is only down 5% off its recent high. This tolerance threshold is set as such because historically, 10% corrections are normal – occurring, on average, every 16 months or so. Ten percent declines are often bought, barring an exogenous shock (such as a global pandemic) or a fundamental breakdown of the underlying mechanics of capitalism and orderly financial market mechanisms (great recession of 2008).
Update 2PM 1/25/2022 – As I was writing yesterday, the market staged a turnaround of dramatic fashion not seen since 2008 – the NASDAQ and S&P500 erased its 5% and 4% loss, respectively, to close the day marginally higher. This is a good sign that the market is trying to find a bottom. Yesterday was also a 9 to 1 day, meaning for every 1 stock going up in price, 9 were declining, another sign of potential capitulation. I also learned overnight that many retail investors were selling during the morning yesterday, pointing to perhaps a shake out of those weak hands previously mentioned. And today, 1/25/2022 we saw another mid-day turnaround from the intraday lows. The more the market finds support, the more likely it is forming a bottom.
All in all, investors are grappling with how to position their portfolio ahead of the 2-day Fed meeting, which begins on 1/25 and concluded 1/26. We are likely to hear revealing information from Fed chair Powell on his rate stance given the recent sell-off. However, it is our belief that the Fed, to preserve its commitment to fighting inflation and retain its credibility, will not change their tone. The other side to this is that market forces may very well be causing some downward pressure on inflation, which may have the effect of doing the Fed’s job for it – reducing inflation- thereby perhaps enabling the Fed to be less hawkish. This would be a positive for the markets.
We’ll continue to communicate to you regularly as the situation unfolds in the weeks ahead.
