“This is the longest period of practically uninterrupted rise in security prices in our history. The rise was more rapid than has ever been seen, and its speculative attraction influenced a larger part of the public than ever before. The psychological illusion upon which it was based, though not essentially new, has been stronger and more widespread than has ever been the case in this country in the past.”
-The Business Week, Nov 2, 1929
Looking forward to 2022, the focus for markets will remain the Fed and rates, inflation, employment, stimulus and, of course, COVID. The Fed has suggested that it plans on raising rates as many any three times in 2022, a likely increment of 25 bps each. For now they act committed to this course of action (along with reducing monthly bond purchases).
However, it remains to be seen if they’ll continue the medicine if the markets start a tantrum. Recall the most recent attempt to raise rates (0.25% three times in 2018) resulted in a 20% drop in the S&P in Q4 of that year, causing the Fed to quickly abandon their efforts.
I would posit that a normalization of rates and the associated cost of capital is needed for the long-term health of the economy and our composition of ongoing concerns. Granted, there are many firms that would likely not survive an appreciable rise in rates (at least not in their current form). But as John Hussman wrote of zero interest rate policy last year,
“What economic activities suddenly become viable at zero interest rates that were somehow not viable before? Only projects so unproductive that any positive hurdle rate would sink them.”
Of course, the market’s performance last year has led many investors, novice and professional alike, to disregard the need to look past anything but speculation. The S&P’s 27% rise in 2021 was impressive indeed. In fact, it was up almost 11% in Q4 alone.
But lest we think this is the new normal and that stocks will continue to rocket higher regardless of gravity or economic headwinds (like many younger investors who have yet to see a real bear markets apparently do), let’s look at from where those recent returns have come. The chart below shows the makeup of S&P 500 total returns since 2011:
You’ll notice that, especially since the floodgates of free money opened even further during COVID, the largest increases in contribution to S&P 500 gains have come from buybacks (green) and Price/Earnings expansion (dark blue).
While earnings per share have looked a bit better recently, the lion’s share of the growth of the index has come not from an increase in productive economic activity, but in the form of companies buying back their own stock (which juices the stock price and their compensation, as opposed to investments in CapEx or R&D) and multiple expansion (because most investors believe their gains are the result of their brilliance are fully onboard the Great Fool Theory train).
On top of this, the leadership to new highs has been extremely narrow. As I wrote in November’s month-end note, “YTD through November the top seven components of the S&P 500 accounted for 53% of the return of that index. Just seven companies out of 500 make up over half the return in 2021. Other than that, the breadth of participation in the recent run up is far from ideal. As of yesterday, more than half of the S&P 500 are trading below their 200 day moving average…” (Note: This may be beginning to change as many of the FAANG+ darlings have begun to weaken significantly as of late.)
As of year-end, more than 40% of the components of the major indexes are in correction territory (down 10% or more from recent peaks). And still we currently sit at or near all-time high equity valuations (both public and private), all-time high leverage (margin borrowing), with our appetite for stimulus (seeming to?) slow – with probably headwinds from rate increases and supply/demand constraints/question marks. The environment could hardly be less certain.
Of course, the indices could continue blindly higher, but the further we go, the more history’s lessons apply – economic fact will eventually win out and the market for many stocks will find no more buyers above – no more greater fools.
I sincerely hope that investors will be spared the worst that we’ve seen in past bear markets that began from these heights, but this is when strong defense, downside protection and the ability to profit from falling markets will be of the utmost importance.
(Note: The above was an excerpt from our December 2021 Investor Letter.)
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