360 Private Wealth Management: 2021 Fourth Quarter Commentary - Looking Forward in 2022
The 2021 Rear View Mirror – 2022 Crystal Ball Edition
I started writing this year’s “Rear View Mirror -Crystal Ball” commentary during the second week of January. I have been modifying it ever since given the developments in the markets over the last couple of weeks and the changing investment landscape. By the time I was ready to send I thought I might as well wait for the January interest rate announcements to see if rates will rise sooner or later and by how much.
I always get a kick out of seeing who will be first out of the gate each year to rehash the investment year that was and make public predictions about what is to come in business and markets, in the year ahead. As with many other things in life “haste can often make waste”.
Here, in late January 2022 are my thoughts and ramblings as we see 2021 fade in the rearview mirror and 2022 gain some traction under our feet. I think taking my time and getting this out with some of the early action is a more useful exercise than getting some out early without some sense of what the factors might be in the year and the early impacts of some of those factors.
2021 was another interesting year. As we flipped the calendar page from 2020 to 2021 here in Manitoba, we were quasi-locked down with the second wave of the COVID pandemic filling hospitals and thankfully, to a lesser extent, ICU beds. COVID continued to dominate the headlines and test the health care system with additional waves through the year. There was a break in the summer months and into the fall before the Omicron wave took hold in December.
The good news so far in this latest Omicron wave is that this variant seems to be a milder, even if more contagious variant. Might it be the variant that turns the COVID-19 pandemic into something more endemic like the flu or cold? Perhaps. Not that endemic COVID won’t be serious. It will likely be more deadly than seasonal flus for parts of the population. But, perhaps it will be less deadly than the previous versions of the disease and less taxing on our health care system. Fingers crossed…
As we approach two years of dealing with the COVID-19 pandemic I am looking back on the experience at a personal level. There are lessons to be learned here which transcend the pandemic experience. The primary lesson I am taking away from the experience is more of a reinforcement of a belief of mine which is “Control the controllables. Manage the uncontrollables. And, understand the difference between a controllable and an uncontrollable!” In life, there are things we can control, like our thinking, our choices, and our reactions to events around us. There are things we normally cannot control like other peoples thinking and choices and, natural and human events occurring near and far. The trick is knowing what we have within our power to do something about and, what is beyond our direct control.
Once we understand this fact and act accordingly, I would humbly suggest a sort of calm will descend on the situation because where can make a difference in our thoughts, words and actions we will apply ourselves to solving the issue. And, where the situation is clearly beyond our control, we can cultivate acceptance and move on with our lives and the aspects we can control. What is that famous British saying we see on t-shirts and coffee mugs everywhere? “Keep Calm and Carry On.” I do believe there is truth in the adage. The trick is to apply it to our lives.
There is a sense to applying the same philosophy to our financial planning and investment management activities. Suffice to say we cannot control all life events, nor can we control what happens in investment markets. However, we can control how we choose to react to events and see-sawing markets. The trick is to develop a clear understanding of our vision; our goals and our objectives in life. Second, we need to develop a measure of “emotional” intelligence to withstand the inevitable situations that may challenge is and threaten our vision from time to time. We can choose to save and invest or, spend. We cannot control the costs of goods and services in the marketplace. We can only control our own buying and saving behaviors. Scarcity and price are only factors if we let them be. In many cases, we have choices as to what we buy and when, or if we will buy at all.
The same can be said of investing. We can choose to commit to an evidence-based investment strategy and systematically execute the strategy over time or, we can chase the latest hot investment stories. The former strategy will deliver a good investment experience and, in all likelihood a good outcome. The latter approach is often the surest way to achieve under-performance.
So, let's look at what happened on the investment front in 2021 and what we might anticipate in 2022.
Looking Back at 2021-
At the end of 2021, the TSX was up 21.7% on the year. In the U.S. the S&P 500 was up 26.9%., the Dow was up 18.7% and the NASDAQ ended the year up 21.4%. Impressive numbers to be sure!
Through the year reopening economies set the stage for business rebounds which, in turn, continued to pump up North American equity market valuations. This was the story, almost unabated, through the fourth quarter of the year with the exception of the tech-heavy NASDAQ index and the TSX. Generally speaking, in 2021, investment fundamentals in many cases took a back seat to things like meme stocks, SPAC’s, crypto-currencies, and non-fungible tokens. Yeah, I know… What is a “meme” stock? Right? Welcome to the latest wave of financial engineering. I will come back to this later.
In the last quarter of 2021, tech stocks, online mega-retailers, social media, and online entertainment stocks started to stumble as inflation became more of a concern to consumers, businesses, and central bankers around the world. Prospects for interest rate hikes started to become more and more likely. Start-ups and fast-growing companies like cheap money. If money gets more costly, growth and expansion get more expensive, and profits suffer.
Even though the S&P500 had a large weighting to the biggest tech, quasi-tech (i.e Tesla), online entertainment, and online retail names (i.e. Amazon), the rotation away from those stocks and other similar stories to more value and cyclically oriented stocks kept the S&P from pulling back until after the start of 2022. In fact, it hit a record high on January 3rd, 2022 before its slide began.
By the end of 2021, the Shiller Cyclically-Adjusted Price Earnings (CAPE) Ratio, which smooths Price Earnings (PE) ratios by averaging PE ratios over a rolling 10 year period, showed the CAPE for the S&P 500 at 39.58. The only time it was higher was in the time leading up to the “dotcom” market crash of 2000-2001 (the S&P 500 CAPE was 44.13 in December of 1999). The issue is that a significant percentage weighting of the S&P 500 is now made up of tech companies whose values have increased disproportionably to the earnings they are generating from a fundamental perspective.
Some people say the Shiller S&P 500 CAPE has lost relevance in this age of ultra-low interest rates. They say low-interest rates make a higher PE ratio more acceptable in the grand scheme of things. However, a notable number of economists and market analysts still follow the metric. The current S&P 500 CAPE number represents very high investor earnings growth expectations for constituents of the index, even after the declines experienced over the last couple of weeks. As an aside, the Shiller CAPE for Canada (based on the TSX index benchmark) is above the mean but not nearly as high on a relative basis as that of the S&P 500. The reason for this is, I think, largely because we have fewer high PE tech stocks in our index and the resource and commodity sectors, which are a significant weighting of the TSX, are still undervalued if we consider the lift inflation might give that sector.
The fact is that the S&P 500 index, representing 500 of the biggest and most successful corporations in America, had reached seriously concerning valuation levels by the end of 2021. As mentioned earlier here, the NASDAQ had already started stumbling in mid-November. The Canadian TSX started to lose steam at about the same time as the NASDAQ. My “spider-senses” were tingling. That’s my attempt at Sheldon (of Big Bang Theory fame) humour. There is a U.S. S&P 500 tracking ETF called the SPDR (trade symbol SPY on NASDAQ) which is sometimes called the “spider”) Clouds seemed to be forming over the markets from the significant jumps in inflation, the possibility of higher interest rates, and what that might do to economies. In short, we started to pull in our horns here and started holding back portions of larger tranches of the new money coming in and, building more cash our already high portfolio cash reserves.
You know excess is in the air when things that don’t make sense start happening and are celebrated. Now about those meme stocks… Meme stocks are stocks with no reason to go up which start surging anyway as was the case in 2021 when investors banded together on social media and started buying these stocks purposely pushing prices higher. This, in a number of cases, caught investors and hedge funds who had shorted the same stocks off guard. Briefly, “shorting a stock” is a way of investing that benefits from the decline of a targeted stock. An investor effectively borrows the stock from another investor and sells it into the market, waits for it to go down, and then rebuys it and gives it back to the investor they borrowed it from. It is a very tricky strategy and can be quite risky if not pursued correctly. It’s one thing to deal with the short-strategy risk under normal circumstances, but when you are targeted as part of a larger strategy then it becomes extremely treacherous. It essentially becomes a game of who blinks first. In the end, most investors who were short the stock were forced to buy the stock in the open market to cover their positions further pushing the stock prices higher. The meme strategy investors then sold their positions and cashed out. When the dust settled a couple of hedge funds were on the ropes and actually had to borrow money to stay afloat!
Meme stocks were one of several investments that seemingly became part of the investment landscape in 2021 including cryptocurrencies and its first cousin of sorts, something called a “nonfungible” token. I am three books into the subject I still haven’t quite got my head around cryptocurrencies. They are based on the “blockchain”, a method of secured and locked bits of information that are virtually impossible to unlock, once locked. The blockchain has applications in the business including effecting secure transactions. However, blockchain is far more readily known as the basis for cryptocurrencies (i.e. Bitcoin, Ethereum, and by now, countless others!) and cryptocurrency “mining”. One dubious element of cryptocurrency is that they have become the preferred payment method of internet hackers and other criminal elements. That, in and of itself, makes me less than inclined to put this on our shelf.
Now just when you thought you might have heard it all I may expand your list with something called a Non-Fungible Token or NFT. A non-fungible token is a blockchain child of sorts. NFT’s can digitally represent ownership in any asset, including online-only assets like digital artwork and real assets such as real estate. Other examples of the assets that NFTs can represent include in-game items like avatars, digital and non-digital collectibles, domain names, and event tickets. The most “interesting” NFT’s that are sold and bought represents a “piece of digital art”, something which cannot be printed or otherwise be created in physical form. You are buying a digital “ownership” certificate (or a piece thereof) of something that resides in the digital world…Think about this for a bit. Then consider this….28,983 investors shared in the purchase of a piece of art called The Merge which only exists digitally (kind of like a saved camera image on your phone). They paid (are you sitting down?) a total of $91.8 million U.S. dollars. Each investor received one “fragment” of the “artwork” in question. Head hurting yet? Google “The Merge NFT”.
I will save “Special Purpose Acquisition Corporations”, otherwise known as “SPAC’s”, for discussion another time. I will just leave you with a brief description of a SPAC. A SPAC is a corporation formed and funded with no reason except to go out into the investment world and buy another business. A SPAC has no goal except to fund itself and then go looking for an opportunity to buy… Needless to say, this is not a normal reason for starting a corporation. I will leave it at that…
Now I have seen this sort of “mass investment reality re-engineering” a few times in my 35+ year history in the investment and financial life planning business, with a couple of particularly notable occasions standing out. The first was the explosion of “internet business investment possibilities” which emerged in the late 1990s and which precipitated the dotcom bubble and the subsequent dotcom stock market crash. Many of these freshly minted dotcom companies were an early version of the 2021 SPAC. Virtually all ended up penny stocks or worthless after the 2000-2001 crash.
The second time I witnessed something remotely similar to what we are experiencing on the fringes of finance we are seeing with things like cryptocurrencies and NFT’s is in the time frame from 2006-2008 with the re-engineering of the debt markets, where people could buy houses in the U.S. with virtually no down payment and with much less than ideal credit ratings. This extraordinary situation culminated in the real estate price crash of 2006-2012, the debt crisis of 2008-2009 and, the resulting ’08-’09 stock market crash.
Why do I bring this up? I bring it up because when valuations get stretched in the financial world, some investors have a tendency to fall prey to absurdities in search of riches. When enough people start thinking that way, things can end badly for the greater whole just like they have, time and time again, since the Dutch Tulip Mania in the 17th century and, likely many times before that, just not as well recorded.
Where we are now is not where we were in February 2020. Back then, asset valuations were high, but it was a non-financial event that precipitated the selloff, namely the COVID-19 virus. By most measures, it could be seen (in hindsight) as a sharp, steep correction. From the time markets bottomed in late March 2020, to where we were at end of 2021 has been not quite an uninterrupted climb to some very high valuations from a fundamental perspective. Now we have some serious financial (labour shortages, supply-chain disruption, inflation, and the prospect of rising interest rates) and a concerning geopolitical issue (the Russia-Ukraine situation) all coming together here at the start of 2022. Something had to give and, in fact, has been giving, since the start of 2022.
Looking Further into 2022-
As I said at the outset, I have been trying to tie this commentary up since the middle of the month but the script keeps changing. As I was putting the finishing touches on things, the U.S. Fed and the Bank of Canada were are both scheduled to make interest rate announcements. Rather than be wrong in making a prediction, I thought I would wait to see what happens. What’s another day?
The Bank of Canada and the U.S. Fed Rate Committee showed their hands today (Wednesday, January 26th, 2022). Both are sending strong signals to the economy and markets that higher rates are coming, likely sooner rather than later. It would have been imaginable that one or both would have raised as early as today but they both chose to set the stage this time around. Be prepared for rate increases as early as March.
Here’s what I think for what it's worth… The first quarter of 2022 will likely be a bumpy investment market ride. If, as anticipated, the Bank of Canada raises rates in March and continues with a few more through the year and the U.S. Federal Reserve raises rates as well, asset prices will have to adjust to the higher rates. How significant is this? Pretty significant…
Higher interest rates will increase the cost of capital for companies which will potentially cause profits to fall. Profits underpin stock prices so; stock prices will fall.
Higher interest rates will also mess with the pricing of dividend-paying stocks, including preferred shares, which are held by many investors for income purposes. Dividend stocks will likely require higher overall dividend yields to justify the risk of stock ownership over a guaranteed investment (GIC’s and bonds). This is accomplished in one of two ways. First, it can be achieved by raising dividends which normally requires an anticipated sustainable increase in net profits or, it can be accomplished by the market adjusting the price of your stock downward until the dividend yield falls back into line with the interest rate environment will allow. It’s hard to raise dividends when the cost of capital is rising. A decline in dividend stock prices is likely to occur if rates go up quickly to adjust the price of the stock to increase the dividend as a percentage of the stock price so as to stay attractive in the face of higher guaranteed investment returns. If this happens to enough companies, it could result in broader indexes moving lower with constituent stock prices.
If interest rates rise high enough, the housing bubble here in Canada may finally pop. There could be some serious fallout for those who purchased a home with high mortgages and long amortization periods. As mortgage rates rise, payments will rise with them, potentially significantly if the new rate is high enough compared to the previous rate paid. If mortgage payments increase too much, homeowners who have high mortgages might have to sell their houses because they can’t afford the new, higher payments. If enough homeowners find themselves in that space, it could plant the seeds for a real estate crash of sorts. The Bank of Canada will be walking a tightrope when it comes to residential real estate. I think they actually would like to cool the housing price surges of the last few years, but it might be tricky. They do not want to cause a wholesale collapse of residential real estate prices. On the flip side, there might be one last burst of housing sales and purchases this spring as sellers take advantage of the high sale prices and buyers to move before the cost of mortgages gets too high.
Inflation is the real unknown in the coming year and beyond. It has already surged and is continuing to track higher. It is the primary reason central bankers are looking to raise rates. They want to cool things off and get inflation back to trend (2%-3%). Economists and central bankers suggest that the inflation we are experiencing here is transitory, meaning it should fade somewhat as economies continue to open up and supply chains return to normal. However, others disagree, including yours truly. There is still the matter of demographics; retiring baby boomers and a lack of people to replace them. The two generations following the Boomers are smaller cohorts and birth rates are low. Unless we increase immigration substantially, it will be hard to replace retiring workers fast enough to replace retiring boomers and expand the workforce to increase economic output. Robots and artificial intelligence (AI) can only do so much. Workers will command higher wages which ultimately will have to be passed on to the consumer. It could become a self-feeding, spiraling phenomena unless the central banks take steps to control it which will create all sorts of pain of its own.
What does this mean for stock investors? It likely means this year will be choppy and uncomfortable (at least for the first six months of the year) as asset prices adjust, including stocks. Bonds in a balanced portfolio might not offer the protection they normally do because it’s generally accepted that bond prices go down as interest rates rise. Some of how bonds will perform this year depending on the average duration (time to maturity) and creditworthiness of the holdings. I think a lot of the stock market damage will continue to be in the tech and new economy and innovator stocks. I think old economy stocks like resources, financials, utilities, and industrials will do OK, even if not great because many of these old economy sectors tend to fare well in inflationary and rising rate environments. Many of our portfolios are tilted in the direction of these old economy stocks. The portfolios with that sort of a tilt did not fare well in comparison to how well the high flying tech and innovator stocks did in the height of the pandemic but the story is changing and along with it the fortunes of the new economy and innovator stocks and of the old economy stocks.
To paint the story of what seems to be happening, I built a chart in YCharts to illustrate the fortunes of two investments. The first is Berkshire Hathaway which is a long-time favorite stock of mine. FYI. I own Berkshire B shares (NYSE ticker symbol: BRK.B). The second is the ARK Innovation ETF (ticker symbol: ARKK; it is U.S. listed) managed by Cathie Woods. As you can see on the chart below over the two+ years from January 1, 2020, through to January 25, 2022, they both arrived at a similar place but with very different paths. Berkshire is a broadly based investment holding company with core holdings in insurance, resources, and transportation stocks along with some consumer stocks like McDonald's and Kraft Heinz. It is important to note that it also owns a sizable chunk of Apple stock so it's not like it has avoided the tech/innovator space entirely. It’s just that it is very diversified and still is tilted to old economy stocks.
Cathie Woods’ ARK Innovation ETF holds a basket of new economy stocks like Tesla, Teledoc, Zoom, Roku, Spotify, Coinbase (a crypto play) to mention a few. It is all in on new economy stocks. Cathie Woods became an investment “rock star” in the height of the pandemic as the stocks she owned and her investment “canvas”, ARK Innovation surged in value. However, as the pandemic continued and the values of some of the companies in her portfolio started to tail off, so did her fund.
Late note: As I press send on this commentary on January 27th, if an investor would have invested $10,000 January 1, 2020, into each of Berkshire Hathaway B shares and the ARKK ETF, the accumulated value of the investments are now running virtually neck and neck!
So imagine the ride for investors in ARKK who have continued to hold the investment? These would be difficult times for an ARKK investor who was there from January 1, 2020, to today... They would have celebrated their smart choice to invest for a period of time, then watched as the investment tailed off with reassuring comments from the manager, saying something like the dip being temporary and that the new economy is real. Then, as their investment profits withered away and their initial capital investment threatens to go underwater, they have to decide to stay a believer or move on. Worse still is the experience of the investor who liked what they saw in the first quarter of 2021 and invested when ARKK was at its peak during the time period in question. The fact is many investors in ARKK have sold their holdings. The investment is now down 58% here as I write, from its peak to where it is today. What does the future hold for ARKK and ARK investors? My crystal ball won’t tell me.
Now, look at Berkshire Hathaway’s price movement over the same period. Less excitement. Less drama and, of late, less pain. In investing, “boring is beautiful!” We like boring. My thinking is if investors want excitement, they can take up sky diving. If they want a good and profitable long-term investment experience own solid companies in core industries or, more ideally, broadly diversified baskets of solid, quality companies in diverse sectors, including tech and new economy stocks (just not a significant overweight). Add new money where you can, especially if there is a notable pullback (10%-20% or more). Make sure you have enough cash equivalent investments (savings accounts and short-term GIC’s and/or bonds) to cover your short-term to medium-term needs and as an opportunity fund to take advantage of the equity market or other (i.e. real estate) pullbacks. To quote Warren Buffett, the affable nonagenarian Chairman of Berkshire Hathaway, “Be fearful when others are greedy and be greedy when others are fearful”. Words for investors to live by…
So, what is an investor to do? If you are already invested there is plenty of evidence to suggest jumping out and then trying to figure out when to get back in is a tough, if not impossible task. If we have done our jobs as well as I would hope, we have you invested in portfolios that align with your stated risk capacity and tolerance and, already have the stable cash equivalents in your portfolio from which to draw income and capital needs, while we negotiate the early stages of these choppy markets.
If you have cash on the sidelines, we might be looking at some good buying opportunities in some quality individual stocks or core portfolio funds and ETF’s.
I believe, regardless of where you are, fully invested or flush with cash to invest, the buzzword to keep repeating is “patience” and diligence.
As always, we are here. If you have questions or concerns, or you just wish to talk, please call or email me. Thank you for your continuing confidence in our services.
Kindest wishes always.
David J. Luke, CFP, RFP, CLU, CH.F.C., CIM, RIAC | Financial Advisor
360 Private Wealth Management | Manulife Securities Incorporated
This publication is solely the work of David Luke for the private information of his clients. Although the author is a Manulife Securities Advisor, he is not a financial analyst at Manulife Securities Incorporated (“Manulife Securities”). This is not an official publication of Manulife Securities. The views, opinions, and recommendations are those of the author alone and they may not necessarily be those of Manulife Securities. This publication is not an offer to sell or a solicitation of an offer to buy any securities. This publication is not meant to provide legal, accounting, or account advice. As each situation is different, you should seek advice based on your specific circumstances. Please call to arrange for an appointment. The information contained herein was obtained from sources believed to be reliable; however, no representation or warranty, express or implied, is made by the writer, Manulife Securities, or any other person as to its accuracy, completeness, or correctness.