There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller that the sardines were no good. The seller said:
“You don’t understand. These are not eating sardines; they are trading sardines.”
Well, we are 1/12th of the way done this year and it sure feels a lot longer than that. We projected/expected some additional volatility this year and got that part of the equation right. But it would be disingenuous if we admitted that there would be this much volatility right out of the gate. The Fed is changing their course and trying – key word there is “trying” to turn hawkish and reduce their massive $9 trillion-dollar balance sheet while raising rates to help stem inflation – something they have never attempted before. So, that alone helps explain why the VIX went from a teenager to a young adult in just a matter of days during January.
What we do find unusual however, is the fact that this news from the Fed is not really new news. Chairman Powell was pretty clear in his objectives and timeline at the December 16th meeting. But apparently investors were too busy focusing on Santa and decided to delay any major market reallocations until January 4th. Many were banking on the Santa Claus traditional rally and the January Effect to soothe themselves before dealing with this change in monetary policy. They got the Santa rally, at least in the major indices, but there was no sign of a January Effect this year as the underperforming down stocks from 2021 such as cannabis, Twitter (we tried that), Viacom, and many other beaten down names failed to mount any sort of bounce.
2022, in terms of the SP-500, we are off to a top-5 worst start since 1980 (-5.2%). It likely is a bit of an overreaction and does make some sense when you consider that most people sell first and ask why later. That has always been a tried-and-true axiom for investors and was on full display in January. We also must always remind ourselves that toady’s markets are highly driven by algorithmic trading programs that tend to feed off themselves both on the downside and upside. This situation tends to lead to two-way overreactions as we saw in particular on January 24th when the SP-500 fell nearly 4% only to recover and finish up slightly on the day.
“Since the 1980s, problems have always been solved by easing. That was true fiscally and monetarily, and the countries that eased more did better than the countries that eased les. We are at a turning point now and things will be much different.” – Greg Jensen, CIO Bridgewater
So, what are the takeaways thus far away from this most interesting start to 2022?
1- Multiple contraction will continue all year. 50x sales is going to be hard to justify in this new environment. The IGV Software index is now the poster child for tech valuations and fell over 11% in January but is nearly 4% off its lows.
2 – Inflation isn’t transitory. Yes, it is a supply chain issue but that’s not going away anytime soon unfortunately. And with China’s insistence on a zero-covid policy and the draconian measures they are implementing the supply chains will likely become more than less stressed than less for the immediate future. But, this could be labeled as unnatural inflation seeing that the economy remains robust by most measures and the problems are supply related.
3 – Politics, unfortunately, will matter a lot this year. From Senator Manchin usurping all the power from the Democrats’ agendas to President Biden polling in the low 30s to the likely shifting of power after the mid-term elections in November. We, sadly, must remain vigilant on what transpires in DC
4 – Geopolitical pressures remain. The Russia/Ukraine spat isn’t likely to go away anytime soon, and the Chinese invasion of Taiwan rumors seem to grow stronger as some feel they are waiting for the Winter Olympics to end before they do anything. We are in the camp that it’s more bark than bite and an invasion of Taiwan would cause a huge international response and likely equate to the complete breakdown of a working relationship between the two countries. That just seems extreme in our opinion.
But those four inputs, while important, are secondary to the Fed. Investors, traders, and even casual observers must now come to grips with a complete shift in rates and, much more importantly, liquidity. We have all been spoiled by the Fed’s massive, consistent injection of liquidity for years now. But tough love is here and it’s time to adapt. This is why we are seeing wild swings in the stock indices and massive moves in the commodity markets (although supply chains and a strong dollar are helping commodities as well)
We are imbedded by a large swath of investors who are accustomed to having their hands held by Fed policy and a low-rate, TINA (there is no alternative) world. It takes time to accept the fact that life is going to get harder and that the comfy blanket you like is now gone. This doesn’t mean you need to panic or give up. But we all have to adapt to this new world we are in. Those who do will find amazing opportunities down the road. Those who don’t will become increasingly frustrated and likely leave the markets, something that we saw in last month when Robinhood disclosed that they had lost nearly 4 million active users.
On January 26th, the FOMC met for one of the most important meetings and ensuing press conferences in a long time. It was the first time in six weeks that Chairman Powell was able to pontificate more on inflation, balance sheet reduction, and where the Fed’s head was at for 2022 and beyond. It was definitely the most important event of this young year and now we will have to wait until March 16th to see if they are all talk or are set to take real action.
We feel like the market sell off that began in early January and continued into the meeting on the 26th was the markets’ way of saying “see what will happen if you don’t lose that hawkish tone?” Powell ignored the markets tantrum and went ahead with his plans and now the markets are really not happy. Keep in mind that we have a whole generation of investors who have never seen a rising rate environment or a Fed balance sheet reduction period.
Many believed Powell would temper his enthusiasm for a hawkish stance and once again soothe the market after the ugly start to the year that has rattled so many. Well, supply chain issues and subsequent elevated inflation levels have apparently kept that option off the table.
Here are a few snippets from the press conference that reiterate this:
“So, I’d say, you know, since the December meeting I would say that the inflation situation is about the same but probably slightly worse. I’d be inclined to raise my own estimate of 2022 core PCE inflation, let’s go with that by a few tenths today. I think to the extent the situation deteriorates further; our policy will have to address that. If it deteriorates meaningfully further, either in the time dimension or in the size of the inflation dimension.” – Chairman Powell 1/26
“This is going to be a year in which we move steadily away from the very highly accommodative monetary policy that we put in place to deal with the economic effects of the pandemic.” – Chairman Powell 1/26
Another line that tweaked investors was this from the press conference:
“I don’t think it’s possible to say exactly how this is going to go. I think there’s quite a bit of room to raise interest rates without threatening the labor market.” – Chairman Powell 1/26
And with those less than comforting words traders immediately gave up any hope that this Fed was going to error dovish going forward. The SP-500 index, along with other indices have traded in a very erratic manor since that day.
By the time the press conference ended, Fed Fund futures were pricing in six rate hikes out to February 2023. Goldman Sachs is now out saying that there could be six hikes this year. Bank of America is predicting five for this year.
But all is not lost just because the Fed is starting to tighten. We found this snippet on Bloomberg and thought it was worth sharing:
“Stocks have risen at an average annualized rate of 9% during the 12 Fed rate hike cycles since the 1950s and delivered positive returns in 11 of those instances, according to Keith Lerner, Truist’s co-chief investment officer. The one exception was during the 1972-1974 period, which coincided with the 1973-1975 recession.”
One thing we carefully watch is the credit spreads. They are the real gauge for market health and thus far have held up reasonably well. Spreads have remained tight and there has been little spillover from the surging VIX and violent intraday swings seeping into the credit arena. That’s not to say there hasn’t been some price damage done. We track 3 credit ETFs in an attempt to get a quick glance during the day in credit. All three are now near multi-month lows. But the internals remain relatively healthy via some statistics from Bloomberg below. This is probably the most bullish takeaway this month in equities despite all the carnage that has ensued.
- BBB spreads (representing the lowest-rated investment grade US corporate bonds) are up to 129 basis points from 121 bp at the start of the year. These are now at 1-year highs (equaling February/March 2021).
- High yield spreads are up to 344 basis points. They were 310 bp at the start of 2022, so current readings are modestly higher. Still, HY spreads are still well below peaks from November (367 bp) or earlier last year (February’s 383 bp).
The good news is that this current inflation problem plaguing the nation is a supply problem, not a demand issue like it was in the 70’s when then Chairman Paul Volcker went nuclear raising rates to crush inflation – and sent the economy into a deep recession. Covid, and more specifically Omicron, have led to massive sick days for workers and have wreaked havoc on Chinese shipping ports that serve as ground zero for supply chains. It was reported this month that automakers currently have just five days’ worth of chips in stock for production versus the usual 40-day supply.
There is no arguing that supply chain problems are the world’s number one issue right now. How and if they can improve will literally affect almost every facet of our lives.
The other good news is that Omicron cases seemed to have crested in most areas and the symptoms have mostly been mild. So, if we continue to see Omicron peter out, and no new dangerous variants evolve, then it is plausible that this pandemic, two years running now, will devolve into a treatable endemic and finally allow the supply chains to become unglued to some extent.
That might seem a bit pollyannish and no one ever confused us with entomologists. But when you look at the recent price action in Moderna -28% YTD, Pfizer -7% YTD, and Novavax -34% YTD we have to wonder (hope) that the markets have sniffed out the end of this awful pandemic?
Bitcoin Update:
It has been a brutal two months for the cryptocurrency enthusiasts. The price action is simply putrid, and any semblance of a bounce is met with a barrage of selling. Fundamentally however, not much has changed. There continues to be rabid demand for private investment in anything blockchain or crypto related, especially in the payments and NFT areas.
- Google announced this month that they have partnered with Coinbase and Bitpay to store crypto assets in digital cards. They also said their Cloud division is forming a team to win blockchain business and have partnered with Dapper Labs, Hedera, and Theta Labs. Also, they hinted that the Cloud division would accept payments in cryptocurrencies soon.
- Man Group, which manages over $40 billion, became the latest large institution to agree to offer a cryptocurrency fund after increasing demand from their clients.
- The Fed on January 27th opened a debate over a possible digital currency and the current administration made more rumblings about regulating cryptocurrency and even called it a “matter of national security.” – however, both the Fed and the White House failed to provide many details on either announcement.
We have long argued that government regulation would be a positive for cryptocurrency in the sense that it would legitimize it more and further allow institutions to become more involved than they already are. Maybe 2022 is the year we will get some clarity on that.
The total value of all virtual currencies is now down $850 billion from its all-time peak of $2.97 trillion in November 2021. If there is one consistent in this space, it is that it is volatile and will remain so.
An area that we have avoided for almost two years now are the SPACs. These once-hot issues have completely crashed and burned and many are now trading well below the $10 “floor” that was once seen as protective level. Half of the SPACs that did deals in the past two years are down 40% or more from their $10 starting price. New deals are now being withdrawn even though millions in fees must still be paid and some investors are staring at losses of over 60% in just a year on some of the more popular issues.
The news and price action are so bad that it is actually becoming attractive. People are giving up on the concept and everything is being tossed away with little regard for fundamentals or valuation. Granted, there is a lot of garbage to sift through and a lot of the issues are down this much with reason. But we plan on looking closer at this sector in 2022 and have subscribed to a research service to help with the process. There is a real chance this is just a wasted effort, and we end up doing nothing in this space. But there does seem like there are some potential opportunities to explore – so we will.
Looking Forward and other Market Commentary:
We still have approximately two weeks left of earnings season to grind through. The majority of the big names have reported, but we are still curious to hear from: Twitter, Amazon, Google, Facebook, Snap, Pinterest, Expedia, Trade Desk, and many others
As for the macro side: The ECB will meet on the 8th and the investing world is waiting to see if they will be as hawkish as the Fed (they won’t be) or if they remain more measured and stick to the “wait and see” mantra (they will). We are already seeing brushback from the Fed’s new tightening policy from China and Japan and wouldn’t be surprised if the ECB chimed in as well. Free money addiction is a tough one to kick.
We are quite sure the Fed will be anxiously watching the data from the following reports set for February:
- January jobs report on February 4th
- CPI report on February 10th
- PPI report on February 15th
- PCE prices for January on February 25th
Obviously, all these reports are directly tied to inflation, which is driving current Fed policy, hence making them as market moving as they have been in decades.
So far, results show about a third of S&P 500 companies have reported and 77% of those have beat Wall Street expectations by an average of about +4%. 75 percent of companies reporting have beaten revenue expectations. That is better than the 5-year average of 68 percent.
The S&P 500 enters February trading at 19.7 times (12 month) forward looking earnings, after starting the year at 20.1 times, and bottoming in late January at 19.2 times. The five-year average forward looking PE ratio for the S&P 500 is 18.5 times and the 10-year average is much lower (16.7).
Let’s look at the recent numbers from Tesla: Adjusted EPS of $2.54 which easily beat estimates. Revenue of $17.7 billion which was good for an annual growth rate of 65%. Gross margins held steady at 30.6%. Operating margins improved 14.7% and free cash flow generated $2.77 billion for the quarter, up 48.5% from Q4 2020.
Hard to quibble that it wasn’t a great quarter. And the payoff? Tesla shares sunk over 10% on the news and now trade near 3-month lows. Which is a perfect example of why it is going to be very tough for these high multiple stocks to prosper in this new tightening environment we are now in. Even if the underlying story/product is fantastic – as Tesla’s is.
Netflix and Peloton are two other examples of once high-flying names that have been crushed recently now that valuations matter. Although it could be argued that Netflix, after a 40% drubbing, is trading at a reasonably respectable valuation and that was further confirmed when Bill Ackman disclosed this month that his firm had taken a 3.1 million share stake in the company. Just another example of how large dislocations can provide great opportunities.
One thing we can certainly take away from the first month is that stock-picking, at least for now, is dead. Macro algorithmic program trading is sweeping the markets and ignoring any individual fundamentals that matter. In 2021 we pointed out that small-cap stocks were constantly displaying bearish characteristics while being masked by the strong performance in the indices. Well, in 2022 the general indices have caught up to the small names price action – which has only further exacerbated the pressure on these names.
There are surely some amazing values being created in select small cap names, despite the horrific charts that accompany them. But so far in 2022 there has been no regard for fundamentals and until that changes, or if it does, then trying to pick bottoms can be an awfully expensive endeavor.
Finally, traders are always looking for anecdotal examples of tops and bottoms in markets. Some examples are when Uber drivers start giving out stock or crypto tips. Or when CNBC builds a special ticker on their screen to track a particularly hot issue – examples lately have included AMC and Gamestop. Other bottoming examples occur when patrons at gyms ask management to turn CNBC off the TVs, so they don’t need to be reminded of their dwindling 401ks or when financial service companies pull their sponsorships from sporting events.
Our point is we feel like the government’s handing out of free testing kits and N95 masks this month, almost 2 years after the pandemic begun, might just signal the top in the pandemic and give us even more hope that the end is near for this nightmare we have all been dealing with.
We aren’t saying what the government is doing is misguided – just a little late to the game. That has all the classic tells of a topping call and we sure hope we are right. It feels to us that people have had it with the pandemic restricted lifestyle and are now comfortable accepting the risks.
The government is historically slow and behind the curve in their actions. Let’s all hope they keep their streak alive with the tests and masks idea.
Occasio Partners, LLC 465 California Street, San Francisco, CA