Wild Wild Wall Street

The equity markets woke up on Monday in an uproar, accelerating last week’s broad market selloff, especially in growth and tech stocks. The S&P 500 remarkably finished higher by almost 30 basis points (.30%) after falling nearly 4% at one point during the day. The tech-heavy NASDAQ collapsed more than 5% before rallying, finishing in the green as well. In a recent update, we noted the potential for the major indexes moving at least 5-10% lower; and they have, with Large Cap stocks off close to 10% from record highs. We are near correction territory, nonetheless, this is a healthy development.

The wild swings in prices also came to fruition. We anticipated they would be here sooner than later, and almost a certainty at this point in the cycle with Fed tightening after years of excess liquidity. Today’s charted performance alone looked like a month’s worth of price movements. The VIX (volatility fear gauge) jumped up to almost 39, the highest read since October 2020. Last week’s 5.7% drop for the S&P 500 was one of the fastest on record. Sharply higher bond yields did not help the situation, although they are staying relatively low by historical standards and rangebound, in line with our estimates.

The volatility may feel unnerving. Yet it shows that the market is starting to reconnect with reality and fundamentals, which is a good thing.

And we were ready for it. All the major items we have acutely strategized and prepared for finally moved into focus for market participants: supply chains, inflation, Fed policy, tensions with Russia and China, and slowing earnings growth. These are variables that are all in some ways intertwined. They will strongly affect current and future economic growth. When any market gets frothy, the best investors stick to what makes sense from a fundamentals perspective. Does the price match the expected cash flows and growth? That is why we are focused on companies with quality earnings and balance sheets and underweight those that are more speculative.

We also have the diversifier of unloved or less enthusiastically covered Small Cap stocks and international stocks in our equity exposure. These allocations will be a long-term growth driver with more of a valuation runway than domestic Large Caps. The rotation out of the crowded Large Cap Growth space into Value and cheaper asset classes is becoming more pronounced and should be here to stay.

Tough Times for Tech. It would be foolish to remove Growth stock exposure or significantly underweight the factor completely. Technology and growth-oriented companies are far too integrated into several sectors and the broad economy. Yet, there are safer ways to play tech – infrastructure, semiconductors, and cloud computing are areas that will continue to require investment, provide cashflow, and are grouped into the Quality factor we have been focused on. We look for managers that take a GARP approach – growth at a reasonable price when selecting tech names.

The problem that Big Tech faces is slower expected earnings per share growth than the S&P 500 despite higher revenue growth as higher costs are cutting into margins. Supply chain pressures will be part of the cost pressure along with wages. This combined with poor consumer confidence will continue to weigh on valuations. These companies are sitting on a ton of cash, and it will be interesting to see how and if they spend it. Increased capital expenditures would improve supply chains and be better for the economy in the long run. More buybacks would keep investors around at least for the short term. Regardless, they warrant our attention given their massive weights in the core indexes.

*As a side note, we have advised against any major exposure to Bitcoin and other cryptos for good reason. Bitcoin has lost half its value from November highs and is not nearly as much of an inflation hedge as many strategists started to think, as it has been much more correlated with tech stocks. We have been bullish on commodities and real assets as an inflation hedge over crypto for a while.

Fear the Fed or will they fan the market flames? The Fed’s first policy meeting of the year is here and with it, comes expectations of our first rate hike announcement. A quarter point raise in March is priced in, but questions remain on how aggressive Fed tightening will be. We will look for hints at faster or larger hikes. The real pain may be when the central bank begins to unwind its balance sheet. Once this occurs, we will keep a close eye on how the market reacts to the news and how participants absorb the higher rates.

Barring an unexpected massive slowdown in the economy, the Fed will most likely continue its hawkish course to head off inflation. Their number one goal should be price stability, especially with a labor market that is very tight (3.9% unemployment rate) and potential wage spiral inflation. Tighter policy may make investors uneasy, but in reality, the greater danger is how far the Fed has fallen behind the curve compared to the last cycle when peering at all relevant employment metrics and inflation targets. Noting the excessive growth of liquidity, the money supply is still increasing at a 13% rate, after consistently hovering in the mid 20’s range since April 2020. That is not sustainable. Countercyclical measures by way of tighter monetary policy will be good for an overextended market.

Finally, the new wild card replacing Covid seems to be geopolitical tensions. The Fed actions (or inactions) are not the only major moves the markets are watching. If Russia invades Ukraine, it could have far-reaching effects, especially in the Euro Zone, whose member countries have much more to lose than the United States with strict sanctions. The increased saber rattling via nuclear missile testing in China and North Korea is not helping to ease tensions either. While the consequences from these major global threats to stability are hard to predict, we remain steadfast in our disciplined approach to measured risks in our allocations. Fortunately, we’ve been prepared for the wild cards and volatility thus far. We will continue to be watchful, nimble, and patient in our process.

Questions, comments? Contact us.