WARNING! Use Extreme Caution!
“After two years of ‘up, up, up’ this must be a great time to be an advisor – it just doesn’t get much easier than this!” This theme was more common than expected as we exchanged holiday wishes with friends and clients. The reality is just the opposite. This environment is as difficult as any of us has ever experienced. That might seem like an odd notion, but the reality is that when markets get so far out of whack, we wind up being pulled into a game of musical chairs, only there are very few chairs and many millions of investors. The music is playing and you ‘have to participate’, but you also need to make sure you find one of those seats when the music stops. Investing today is as difficult and nerve wracking as it has ever been, and despite some sizable declines in some of the most speculative tech stocks, we do not believe this is over. Valuations remain very high, and while valuation alone is not a reason to sell, we believe it is time to use extreme caution.
The outgoing CEO of T. Rowe Price, Bill Stromberg, was interviewed by the Financial Times and had the following to say. “Over [the] last two years there has been a way above-average amount of speculation. We’ve been in a cycle where there has been very free-form risk-taking. It is time to be managing away from the most speculative investments — things that have very high valuations without revenues to support it. Investors should remain disciplined. I can’t tell you when that period of speculation will end, but it won’t be sustained” (our emphasis).
The riskiest of stocks. Many of those with high growth potential but little or no cash flow, have already taken a beating. Here are some examples:
On the other hand, “Quality” tech has performed rather well, as shown below:
To us, these results are not surprising. The taper has been accelerated, the market is pricing in almost 3 interest rate increases in 2022, and long duration stocks, like those in the first chart, are the first to get hit. The question is whether this is it; is the correction is over? Or is there reason to believe the correction will spread to quality tech and so on down the line. We believe the latter is more likely in 2022.
After almost 2 years of this record run from the pandemic low, the facts are changing for 2022.
- Monetary policy is tightening. Yes, it is still accommodative, as many will tell you on TV, but markets move on the margin, and on the margin, policy is clearly tightening as the Fed ramps up to address a budding inflation problem.
- Fiscal policy is gone and not likely to return. The massive pandemic stimulus is over and will not be repeated. The Build Back Better bill is on life support, at best. The infrastructure bill is passed, but little will happen in the near term – the spending is spread over 10 years.
In short, the policies that created and perpetuated this massive market run from the nadir of 2008 are in the process of ending. Combine that with high valuations and stock market returns should be expected to be meager at best, with the distinct possibility of a serious correction (down 20% or more) this year.
The question we have asked ourselves is whether the decline of the most speculative stocks is enough of a correction, or whether we except more to come. To give us some perspective, the chart below is the trailing P/E multiple of the S&P 500 over the last 30 years (through 2020). The average over that time frame is about 25, and we note that the average includes the very large numbers post tech bubble on the early 2000’s and the housing crisis in 2008-09. In fact, we note that the ONLY times the trailing P/E has been higher than the current level is in the middle of a major market crisis. In our view the average P/E during normal times is more in the high teens to 20 range.
We calculate the current trailing P/E of the S&P 500 at about 36, and if we trim outliers (defined as a P/E in excess of 100) out of that analysis it brings it down to about 31. But as the financial press has trumpeted all year long, the market has been dominated by the large tech companies that make up an outsized portion of the index.
This led us to do some re-calculations. If we look at the trailing P/E for each company individually (data from YCharts) and weight each P/E by the weight in the index, we get a weighted average P/E of about 41 (again trimming out the outliers.)
Most importantly, we wanted a sense of whether a large swath of the stock market was overvalued or just the tech sector, so we looked at the average P/E multiple of the index stratified into 100 stock segments. Not surprisingly, as we go down the list, the P/E get smaller, but what comes through loud and clear is that most of the S&P 500 index is indeed overvalued by any historical measure.
It won’t be valuation that kills this bull market, but the stage is set for 2022 to be the year when the very strong policy tailwinds finally reverse and smack directly into high valuations. It’s time to use extreme caution.
What Are We Doing About It?
You may have noticed a holding in your portfolio with the imposing name of Market State Tactical Beta, symbol MSTB. This is one way we are addressing our concerns. MSTB is a fund that generally invests in the S&P 500 index fund, but it also layers an actively managed equity hedge on top. The result is that most of the time, the fund is invested in the S&P 500 index, but in times of stress it implements a position using VIX (volatility) options which hedge the stock market risk. The fund is only about a year old, but it was available in other forms since 2016 and has a very good track record. It is designed to work such that when there is a modest market correction in the range of 0 to 5%, there is little benefit. However, in the event of much larger corrections, the managers are poised to aggressively hedge equity risk and potentially even make money in a down market. Because of the cost of hedging, they are unlikely to match the S&P return in calm times, but we are willing to trade that for some protection from a large decline.
What We’re Reading
WSJ Opinion: Hits of the Year (3 Min. Video)
WSJ Opinion: The Year’s Worst Misses (3 Min. Video)
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