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Strategy Update

A Thin Rally Breaks

The Standard & Poor’s 500 Index (S&P 500) finished the year on a high note, closing within a hair of an all-time high. The index rose steadily throughout the year, with very few pullbacks along the way. The obvious interpretation was that investors were optimistic about the future. But despite the new highs, we saw a market increasingly predicated on caution and even some fear. This contradiction arose because the S&P 500 is so heavily weighted to a few gigantic technology companies that it is no longer representative of the broader market. In fact, the shares of the average company had begun to falter much earlier in the year, and told a much more pessimistic narrative. That pessimism has now spread to small and large companies alike. The thin rally upon which the market was riding has broken, and the S&P 500 is falling.

Although the S&P 500 is commonly cited as a barometer of overall market health, the 500 companies in the index are not weighted equally, but in proportion to the total value of each company’s shares. At the end of 2021, the shares of the seven most valuable companies in the world (Apple, Microsoft, Google, Amazon, Tesla, Facebook and Nvidia) collectively accounted for over 25% of the entire index. The success of these tech giants was fundamental to the success of the S&P 500, despite the hundreds of other publicly traded companies in the index (and the thousands outside it). While the shares of the top seven companies generally performed well last year, many smaller companies collectively struggled.

As the year progressed, this divergence became glaring. In just the second half of 2021, shares of Apple were up 30%, while the Russell 2000, an index of 2,000 smaller companies, was down 2%. The size of those 2,000 companies together amounted to $3.6 trillion, while Apple’s valuation alone soared to $2.9 trillion. Put simply, the highly optimistic bets placed on a single company outweighed the generally pessimistic bets placed collectively on 2,000 companies. Investors crowded into shares of Apple and its peers, making those shares more richly valued in the process, while shares of so many smaller companies stagnated or declined. In fact, over one thousand companies went public in 2021, in a record surpassing even the dot-com era. But as we entered the new year, nearly two-thirds of those newly listed companies were trading below their IPO prices. And it wasn’t just fresh IPOs that fared poorly: as 2022 began, nearly 40% of the companies in the technology-heavy Nasdaq Composite Index had fallen by 50% or more from their 52-week highs. The market rally, as represented by the S&P 500, was a very thin one indeed. In our view, it masked growing pessimism.

There were good reasons for the storm clouds that gathered in the second half of the year. The successive waves of the Delta and Omicron variants delayed any true return to normalcy for at least another year, relative to the expectations that most investors began the year with. Supply chain bottlenecks, along with manufacturing and labor constraints, created headaches for consumers and investors alike. And perhaps most significantly, inflation appeared far stickier and more problematic as the year progressed. Modest levels of inflation are historically well tolerated by the stock market, but persistently high inflation has been far more problematic. With new data in late 2021, it became harder to say for certain which inflationary path we were on. There are myriad reasons why shares of particular companies would succumb to these fears, while others would prove resilient or even advance. The simplest, in our view, is that investors thought it safer to ride out the growing storm in a massive company like Apple, an ocean liner in contrast to the sailboats and kayaks of the Russell 2000 Index.

As the start of the year has shown, however, thin markets can be dangerous markets. Sentiment has finally broken on all stocks, including the largest members of the S&P 500. Inflationary fears are now omnipresent, and all indices are now falling in fairly coordinated fashion. Other assets which performed well last year, including crypto currencies, are joining the decline. Most stock indices have reached a correction level (defined by a decline of 10% or more), while some of last year’s highest fliers are now hinting at the washout of the dot-com bubble.

Current Strategy

Guessing at market bottoms is as much an exercise in psychology and emotion as it is financial math. We would argue that, with the large pullback in technology shares, valuations are becoming reasonable once again. This does not mean that the overall market will reverse course exactly as the financial math predicts. Sharp market declines are emotional events, and fear can take hold for weeks on end. But this environment strikes us as a necessary revaluation of stocks that had become too expensive. This is a far different catalyst than the panic investors felt in March of 2020, amidst the outbreak of the pandemic, or in 2008 in the early stages of the financial crisis. Investment history is populated with far more corrections than massive bear markets, and we still believe we are experiencing the former.

For this reason, we see an emerging opportunity to sell safe-haven investments that have performed well, like consumer staples companies, and buy a mix of technology companies whose shares have fallen significantly, or deeper value stocks that were left out of much of last year’s rally altogether. Both categories likely offer upside over the coming year, in return for tolerating shorter-term volatility.

As the bond market and the Federal Reserve both wake up to the very real possibility of more persistent inflation, short-term bond yields are rising. The Fed is now steering investors to anticipate several interest rate increases this year, and bond prices have started to reflect this. We think it is finally wise to begin rotating out of cash, which still yields roughly 0%, and into short-term Treasury bills, which are moving towards yields of 1%. So far this is a small move, but the opportunity is finally emerging for more productive cash management. Only when longer-term bond yields reflect greater inflationary worries, however, driving yields higher still, will we step out into longer-dated, higher yielding bonds in any significant manner.