The Purge

The Purge

The purge of some of the most speculative aspects of the equity market has been underway for some time. The initial public offering (IPO) market, which was quite robust in 2021 and populated with hundreds of SPACs (special purpose acquisition companies), performed very poorly. In fact, they were terrible investments. Moreover, the meme stocks, popular in early 2021, produced significant losses to many of the participants as the year progressed. Robinhood, the platform used by many meme traders, went public on July 28, 2021 at $38 per share, and reached an intraday high of $85 on August 4, 2021. It traded at $15 on February 4, 2022. Also, many of the concept stocks, whose paths to profitability were not discernable, have come under pressure as the Federal Reserve began to communicate that a change in its extremely accommodative monetary policy was forthcoming. The movement up in interest rates in anticipation of a change in Fed Policy punctured many speculative excesses and helped set in motion the market correction.

The aggressive and highly leveraged posture taken by many hedge funds proved to be their undoing. As reported in the Wall Street Journal on February 3, 2022, hedge funds piled up losses in January. Even more telling is the number of losses these funds experienced in 2021 – a strong year for the equity market. For example, Whale Rock Capital Management lost 15.9% in January 2022, following a 9% loss last year, and Tiger Global Management, which also lost money last year, was down 14.8% in January. An even more startling result: Melvin Capital Management and Light Street Capital Management both lost 15% following double digit losses last year.

Such hedge fund performance most likely led to forced selling to meet cash needs. The sale of what many refer to as the “strong stocks” (large cap, highly liquid, and strong fundamentals) occurs frequently at the end of a market correction. They are sold as a last resort.

At the November 3, 2021, FOMC meeting, the Federal Reserve indicated that it would begin reducing monthly purchases of bonds – the first sign of a change. At the December 15 meeting it accelerated the pace of the reduction – still adding reserves but expecting to end it by March 2022. The January 26 meeting reinforced market expectations of an early end to the purchases, a rate increase in March, several additional increases, and a possible balance sheet reduction this year.

Market analysts and commentators were quick to forecast from 4 to 8 rate increases. The frenzied pace of changing forecasts and expectations most likely played a key role in the market selloff in January. The market action of January 24 – the volume, intraday reversal, gap price action, negative sentiment, and fear – may well suggest that an interim bottom has been reached and forced selling is running its course.

In contrast to the schizophrenic action in the market, the monetary authorities are still likely to respond cautiously in an uncertain environment. Communication and an orderly response are the basic character of the Federal Reserve under Powell. Despite all the speculation surrounding interest rates, it probably will not be until the next FOMC meeting on March 16, 2022, that the market will get a better understanding of the pace of the rate increases.

Even assuming 4 or 5 rate increases this year, the Fed Funds rate would only be 1.25% by year end, well below the inflation rate (a negative real rate).

Keep in mind that these rate expectations are predicated upon continued economic strength throughout the year. Most certainly the reopening of the economy is providing impetus to business activity, as evidenced by the strong employment gains in recent months. The monetary authorities have made it clear that their actions are data dependent.

If the tempo of economic activity in the second half of the year slows, the pattern, magnitude, and frequency of rate increases could be quite different from recent expectations. Consumer confidence, as measured by the University of Michigan Survey, is low at 68. The consumer saving rate has now fallen to 7 to 8%, and fiscal stimulus has ended. As the year progresses, the underlying growth rate of the economy is likely to slow.

Moreover, the burden of inflation is weighing on consumers. Real incomes are not keeping pace, and rising home prices and mortgage rates are reducing the affordability index, thus changing conditions in the housing market. Energy prices are also adding to the individual’s financial burdens, an area over which Fed policy has essentially no influence. These constraints are likely to temper the consumer’s spending enthusiasm.

As a result, handicapping the Fed’s action as the year progresses will get increasingly difficult. The recent comments from the monetary authorities and Federal Reserve Bank presidents have already influenced rates. The 10-year Treasury has risen to 1.9% from 1.5% in the last month, and the yield curve, though still positive, has flattened somewhat.

From the equity market’s perspective, a reaction to higher rates has already occurred, even though no action has been taken by the Fed to raise rates.

What is of particular importance to the equity market over the intermediate and longer term is the risk of a recession and the ability of companies to maintain their profitability.

The rate of monetary growth from December 2020 to December 2021 was 15% for M1, a level well above the inflation rate. This phenomenon would suggest that a recession is not visible within a reasonable investment horizon. Moreover, negative real rates and a positive sloping yield curve supports the same conclusion. From a profitability perspective, many companies have been able to pass along their higher costs into higher prices. Consequently, pricing power has largely been maintained.

Over 77% of the S&P 500 companies have beaten earnings estimates. However, guidance has generally been conservative. The volatility in the stock market, the uncertainties with regard to COVID, supply chain disruptions, the crisis in Ukraine, and the Fed’s monetary policy posture have provided the framework for companies to under promise.

This posture would set the state for better-than-expected results for Q2. Cash flow generation has been strong and should remain so in 2022. In January alone, 33 S&P 500 companies raised their dividend. Moreover, stock buyback activity and mergers and acquisitions (M&As) are picking up.

At the end of the 3rd quarter of 2021, companies in the S&P 500 held $3.78 trillion in cash which is an increase from $3.41 trillion the year before and $2.19 trillion in 2019. In 2022, earnings and cash flow should turn into dividends, buybacks, and M&As. In our judgement, these trends are likely to more than offset the effect of rising interest rates.