Trying to understand how markets react over short periods can be perplexing. A conundrum wrapped in a riddle of a black cat in a darkened room that maybe isn’t really there.
This was demonstrated in early 2020 when the pandemic struck globally and markets around the world went into free fall. They fell 30%, a true black swan event. All bets most definitely off.
A few months later Covid is blazing, economies are melting, markets had recovered, and some were up!?
The explanation: all the big central banks hosed their economies with a tsunami of cash. They bought financial instruments to keep markets liquid with no limit, they paid businesses to shutter, they paid workers to stay home. They really paid everyone anything to do nothing. Markets loved it though Covid remained a huge unknown.
2021 was then way more of some things and less of others.
Interest rates stayed rooted to zero, money kept pouring out of Central banks, flowed into markets and asset prices especially at the outer edges went parabolic.
- SPACs boomed; issuance went through the roof
- Crypto coins went stratospheric
- NFT’s commanded multimillion dollar bids at art house auctions
- Collectable prices rocketed
- New technology companies mooned
But here’s the interesting thing.
The average stock price for 2021 peaked in ……. around February for the so-say Covid winners.
The indexes overall did great for the year but former highflyers got slammed after the first quarter of 2021.
A central reason the market overall performed well, was the continued mega profits of the biggest names in tech; they were big and still growing strongly and their upward momentum made the difference. Alphabet up more than 60%, Nvidia doubling, Apple and Microsoft each 30% plus. Absolute juggernauts.
Under the surface though the markets rotated progressively out of the ‘jam tomorrow but no profits today’ stocks into the recovery plays like airlines and hotels, financials, energy and industrials and here’s why.
The return of value (for a time?)
So, in the environment we had in 2020 and 2021 the thinking went that cash yields were zero or negatively to inflation so offered no risk free return rate. The risk-free rate is the yield investors can achieve in assets perceived as bombproof, e.g. a U.K. Government Gilt, German Bund or US Treasury.
When looking at tech companies who have massive potential in their market but are in a hyper growth phase so make no profit or are making losses to build out their infrastructure, this then doesn’t matter. It doesn’t matter as there is no drag on a discounted cash flow as no risk-free return is available to an investor or negative to inflation.
A discounted cash flow calculation is to project forward profit growth of a company and then discount the return by what can be received risk free from say a 10-year Treasury bond. This gives you a net return which compensates for risks and volatility likely to be endured in a stock. The higher the return the more attractive to take risk.
So hyper growth non profitable companies are most attractive to investors in a low-rate environment. More attractive at a zero rate.
During 2021 the thinking was firstly the pandemic winners had no more runway. They had gained all they were going to in extraordinary times which juiced their growth. Peloton, Ocado, Teladoc and Zoom as examples, got cratered.
As the year went on and inflation got hairier the markets started to factor in the likely Central Bank response. Stop pumping money in, start siphoning money out and then raise interest rates. The question was then, when, and how aggressively?
In November, Federal Reserve Chair Powell who was in the midst of reconfirmation hearings in Washington and bombarded by politicians demanding action on inflation said, yep, we’re going to put rates up next year (2022). No specifics but that was enough. Markets were unnerved as estimates rose from 2 rate hikes to possibly 5 in a year.
Let’s be clear here, 5 rate rises still means rates lower than 2% with inflation at 7%, so even if inflation halves still a negative real yield. But the narrative had fundamentally changed.
Time and rotation
If you have made it to this point you may well be thinking, well, that’s all fairly logical.
Rates need to go up. Economies have way too much money swilling about as the stimulus of ’21 was largely unnecessary in retrospect, so I’m ok with rates up and liquidity stabilised then drained off. If you are I agree with you.
What is less understandable is how supposedly long-term investors are reacting by rotating aggressively out of growth stocks and into the value parts of the market.
The best performing sector in 2022 has been energy; oil! These stocks were left for dead in 2020 and 2021 and were supposed to be in a secular decline with ESG making them uninvestable for a large proportion of funds. Remember in 2020 the price of oil went negative. There was a moment where literally nobody wanted it and the person who took delivery of a tanker had to be paid to do so. That’s the oil for free plus a fee.
Now here’s the reality. Sure, oil and coal will decline as fuels for Western economies but not yet and not for a good while. The oil companies are not spending on drilling new fields now, they’re busy talking about how they’re moving to renewables such as wind and solar.
No new production, a reduction in existing production post Covid and so tight supply.
Oil has risen in the last 18 months from free to $90 a barrel and the oil company shares have doubled. It makes logical sense in retrospect, but does anyone think oil shares are the future?
So, 2022 has started with the two main investment themes being.
- Buy oil companies
- Sell technology Companies
This happening whilst the world has fully woken up to the imperative of reducing carbon emissions and in the early innings of transformative technology revolutions changing mostly everything pretty much everywhere.
My personal mantra through times like these (which hammer some of my personal shareholdings) and so make me feel like an idiot is this.
Stay calm, you know where it’s going but you know you don’t know how it gets there.
To put it my plainly, it’s the ‘taking the unruly dog for a walk’ analogy.
You as the investor know when you leave one place on a journey where you want to and will end up.
The markets are the unruly dog you are walking with off the lead, that just goes manically haring around everywhere as you travel.
You’ll get to your desired destination just fine though as long as you don’t follow the dog.
Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog, and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.