“If something cannot go on forever, it will stop”
January 26, 2022
Market Summary – 4th Quarter, 2021
The headline of this newsletter cites what is known as “Stein’s Law”, coined by the late economist Herbert Stein. A former chairman of the Council of Economic Advisors for two presidents, he was the father of Ben Stein, who longtime readers may remember as a past presenter at our MPMG Speaker Series event. While the elder Mr. Stein’s sentiment may appear to state the obvious, there are repeated examples through history of investors being seemingly oblivious to the possibility of a hot trend ending. Today’s market presents a clear example that supports Mr. Stein’s thesis – the potential conclusion of an extended period of “free money” caused by an accommodative Fed, a stance that has resulted in a speculative boom across many asset classes.
The leading indicator that may best explain the investment environment of the past 13+ years is one that gets little notice from the media – the balance sheet of the Federal Reserve. This fairly innocuous data point first garnered attention in 2008, and has since become even more consequential.
The assets held by the Fed represent the dollars that the institution puts to work primarily in government securities and loans extended to regional banks. The Fed’s purchase of assets are financed through new money that it creates. The assets owned by the Fed stood fairly steady at less than $1 trillion for much of the early 2000s. What changed in 2008 was the implementation of an unprecedented quantitative easing program – an intentional decision by the Fed to provide more liquidity to the markets (buying more assets with newly created money) in order to help keep the economy afloat during the financial crisis. This massive infusion of “free money” more than doubled the Fed’s assets on its balance sheet by the end of 2008. Even though the economy stabilized by 2009, the free money bonanza did not. The Fed’s balance sheet continued to grow, virtually doubling again by the end of 2014.
The impact of such liquidity was to keep interest rates low, creating cheap capital that would reflate depressed asset prices. Equities were among the beneficiaries, but the good fortune was not spread equally. As the chart below shows, the Fed’s easy monetary policies enabled momentum-based growth stocks to enjoy an unprecedented period of outperformance (both in duration and magnitude) versus value stocks.
“Everybody, sooner or later, sits down to a banquet of consequences.”1
The problem with extreme policy is that ultimately, there are consequences. Just as the Fed began to reduce its balance sheet (by letting the bonds that it purchased mature and not reinvesting the proceeds), COVID-19 emerged as a challenge, creating a new period of uncertainty for the economy. If investors thought that the Fed’s quantitative easing actions in 2008 were stunning, the steps it took with the advent of the COVID economy were downright breathtaking. In just a matter of months in early 2020, Fed assets nearly doubled (again!) from their already crisis levels, and the balance sheet continued to grow through 2021. The amount of Fed assets injected into the economy grew almost ten-fold from 2007, and now stands at slightly less than $9 trillion.
Add in similar measures by the European Central Bank and the Bank of Japan, and close to $25 trillion has been put to work to boost the global economy.2 It represents an unprecedented level of intervention by central banks throughout the world.
But just when you thought such intervention would go on forever, the Fed announced in December that it is being forced to shift gears in a dramatic way. As the late Mr. Stein noted in establishing his law, it wasn’t government intervention or political pressure that brought about this shift – it is a matter of external factors, “natural” economic forces and their consequences – guiding the Fed. In this case, inflation, a virtual non-issue for decades, suddenly emerged in 2021 as a real concern. With the headline inflation rate hitting seven percent for the first time in 40 years3, and higher inflation persisting longer than first envisioned, the Fed’s hand was forced. Quantitative easing can’t go on forever, and so it will stop.
Notes from a Fed meeting in December made clear that its plans to start reducing its balance sheet sometime in 2022. It is a recognition that its longstanding monetary easing policy is exactly the wrong prescription for the environment we find ourselves in today. That means the Fed will be subtracting liquidity from the market.
The extremely easy money policies (both monetary and fiscal – i.e., government checks sent to households and businesses) created an environment that was perfectly suited for investors attracted to speculative growth stocks. As long as the Fed kept its foot on the monetary accelerator (and the federal government chipped in as well), growth stocks could enjoy a significant advantage over value stocks.
The fine line between being wrong and being early
It took a rugged bout of inflation to change course, but it appears that the Fed is finally headed in a different direction, much as we have anticipated. While most investors have been eager to join the crowded momentum-chasing trade, MPMG has been positioning for this rotation. The criticism of being early in our prediction on the timing of this long-expected rotation is fair. In reality, it began years ago, but was sidetracked by the unanticipated events of COVID-19 (and then the Delta and Omicron variants), which created another excuse for the Fed to continue its party. Today, the question must be asked – if the Fed’s ultra-easy money policy was beneficial for the speculative styles of investing we’ve experienced in recent years, what is the impact on the markets when the Fed’s policy goes in a completely opposite direction? At what point will company-specific valuation again be recognized as the critical measure of investment opportunity?
Canaries on life support?
Under the surface, we may already have received a hint of what’s to come. As the Fed’s new approach gained steam late in the year, some investors recognized that the status quo was no more. Hidden from view in a stock market that continued to set new records is that the bottom fell out for a number of stocks that were beneficiaries of the easy money policy.
While the mega-cap technology stocks that dominate the S&P 500 (i.e. Apple, Microsoft, Alphabet, Tesla) continued to be held dear by the market, many well-known, but more modest-sized growth stocks, primarily with a tech industry connection, suffered dramatic declines. Today, nearly 40% of all NASDAQ listed companies are down 50% from their highs.4 This includes some of the darlings of the pandemic such as Zoom, Peloton, Roku and Door Dash. The performance of stocks like these (and there are many more) may be the “canary in the coal mine” signifying a shift of leadership in the market.
To this point, the mega-cap technology stocks have been spared from this reversal of investor sentiment. Nevertheless, investors putting their eggs in the basket of even those seemingly untouchable stocks should pay heed to Stein’s Law. As owners of shares of the 40% of NASDAQ stocks that have lost half of their value have painfully learned, rising prices can’t go on forever. Eventually, valuation is to markets as gravity is to physics.
A time to be opportunistic
The changes now underway may alter the character of the equities market, but they do not signify the end of opportunity. Instead, it may represent the early (and long overdue) stage of a significant rotation from growth stocks to value stocks. Dollars invested in growth stocks are at risk of becoming dead money for years to come if the documented history of such market rotations is any guide. The growth stock seas are getting stormier, and not even an “ARKK” will protect those who overpay for the approaching tsunami.
A comparison of valuations shows that the most popular mega-cap technology stocks (the so-called FAANGMs5) are likely greatly overvalued, particularly in comparison to the top ten holdings in MPMG’s All Cap Value portfolio.
It is a reminder that the speculative nature of the stock market in the years leading up to 2022 were mostly a one-sided affair, in favor of growth stocks and other types of assets that may have lacked a fundamental underpinning of value. Shortly before the end of 2021, it was reported that only five mega-cap stocks were responsible for more than one-third of the total return generated by the S&P 500 (see chart on next page).6 That means the other 493 stocks split the remaining two-thirds of index performance.
As we’ve been saying – the year in review
The shift that seems to be in motion today has been the topic of our newsletters of the past year. In the first quarter (“Shall we play a game?”), we focused on the speculative nature of the market, an environment that almost treated investing as a game, and not the serious pursuit of investors who are trying to create and protect wealth. In the 2nd quarter newsletter (“The future is not something to predict…but rather to navigate”), we outlined a number of very attractive investment opportunities, focusing on seven key themes that are prominently featured in our portfolio. In the 3rd quarter letter (“The conversations that you never hear”), we reiterated that despite their popularity, the end was nigh for the period of domination by the FAANGM stocks and other growth stocks and that a rotational shift was coming.
Our story hasn’t changed, but the circumstances that impact the markets have – the Fed’s strategy shift being the most notable. If investors weren’t listening before, it’s important to pay attention to the change today.
It’s not if you are invested, but where you are invested
As 2022 gets underway, there are many reasons for optimism about the potential for opportunity in the markets. Economic growth is solid, corporate earnings are strong and growing, the banking system is stronger than perhaps any time in history, and the forgotten value stocks are trading at multiples lower than a decade ago when the Fed’s ultra-easy policies were in their infancy. If the market suffers bouts of volatility as the market rotation takes place, investors need to keep these facts in mind. Opportunity remains abundant – but this time, with rewards for well-reasoned, selective investing rather than for speculative behavior.
The rising tide lifting all boats is no more. Investors can choose between overpaying for the popularity of the past as the tides change…or positioning themselves for a great and long overdue rotation. As MPMG embraces the New Year, investors are welcome to join us comfortably “sitting on the dock of the bay, watching the tide roll away.”7
MPMG IN-HOUSE NEWS
MPMG is pleased to announce that Managing Director Herb Schechter has been selected to work on the development of Personal Financial Planning items for inclusion in the uniform CPA examination The CPA Exam is used by the regulatory bodies of all fifty states plus the District of Columbia, Guam, Puerto Rico, the U.S. Virgin Islands and the Northern Mariana Islands. Herb previously served on the AICPA standard setting executive committee that sets the standards of professional practice for CPAs.
MPMG is also pleased to announce that Grant Seymour has joined MPMG as Operations and Trading Associate. Grant is a graduate of the University of North Dakota (BBA, Investments). Grant worked as an account manager in the Corporate Trust department at Wells Fargo before joining MPMG in December. In his short time here, Grant has already proven to be a quick learner with exceptional attention to detail. Please feel free to say hello to our newest associate the next time you call.
1 Quote attributed to the author Robert Louis Stevenson.
2 Yardeni Research, Inc., “Central Banks: Fed, ECB, BOJ Weekly Balance Sheets,” Jan. 6, 2022.
3 December 2021 Consumer Price Index (CPI)
4 Hajric, Vildana, “Number of Nasdaq Stocks Down 50% or More Is Almost at a Record,” Bloomberg.com, Jan. 6, 2022.
5 Facebook (Meta Platforms), Amazon, Apple, Netflix, Google (Alphabet), Microsoft
6 S&P Dow Jones Indices, “S&P 500 Fact Sheet, Dec. 31, 2021.”
7 “(Sittin’ On) the Dock of the Bay”, song by Otis Redding.
Established in 1995, Minneapolis Portfolio Management Group, LLC actively manages separate accounts for individuals, families, trusts, retirement funds, and institutions. Our proven value-oriented investment philosophy has created long-term wealth for our clients.
Visit our website at: www.MPMGLLC.com
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.
Companies mentioned in this document were chosen based on MPMG’s view of the products and/or services offered or provided by the companies in light of current economic and market observations and reported trends. For a complete listing of MPMG’s recommendations over the preceding 12 months, please contact MPMG at (612) 334-2000.