Last spring, my wife and I took our daughter to Disney World. We had been recently vaccinated and we were feeling empowered and brave. It helped that Disney was operating at 50 percent capacity—it was a luxury I will require for future visits. Anyway, as my daughter and I were exiting Space Mountain, my Apple watch started to vibrate and I saw I had a call coming in from 911. Startled, and a little out of breath, I answered, not really knowing what to expect. Turned out that our technological overlords had determined that based on the violent maneuvers and abrupt stopping, I might have been in a car accident, and they were calling to ask if I required assistance. I thanked them and told them I was just a middle-aged guy on a roller coaster and we all had a chuckle.
After January’s ride, I half expected my watch to start buzzing again today.
While the history books will show that the major market averages were lower for the month based on month-end pricing, they will not capture the mileage. Yes, January concluded with the Dow down 3.3 percent and S&P 500 down 5.3 percent, but those figures obscure the intra-month declines that landed the other major US index, the tech-heavy NASDAQ, well into correction territory, even though a furious rally these last two days enabled it to post just a 9 percent decline for the month.
For the majority of the overall market’s near two-year trip out of the COVID-19 crash of March 2020, the experience has been more akin to the Seven Dwarfs Mine Train than anything that would require a height minimum. That has changed. It was only three days ago that the Russell 2000 Growth Index had fallen 19 percent since year-end, a single percentage point from a bear market.
Almost right out of the gate, the markets had begun to behave differently than they had in months. Ironically, as COVID-19 finally appeared to be losing its grip on the U.S. economy, markets began to focus not on the virus, but on the side effects of the cure—not the vaccine, but the enormous fiscal and monetary stimulus intended to keep the economy afloat during the dark days of 2020 and early 2021.
Those treatments, coupled with persistent supply chain problems and an extraordinarily tight labor market, have resulted in price inflation not seen in this country since 1982. The Federal Reserve, having successfully achieved its stated goal of strengthening the job market, and then some, will now turn its focus to dampening inflation through a combination of reducing its ownership of financial assets and raising interest rates. Accordingly, the yield on the ten-year Treasury has jumped from 1.51 percent on New Year’s Eve to about 1.77 percent as of the end of January.
While markets had been expecting two rate increases in 2022, the markets are now anticipating five rate hikes before the end of the year. That’s a big difference, especially given how low rates have been, and markets quickly began to reprice assets based on that big difference.
Now, as a general rule, markets do not really like rising interest rates, especially markets for expensive assets such as “growth” stocks—you know, the kind of stocks that have been doing well for years. Investors pay more for “growth” stocks because of the promise of earnings growth that will yield big future profits for those companies. The trouble is, in an environment where we have rising interest rates (because of rising inflation) those future profits aren’t going to be worth as much. As a result, other less expensive stocks, of companies that already have strong earnings even if they’re not promising future trips to Mars, look that much more attractive. Intuitively, this makes sense, right? In an economy such as ours that’s chugging along quite nicely in which lots of companies are generating strong earnings, who wants to pay nosebleed multiples for discounted future earnings when we’re swimming in strong earnings today?
What happened in January was a giant rotation out of “growth” stocks and into “value” stocks. At one point, the Russell 2000 Value Index was outperforming the Russell 2000 Growth Index by more than 1000 basis points, or ten full percentage points in just 19 trading days.
Growth made up considerable ground during the last two trading days of the month to trail by slightly less than 8 percentage points, but that’s still a huge move.
Of course, while we as investors have had the luxury of enjoying a relatively smooth ride recently, it is actually perfectly normal for there to be a 10 percent drawdown; in fact, there’s one just about every year.
But what if this really is something more serious? What if this is an extended drawdown? That would be rare indeed—we’ve only had 12 drawdowns of more than 20 percent since 1946. They usually accompany recessions and yet American corporate balance sheets have perhaps never been stronger, but let’s just say for argument’s sake that this might be serious. What might it look like? Well, if monetary conditions tighten significantly, that’s almost certainly going to be harder on the more speculative areas of the market than the less speculative. The reality is that the Fed is going to beat down inflation, sooner or later. The trouble is, falling inflation feels a lot like rising interest rates, whether nominal rates rise or not. With the 10-year where it is and core CPI at 5.5 percent, that translates into a current real interest rate of negative 3.7 percent. As inflation subsides, it’s just hard to see how we even get back to a real interest rate of zero without some price volatility, particularly for long duration, pricier assets.
All that said, we are not in the market-predicting business. We are in the optimal long-term allocation business, with a tilt toward value (and small caps, and international, and profitable companies). Naturally, this positioning is unlikely to outperform markets when speculation and accommodative monetary policy is ascendant. However, the existence of markets such as this one, characterized by heightened volatility, is incorporated into our long-term view, and, so far anyway, the value-tilt is performing as one might expect.
One of my favorite Warren Buffett observations is that in the near-term the market is a voting machine, but in the long-term it is a weighing machine. Sooner or later, all companies must demonstrate the ability to generate earnings, not just promise it.
Because when the ride gets so bumpy that your watch starts to buzz, it will be the weight of the portfolio that counts, not the number of “likes” it has.
Burke is Trust Company’s Investment Strategist. Based in the Raleigh office, Burke works closely with the firm’s Chief Investment Officer helping develop investment strategy and communicating with clients.