To say this quarter has been unusual would be an understatement. Before the start of 2022, we cautioned that easy money had been made in stocks, considering ~25%+ annual returns over the last three years. We did not expect this type of volatility:
• Inflation accelerated even further with oil up 80% at one point. Many other commodities were even worse.
• The VIX (volatility index) doubled into February before sliding back to normal levels while the global economic picture worsened.
• The S&P 500 January return was the worst since 2009.
• Russia invades Ukraine, they can’t win as fast as they hoped, the European Union finally works together, sanctions and corporate pullouts pressure Russia’s economy, and commodity supplies get even tighter than during the pandemic.
• 70% of the Nasdaq and Russell 2000 stocks were in bear markets (down 20%).
• 50% of Nasdaq (growth) stocks were down more than 40%.
• 25% of Nasdaq stocks were down over 75%.
• The 10 year / 2 year Treasury yield inverted intraday, signaling a recession is increasingly possible over the next few years.
• 2-year Treasury yields spiked from 0.73% to 2.35%…in just 3 months!
Typically, this set of circumstances would lead one to believe that stocks were crushed during the quarter. They were, but have staged a massive rally during March, leading the S&P to only be down ~5%. Growth suffered while Value handily outperformed. The Russell 1000 Value Index was basically flat and the Russell 1000 Growth Index dropped 9%. Quite the contrast from the past decade, but well within the range of normal annual pullbacks.
In total, if you did not own Utilities, Basic Materials, Energy, Gold and Consumer Staples, then your portfolio suffered. Historically categorized as boom or bust companies, Occidental Petroleum, Halliburton, Mosaic, Baker Hughes and Schlumberger were up 45% – 100% during the quarter. Newmont Mining, the only pure gold miner in the S&P 500, was up 27%. Defense stocks also advanced as one might expect with fears of World War III surfacing. One might call this an ESG nightmare.
Utility stocks defied logic with impressive gains during a period where interest rates rose substantially. Normally, when bonds offer an attractive return, investors will shift assets out of no-growth, dividend payers and into fixed income. Why take the stock market risk when interest rates offer similar returns to dividends? It is not like Utilities are all of a sudden going to be growth stocks, although the pop in Energy prices is passed on by them. Lastly, insurance companies and others followed the playbook correctly and rode the interest rate wave higher, with ~20% gains seen in Allstate, M&T Bank, Travelers, and American Express among many others.
Just about anything growth, high P/E, housing, consumer discretionary and cyclical related were taken to the woodshed. Netflix#, PayPal#, Meta Platforms#, D.R. Horton, Etsy and Sherwin Williams were down 25%+. Even a conglomerate, industry stalwart like Home Depot# suffered with a 28% drop already this year. Most negatively affected stocks were overvalued or in sectors that typically see a slowdown in business operations when rates spike and GDP slows. Although consumer balance sheets are strong, higher rates will eventually make it difficult to refinance or obtain favorable loans. Higher inflation will crimp discretionary spending somewhere down the road.
Then there is a bucket of stocks that continue to diverge from economic reality. Tesla’s request for an additional share authorization has opened the floodgates to those who believe stock splits make a company more valuable. Finance 101 textbooks are thrown out the window as Tesla stock has added the equivalent of the entire market cap of Volkswagen since the announcement. Tesla has already gained 57% since late February and trades at 75x 2024 estimates…2 years from now, where no one knows what the economic landscape will look like.
In theory, long-duration assets like Tesla, which isn’t projected to make any real money for several more years, should be revalued lower when long-term interest rates spike higher. Traditional economic theory takes projected future cash flows and discounts them back to a current price. In simple terms, $100 in 2030 will not be worth $100 in today’s dollar. It will buy a lot less goods in 2030. That discount is determined by interest rates. I don’t know of any model that would come up with a price target 57% higher AFTER rates spike by 70bps+ across the board for a stock like Tesla.
On the fixed income front, these will be the worst quarterly returns in quite some time. The 2-year yield tripled during the quarter, rising 155+ basis points for the largest rise since 1984. However, back then the rate was 13%, not 2.4%! Historians will recall that this was also the last inflation scare, albeit one that lasted a decade. One of the largest bond ETF’s is the iShares Core US Aggregate Bond fund, and 70% of its assets are in high quality, AAA rated issues. For the quarter, it is down over 6%, worse than many stock indices. Vanguard’s Total Bond ETF shows similar returns, along with high yield (junk) bond funds. The fact that junk bonds are holding up equal to high-quality issuers is a positive from a market standpoint. One would worry more about a recession if junk bond spreads were significantly widening due to bankruptcy or default fears. However, if rates continue to rise and more pieces of the yield curve invert, junk bonds could suffer much greater losses later this year.
Going forward, there is still much to dissect. How long will the Russian invasion last, and more importantly for investors, how long will sanctions impact the flow of commodities? Will the Fed get more aggressive and lead to further yield curve inversions? How long before consumer savings accounts are tapped out from pain at the gas pump and food stores? Will there be a soft landing? Can corporations continue to pass along price increases and maintain elevated margins? Will Europe tip into another recession? Much of what investors need to know before getting aggressively positioned on stocks will take months to figure out, and we have no more answers than before this year started.
All of this keeps pointing to range-bound markets, with a continued rotation underneath from sector to sector and stock to stock. Not all areas are negatively impacted, and not all stocks have products or management teams that can cope with this “New Normal”. Selectivity and not letting the daily news flow affect long-term decision making are still key ingredients for 2022. Some stocks are below pre-Covid price levels and have great long-term futures. At the same time, this New Normal will carry higher inflation, possibly higher interest rates and more geopolitical headlines than before. Companies that can adjust are offering decent value today. Pops in the market like we’ve had over the past few weeks are great times to readjust.
Today, we’ll get another look at the jobs market which continues to be robust. A perfect scenario would be a repeat of February, a lot of hires and a gradual slowing of wage growth to the 3% – 4% range. Earnings reports will be rolling in over the next several weeks as well. Much of this is old news. However, it will be a good time to listen to management’s discussion on pricing power, consumer purchasing intentions, margin pressures and what is being done to combat a more difficult economic picture. Futures are solid so far, aligning with the historic trend of April being one of the strongest months for stocks. In fact, the S&P has risen in April in 15 out of the last 16 years.
YouTube/Boxing/Reality star, Logan Paul is 27 today.
James Vogt, 610-260-2214