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The Brave Report: Market Commentary for February 2022

Click here for .pdf version of this report: The Brave Report-Feb 2022

Can we start over? After a seemingly straight line move higher off the March 2020, pandemic lows, markets finally hit a bit of a roadblock to start the year. The markets moved straight down throughout the month only to get a small reprieve in the last few days. This marked one of the worst starts to a year in history, especially for the tech-heavy NASDAQ. The strongest selling was in the high multiple tech stocks but outside of the energy sector, there were very few sectors spared.  Volatility soared throughout the month, and we saw some aggressive intraday moves that brought back memories of the financial crisis and the dot-com years.  While I think we will continue to see increased volatility moving forward, especially in the high multiple names, barring any major surprises I expect much of the indiscriminate selling to be over. I do not think we will get a quick V-shaped bounce back as we have seen in recent corrections. However, we could have a great opportunity over the next few months to increase the quality of portfolios by adding to highly profitable companies that are now trading at a discount. As is often the case though, patience will be key.

Market Overview

The markets just completed one of their worst Januarys on record with the NASDAQ falling almost 9%.  The Dow and the S&P faired a bit better but still lost 3.4% and 5.2% respectively.  If it hadn’t been for the sharp bounce in the indices on the final two trading days of the month, the NASDAQ would have experienced its worst single month since the 1980s.  Bloated valuations in certain areas of the market, high inflation and a change in tone from the Fed all capitulated to force investors to reassess their allocations and cause volatility to spike.  The sharp intraday swings created an environment that few traders and investors could stay ahead of. Indiscriminate, program selling, especially in the last hours of trading on a number of days shook investor confidence and brought all the perma-bear pundits out of the woodwork to spook investors even more.

On the fixed-income side, rates continued to rise as the Fed laid out the plan to start to raise rates and taper their asset purchase program.  The rate on the 10-year treasury spiked quickly to start the month, rising from a yield of 1.5% to 1.8% in the first week of the month only to stabilize and trade in the 1.8% range for the remainder of the month.  Along with the spike, we also saw the yield curve flatten, especially on the short end of the curve.  The rate complex will be important to watch in the coming weeks as investors try to handicap how aggressive the Fed is going to be and assess what impact this could have on the overall economy.

As we unpack the performance of the last month there were a series of risks that all seemed to capitulate to send the markets into a tailspin.  With inflation numbers continuing to come in hot, the Fed signaled it will be looking to raise rates faster than anticipated just a few months ago while also simultaneously tapering its asset purchase program.  This seemed to be the major catalyst that started the selling, especially in technology names and what I like to call “story stocks.”  These are the stocks that have little to no revenue and have yet to become profitable.  Their runup since the pandemic has been based on the prospects of growth well into the future.  In a rising rate environment, the high multiple stocks will always suffer the worst.  Once selling started there, it seemed to spill across most areas of the market as investors began to take profit in the names that have propped the major averages up over the past few months. This catalyzed the rush to the exits.

Whenever we see pullbacks or corrections like this, we also see the parade of perma-bears or other pundits shout that the market is crashing, or a bubble is bursting.  I think takes like this are lazy and unhelpful.  While I agree there were many areas of the market that deserved some selling, and we were due for some profit-taking, that does not mean the whole market is going to be cut in half, as perma-bear, Jeremy Grantham, announced a few weeks ago.  There are too many great companies earning amazing profits and growing rapidly.

If we peel back the layers of the market, we can see that a lot of damage has already been done that isn’t reflected in the major indices. Starting as far back as last February, many of the “Story Stocks” started selling off.  Yes, this selling intensified over the past month but much of the needed repricing in these names was going on under the surface for a while. At one point last month, more than 40% of the stocks trading on the Nasdaq were more than 50% off of their high. This is a massive repricing and something that is much needed if the overall market is going to continue higher.  The markets perform much better and are less susceptible to crashes when they are led by real, profitable companies and not by high-flying momentum names.

In terms of interest rates, the Fed has now all but assured that they will raise the Fed funds rate in March and start to taper their asset purchases. They continue to hold the line that any future rate hikes will be data-dependent, but the market is pricing in 4-8 hikes over the next two years.  While this may seem like a lot it is important to remember that we are starting from a 0% interest rate. It is also important to put the current rate into historical perspective.  The chart below shows the Fed funds rate since World War Two.  Even if the high end of projections plays out, we are still well below long-term normal.  Additionally, if supply chain issues and inflation start to normalize on their own, we will see these aggressive rate hike projections get walked back.

Source: Macrotrends.net

The prospect of rate hikes has been blamed for a lot of the selling in high multiple names.  I have discussed this in past commentaries and feel that the negative valuation impact is a bit overdone, especially for larger profitable names.  We are not talking about raising the rate from 0% to 5% all at once.  At the high end of projections, we are talking about getting the Fed funds rate up to around 2% over two years. Even with these expectations, the rate on the 10-year treasury still remains below 2%. To put that into perspective, prior to 2011, the rate on the 10-year had never been below 2%.

While most of the focus has been on the Fed raising rates.  I think a larger economic impact will be felt by them tapering their asset purchase program.  They have committed to starting this in March but there are still a lot of unknowns in terms of execution and how fast they will look to shrink their balance sheet, if at all.

With all the recent commentary about the negatives of rising rates, historically the markets have performed fine in rising rate environments. Returning the Fed funds rate back to a more historically normal level can also have several positive impacts. First, and most importantly in the short run, increasing rates will help to get rising inflation under control.  While I believe much of the upward pressure on inflation is due to the supply chain issues brought on by Covid, raising rates will be able to mute any continued increases and get inflation back to more historically normal levels.  The big variable here will be if the Fed can successfully get inflation under control without causing the economy to slow too much.  GDP rose by 4.5% last quarter, which was well above expectations, so this gives the Fed a good starting point. This growth rate is expected to slow so it will still be a difficult needle to thread.

Another positive of getting rates back to a more normal level is it provides the Fed with future ammunition should there be another shock to the world financial landscape.  With rates at 0%, there isn’t much the Fed can do to help prop up the economy besides being the buyer of last resort. By increasing rates and decreasing their asset purchases it provides them with a greater cushion should they need to step in to help again.

So now that we have seen this increase in volatility and a transition in market leadership, where do we go from here? It is very clear that certain parts of the market got overvalued over the past year but that does not mean all stocks that have performed well are overvalued. As the dust settles over the next few months we will start to see more dispersion amongst individual names and sectors.   Whenever we see selling like we have over the past month it always presents opportunities for the disciplined long-term investor. While my overall long-term allocations aren’t going to change very much, I will be looking for opportunities in a few areas to round out this allocation:

  • Profitable Growth: This will be my main focus as I look to add to any portfolios.  There are dozens of names that sold off hard with the rest of the market that are performing extremely well and are minimally impacted by rising interest rates. Look for companies that continue to grow rapidly and churn out great free cash flow.  These types of companies straddle a number of sectors but tend to be concentrated in large technology.  The one concern here is that many of these names are already highly owned and make up a large part of many of the equity indices. It is important to keep this in mind so your overall asset allocation does not get out of whack.
  • Defensive/ Value:There has already been a large rotation away from growth and into more defensive, value names.  Due to growth’s outperformance in recent years and the prospect of rising rates, this is not surprising.  I will look to add to these positions in any of my portfolios that are still underweight value.  Additionally, if the recent volatility has given you pause this is not a bad place to look for opportunities or at least park your money while we wait out the volatility.
  • Story Stocks:I know I have discussed that many of these names ran up far too quickly, got very overvalued and were due for a haircut. That does not mean they are all still overvalued.  We have seen some of these names give back 50, 60 or even 80% of their value from their all-time highs and that could create some great long-term opportunities if you are selective and have the stomach to deal with the volatility.  I would only be adding in small bits around the edges but with some of these names that have sold off so much, it could be time to plug your nose and nibble. As you try to identify potential names in this area you should look to understand a few characteristics of the companies:
    • Why did the stock run-up in the first place? Was it based on their actual business potential or was it just a popular stock?
    • Do they have a clear path to profitability or is their valuation based on hopes and dreams?
    • Do they have some sort of moat around their business or competitive advantage against any incumbents?
  • International: The last area I will look to add to (and have already) is developed international.  At this point, it looks like the US Fed will be one of the early movers to raise rates and cut off the liquidity spigot. With a slower pace of rate adjustment in Europe expected, there should be some opportunities for outperformance. We have also seen Europe underperform the US in recent years so valuations aren’t nearly as high.  If you were underweight international coming in, it is now time to start bringing that allocation back up.

While these will be some areas I will look to add to, it is important to reiterate that I am not rushing out to buy on every dip or pullback. I think we are now entering a stretch of elevated volatility that will be around for a few months.  I do not expect to see a quick V-shaped recovery like we have seen in corrections over the past few years.  There will be some names that do snap back quickly but I think patience will be greatly rewarded. It is important to fully understand the risk-reward tradeoff in all of these buckets (especially in the story stocks) and make sure you don’t do anything that will take your portfolio outside of your risk profile.

Strategy Commentary

Over the month, I trimmed some equity exposure slightly to have some extra cash available. These trims were very small and were often to try to harvest some losses to have available for future rebalancing. Most of this trimming was in my small-cap exposure. I am not rushing out to buy this dip quite yet.  I want to see a more solid bottoming happen before sounding the all-clear.  As I have mentioned, I do not think the whole market just bounces straight back up and I think we will have the opportunity to add strategically over the next few months.

I continue to maintain my overweight to technology but have been working to update the quality of this exposure as I expect there to be a strong bifurcation between the high-multiple “Story Stocks” and the highly profitable stocks that continue to put out stellar numbers.  From a sector standpoint, I really missed out on adding to Energy last year.  With oil prices continuing to rise I may look for an entry point. The sector has moved up quite a bit over the past year and I hate to chase a trade this late in its move but unless there is a major policy shift the upward pressure on oil prices should continue.

Internationally, I began to add to some developed markets equity, primarily in Europe.  While these markets are also dealing with inflation and will eventually look to raise rates, I think they will be a little slower than the US in doing so.  These markets also are a little cheaper than the US from a valuation standpoint so offer more attractive defensive characteristics during a time of rising rates.

I continue to hold increased cash positions as a replacement for some of my fixed income allocation.  With both stock prices and bond prices dropping over the past month, the diversification benefits of fixed income have been muted.  With continued upward pressure on rates, I do not expect to add any fixed-income positions in the short-term.