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The Brave Report: Market Commentary for December 2021

Click here for .pdf version of this report: The Brave Report-December 2021

Is Santa Claus coming to town? The first three weeks of November saw markets grind higher adding to their gains from October and notching new all-time highs.  This performance was thrown into disarray in the final week of the month (which has continued into December) as the Fed hinted at speeding up its reduction of asset purchases and the appearance of the new Omicron COVID variant rattled markets.  These new uncertainties were all the markets needed to quickly sell-off, especially in the high multiple technology names. Volatility spiked rapidly as investors moved to the sidelines while they wait for more details around this new variant.

Market Overview

After notching all-time highs midway through the month, the three major indices sold off hard to close things out. The Dow was the biggest laggard, albeit because it didn’t pop as much earlier in the month, finishing the month down more than 3%.  The NASDAQ and the S&P 500 both finished the month around the flatline but just in the last week of the month, the NASDAQ lost more than 4.5% from its intra-month high. This selling continued as we entered December. A rush to safety, due to inflation worries and the Omicron variant have brought volatility racing back to the markets and we will have to wait and see if a Santa Clause rally is still in the cards.

On the fixed-income side, we saw quite a rollercoaster during the month of November.  Rates spiked as inflation data came in hot and the Fed hinted at speeding up its tapering efforts.  This spike, however, was short-lived. The emergence of the Omicron variant sent investors rushing to safety and driving rates back down.  After hitting a yield of 1.69%, its highest level since May, the yield on the 10-year plunged as low as 1.41% over 3 days. This was accompanied by some flattening across the entire yield curve.  With more data expected about inflation and the new variant over the next few weeks, we will see if this sudden drop sticks or if it is simply a temporary knee-jerk reaction.

As we move forward into December the uncertainties around the new variant and how the Fed is going to handle inflation still loom over the markets.  Even with these uncertainties, many are still predicting a strong rally into year-end.  The underlying fundamentals of the economy support this but what we often see during times of uncertainty is increased volatility while investors try to get confirmation on the direction of the markets.  While the volatility of the last two weeks caused major swings across the entire market there was some diversion in terms of where the selling was more pronounced.  Technology and high multiple names bore the brunt of the selling while investors rotated into more value-oriented names but if we are going to see a Santa Clause rally this year, we will need to see money flow back into some of the higher quality tech names.

Many of the high multiple names that sold off were in need of a repricing at some point as many had flown far too high, too fast. These new uncertainties were all investors needed to rapidly reprice these names.  The initial selling started when the Fed hinted at speeding up their reduction of their asset purchase program.  This sent rates higher which has been a sign to markets to sell off the high multiple names.  However, rates quickly pulled back again as the emergence of the Omicron variant sent investors to the sidelines.  This just accelerated selling in these high multiple names as investors took profits.  As is often the case in these rapid selloffs, many other names with much more reasonable valuations get caught up in the carnage. What we have seen with these selloffs over the past two years is that these dips have been a great opportunity to get back into some high-quality names at a steep discount to just a few weeks ago.

While I think volatility will persist for the next few weeks, getting some clarity around the Omicron variant will be key to releasing some of the tension in the markets.  We have been investing in a pandemic economy for almost two years now and we have gone through the emergence of a new variant, Delta, before so we already have a playbook for how different areas of the markets will react.  The question that remains is will this new variant follow previous COVID spikes or will this thrust us into a whole new chapter of the pandemic?

Early indications are that this new variant is more infectious but seems to come with lighter, less severe symptoms.  We also have no data yet as to how effective the current vaccines will be against the new variant.  As more data comes out in the next few weeks, we should get a clearer picture of how this variant will impact the economy.

In the most bullish, Goldilocks scenario, this new variant is more infectious but with only the symptoms of a common cold.  Its infectiousness leads to it being the dominant variant around the world, pushing out delta, while also reducing the incidence of severe outcomes, hospitalizations, and death. This leads to increased immunity around the globe and signifies the beginning of the end of the pandemic.  In this case, the global economy continues to fire on all cylinders and the bull run we have seen continues.

On the other side, the doom and gloom scenario is that the infectiousness is much higher while also having very severe symptoms and an increased mortality rate.  Current vaccines are not effective against it and we are forced to implement restrictions until a suitable vaccine booster can be rolled out.  This would lead us back to the playbook we saw at the beginning of the pandemic where the stay-at-home stocks rally and travel and leisure stocks suffer. It also means the pandemic will continue to draw out well into the future, having a negative impact on major parts of our economy. This would force the government to continue to print money to provide stimulus further compounding our inflation issues.

I think the actual outcome will be somewhere in the middle of these two scenarios but until we get some more data investors are just left to speculate. This leaves us in a wait-and-see market with increased volatility.  While I’m waiting, I will also be making a buy list of some names that have been unfairly beaten up during this selling and will look to add to them if this selling continues.  These will include high-quality names that got thrown out with the bathwater but have consistent, growing cash flow and are less impacted by rising rates. I will also be looking at some of the high multiple names that actually have revenue and earnings, and whose fundamentals warrant a higher multiple. I think these will be the names to snap back the quickest if some of these uncertainties dissipate.

I would also be doing a disservice If I didn’t mention the inflation situation.  Recent inflation has been real and (until Omicron) was putting upward pressure on rates.  The Fed seems to be walking a fine line between trying to tighten things to combat inflation while also trying to avoid sending shocks through the markets by tapering too quickly.  If inflation can come down on its own and it does turn out that it was transitory then the negative impacts should be muted or behind us soon.  If the Fed is forced to combat inflation more aggressively and we see the economy start to slow then I do think we could see some continued downward pressure on markets in the first half of next year.

Energy prices, one of the leading causes of inflation recently, have already started to recede and it seems supply chain issues are starting to abate a little as well.  If this can continue then I think we can avoid a more aggressive Fed approach.  But again, we will wait and see.

Strategy Commentary

I have continued to maintain my overall equity allocation, even during the recent volatility.  I have used this pullback to rebalance some positions to a normal allocation and harvest any losses I possibly could. However, with the prolonged bull market we are on, identifying losses has been difficult. While the uncertainties I have mentioned in this report are real, I think over the medium and long term the economic backdrop is strong and should provide legs to the market.  As more data comes out about the new variant and inflation, this stance could change but for now, I view them as short-term blips.

I continue to maintain my overweight to technology.  Volatility has increased in the sector, especially in some of the higher multiple names but the larger tech names continue to provide long-term stability for the sector. I have added to small and mid-cap equities in some portfolios as they have underperformed so were below their normal allocation targets. This is more a rebalancing exercise than a conviction on the positions. If inflation does seem more permanent, I will look to adjust my allocation accordingly but for now, I think inflation will subside during the first half of 2022.

Internationally I continue to maintain my current exposure.  As I mentioned in October, I continue to be astonished by the destruction of valuations in China. Some of this selling has been for good reason but there are still a lot of very high-quality names that continue to get pounded.  While the regulatory overhang will persist for the foreseeable future there will be a point where you might need to just plug your nose and buy some of the high-quality names. If the government can step aside for a bit, these stocks should be rewarded.

With the current inflation number and the potential for rising rates, I have continued to maintain my extra cash allocations as a replacement for some of my fixed income positions.  Even with the drop in rates due to Omicron, the risk of continued upward rate pressure as the Fed reduces its asset purchases only adds conviction to this position.