-Brian Dress, CFA, Director of Research, Investment Advisor
For most of 2021, we have seen a continued rise in the major market indexes, with the S&P 500 rising more than 24% and the NASDAQ up 17.8% for the year (as of Thursday 12/16). But throughout the year, we have observed a very different picture under the surface. On February 9 of this year, many growth stocks topped out and have struggled ever since. A great illustration of this point comes from the movement in the Global X Cloud Computing ETF Global X Cloud Computing ETF (CLOU) index in 2021, which in contrast is down nearly 6% on the year and 12.9% since February 9. Stocks in this index were some of the strongest in 2020 in the immediate aftermath of the pandemic, but have languished for most of 2021.
Strength in the stocks that dominate the index weightings has masked the weakness in smaller stocks. Note that year to date for 2021, we have seen great strength in mega cap tech names, with Microsoft (MSFT) up 46%, Apple (AAPL) advancing 30%, and semiconductor leader Nvidia (NVDA) gaining 117% in value.
The narrative has been of an advancing stock market in 2021, but the harsh reality is that there are bear markets developing in the technology and communication services sectors. We see additional weakness beginning to show in consumer discretionary sector in recent days. Clearly, we appear to be entering a new market phase, separate and distinct from the one we saw in the late 2010s, which favored high growth tech businesses. Note that many of the most successful stocks over the past decade have negative profits.
In today’s letter, we are going to look deeper into what’s working in the new market environment: what’s not working, along with what signs we are going to be looking for to signal the end of the current swoon in growth stocks. Because fears of inflation and higher interest rates seem to have taken hold in the general consensus, the time is now for investors to play more defense with portfolios. Companies that generate negative net income (profit) may continue to struggle in the coming weeks, while companies with profits in the present and carry lower multiples are gaining relative strength. Below, you will see the Left Brain view on recent trends, whether we think it will continue, and how best to respond.
For the five days covered in the report, stock market action has been volatile, as you can see in the chart of the NASDAQ Composite below. Weak days on Tuesday and Thursday of this week were separated by a short-covering rally on Wednesday after the release of the Fed decision. In terms of the major averages, the broad-market S&P 500 gained just 0.03%, while the tech-heavy NASDAQ Composite lost 2.17%. The small-cap Russell 2000 lost 3.05%. A new feature of the Jarvis letter will be the weekly data table, which will give you Thursday close prices and weekly change percentages for selected indexes (see below; covers dates 12/10-12/16).
When markets remain volatile, we know from experience that making the right investment decisions can be challenging and confusing. Should you buy the dip or sell into weakness? Whether you manage your own portfolio or currently work with an investment professional, we are here to help. Fill out our form for a Free Portfolio Review and a member of our Investment Advisory team will contact you to set a meeting. We will give you our views of whether you are properly positioned, given the current market conditions and our outlook for 2022.
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With that all being said, let’s get into it!
In the last few weeks, we have spoken frequently to the cross currents present in the financial markets. If you have been paying attention to the stock market lately, you will know that concerns over inflation have dominated the conversation. We saw on last Friday that the concerns are playing out in the data, with the Consumer Price Index rising 6.8% for the month of November, a 20 year high for inflation. We continue to think inflation will eventually work itself out as supply chain issues subside, but there is no denying the current reality of rising prices.
In related news, the Federal Reserve announced an acceleration to the end of its bond buying program. In the so-called “taper”, the Fed will end the bond buying program at some point in the spring of 2022. Additionally, Fed Chair Jerome Powell and his Board of Governors signaled a likely series of three interest rate hikes in 2022 and three more in 2023. It is clear that the Fed takes the threat of inflation seriously and has telegraphed a relatively aggressive policy prescription to address the concern.
For investors, a more hawkish tone from the Fed represents a significant shock to the system. Since the 2008 Financial Crisis, investors have become accustomed to a very easy (or dovish) monetary policy coming not only from the Fed, but also from other central bankers around the world. You can visualize this concept in the chart of the Fed Funds Rate below. This week we saw a signal of tightening monetary policy not just from Jerome Powell. In a surprise announcement Thursday, the Bank of England decided to raise interest rates in response to inflationary pressures. This at least contributed to the swift selling action of Thursday’s session.
As we can see from the above chart, there is an entire generation of investors that has not experienced a significant period of interest rate hikes. Our observation is that fresh expectations for rate hikes are causing immense confusion in markets, as investors scramble to position themselves accordingly in anticipation of a changing monetary policy.
We also see some similarities to 2018, the last major pullback in growth stocks. That came in the midst of the last tightening cycle, but also amid trade tensions with China. For the next few weeks, we will be studying that period closely to help us determine the signs we will be looking for that will indicate the end to the current contraction in growth stocks. For us to call the end of the pullback, we will need to see the volatility to stop (large pullbacks followed by sharp rallies), as well as the market will need to stop closing on its lows, as it did on Thursday of this week.
Take a quick look at the stocks that have held up the best in 2021, mega cap tech. A glance at their prices over the past week suggest that the market may even be turning on such transcendent businesses as Apple (AAPL), Microsoft (MSFT), Nvidia (NVDA), and Alphabet (GOOGL). Since these stocks have been so strong, our concern is that reversals in these shares could result in an even broader market selloff. For us, this would be the ultimate “risk off” signal.
Until that occurs, we will be looking for ways to make portfolios more durable and we think investors should follow suit. Below, we will share our thoughts on what types of stocks investors should be adding to respond to the current environment and which stocks investors should trim or remove from their portfolios.
Generally speaking, what is working are the stocks that have struggled over the past two years and from the most defensive sectors (consumer staples, utilities, health care). Profitability is also a key factor in those stocks that are performing best currently. As we take a look at our top 50 stocks in the Jarvis system, we notice a compelling pattern emerging. Among our top 50 stocks in Jarvis this week, 49 of them carry a positive Return on Invested Capital (ROIC), which is one of our preferred metrics for a company’s profitability.
As interest rates rise, relative valuations of stocks change due to the way that investors “discount” future cash flows. With higher interest rates, future profits begin to carry a lower present value, since interest rates are an input into the equation that many institutional (and other) investors use to evaluate stocks. The converse of this is also true: when interest rates rise, investors begin to value profits in the present more favorably. Therefore, we can expect to see companies with high profitability in 2021 to perform more strongly than those companies that do not yet have positive net earnings.
This week we did some study in the “ETF List” of the Jarvis system to see which sectors were most in favor over the past week. The three top rated ETFs in our software system this week were iShares US Consumer Staples ETF (IYK), Invesco S&P 500 Equal Weight Consumer Staples ETF (RHS), and Consumer Staples Select Sector SPDR Fund (XLP). Key components of these ETFs are companies like Proctor and Gamble (PG), Coca-Cola (KO), and Walmart (WMT). These are the types of stocks investors tend to favor when they are focused on making portfolios more defensive. Additionally, these companies tend to have some measure of pricing power, which means they are able to cope well with an inflationary environment.
Other notable top performing ETFs in our list this week were Utilities Select Sector SPDR Fund (XLU) and Health Care Select Sector SPDR Fund (XLV). These are two sectors that historically do well in defensive or “risk off” environments. The fact that consumer staples, utilities, and health care stocks are dominating the markets on a relative basis suggest that we are currently in the midst of a bear market, at least for growth shares.
Financial firms, particularly in the insurance side of the industry, are doing well in the current environment. Because one of the major revenue sources for these firms is to collect insurance premiums and accumulate profits by investing these funds in long duration fixed income securities like bonds, higher expected interest rates tend to provide a tailwind to these businesses. In our Top 50 stocks in Jarvis this week, we see plenty of examples that fit this bill: property & casualty insurer Chubb (CB), reinsurer Greenlight Capital Re (GLRE), and Hartford Financial Services Group (HIG) all showed relative strength over the past week of trading.
To illustrate some of the points we have made here, we wanted to direct your attention to a practical example, by looking at two firms that are competitors in the digital transformation business: Accenture (ACN) and Globant (GLOB). Below you will see the chart of the two stocks charted next to one another over the last three months.
As you can see, ACN has outperformed GLOB during the last 3-month period. We stated above that profitability has been a factor in whether stocks remain strong or have sold off in the recent past. Accenture carries an ROIC of 28.1%, while Globant carries an ROIC of 7.5%, so both companies are significantly profitable. But look to the revenue growth line for another clue as to what is happening here. Accenture is growing revenues over the past 12 months at a 14% clip, while Globant is growing its sales line at a very high 65%. Our takeaway is that, all things being equal, the market is punishing higher growth companies relative to similar companies with lower rates of growth, regardless of profitability.
We think eventually that this will result in great opportunities to buy premium growth businesses at lower valuations. With that being said, we think this trend could easily continue into year end because of tax-loss selling and many other factors. We think it makes sense for investors to shift some portion of their portfolios to slightly more defensive sectors or other sectors that benefit from rises in interest rates. These sectors include health care, energy, and financials. Adding stocks from these baskets can help growth investors to stem the current tide of selling, while also bringing more balance to their portfolios.
What’s Not Working?
In a word: growth.
As we mentioned in the previous section, companies whose business models assume profits some years down the line, while delivering losses in the present day, are under consistent selling pressure as we approach year end. There are a few reasons for this: (1) the present value calculation we mentioned above means that growth stocks’ valuations are currently compressing, in the face of higher expected interest rates and, (2) for investors that purchased some of the most high-flying of growth stocks during 2021, most of them are carrying significant unrealized capital losses. Remember in previous editions of the newsletter, we have spoken with you about certain end-of-year tax optimization strategies that take advantage of capital losses in a portfolio. We think this strategy is adding fuel to the fire of the growth sell-off.
Let’s examine the Jarvis data for the “Worst Performing” group from our ETF List. Among the worst performing ETFs over the past week were high-flyers such as Invesco Solar ETF (TAN), ARK Innovation ETF (ARKK), and Innovator ETFs Trust - Innovator IBD 50 ETF (FFTY). Note also that the very worst performing ETFs were crypto-focused, led by ProShares Trust - ProShares Bitcoin Strategy ETF (BITO) and Grayscale Bitcoin Trust (BTC) (OTC:GBTC). This is interesting in the context of increasing inflation. Many believe that cryptocurrencies are hedges against inflation, but the asset class has recently traded more with risk assets like tech stocks. This is an indication that cryptos may be “risk on” assets than anything else.
Among our bottom 50 stocks in Jarvis rank, just 4 carry a positive return on invested capital (ROIC). ROIC seems to have a very strong correlation to performance over the past month.
Let’s look at another practical example of what’s working versus what is not working. Payments is clearly a growth industry, with such exciting companies as PayPal (PYPL) and “buy now, pay later” provider Affirm (AFRM). At the same time, old stalwarts like Mastercard (MA) still have significant growth (14% over the past twelve months revenue growth). Again, in payments, we see yet another example of relative performance where the slower growers like MA are currently outperforming hypergrowth stocks in the same industry like AFRM (55% Q3 growth) and PYPL (23% last twelve month growth). The chart below shows that the performance of these three stocks over the past month illustrate the point: investors appear to be favoring lower growth companies in a particular industry over their hypergrowth counterparts, all things being equal.
How Should Investors Respond
Is it time for you to make wholesale changes to your portfolio? It’s hard to answer this question definitively with a ‘yes’ or a ‘no’. It certainly depends on your risk tolerance, goals, and other financial circumstances.
Investors that have cash needs in the next 5 years or so should certainly consider de-risking their portfolios, just in case we are actually entering into a bear market. If you are not in that boat, you do not need to be as aggressive to shed risk, but we would still advocate for you to tinker around at the margins of your portfolio. You want to position yourself to take advantage of a continued pullback in growth for a buying opportunity in 2022.
So specifically, what should you do? In terms of your growth positioning, we think it is legitimate for investors to hold on to mega cap tech and other tech stocks that correspond to currently profitable businesses. On the other hand, we would suggest trimming back exposures to hypergrowth companies with very negative returns on capital. We think if this period of selling is to continue, money losing companies are likely to be sold heavily, until valuations are much more reasonable. Acting now to reduce growth exposures could put you in a position to purchase these shares back at a better price at a later date. Additionally, you may be able to use some of the associated capital losses to offset realized capital gains.
We think investors should consider rebalancing a portion of their portfolios into sectors which they are currently underweight. From our point of view, we have been overweight technology and underweight energy, financials, and health care. Over the coming weeks, our research will be focused on finding well-run businesses in these sectors to replace the hypergrowth names that have slowed. In doing so, we expect to bring portfolios more into balance. At Left Brain, we love to let winners run, as we have over the past years in technology. But when the tide goes out, it is time to trim back overweight positions and allocate to sectors that will do well in an inflationary environment.
For additional color on end-of-year positioning and strategy, my colleague, Freddy Garcia, spoke on the Left Brain Thinking Podcast last week. Rebalancing has been the topic of interest in the office over the past few weeks, so we think you will gain some great insight from Freddy’s appearance. And if you like the podcast, don’t forget to click 5-stars and leave a review. It helps the podcast be found by other like-minded investors!
Takeaways from this Week
This week the selling continued in earnest, with hypergrowth stocks continuing to bear the brunt of the market action. We think it is time for investors to consider trimming back outsized positions and exposures to particular sectors like technology. The rotation continues into sectors that will perform relatively well in inflationary environments or a possible bear market. These sectors include financial services, health care, energy, along with some selected retail names that have significant pricing power.
It can be difficult to let go of positions in companies with strong business models and exciting growth prospects. As investors, though, we have to control what we can control. Sentiment has clearly changed and it is the time to de-risk portfolios to some degree to prepare for possible continued selling in the growth segment of the market. At Left Brain, we have moved away from a handful of our favorites, in the interest of risk management. We will continue to monitor these companies for the right time to return to those positions. Watch this space.
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