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The January declines in the S&P 500 Composite Index (-5%) and the Nasdaq Composite Index (-9%) were the worst in two years, since the Covid-19-inspired mini crash in March 2020. While equities staged a remarkable recovery in the last few days of January, at their lows on January 24, the S&P was down over 12% and the Nasdaq almost 17%, well into correction territory, with the latter nearing the usual definition of a bear market (a decline of 20% or more). So is this the end of the bull?
The U.S. Federal Reserve (the Fed) made it plain in its Jan. 26 statement that inflation, which reached 7% at the end of 2021, remained its principal focus and that it is ready not only to end its quantitative easing (QE) program, which has already been reduced, but also to start selling off its holdings. In addition to a forecast rise in the short-term federal funds rate to 0.5% from 0.25% in March, this would put further strain on the extended valuations of the growth sectors of the market, such as technology, biotech, and the beneficiaries of the work from home phenomenon in 2020, such as Peloton, Zoom, and food delivery companies.
Famed fund manager Kathie Woods’ ARK Innovation Fund, regarded as the poster child of momentum investing for its ownership all the unprofitable high-growth concept stocks, is down by over 50% from its peak a year ago, and many of the former Covid-19 favourites are down even more. The so-called meme stocks, such Gamestop Corp. and movie chain AMC Entertainment Holdings Inc., which had been driven up five or 10 times during the Reddit Revenge against hedge-fund short sellers, have all come back down to earth, and in some cases below where they started. Online trading platform Robinhood Markets Inc., which specialized in these trades, reached a high of US$85 after its IPO last August, is now trading below its IPO price!
The enthusiasm for Special Purpose Acquisition Corporation (SPAC) has also faded. Investors essentially gave a blank cheque to these investment companies to buy a business in the next two years. All went to big premiums on the cash they held, and now have similarly come back to earth. Non Fungible Tokens (NFTs), an digital means to “own” a sports clip or picture, have similiarly lost their lustre. And cryptocurrencies have sold off sharply, with Bitcoin and Ethereum down 50% in the last three months, watering down the widely-promoted investment argument that they were not correlated with equities or other assets.
All of these asset classes have been affected by the tightening of monetary conditions, not merely by the Fed, but by other central banks. The Bank of Canada ended its QE program a couple of months ago, and the Bank of England raised its policy rate to 0.5% after hiking rates to 0.25% on Dec. 16.
With some observers, such as Goldman Sachs and Bank of America, forecasting anywhere from five to seven rate hikes this year, equity markets are now facing headwinds for the first time since Fed Chair Jay Powell reversed his previous tightening program at the end of 2018.
Investors awaiting the same reversal by the Fed may be in for a disappointment as inflation was running below 2% in 2018, global supply chains were working well, and a pandemic had not seen the largest-ever expansion of monetary support in history as well as extensive fiscal programs such as furlough schemes and paycheck protection.
If central banks are to retain any credibility, they need to raise interest rates enough to at least approach inflation. At present the real interest rate (after inflation) is -6.75% in the U.S. and -5.15% in the U.K. and Germany. The last time real interest rates were this negative was the 1970s, when a crude-oil supply shock combined with economies running near full capacity and low unemployment to produce stagflation, a combination of low growth and high inflation.
Although the U.S. Producer Price Index (PPI) was 9.2% in December, it is unlikely that inflation will get into double digits as it did in the late 1970s and early 1980s. Should it remain in the 3%-5% range rather than the sub-2% level of much of the last decade, investors will need to temper their expectations about profit growth and margins as cost pressures are not being passed through immediately.
While earnings growth for S&P 500 companies that have already reported fourth-quarter results is slightly ahead of expectations, those companies that disappoint, such as streaming service Netflix, have seen their share price crushed, down 29% this year. Even those that have delivered excellent results, like electric automaker Tesla Inc., are still down 11% so far, worse than the broader market.
By way of contrast, energy stocks are up strongly as the price of oil exceeds US$90 a barrel, owing to a cold winter and geopolitical tensions over Russian gas supply to Europe and the possibility of conflict over Ukraine. The S&P Energy sector is up 19% and the S&P/TSX Energy ETF is ahead 17%, while commodity and financials-dominated indexes like the U.K.’s FTSE 100 the S&P/TSX Composite, and MSCI Emerging Markets ETF are flat or just slightly ahead. Commodities generally, especially those metals used for the production of green energy (electric vehicles, solar, wind, nuclear, etc.) are all doing well too.
Investors who haven’t already done so over the past month or two should consider any rebounds in large-capitalization growth and technology stocks as an opportunity to take some profits. Companies like Apple Inc., Microsoft Corp., Alphabet Inc., Meta Platforms Inc., Nvidia Corp., Amazon.com Inc., and Netflix Inc. are all vulnerable to increasing volatility.
Owning some of the sectors that are reasonably valued and have been strong performers over the last year as the global economy has reopened will likely prove to be better performers than owning the broader US market. These include companies in energy, materials, healthcare, and consumer discretionary. Investor might also consider testing international markets that are more reasonably valued than the U.S., such as the U.K., Japan, and emerging markets,.
Gavin Graham is a veteran financial analyst and money manager and a specialist in international investing, with over 35 years’ experience in global investment management. He is the host of the Indepth Investing Podcast.
Notes and Disclaimer
Content © 2022 by Gavin Graham. This article was originally broadcast as a podcast on Indepth Investing, hosted by Gavin Graham. Used with permission.
The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.
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