BY GUY CARSON
Equity markets have started the year in a volatile fashion. At the time of writing, the S&P 500 is down 2.2% whilst the Nasdaq is down 4.8% year to date. The difference between the two highlights the discrepancies currently occurring under the surface. Equities with high expectations of future growth are falling and the key driver behind it is the Federal Reserve.
On January 5th, the Fed released their minutes of their December meeting. The minutes were significantly more hawkish than expected and indicated they expected to raise interest rates four times this year. As stock valuations are based on future cash-flows discounted back today, higher interest rates reduce those valuations. The stocks most impacted are the “higher duration” ones, i.e. the ones on higher earnings multiples (or which have no earnings at all) and more reliant on cash-flows further out from today. It was these stocks that we warned about at the beginning of last year (see Bubbles and Fraud)
It was clear at the time of writing the article ‘bubbles and fraud’, that significant parts of the market were in a bubble. Every bubble has a poster child and this time around it appears to be Cathie Wood from Ark Invest. Ark Invest was founded in 2014 and has been focused on innovation. They invest in disruptive technologies with little to no focus on near term valuations or cash-flow. After solid performance through 2018 and 2019, the flagship fund, the Ark Innovation ETF (ARKK) exploded in 2020. Eleven months ago, the fund had outperformed the Nasdaq by 430% since its inception. Fast forward to today and that gap is just 10%.
You might correctly point out that they have still outperformed since inception. Whilst true, the other side of the coin is the number of investors who chased their performance and invested near their peak. In fact, on aggregate investors in ARKK have lost over $1.8bn. From the below chart we can see how the flows chased the performance.
The bleeding doesn’t appear to be stopping. The ETF owns substantial positions in non-profitable stocks and these stocks are the ones being affected by the likelihood of rising rates. Compounding the problems is that inflows have switched to outflows and this will provide further pressure on share prices.
The above capital flows and subsequent losses provide an interesting insight into the behaviour of individual investors. They tend to chase one year return numbers and as a result underperform. When raising capital from these investors, there is nothing more powerful than a strong one-year return. However, in investing, one year is just noise. Investors should (but on aggregate don’t) look at longer timeframes as well as investment processes. Instead, many tend to chase hot returns and reversion of the mean catches up with them.
So far, stocks with little to no earnings have led the decline. However, the market as a whole has held up reasonably well. This is driven by the largest companies. If you strip out the largest 5 companies from the Nasdaq (Apple, Microsoft, Amazon, Meta / Facebook, and Alphabet / Google), the index would have been down over 20% last year. Likewise in the S&P500, the top 5 stocks have had a disproportionate impact. We wrote about the increasing concentration of the index back 18 months ago (see The Rise of Monopolies). In that article we noted “the winners will be the large companies which continue to take a greater share of our wallets.” That has played out as expected, however in the process the rise in valuations of these companies has made the index significantly overvalued with regards to recent history.
Recently we have heard things such as “Valuations don’t matter” and “Valuations are not a good investment tool”. In recent times, that has been true. Momentum and growth have dominated the last decade. Although from the above we can see the cracks below the surface in both those factors. The remaining driver of the market is the large cap technology stocks which now dominate the indices. Investors are still happy to pay any price for these companies and the situation shares many similar characteristics with the late 1960’s / early 1970’s where investors were obsessed with the “Nifty Fifty”. This was a group of companies that investors believed they could buy at any price for the long term. It included names such as Revlon, Procter & Gamble, Philip Morris, Pepsi, Pfizer, Merck & Co, Eli Lilly, Coca-Cola, IBM, Gillette, Wal-Mart, Disney, Eastman-Kodak and Polaroid. Unfortunately, the 1973/74 bear market came along. The “Nifty Fifty” stocks initially held up well compared to the rest of the market but eventually they broke. From their highs, some of the share price declines to 1974 lows were devastating: Xerox (-71%), Avon (-86%) and Polaroid (-91%). The vulnerability of highly-rated companies to rising risk aversion was starkly revealed.
Interest rate rises will test valuations of the large companies at some point this year but it may take a rate hike or two to get there. Ultimately, there appears to be a shift away from Growth investing to Value investing occurring. Boring businesses with real assets are starting to come back in vogue. The transition isn’t complete yet and one company may dictate the direction of the overall market this year. That company is Tesla. Tesla is the most debated company in the world. Its investors claim Elon Musk is a genius whilst others claim he is a fraud. The stock has an extremely high P/E multiple and the market capitalisation is more than the rest of the entire global automotive sector. Despite this high valuation, the true believers have held the stock up well whilst the rest of the high valuation stocks have suffered. Investors should keep an eye on Tesla because it could be the bellwether for large Technology. If Tesla breaks, the others may go too. 2022 is shaping as the year that Value Investing returns.