Quarterly Letter

January 2022 – Quarterly Letter

By February 1, 2022 No Comments

February 4th, 2022

The Omicron variant popped up in South Africa in late November. Just a couple  days later, Federal Reserve Chairman Powell signaled that the Fed is getting serious about using monetary policy to confront higher inflation. The nature of the omicron wave and the pace of the shift in monetary policy are two major sources of uncertainty that the market must process.

Higher interest rates and higher volatility create some competition for risk assets. How much return do investors require as compensation for enduring the higher volatility of the stock market? The S&P 500 has generated about ten percent returns since its creation in 1957. Since 1950, inflation has been about 3% annually. This means that stock market investors have required a return of 7% after inflation.

Since the early 1990s, inflation has stayed within a range of about -1% to 5% which is in line with the long-term average. So, what happens when inflation spikes higher than 5%? We have to look back to the 1970s to get a sense of market behavior during a period of elevated inflation. From 1970 to 1982, inflation ranged between 5% and 15% annually.

The required rate of return is the sum of the risk-free rate (rate that you would earn from fixed income) plus the equity risk premium. The risk-free rate increases with inflation. The higher required rate of return drives investors to sell lower yielding investments. The stocks with the highest valuations or negative cash-flow are the lowest yielding stocks.

Market behavior this year suggests that the most speculative segments of the market are uniquely vulnerable to higher inflation and higher interest rates. This time last year, new investors were obsessed with meme stocks like Gamestop and AMC. Robinhood went public at $38 a share before peaking at $85. Today, Robinhood trades under $10. Gamestop, which traded as high as $485 closed at $93. Bitcoin, which traded up to $69,000 is down about 50%.

The prices for these assets were untethered to their intrinsic value so it’s hard to know when the fundamentals will again support stock prices. Investment banks took over 300 special purpose acquisition vehicles (SPACs) public in 2021, raising an insane $100 billion in the process. SPACS are literally referred to as “blank check companies.” This is more audacious than anything I can recall during the late ‘90s dot-com bubble. Fortunately, the rest of the market performed in line with economic fundamentals.

We do not know how to value “blank-check companies,” or companies with negative operating cash flow. Our portfolio is made up of companies like American Express, Visa, Microsoft, Apple, Adobe, and Google. These companies have very high earnings predictability which gives us visibility into future cash flows.

The epicenter of the recent volatility is the speculative story stocks. When one area of the market collapses, it can have a spillover effect on the rest of the market. Many investors use leverage which forces them to sell positions in solid companies to cover their losses.

We’ve discussed previously how higher volatility causes rules-based funds to sell. When the volatility returns to normal, these funds will increase their allocation to the stock market. Large institutions will also buy stocks when they rebalance at the end of the month or quarter. If they have a set asset allocation target, when stock prices fall the allocation to stocks also falls. Their process requires them to buy more stocks to bring their equity allocation back in line with their target asset allocation.

These periods of volatility are opportunities for long-term investors. Investors are not selling quality companies because they want to, they are generally selling an asset class because they either have to, or don’t have the confidence to stay in the market long-term.

The current volatility follows an exceptional year by any standard. Not only did global stocks return almost 20%, but the maximum drawdown was only about 5%. Typically, investors can expect to experience a drawdown of 15% on average at some point during each year.

U.S. household net worth is now $143 trillion. Our demographics are very strong with the largest part of the population now entering into their most productive years. The U.S. continues to lead the world in terms of corporate development and innovation. We are coming off a run of three straight years of double-digit returns. This has only happened one other time in my career (1995-1999). It would not be surprising for the stock market to underperform earnings growth this year.

An additional obstacle is that the second year of the presidential term tends to be tough for the markets. Normally, the party that won the presidential election faces a reversal in the midterms. The rebalancing of political power creates an element of uncertainty that leads to the market underperforming in the first half of the year. In the past, once we get some clarity as to how the mid-term elections will play out, the market resumes course following its pre-existing trend.

During periods of volatility, it is essential to attempt to filter out the noise and focus on the fundamentals. The market dropped about 11% from January 3rd before rebounding about 4%. During that time, 2022 earnings estimates for the S&P 500 increased 2%. Ten-year interest rates moved from about 1.5% to 1.9%. This increase is not enough to explain the recent downdraft.

Right now, the market is trying to figure out how high interest rates will go. Once those expectations stabilize, investors will recognize that higher rates do not mean the end of the bull market. The economy is continuing to recover from the pandemic. It no longer requires the extraordinary support from the extremely accommodative Federal Reserve policy. From these extremely low levels, investors should view higher interest rates as a sign of healing and normalization.

The current volatility should not come as a surprise given the nearly continuous rally since March 2020. Long-term investors should view volatility as an opportunity at best, a nuisance at worst. We continue to own companies with promising growth prospects that are attractively valued. As volatility eventually subsides, investors will return to high quality companies such as those in your portfolio.

Eric Barden, CFA