Rough Waters Demand a Steady Hand
Since early November we’ve seen higher-multiple growth stocks and risk-assets like Bitcoin reprice lower as they’ve experienced higher than normal levels of volatility. What was the trigger that got this process going? Where do we stand as we look out at the market over the next several months? And has anything of significance changed in the last month or so? The answer to this last question would be, yes, a rather significant Fed pivot. But what does this mean for investors?
My colleague ACM portfolio manager, Kevin Strauss, has astutely observed and pointed out that there have been several rolling sharp corrections within the market over the last couple of years, even though the broad market continues to march higher. Indeed, relative to its pre-COVID high on Feb 19, 2020, the S&P 500 is up 42%, which amounts to an average annual gain of about 20%. But within the market there have been sectors or themes of stocks that’ve experienced sharp selloffs. Currently we’re experiencing one of these sector-specific corrections. The iShares Expanded Tech-Software ETF, is an excellent proxy for high-multiple, high-growth stocks, and it has declined by 20% from November 9th through mid-January. What caused this 20% (bear market) drawdown? You could likely point to the collective wisdom of the crowd, as the market started to see the yield on the 2yr-Treasury move higher (chart below). It started its move in October well before Chairman Powell’s Nov 30th testimony to Congress where he said that the Fed no longer saw inflation as transitory and that they were leaning towards tapering faster than originally planned. This was the beginning of the Fed pivot. Equity markets saw volatility move sharply higher as the VIX spiked to over 31 on this change in language from the Fed. The 2yr-Treasury tends to lead the eventual move in the Fed Funds rate, and growth stocks started to reprice lower well before the Fed Chair’s comments at the end of November.
The 2yr-Treasury Note:
We’re now in mid-January and the Fed pivot has gotten even more pronounced. Fed Fund futures are currently reflecting at least three and possibly four 25 basis point hikes in 2022. As well, the Fed is clearly indicating that it’s now inclined to begin letting its bond portfolio runoff (meaning they won’t buy new bonds to replace the bonds that are maturing). So, in less than two months’ time the Fed has gone from very accommodating and “inflation is transitory” to now ending QE in March and likely raising rates for the first time also in March. And then at some point later in 2022, it’s going to begin quantitative tightening (QT) by letting its almost $9 trillion bond portfolio begin to wind down by some monthly amount to be determined later.
Where do we stand as we look out at the market over the next several months? Consumer balance sheets are healthy and in better shape than at any time in the last twenty years. And consumers are employed and finding it rather easy to quit their jobs and find new ones, often at better pay. This has led to an unemployment rate of 3.9% (it was at 3.5% in Feb 2020). This, in turn, has led to an increase in consumer spending. Recent credit card spending trends are starting to move higher. As well, the housing market remains very healthy – some would argue that it’s too healthy. US home prices have risen by about 19% over the past year, reflecting a shortage of housing. This helps build consumer wealth and confidence along with it.
As mentioned above, the important observation to keep in mind in regards to all of this is that the broad market continues to move higher despite the shock to growth stocks and higher-risk assets that we’ve seen over the last couple of months. The S&P 500 is currently trading at 19.2x next-year’s earnings. This compares to the 17.5x average over the last five years. So, somewhat elevated but certainly not excessively higher, particularly with respect to the low level of interest rates. Investing in stocks remains attractive, especially those sectors likely to benefit from the reopening of the economy, higher inflation and higher interest rates. Higher growth companies can also be attractive for investment when not fully priced for that growth. As always, investors must also be prepared to stomach the occasional bout of market volatility.
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