Coming off a truly unprecedented year that upended daily life, no one was quite sure exactly what to expect of 2021 as the disruptions from the pandemic dragged into a second year. Investors were cautiously optimistic, mindful of relatively elevated valuations but also buoyed by the massive amount of fiscal stimulus lifting consumer demand and the accommodative monetary policies from the Federal Reserve supporting the overall economy. We felt strongly that 2021 was going to be a “stock picker’s market,” with investors refocused on company fundamentals and valuations mattering again following widespread investment gains coming off the market lows of March 2020.
January trading supported our belief, as companies that benefitted from the “Work From Home” trade in 2020 and entered the year with lofty valuations underperformed. An attempted “short squeeze” of GameStop introduced “meme stocks” into investor lexicon. A new cohort of retail investors jumped into financial markets, which fanned plenty of media interest as many tuned in to watch the wild daily swings of these names. Q4 earnings season stabilized volatile markets in February, with reported y/y growth rates supporting widespread optimism around the accelerating trajectory of the economic recovery. Sentiment was further lifted by the passing of the nearly $2 trillion COVID relief bill, providing another boost to the economy as re-openings accelerated behind greater vaccine rollouts. Consensus built behind the narrative that the domestic economy was set-up for a period of robust growth supported by the release of pent-up consumer demand. Positive sentiment reached a crescendo during a very strong April, in which all three major stock indices rose more than 5%. Participation in this rally was nearly universal (with roughly 95% of the S&P 500 constituents in an uptrend), behind leadership from the more economically-sensitive sectors – Financials, Energy, and Industrials.
However, underneath the hood, there were data points hinting at the inflation concerns that would come to dominate the back half of the year. As we wrote in our May 4th newsletter, “supply chain bottlenecks and tightening in certain pockets of the labor market suggest the possibility for higher input costs . . . these input cost pressures could consequently lead to higher inflation as demand continues to strengthen as the economy re-opens.” Performance began to diverge, contrary to the mostly widespread gains off the pandemic lows, and the next few months saw numerous changes in “the flavor of the day”: Growth outperformed Value, Value outperformed Growth, Small Cap outperformed Large Cap, along with what seemed like every other combination of leadership. The summer saw major indices grind higher behind strong 2Q GDP growth, even as individual names were beginning to see pullbacks on concerns of elevated valuations, supply chain disruptions, and inflation. In response to increasing inflation concerns, we saw the beginning of a hawkish pivot from the Federal Reserve during the June FOMC meeting, with the forecast for the first target interest rate hikes moving into 2023 (from 2024) and the introduction of language around when the Fed would begin to taper their asset purchases.
Notably, despite elevated valuations and the potential for rising rates being considered negative for Growth stocks, Growth managed to outperform through the end of the summer, reversing the broad trend from the first half of the year. 2Q earnings season again smashed expectations at the company level, and more cyclical names sold off on concerns of the emergence of the Delta variant and weakening long-term economic growth forecasts together with increasingly concerning inflation readings. It was a reversion back to the “pandemic” trade of 2020, as investors again prioritized purchasing any company level growth they could find, selling off cyclical names and those most correlated to overall economic growth. Much investor (and eventually political) concern arose around how “transient” the inflationary dynamics of the economy would be, as the Federal Reserve tried to walk the tightrope between accommodating a still fragile recovery and letting the economy run too hot.
Negative sentiment peaked in September, with all indices selling off and a significant number of stocks entering “correction” territory, down over 10% off their prior highs. Most alarming was the deceleration of leading economic indicators while the Federal Reserve was still talking about tightening monetary policy. Bears argued that the economy had been allowed to run too hot and that temporary supply chain induced inflation had become more permanent, setting the domestic economy up for weak future growth. Unprofitable growth stocks, specifically the ones years away from profitability, saw the biggest sell-offs from this sentiment shift, as the incredibly lofty valuations ascribed to these companies for most of the preceding 18 months were quickly rationalized.
Markets stabilized in October and early November, as rolling corrections in various pockets of the market helped reconcile valuations with lowered forward growth expectations. Despite overblown media narratives, astute investors recognized that weakening economic indicator data was mostly supply driven, with underlying demand remaining strong. As we wrote in our November 2nd newsletter, we were (and still are) willing to accept some hampered short-term performance and guidance for companies in our portfolio knowing that they are gaining market share from weaker competitors in the tougher supply-constrained operating environment. Even a late November sell-off, behind continued greater than expected inflation readings and concerns on the fast-spreading Omicron variant, was reversed in early December, with markets pushing toward all time highs into the end of the year.
Ultimately, 2021 rewarded patient investors, with the frequent changes in market leadership punishing those trying to chase momentum. Fundamentals and valuations began to matter again, as some of the best performing names in 2020, specifically ones where valuations had detached from what could be justified by business operations, finished this year as some of the worst performers in the index. While most names performed well (approximately 85% of the S&P 500 finished up in 2021), return dispersions were well above historical levels, proving proper stock selection was rewarded with greater outperformance than normal.
As we look forward into 2022, we would argue for the continuation of major themes from the past few months. Market level valuations, despite some of the rationalization over the past few months, remain elevated in comparison to pre-pandemic levels. While the past few years of equity returns have benefitted from multiple expansion, forward returns from here will likely have to be driven by earnings growth, with expectations for steady, or even contracting, multiples. Considering consensus 2022 earnings growth estimates have settled between 5% and 10%, it would therefore be tough to expect broad index returns above these levels. With the Federal Reserve also signaling an accelerated timeline for target rate hikes, we would not be surprised to see a small renaissance for Value stocks, as these names are, all else equal, less affected than Growth stocks by higher rates discounting future cash flows and are currently trading at valuation levels less susceptible to potential multiple contraction. Re-iterating our call from last year, we again believe that the upcoming year is set-up to be a “stock picker’s market,” with outperformance possible for those who synthesize company and sector specific growth narratives to properly establish over- and under-weight positions to the market indices. Specifically, identifying companies that can exceed the market’s projected 5%-10% growth rate and are trading at more reasonable multiples (and therefore less susceptible to multiple contraction) could lead to outperformance. In a year of potentially lower index returns than the past few years, dividend yield may also become a more important consideration. Not only does the extra return from the dividend matter more for total return when overall price appreciation is modest, but, in aggregate, companies with a history of steady dividend growth are cheap relative to the S&P 500 index, as they have been for much of the past decade.
We continue to remain positive on the overall trajectory of the economy, led by consumer strength. Demand should continue to remain robust as consumers continue to work off elevated levels of personal savings from the pandemic and employment data remain encouraging. We are not witnessing the extreme leverage nor credit concerns in household balance sheets that preceded the Financial Crisis and consumer health metrics such as debt service-to-income ratios are the strongest they’ve been in almost 50 years. Notably, while consumer spending levels have returned back to the pre-pandemic trendline, there has been a mix shift toward Goods, away from Services (such as travel, dining, and entertainment), which continue to be affected by the lingering effects of the pandemic, even though goods spending remains hamstrung by supply chain constraints. As long as consumer demand and sentiment remain strong, we’d expect this strength to overpower the drags of inflation, which will continue to be a talking point for as long as supply chain concerns persist. Evidence has appeared recently suggesting that the economy reached “peak” bottleneck in 2021Q4, however the next few months will have to confirm that supply chains are normalizing. We continue to work to position the portfolio for this base case, while cognizant of potential threats from lingering inflation, monetary and/or fiscal policy missteps, and any other of the many potential maladies that can influence markets. As was the case in 2021, it is likely that the Fed’s response to the ebbs and flows in inflation data as well as the government’s policy response to the trajectory of Covid cases will influence financial markets more than the underlying threats themselves. As the past two years have proven, anything is possible; and while we can’t predict the future, we can use our years of experience to try and navigate shocks, be them minor blips or once-in-a-lifetime phenomena.
At a time when there has been more interest in investment markets than ever before and it seems like everyone has a new avenue (be it meme stocks, cryptocurrencies, NFTs, etc.) they want you to believe will lead to exorbitant wealth, we think it prudent to re-iterate our focus here at the Wise Investor Group. A light-hearted way to do this is through a metaphorical commute. Now there are plenty of ways to get from Point A to Point B and, as those in this area are well aware, there are even more ways to delay your drive. We’ve seen it all on the roads in this area, a myriad of different driving styles that end up surprisingly analogous to different investing styles. There are those who are constantly refreshing their GPS, searching for backroads and shortcuts, willing to take an incredibly complex path to potentially shave a few seconds off their commute. We liken those to the meme stock investors, direct descendants of the “hot stock tip” investors who would follow any idea they thought could make them rich. Then there are the momentum investors, drivers of the cars that are constantly jumping into the lane that is moving the quickest only to shortly change again as those in the lane they just left begin to speed past them. There are even the overly conservative investors, who are content to coast in the far right-lane under the speed limit, knowing they’ll safely get to their destination even if they are a little late. Here at the Wise Investor Group, we humbly liken our time-tested value-oriented principles to that of a chauffeur driver, one who will safely drive at the speed of traffic while taking advantage of our deep knowledge built from years of commuting. We know the shortcuts that work and those that don’t, which lanes back up with traffic, and where construction might be causing delays. Perhaps most importantly, in placing your trust in us you can take that time spent commuting and focus on the other things in your life that bring you joy. We trust our team’s due diligence process and depth of knowledge to successfully navigate a variety of market conditions, without sacrificing our principles or your well-being in an ill-fated chase for returns. We remain grateful that you continue to place your trust in our team and always promise to do our best as your chauffeur along the long commute to securing your financial future. We wish you a safe and prosperous 2022 and look forward to our conversations throughout the year