2021 Q4 Commentary
By Jason Lesh, Managing Principal
It has been quite the past 12 months on all fronts. On the personal front, this time last year my family and I were finishing up our home remodel, living in a tiny rental, and helping our kids through online, remote learning. The pandemic had slowed the economy but was starting to come back. Nick and I would Zoom each other discussing the insanely high valuations on technology companies while betting the farm that inflation would impact more than just lumber and construction costs.
As we begin 2022, the house project is behind us, my kids are back to in-person learning, inflation is real, and the darling tech companies of 2020 are the casualties of the day. Fortuitously, being stuck at home perhaps sharpened our awareness of the craziness of these times: as you know, we had built portfolios that were anything but conventional which has served us very well – both through 2021 and the beginning of 2022.
We stayed away from US Large Cap Growth like the plague (pun intended?), and instead invested in cheaper markets and securities that would do well if inflation truly took off. And while volatility has clearly returned, we have been more than adequately compensated to date with healthy returns and out performance to start the year. We feel very comfortable with the current positioning of portfolios and anticipate continued volatility to present opportunities for us down the road.
While the past two years have allowed us to truly lean into our work managing investments, the challenges of the pandemic have kept us from arguably the most rewarding part of our jobs and that would be meeting as often with clients and prospects. We would love to spend more time meeting with you in the coming months: whether that be on the phone, over Zoom, or in person. Please do reach out if you would like to schedule a time to discuss your specific situation and how we may able to help!
I hope this note finds you well and here’s to a healthy and prosperous 2022!
All eyes are on the Federal Reserve right now as the most important variable in markets as we have experienced the most significant inflation since the 1970s. We are not sure how much of this inflation is due to supply chain disruptions with Covid and how much is attributable to the amount of liquidity in the market. The market has begun pricing in 3 or 4 rate hikes by the Federal Reserve for this year and Jerome Powell (the Fed Chair) has said that they essentially will do whatever it takes to manage inflation. Why does this matter? The entire market, no, the entire formula of global pricing/valuation of assets has been built upon a narrative of a stable US dollar and low interest rates. This narrative has supported unprecedented capital flows and debt accumulation for the purpose of capital expenditure investment and consumption - the backbone of the global economy.
The Federal Reserve spent the greater part of a year saying that inflation wasn’t a concern, it will be temporary, and rather insignificant. Obviously, they were wrong, and it has been much more significant. Whether you go to fill up the car with gas or go to the grocery store, prices are much higher. On one hand, in the absence of higher wages, it’s hard to imagine how inflation could be sustained. On the other hand, once inflation takes hold, it can have a spiral like impact. I know smart people who disagree on this: in other words, nobody really knows and there’s no historical precedence to look at. This time really is different.
This uncertainty is sure to lead to continued volatility until the market gets comfortable with what is happening and this latest Covid Omicron surge is behind us. This is sure to create opportunity.
Here is what we will be following as this unfolds:
The yield curve: the difference between the short end of the curve (treasury bills) and the long end of the curve (treasury bonds) is the bond market’s pulse on the economy. The curve has been flattening of late, which signals that the economy may be slowing. If this continues and inverts, then economic growth and perhaps inflation will slow.
Atlanta Fed’s GDP Now Estimate: an amalgam of several important economic indicators used to understand economic growth. As the impact of Omicron fades, the GDP Now estimate will show us how strong the economy is. Does the estimate continue to fall or stagnate or do we experience a jolt of growth with the economy re-opening, especially the service sector.
Our clients have noticed that we have not experienced the same drawdown as the rest of the market. That is because we are not invested like most of the market. I am sure we will see some volatility, but for now we have held up better than the market.
The assets that performed best over the last 5-7 years will likely not be the assets that perform over the next 5-7 years. At least in the short-term this has been on magnificent display starting early last year (2021). We think this trend will last longer and be more pervasive over the long-term, albeit in fits and starts.
As many of you know, our portfolios have been positioned away from the bubble-like assets most vulnerable to a repricing and positioned to benefit from the narrative shift that we knew was coming. Sure enough, our portfolios have held up well while the stock market has been fickle.
The sexiest growth stocks have recently become quite volatile. The poster child for the recent excesses may end up being the ARK Innovation ETF. After an absolutely spectacular rise in 2020, it has retreated quite substantially, down more than 50% and erasing the recent gains. The catalyst for this recent fall was quite simply the difference in valuations (by every measure). Consider the valuation metrics difference between US value (which we prefer) and US growth (like the holdings within the ARK ETF).
Perhaps some of the names within the growth index deserve a higher valuation. Nearly twice the valuation by most measures seems excessive though. Consider the recent drawdowns experienced among these “hot” name, Yikes!
Similarly, when we look at valuations outside the US, there is quite the dispersion in valuations.
While US “growth” stocks are quite risky in our view, international and emerging market stocks (specifically the cheapest 25%) are quite attractive and will likely give us a fine return over the next 10 years. That is not to say we won’t experience volatility, but there is nothing worse than experiencing massive volatility and then taking years to break even.
To be clear, we are being extremely vigilant right now due to the uncertainty that exists. As of now, portfolios have performed even better than we anticipated. We will continue to monitor the environment, but the potential for this hiccup turning into a major correction is legitimate. In the end we get excited when market prices decline and we have the opportunity to redeploy some of our safe assets (cash, short-term fixed income and hedges) into areas where we can earn a great long-term return.
