Q4 2021 Commentary

2021 proved to be another remarkable year. 

Spurred by an economic recovery and monumental levels of monetary and fiscal stimulus, stocks continued to ride the momentum that began shortly after the Spring 2020 COVID-19 market panic. 

When massive stimulus sent stocks to record highs to close 2020, we acknowledged that it was quite possible that the trends could continue, particularly given the fact that the new administration was likely to throw even more fiscal support to the economic recovery.  We were also forced to acknowledge downside risks associated with valuations, which had reached earnings multiples that had only been breached one other time in history – during the tech bubble. 

The sensational price multiples became even more stretched in early 2021.  The move was led by extraordinarily speculative areas of the market, that, broadly speaking, had little to no earnings.  These profitless assets dominated special purpose acquisition companies (SPACs) and the holdings in the trendy Ark Capital Innovation fund (ARKK). Given the public speculation in cryptocurrencies (which generate no profits), it is worth grouping them in this category as well. 

The party did not last long, however. SPACs (as an asset class) and non-profitable tech companies peaked in February – losing more than 40% by the end of the year.  Cryptocurrencies peaked later, but Bitcoin still closed the year more than 30% off of its own highs. 

The major indices, meanwhile, continued to add to their gains throughout 2021. There is a popular belief that the resilience of mainstream stocks during the collapse of these speculative investments is be an encouraging sign.  Unfortunately, history suggests that a peak in the most risky, high-flying assets could merely be the first stage in a broader re-pricing of equities.   

For evidence, we can ignore the price of stocks, and instead focus on valuation multiples. Shortly after non-profitable speculative names reached their highs, the price/peak earnings multiple for the S&P 500 crossed 30 – a 50% premium to the previously sustainable peak valuation, and within 15% of peak tech-bubble valuations.  Over the next eight months, stock prices went higher (thanks to skyrocketing corporate profits), but multiples fell 20% from their peak. 

The fall in profit-less assets and the fall in valuations of S&P 500 stocks are all part of the same story.  The speculative excesses fueled by massive stimulus are wearing off. The assets that actually produce value (commodities, earnings generating businesses) have continued to appreciate in price, and those assets that produce nothing have fallen notably. It is how bubbles begin to end. 

Though this past year never quite reached tech-bubble levels of speculation, the 2000 peak remains the most suitable analog if we are trying to deconstruct the unwind of a modern bubble – and the comparison does not offer much comfort.   

Stock prices peaked in March of 2000, but price multiples peaked almost a year earlier, in April of 1999.  Over the course of that year, valuations fell nearly 15%, but corporate earnings grew more than 30% – easily offsetting the multiple contraction.  Just like today, it seemed that corporate earnings growth would bail out investors.  We know that optimism was not warranted. 

In another suitable analog, markets had a strong second wind in the summer of 2000, thanks to a rotation away from speculative growth to more conservative value stocks.  Over that timeframe, the most speculative internet sector lost half of its market cap, while the S&P closed within 0.5% of its all-time high.  Once again, “responsible” investors appeared to have prevailed against the speculators, and once again, that optimism was misplaced, as the S&P eventually fell 50%. 

It may seem that the investors in productive assets have escaped unscathed, but valuation bubbles often resolve themselves over multi-year periods.  We may be in the early phases of a massive market repricing.  With S&P 500 stocks still priced about 25% above their previous sustainable peak, there is plenty of room for further unwind of equity prices. When stocks decline, they tend to do so faster than they rise, and they tend to overshoot fundamentals to the downside.  At valuations this high, that leaves significant potential for loss of capital.   

Today’s market followers have gotten used to buying brief and sudden dips, but the mere fact that we are already eight months into a rather steady multiple contraction is substantive evidence that this may be a prolonged process. 

Going into 2022, there are real fundamental reasons to believe that multiple contraction will continue, led by rising interest rates. Given the pace of the recovery and high inflation, the Federal Reserve has no option but to raise short-term rates from zero.  Longer-term rates have been somewhat stubborn, but ten-year yields recently broke above their 2021 highs, and if the history of inflation/interest rate dynamics is any guide, rates will continue to climb.  Rising rates have the effect of lowering price multiples by reducing the present value of future earnings, as well as reducing the attractiveness of equities versus lower-risk assets. 

There is always the chance that rising profits continue to offset falling valuations, but we remain less optimistic than the market’s consensus earnings estimates.  2021 was a major outlier year in terms of corporate earnings growth. Historically, strong outlier years have been followed by very low, or even negative, profit growth.  A reduction in profits could come from multiple angles, including falling profit margins and customers with far less disposable income than last year. 

A combination of flat or falling earnings and multiple contraction would be seriously disappointing to investors, but is a very high-probability risk.   

For much of the last several years, our valuation-focused concerns have been counter to the trend – always a difficult place to position oneself.  But the valuation trend is now very clear, has shown durability, and has fundamental tailwinds.  We feel that the current setup poses the highest risk to equity prices in over twenty years. 

As with the last several years, we will continue to default to rather conservative positioning, but as we have shown in recent years, that does not mean that we will abstain from accumulating stocks when suitable short-term conditions arise. All managed accounts maintained high cash allocations throughout the year, with limited buying during the year. 

Though we continue to maintain a heavy focus on downside risks, we are also expanding the use of fully-invested long-only strategies, building upon the core five-stock portfolio that we now default to at low investment levels in Time Overlay accounts. 

Wishing you a happy and prosperous New Year,

Robert B. Drach