It’s Good to be King
“It's good to be king and have your own way (enduring the pandemic-financially)
Get a feeling of peace, at the end of the day (Ahhhh – everything is ok)
And when your bulldog barks, and your canary sings (the Jim Cramer’s)
You're out there with winners (the growth leaders in the market), it's good to be king” -Tom Petty
I doubt Tom Petty had thematic views of the stock market in mind when he penned “It’s Good to Be King” on the deeply personal “Wildflowers” album in the early 90’s. With parallels between rock stardom and reaching the top, I naturally thought of the stock market and whether many of the growth stocks can keep up the pace in 2022, whereby these high valuations are simply a “new normal” for stocks, even in an environment that sees higher interest rates. I have my doubts. While we will gladly accept the double-digit returns in 2021, the corporate juice has been squeezed, and earnings may be more difficult to come by (Source - First Eagle December 2021). The question remains: Can the growth stocks continue to lead without the assistance of the Fed and Treasury, or is this song about to end?
Higher yields compress and push down stock valuations because the risk-free rate (which is increasing) makes future company earnings less valuable. It is that simple. Furthermore, growth stocks are the most affected by an increasing interest rate environment due to borrowing costs. The crystal ball is foggy, but perhaps becoming clearer with strong signals from the Federal Reserve. This is a skewed stock market that has heavily favored growth stocks over value stocks – for years. I sound like a broken record.
Our firm remains value-conscious: we don’t chase continued winners, and we put a premium on capital preservation first. Investors win long-term by not losing. They win with the understanding that you can’t predict markets which can remain inefficient for years. Markets are illogical and emotional and rarely priced correctly. There is potential value in equities, but it likely resides in those stocks that are more value-thematic and less sexy.
2021 in Review
The old adage goes that there are two types of forecasts: Lucky and Wrong. After a year like 2020, forecasting what 2021 would hold was especially difficult as the uncertainty normally associated with markets was amplified by the unknowns of a rapidly developing pandemic. 2020 saw the S&P 500 simultaneously fall 34% (Feb-March 2020) and rise 68% (through the end of 2020 – Source Morningstar 1) and after gains of that magnitude, it would be understandable to expect equity markets to cool down in 2021. But they did not. And the beat goes on. And the canaries sing.
With the economy coming out of a pandemic-induced recession, consumer demand surged, flush with cash from government Covid-19 impact payment. Consumers bought everything off the menu – be it be cars, steaks, jewelry, or lumber. Companies raked in the profits from the huge sales, and analysts were quick to revise their earnings estimates higher.
Stock indexes continued to rally globally in 2021 and the outperformance of US stocks persisted. The S&P 500 saw a total return of 28.7% for the year, compared to just 7.8% for the (rest of the) World Index. Domestically, energy was far and away the leading sector, with a 53.4% return, and Real Estate, Financials, and Technology also outperformed the overall S&P 500. (Source – Morningstar 2)
A deeper dive, however, reveals an interesting dynamic at work. There was a major disparity in 2021 between growth and value indexes that varied widely based on the size of the companies.
No market cap wildly outperformed across the board, nor did Growth or Value. But that closer look reveals an interesting trend: the smaller companies performed better in the value camp, and the larger companies performed better in the growth camp. Environments like this are where active managers can demonstrate their value and some of our favorites did exactly that.
The spike in the aforementioned demand ended the year with headwinds, such as supply chain bottlenecks, enormous inflationary pressure (the highest in 40 years), rising prices and hinted interest rate hikes (supposedly three to five times in 2022 – Source 4 Barron’s January). Don’t forget about potentially lower earnings moving forward. This doesn’t account for international political instability and domestic polarization, which in my mind, remain the two biggest long-term threats.
To conclude, the best offense may be defense, but we couldn’t have more faith in our fund managers who are hard at work, paging through balance sheets to find strong companies at reasonable prices.
The king grows weary and more agitated from outside sources these days. And while there are no term limits for kings, one wouldn’t be surprised if a new leader comes into power (a shift within the market). We would welcome a healthier regime. The canary tunes are getting old.
Source 1 - First Eagle December 2021
Source 2 – Morningstar January 2022
Source 3– Morningstar January 2022
Source 4 – Barron’s January 2022
Source 5 – Morningstar January 19, 2022
Source 6 – Kitces – January 2022
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.