You have to go back to March 2020 to find a drawdown similar to that experienced so far this month.
The S&P 500 entered correction territory on Monday—down 10% from its recent peak—while the Nasdaq is down 15% so far this month1. Any recent rebounds have been fleeting, ending in sharp reversals by close of trading.
In this week’s commentary, we look at: what’s going on, when it might stop, and what investors should do in the meantime.
Negative fundamentals and terrible, horrible, no good, very bad technicals
The markets are clearly frightened of persistently high inflation and are concerned that the Fed has been behind the curve in reacting to it and must now play catch up. Compounding this, earnings growth is slowing, labor costs threaten corporate margins, and pandemic bottlenecks persist.
This is already a bad combination, and it is being exacerbated by market illiquidity as severe as in March 2020 and immense amounts of selling pressure from all corners of the markets.
- Liquidity: Indeed, the number of S&P 500 futures contracts on offer last Friday was the lowest since April 20202. This made it very difficult to move large amounts of risk in such a thinly traded market. And when selling pressure is so overwhelming, all else equal, this exacerbates moves to the downside.
- Selling pressure: Hedge funds, volatility-targeting funds, commodity trading advisors (CTAs), fund managers, and retail investors are all selling risk positions, though not yet to extremes.3 There are also non-economic sellers like trend-following managers that have to sell (irrespective of fundamentals) if the trend dictates. This could be when key moving-average levels are breached, like the 200-day moving average on the S&P 500 and Nasdaq, or when the VIX (a popular measure of stock market volatility expectations) spikes, as it did recently.4 In retrospect, many (including ourselves) underappreciated how much repositioning was needed after two years of (mostly) one-directional market upside, underpinned by extreme policy accommodation and a rebound in economic activity. This drove up certain valuations to extremes as investors crowded into the same trade – long risk, which now has to unwind as circumstances change.
It stops when the Fed narrative changes
The Fed started this, and the Fed could stop it. Wednesday’s FOMC meeting will be crucial. Markets are terrified of the combo of slowing growth and tightening monetary policy. Fed vice chair nominee Lael Brainard’s statement that, “We have a set of tools—they are very effective—and we will use them to bring inflation back down”5 enflamed market concerns. It may be best for the Fed to deliver the message that growth is still solid, though slowing, and withdrawing accommodation is prudent when economic growth is strong—U.S. GDP growth is expected to be 3.9% this year. If the Fed Chair clearly delivers this message, markets might calm down, provided that the Fed indicates that there will be no more than four rates hikes this year and only hints at mid-year balance sheet run-off for now, in line with market consensus.6
But will it? What about 5.5% core inflation?7 How much does the Fed have to hike to stem this?
We think that the Fed does not have to hike rates for 7% headline or 5% core inflation, but rather enough to control 3% core inflation. According to estimates, pandemic-related supply constraints are responsible for close to half the current inflation overshoot.8 If the Fed hikes rates as if it is trying to control 5% core inflation, it risks overtightening and exacerbating the current slowdown.
The Fed cannot control employee absenteeism due to COVID. Instead, public policy measures to end the pandemic are the best tool to reign in this portion of inflationary pressures. In combination, the current Administration, state governors, public health authorities, and corporations can act to resolve these bottlenecks. Thus, we think the dovish surprise could be that the Fed focuses on inflation it can actually control, which should not require the degree of tightening that has spooked markets.
“If you are going to panic sell, panic sell later and get a better price”
This is one of my favorite quotes from a podcast we recently recorded (“The Long and Short of Tech Stocks”) with Honeycomb Asset Management’s David Fiszel, which he ascribed to Steve Cohen, his mentor for many years.9 Today it does feel like it is too late to panic sell many growth equities, some of which are down much more than the S&P 500. However, now that we are in a broad market correction and concerns about Fed policy mistakes remain, what should investors do? We offer 2 suggestions:
1) Rotation opportunities still make sense. One way or another we will be living in an environment of high shelter inflation, higher interest rates, and lower economy activity for the next one to two years. That’s the base case. Against this backdrop, we like opportunities in private credit and commercial real estate, which we highlighted in our 2022 Outlook. In public markets, we do not think investors should chase the value or cyclicals trade, as both manufacturing and services PMIs have been declining of late. Instead, add to dividend-paying and/or dividend-growing equities.
2) We recommend building a Tech stock shopping list with a 12 month-plus time horizon. When the dust settles after the Fed’s policy announcements, market volatility, and latest wave of the virus, we will likely be faced with a notable shift in market leadership. There will be no more easy pandemic trades, no more cheap reopening trades, financials will no longer be a slam dunk, assessing cyclicals and value stocks may not be as straightforward, and high-multiple, unprofitable tech may still be tough without low rates to underpin valuations. Amidst that, targeted opportunities in non-pandemic-dependent, reasonably priced tech (including software) should shine. Info Tech net profit margins are roughly 24%, double the S&P 500 average of about 12%10, which could give the sector a lot more room to absorb higher costs and the economic slowdown.
(1) Source: Bloomberg, as of January 24, 2022
(2) Source: JPMorgan Securities, as of January 21, 2022
(3) Source: JPMorgan, Goldman Sachs, January 21, 2022
(4) Source: Bloomberg, January 24, 2022.
(5) Source: New York Times, January 13, 2022.
(6) Source: Bloomberg, January 24, 2022
(7) Source: Bloomberg, as of December 31, 2021
(8) Source: Goldman Sach Economics, January 22, 2022
(9) Source: iCapital, Alternative Viewpoints Podcast, January 24, 2022.
(10) Source: Factset, January 13, 2022.
This material is provided for informational purposes only and is not intended as, and may not be relied on in any manner as legal, tax or investment advice, a recommendation, or as an offer to sell, a solicitation of an offer to purchase or a recommendation of any interest in any fund or security offered by Institutional Capital Network, Inc. or its affiliates (together “iCapital”). Past performance is not indicative of future results. Alternative investments are complex, speculative investment vehicles and are not suitable for all investors. An investment in an alternative investment entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. The information contained herein is subject to change and is also incomplete. This industry information and its importance is an opinion only and should not be relied upon as the only important information available. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed, and iCapital assumes no liability for the information provided.
This presentation contains forward looking statements. Forward looking statements include, but are not limited to assumptions, estimates, projections, opinions, models and hypothetical performance analysis. Forward looking statements involve significant elements of subjective judgments and analyses and changes thereto and/or consideration of different or additional factors could have a material impact on the results indicated. Due to various risks and uncertainties, actual results may vary materially from the results contained herein. No representation or warranty is made by iCapital as to the reasonableness or completeness of such forward looking statements or to any other financial information contained herein.
Products offered by iCapital are typically private placements that are sold only to qualified clients of iCapital through transactions that are exempt from registration under applicable securities laws, including the Securities Act of 1933 pursuant to Rule 506(b) of Regulation D promulgated thereunder (“Private Placements”). An investment in any product issued pursuant to a Private Placement, such as the funds described, entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. Further, such investments are not subject to the same levels of regulatory scrutiny as publicly listed investments, and as a result, investors may have access to significantly less information than they can access with respect to publicly listed investments. Prospective investors should also note that investments in the products described involve long lock-ups and do not provide investors with liquidity.
iCapital may have issued, and may in the future issue, material that is inconsistent with, and reaches different conclusions from, the information presented in this document. Those documents reflect the different assumptions, views, and analytical methods of the analysts who prepared them and iCapital is under no obligation to ensure that such other reports are brought to the attention of any recipient of this document.
Securities may be offered through iCapital Securities, LLC, a registered broker dealer, member of FINRA and SIPC and subsidiary of Institutional Capital Network, Inc. (d/b/a iCapital). These registrations and memberships in no way imply that the SEC, FINRA or SIPC have endorsed the entities, products or services discussed herein. iCapital is a registered trademark of Institutional Capital Network, Inc. Additional information is available upon request.
© 2022 Institutional Capital Network, Inc. All Rights Reserved.