Jan 27, 2022
Meritage Current Market Update
We thought we would pass along a few thoughts about the heightened volatility in the equity market. We don’t want to attach too much significance to the first 3 ½ weeks of the year (now officially the worst start ever) but we think it is worth observing what has changed that may have triggered this abrupt shift in sentiment around stocks.
Going into this year, the markets already knew the Fed had misjudged inflation and had planned a more aggressive course in raising interest rates and winding down monetary stimulus. There is also the possibility that markets simply got ahead of themselves and after three years of well-above average gains, we were overdue for a correction. Probably true, not a very satisfying explanation.
We are also reminded that day-to-day market activity is not always driven by fundamental reasons, and volatility is often exacerbated by computer trading algorithms. This may explain some of what we’ve seen this year, but there is nothing new here. To make sense of the weak start to 2022, we can focus on three likely catalysts:
1. An important change to Fed policy was disclosed on January 5th. The minutes of their last meeting discussed allowing their bloated $9 trillion balance sheet to shrink once rate hikes had begun. This removal of liquidity from the financial system (Quantitative Tightening) was not expected to occur this soon and simultaneously with other tightening measures.
This more aggressive approach was a surprise and has caused the market to recalibrate the implications of removing the financial safety net faster. The natural risk to this is the Fed overshooting its targets in the process and inadvertently undermining economic growth that investors are counting on.
2. The valuation characteristic of stocks has become more relevant. Bond yields gapped higher this year as the Fed appeared to be behind the curve in controlling inflation. Higher rates reduce the value of future earnings, which has a disproportionate effect on growth stocks. A significant rotation from growth to value picked up with the Fed’s more aggressive posture to contain inflation. While undercurrents of this shift to value began last quarter (especially in the more speculative areas), it resumed in earnest this year. After numerous head fakes in recent years, with the cover of zero interest rates and easy money policies going away, we believe investors will continue to place more emphasis on valuation, in conjunction with key growth metrics.
More recently, general market weakness has broadened to include all stocks. The bond market is also concerned that a more aggressive Fed may jeopardize a stronger economy and bond yields have actually pulled back from recent highs. As is the mechanism of the bond market, anything that pulls forward the possibility of the next recession will inevitably put pressure on bond yields.
3. The shift in sentiment is a key piece of this current downturn. The defining characteristic of this extended bull market has been the market’s ability to attain new highs after every material pullback since the Financial Crisis in 2008. A “buy the dip” mentality has served investors well. Three weeks into the new year is too soon to declare a change in this mindset, but with the directional change in the Fed’s supportive role, investors may be less prone to follow these tendencies.
As we’ve come to expect, steep market moves in either direction can be concentrated in shorter and shorter timeframes with sentiment shifting from one extreme to another. We do recognize that investor sentiment has been bolstered by the belief that the Fed has had the market’s back if conditions deteriorated to a certain level. Rising inflation and the tight labor markets will likely raise the threshold on what those conditions would be to compel the Fed to come to the market’s rescue again.
Stepping back from the day-to-day, the markets have handled this inevitable inflection point in Fed policy reasonably well. Over the past year, the Fed has gone from promising no rate hikes well into 2023, to beginning a sequence of rate hikes, probably starting in March. Fed Chair Powell’s objective is to convince investors that they will do whatever it takes to contain inflation, while at the same time, maintain confidence that the economy will remain healthy in its continued recovery. To the latter point, news from current corporate earnings releases should provide a timely measure of support.
Our portfolio activity has been focused on a few marginal changes to improve our holdings in our respective styles, but no major thematic or strategic changes are planned in the midst of this volatile environment. We appreciate that the volatility and weakness we’ve seen is unnerving to everyone. We welcome the opportunity to speak with you anytime regarding your own circumstances.
The Meritage Investment Team