- Both 2020 and 2021 saw a historic capital rotation hidden in plain sight. Investors should expect more of the same in 2022.
- Faster-than-anticipated economic growth could spark a faster than anticipated normalization of monetary policy.
- Part of this normalization of monetary policy could include higher long-term interest rates, which will spur an already ongoing historic capital rotation.
- The difference this year, versus the past two years, is that valuation-insensitive passive investors are about to experience the stealth bear market that has been occurring under the surface.
- Ironically, higher-than-anticipated global economic growth could be a catalyst for the next leg of the growth-to-value rotation.
- This idea was discussed in more depth with members of my private investing community, The Contrarian. Learn More »
Seeking Alpha is running a series on 2022 market outlooks. Here is our take, question by question below.
What do you expect to be the key driver of stock market performance in 2022? What items will impact market performance - for better or worse?
Normalization of monetary policy, a normalization of interest rates, and a continued stealth growth-to-value rotation are all going to be key drivers of stock market performance in 2022, from our vantage point.
Specific to monetary policy, tapering is afoot, and once that progresses far enough, interest rate hikes will follow. After almost 13 years of emergency monetary policy (think about that for a minute) in one fashion or another, perhaps the biggest surprise in 2022 could involve a relatively stronger economy driving a normalization of monetary policy and a normalization of interest rates.
On that note, fourth quarter 2021 GDP growth is looking surprisingly robust according to the Federal Reserve Bank of Atlanta.
Against an investing backdrop featuring accelerating COVID case counts, GDP growth estimates from the Atlanta Fed's GDPNow model have held up very well, and remained surprisingly strong for Q4 2021. Perhaps this unexpected economic strength, and the realization that the Fed taper is accelerating, which means less bond buying, particularly at the longer end, led to the bond rout that happened on the first day of trading in 2022.
More specifically, the U.S. Treasury 10-Year Yield climbed over 7% on Monday, January 3rd, 2022.
This led directly to a 2.6% loss in the iShares 20+Year Treasury ETF (TLT), which is illustrated in the chart below.
If longer-term yields can break out to the upside, this will pave the way for further Fed Funds rate hikes as the yield curve steepens, while also providing a tailwind to a historic capital rotation that has been generally ongoing since the broader market lows that occurred on March 23rd, 2020. Over this time frame, many investors would be surprised to find out that the heart of the value equity opportunity, specifically energy stocks and basic material equities, have far surpassed the performance of the largest growth stocks, as measured by the Invesco QQQ Trust (QQQ). Keep this in mind as this is something we will revisit later in this article.
As we approach 2022, are you bullish or bearish on U.S. stocks? In terms of asset allocation, how are you positioned heading into the New Year?
Building on the above narrative, I am bullish on equities that have been out-of-favor for most of the bull market dating back to March of 2009, particularly value stocks, and more specifically commodity equities. These equities have been outperforming for two years running, however, they have a lot of catch-up potential in a relative sense, and healthy absolute return potential too.
Specific to the broader market, this is a more nuanced question, as there has already been a stealth bear market that has quietly been underway for many months now, really dating all the way to February of 2020.
In fact, according to Bespoke, on December 13th, 2021, the average Nasdaq Composite (COMP.IND) stock was down 39.1% from its 52-week high.
Looking at the market from this prism, the average Nasdaq stock is firmly in a bear market, which again is epitomized by the ARK Innovation ETF (ARKK), which finished down 23.6% in 2021.
Bigger picture, the ARK Innovation ETF finished 2021 off over 40% from its 2021 highs. On multiple occasions, I have written about the poor starting valuations at the ARK Innovation ETF, and as technology stock performance has broadly deteriorated, there is more room for further price declines as the market structure and momentum investing work in reverse.
Going further, this weaker breadth is going to eventually catch-up to the teflon clad, seemingly bullet-proof, large-capitalization market leaders. Similar to 2000, when the underbelly of the historically overvalued market crumbled first, the breadth weakness will eventually find its way into the nameplate equities, and nameplate indices, that almost every investor thinks is impenetrable today.
Which domestic/global issue is the biggest risk that could adversely affect U.S. markets in the coming year?
The answer here is a succinct one, which is sustained inflationary pressure, which could upend both the stock market, and the bond market.
As discussed in the previous two sections, inflation pressures are adding to the ongoing change in market leadership, as higher inflationary readings have historically been absolute and relative headwinds for technology shares.
Somewhat unbelievably, as of December 10th, 2021, these five stocks represented roughly 65% of the 2021 year-to-date gains in the Nasdaq Composite according to Bank of America. This concentrated leadership strength actually was amplified in the closing days of 2021, as investors took shelter in these market stalwarts.
(Source: Bank of America, Bloomberg)
This concentration of market leadership, specifically a narrow market leadership amidst a broader bear market, think 2000 again, or 2008, is often a precursor to a full-fledged bear market.
Is rising inflation a legitimate fear that could squeeze profits and/or cause valuation multiples to contract?
Yes. More specifically, higher long-term interest rates could raise the implied discount rate, and make the perceived safe-haven technology leaders, which are effectively bond proxies, feel their negative correlation to higher interest rates.
How does the political/regulatory climate affect the risks and opportunities for next year?
The Federal Reserve is clearly behind the curve, with mechanical projections of appropriate monetary policy, like the Taylor Rule, suggesting a 5% plus Fed Funds rate.
Thus, a predominant risk is that inflation persists longer than expected, necessitating a further tightening in monetary policy. Needless to say, the broader markets are not positioned for this outcome, nor the political blame game that would ensue.
What role will the Fed play in the coming year?
An enormous role, per their still historic levels of involvement in the financial markets. On that note, the Fed, and their associated policies, are the proverbial elephants in the room. For this reason, there is a need for the Fed to step back out of the spotlight, which may not be an easy transition. A more benign view would be that the Fed will pull back as the private sector takes the lead in credit creation.
Do you see value stocks or growth investing leading the markets in 2022?
Value stocks, and if this happens, it will be the third year in a row that value stocks have quietly outperformed in a slow-motion replay of the 2000-2007 investment backdrop.
(Source: Author, StockCharts)
Adding to this narrative, even though most investors think growth stocks have led the advance off the March of 2020 lows, value stocks, led by commodity equities, which are the heart of the current value opportunity, are actually the out-performers. Digging deeper, while the Invesco QQQ Trust has risen 138.2% since the March 23, 2020, broader stock market lows, and the SPDR S&P 500 ETF (SPY) has risen 114.3% over this time frame, the real stars of the market outperformance the past two years have been the economically sensitive and inflationary sensitive areas of the market.
More specifically, the SPDR S&P Metals and Mining ETF (XME), led by steel stocks, is higher by 220.5% since March 23rd, 2020. Coming in close behind, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) is higher by 219.1% over this time frame. The Energy Select SPDR Fund (XLE), led by Exxon Mobil (XOM) and Chevron (CVX), is higher by 147.0%. Only the VanEck Vectors Gold Miners ETF (GDX), which is higher by 55.5%, has been a laggard when compared to the performance of broader equity markets since the March 23, 2020, lows.
Said another way, value stocks have been outperforming for two consecutive years, inclusive of 2020, and 2021. 2022 should be the third year in a row that value stocks lead their growth counterparts. The magnitude of the cumulative relative outperformance could lead to a broader embracement of this historical capital rotation that has been ongoing quietly, hidden in plain sight for the past two years.
We have chronicled this historical capital rotation, including the partial list of articles below, yet many investors remain blinded by the bright lights of the price insensitive and valuation insensitive index benchmarks.
- "A Historic Capital Rotation Is On Tap" - Published October 18th, 2020
- "A Historic Capital Rotation Is Happening Hidden In Plain Sight" - Published November 25th, 2020
- "The Historic Capital Rotation Is Continuing" - Published December 4th, 2020
- "Goldman Is Trumpeting A New Secular Commodities Bull Market And Investors Should Listen" - Published December 16th, 2020
- "Not All Energy Stocks Are Created Equal" - Published December 24th, 2020
- "A Historic Capital Rotation Is Quietly Marching On" - Published October 29th, 2021
For now, the relative anonymity of this historical capital rotation is a good thing, as there are still many investors and traders that have not jumped on board this developing trend, providing further fuel for it to continue.
The U.S. dollar rallied strongly in the second half of 2021. What's the outlook going forward?
The Dollar is set to retreat as global economic growth surprises to the upside, which is really the opposite backdrop of what we witnessed for much of the past decade.
For a similar backdrop, look to the year 2000, shown in the chart above, and the path that ensued for the Dollar.
Looking backwards in the rear-view mirror over the past decade, in a world where global growth disappointed, the U.S. global growth leaders were championed, and embraced by both domestic and international investors.
However, with many technology stocks already in a bear market, and the last dominos set to fall, potentially happening as long-term interest rates rise, in an environment where growth surprises to the upside, almost all investors are ignoring the historic reversion-to-the-mean opportunity hidden in plain sight.
Elaborating further, with household balance sheets in terrific shape after roughly a decade of deleveraging, the irony of ironies could be that private sector led economic growth causes a further rotation out of the most in-favor investments today. This includes a crowded fixed income market, and more importantly, large-cap growth stocks, which are effectively the longest duration assets in the investment market.
Quietly, we have already seen a passing of the baton of market leadership. Most investors are simply not aware of this leadership transition yet. Recognizing this changing backdrop after years of study, including being too early, I have been pounding the table on the extremely out-of-favor commodity equities for several years now, and I still think we're in the early innings of what will be a longer-term price appreciation. Personally, I think we will supersede the capital rotation that took place from 2000-2007.
Investors skittish of commodity equities should research cast aside financials as they also will benefit from rising inflationary expectations and rising long-term interest rates. Understanding the bigger picture, then having an understanding of the bottoms-up fundamentals has been the key to outperformance, and this is a path that has not been easy with those participating confirming this reality. However, the road less taken is sometimes the better one, and I firmly believe that today, as traditional stocks, bonds, and real estate offer very poor starting valuations and very poor projected future real returns from today's price levels. More specifically, the out-of-favor assets and asset classes, including commodities and commodity equities and out-of-favor specific securities, are where the historic opportunity has been, and that's where it still stands, from my perspective.
There is historic opportunity in the investment markets today. I have spent thousands of hours analyzing the markets, looking for the best opportunities, looking to replicate what I have been able to accomplish in the past. From my perspective, the opportunities in targeted out-of-favor equities today are every bit as big as the best opportunities in early 2016, and late 2008/early 2009. For further perspective on these opportunities, consider a membership to The Contrarian, sign up here to join.
This article was written by
KCI Research, aka Travis, has been a financial professional for over 20 years. Formerly a director of research at a mid-sized RIA, and one of four strategic investment decision makers at one of the largest RIA's in the United States, Travis founded his own boutique investment firm in February of 2009. He specializes in against grain investing backed by real-world wisdom and experience by targeting out-of-favor, contrarian investment opportunities.Travis is the leader of the investment group The Contrarian where he shares premium research and uncovers investment gems hidden in plain sight. Travis shares an all weather portfolio for minimal volatility along with a concentrated best-ideas portfolio Learn More.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of CVX, AND XOM, AND SHORT AAPL, ARKK, NVDA, QQQ, SPY, AND TLT either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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