What's in store for 2022

As we embark on 2022 many market pundits are putting out their yearly predictions. We always find these more entertainment and theater rather than actual advice because the honest truth is, no one has any clue what the future holds and the market doesn't care about my opinion. Frankly there are always issues to worry about: Omicron shutdowns, new variant, supply chain glitches, labor shortage, school closures, higher inflation, rate increase cycle, Mid term elections, military conflict, etc. Our investment philosophy isn't predicated on predicting the future but rather reacting to current data. We use current and past data to help shape a thesis for potential outcomes in a scenario analysis manner. Then when events and conditions change we adjust our positioning and risk accordingly. The old adage sums it up perfectly, "the only constant in life is change".

With that said, to look out to next year we need to first assess what has actually taken place in real time. 2021 provided great returns across the asset class spectrum for everything except gold and treasuries. Jurrien Timmer from Fidelity sums this up in his table of investment returns.

Even as the general market provided health returns there was plenty of churn under the surface. Remarkably, the average Nasdaq drawdown from YTD highs is a whopping -42%.

Cathie Wood has taken a lot of heat this year as her Ark funds have under performed. But a simple ratio chart of the ARKK ETF to the SPY shows how dramatic the selling has been in high valuation growth names. ARKK peaked in February and has drastically under performed the S&P since then. Currently it is more than 50% of it's YTD high. 

 

Most of the destruction in high beta growth can be attributed to the pivot from the Federal Reserve to speed up the tapering process to fight inflation they let get out of control. A tweet from Puru Saxena highlights how expensive stocks have lagged all year when plotted against the Fed's balance sheet.

This begs a bigger question. What is the impact from QE on the markets. Clearly quantitative easing has been a tailwind to the S&P. However, the reversal of QE (tapering) that reduces liquidity in the economy seems to be a headwind. The following two charts from William O'Neil touch on this.

On top of that the Fed's actions have historically triggered greater volatility. 

 

The following two charts increase the likelihood for the potential for a more volatile environment next year. Low volatile years like 2021 are historically followed by more volatility.

The presidential cycle doesn't do any favors either. The first three quarters are weaker than normal heading into the mid term elections.

 

One of the biggest market concerns is the rate of inflation and the pace of interest rate hikes from the Fed. However, should we be scared of rate hikes? Bespoke has great data on this. What I found most interesting was, "as shown, the broad market tends to do poorly in the first three month of a tightening cycles over recent year, bu longer-term that's a buying opportunity as forward returns average 7.1% (86% positive) over the first six months follow a rate hike."

Ken Fisher validates this theory that the market shouldn't be spooked by rate hike cycles. Outside of the mid 70's stagflation, equity returns have been positive during rate hike cycles.

Some more data points in the bull case shows how strength begets strength. One of our favorites Ryan Detrick shows what happens after big up years in the S&P 500. The average return next year is 11.6%.

Another interesting stat lies in the fact that 2021 was a unique year. It was only the 5th time in history going back to the 1920's that the S&P finished up double digits three years in a row. We looked at what happened the 4th year after three straight double digit years. The returns surprised us.

Year	Yearly Return
1942	12.43%
1943	19.45%
1944	13.80%
1945	30.72%
1949	10.46%
1950	21.56%
1951	16.46%
1952	11.78%
1995	34.11%
1996	20.26%
1997	31.01%
1998	26.67%
2012	13.41%
2013	29.60%
2014	11.39%
2015	-0.73%
2019	28.88%
2020	16.26%
2021	26.89%
2022	?
Average 4th Yr Returns	17.11%

In conclusion, the data points to a mixed bag and has something for everyone. The bears can highlight tapering and volatility while the bulls can point to continued momentum. Our best guess is the first half will be more volatile than normal with multiple pullbacks. But as the supply chain gets worked out after Omicron dies down that should help inflation ease. Tapering should be done by the first quarter and we should have the first rate hike behind us sometime in the first half. That could set the stage for a second half rally as pent up demand comes on board and a strong finish once the Midterms are behind us. As I said in the beginning, the market doesn't care about my opinion. That is why we prefer to see how the tape reacts to new information and we'll adjust accordingly. 

Happy New Year!

What to do when out of sync with market?

After a banner year last year for growth and momentum, 2021 has been a historically frustrating year. With the S&P up double digits again YTD it is surprising that certain sectors are drastically underperforming. So what do you when your strategy is out of favor while the general market doesn't show any signs of weakness? If you invest long enough all investors and managers will go through difficult periods. The key is to know your strategy in and out and know when it is time to be aggressive and when it is time to be more risk adverse and selective. If we take a quick look at some data and statistics we can get a better idea of what is being rewarding in this environment.  

Lets take a top down approach and look at which asset class is leading. We can see that commodities are in the lead as bonds lag drastically. 

 Commodities have been on fire.

If you want a reason for why commodities are surging we can look at the recent March PPI prices:

• Plywood (construction): +53 percent vs. last year
• Cold rolled steel (durable goods): +75 pct
• Copper (construction, durable goods): +43 pct
• Corn (food, animal feed): +44 pct
• Wheat (food): +32 pct

One of the big surprises of the first quarter was the historic rise in interest rates. The 10-year treasury note started the year around 90 basis points roughly doubling to 175 basis points. Albeit from a very low starting point, the 10-year yield put in the biggest 40-week rise in rates, by a long shot, going back 50 years. Below shows how dramatic the rise in yields has been YTD across duration's.

 

The increase in yields put the biggest pressure on high valuation growth stocks. Many growth stocks are in bear market territory even with the general market positive on the year. This bifurcation is the exact opposite of what worked last year. Toni Sacconaghi, a longtime technology analyst at Bernstein, encapsulated the dynamic in a fascinating piece of research. “He points out that, in 2020, investors seemed to be buying techs almost because of their high price tags. In fact, if you divide the tech universe into quintiles ranked by price/earnings ratios, the returns were lowest for stocks with the lowest valuations—and highest for those trading at the loftiest multiples. The average tech issue outpaced the broad market by 28 percentage points last year, but those in the top quintile outperformed by 60 percentage points. Writes Sacconaghi: The more expensive a stock was in 2020, the better it generally fared. But investor behavior is shifting. Tech shares have underperformed the broad market by about four percentage points this year, according to Sacconaghi. The most expensive names are running 10 points behind and the stocks at the other end of the valuation spectrum—the cheapies—have beaten the market by about 6%. In short, what went up is indeed starting to come down, he writes.”

The correction in high quality growth names will set up future opportunities, as YTD is a tale of two tapes and the opposite of last year. There was a huge rotation out of growth and into value, small caps, and the reopening theme. Below is a good representation of the shift out of growth and into value. It is a ratio chart of the VUG (Vanguard Growth ETF) to the VTV (Vanguard Value ETF). When it is rising, growth is outperforming which we see with the historic rise last year. This trend started to stall out in the fourth quarter of last year and broke down in the first quarter of this year as money rotated away from high growth and into more value centric ideas. It now has the look of a big head and shoulders top with a retest failure.

When we drill down to market capitalization we can clearly see smaller caps are outpacing large caps. 

Lastly is a list of sector returns year to date. When beaten down energy and financials are leading the market that is not a ripe environment for growth. The current market clearly favors cyclicals and commodities. 

Now that we have an idea what is working and what isn't we can look at a few data points that gives some future potential. A few studies from Ryan Detrick show conflicting possibilities. Even though we are entering the worst 6-month stretch of the year, based on some recent data the future looks brighter. 

 

A second tweet from Ryan Detrick shows how this current bull trend could be getting close to exhausting itself in the short term. 

As we enter the sell in May and go away theme for the next six months, one data point helps back up this case. A recent note from DataTrek research shows "the latest Investment Company Institute money flow data for long term mutual/exchange traded fund flows paints a less optimistic picture. We now have data through April 28th (essentially month end); here’s how it looks:

• Fund investors redeemed $17.8 bn from US equity funds in the final week of April, enough to flip whole-month flows negative to the tune of -$7.8 bn.

• There were also $4.6 billion in non-US equity fund redemptions, but April’s total is still positive by $17.6 bn.

• Fixed income fund flows, by contrast, were strong last week (+$19.2 bn) and April as a whole looks like inflows will total $76.2 bn. That’s the best month for this asset class since January’s $93.8 bn of inflows.

• Commodity fund (mostly physical gold) inflows last week were slightly positive (+$119 mn) but April’s outflows still total $1 bn.

Takeaway: it’s just one week of data, but the sudden and sizable reversal in US equity fund flows after 2 solid months of inflows isn’t something we can just dismiss, especially given the money market fund data. Perhaps investors are starting to sell positions with large capital gains (those would more commonly be in US vs. non-US equities) now that the current Administration’s tax plan is out. Perhaps stimulus money going into US equity funds has run its course. Perhaps late April’s sales were just rebalancing. Perhaps it’s all of the above. One thing is for sure: it will be much easier for US equities to continue their rally if flows turn positive again. We’ll know soon enough."

The question is what do we do when our strategy is out of favor. I have been in the business long enough to know that styles ebb and flow with market cycles. Not one strategy dominates every market year in and year out. Where most amateur investors fail is they get complacent and chase the next hottest investment product. However, if you know your methodology and trust the process you have confidence that opportunities will eventually present themselves. Sometimes the best trade is to do nothing while the hardest trade is to keep powder dry while reducing risk sitting patiently for asymmetrical bets to turn up.

A quote from Dr. Brett Steenbarger sums up how a trader should react under uncertainty, "that is where meditation and self-control techniques learned through biofeedback can be very helpful. If market volatility has picked up, there will be plenty of movement to participate in. The key is standing back, slowing yourself down, consulting the data and then looking for opportunity. Because the volume and volatility are coming from large participants in the marketplace, their behavior can create significant directional opportunity. You just want to be at your mindful best at those times so that you size positions properly and don’t let the excitement lead to overtrading. A lot of money can be lost quickly under chaotic conditions."