Last year saw the recovery in equity markets continue apace. Investors flooded into equities and were rewarded with impressive returns – especially in the US market, which made 68 all-time highs. However, below the headline market returns, unsettling signs of rising volatility and narrowing breadth suggest a flatter and more volatile year ahead. The cause is not Omicron, but weaker fundamentals and ebbing liquidity.
Equity markets have been supported by impressive corporate earnings momentum, negative real interest rates, and emergency levels of policy stimulus. The strength of these forces is beginning to wane. Inflationary pressure continues to build, and the Federal Reserve is bringing to an end a period of super easy financial conditions. By mid-2022, the US central bank will have completed its quantitative easing taper and begun raising interest rates.
The cause is not Omicron, but weaker fundamentals and ebbing liquidity.
While expectations are for record current levels of profitability to increase again in 2022, high input costs and rising wage pressures seem likely to constrain margin progression. In combination with higher corporate taxes, there is now scope for earnings to disappoint.
Warning from the past
While speculation over the direction of US monetary policy has checked momentum in the broader global equity market, the largest US stocks have continued to enjoy a high proportion of flows. For every dollar flowing into the Nasdaq, 48 cents go into six large-cap tech stocks.
High retail participation in markets has ‘gamified’ popular stocks. The market cap of Tesla rose by $390bn in 2021 and of Nvidia by $410bn. While they have an aggregate market valuation of nearly $2trn, they saw combined profits of $12bn this last year. Meanwhile, speculation is rife in other risky assets. The price of bitcoin rose 59% in 2021. Decentraland, a metaverse currency, rose almost 600% in the wake of Facebook renaming its holding company.
For every dollar flowing into the Nasdaq, 48 cents go into six large-cap tech stocks.
In isolation, there may be a rationale for each of these examples of apparent excess. In combination, they have all the hallmarks of hubris. In 1999, one in four IPOs went on to be successful companies. However, the market was pricing them all as winners. This is the consequence of excess liquidity combined with a good story.
Cheap money is also spilling over into the real economy. US home prices increased by 18% year-on-year in September 2021. Rapid increases in house prices have proved an Achilles heel for economies in the past; the Fed will not want to repeat the mistakes of the 2008 financial crisis.
End to the excess?
There are signs the excess in the US equity market is giving way. Breadth is declining and the number of S&P 500 stocks trading at 52-week lows is rising rapidly, S&P valuation dispersion is at its widest since the late 1990s and equity volatility is picking up.
The US equity market now looks vulnerable to any reversal of flows. We have already seen mini bubbles collapse in meme stocks, SPACs and clean tech this year. Apple is now valued at 29x 2022 earnings and Microsoft at 35x. These valuations may be defensible with the 10-year real interest rate at a multi-decade low. But should financial conditions tighten for any reason, the support would be removed.
Fortunately, opportunities remain within the market for stock pickers. The hype cycle has a familiar pattern: excess and mania lead to a backlash, adjusted expectations and lower prices. A valuation reset in a polarised market provides terrific entry points into new, exciting thematic investments.
Think thematic
As Covid-19 becomes endemic, we will see medical procedures and cross border travel recover. This will benefit thematic portfolio holdings in healthcare, payments, retail and experiences.
We have already seen mini bubbles collapse in meme stocks, SPACs and clean tech this year.
Earnings and price momentum strategies have been particularly successful in 2021. Stocks in defensive sectors such as consumer staples, growth utilities and specialist REITs have been left behind and offer valuation upside. Finally, a market seeking simple stories has shunned the more complex restructuring opportunities in the past 18 months. We see significant value in the special situation investments in our portfolios.
Covid-19 will also prove a huge catalyst for innovation and creativity. For example, a consequence of current supply constraints and a shortage of labour is the desire for companies to strengthen their supply chains. This will particularly benefit the stocks in our automation theme and industrial software companies.COP26 also demonstrated the private sector will be critical for financing new technologies to reduce greenhouse gases.
As policy shifts from the virtual world of Wall Street to the real world of Main Street, it is time for equity portfolio managers to diversify away from the larger US growers and accept more benchmark risk. While a period of lower equity returns and higher volatility is ahead, this reality will bring rewards for stock pickers in a wider array of themes.
Jerry Thomas is head of global equities at Sarasin & Partners
The year ahead and perhaps beyond are definitely going to be periods during which equity investors are going to have to summon all their resolve to resist selling out and crystallising paper losses. As ever, all too many won’t.