Your December statements have been released and should be arriving shortly if they have not arrived already. 2021 was another positive year for US equities due to the continued accommodations by both fiscal and monetary stimulus. Additionally, the much-anticipated recovery of 2022 for industries still bogged down by the pandemic began being priced into the market. Despite the positive returns seen in US equities last year, 2021 presented many challenges to the global economy. It was a year marked by supply-chain woes, inflation, and labor issues. The many economic challenges that unfolded proved challenging for many businesses throughout the world.
The stocks that performed the best were those that lagged in 2020 and the stocks that underperformed were the outperformers of 2020. The outperformance of pandemic darlings such as Zoom, Teledoc, and Peloton were among the worst performers in 2021. Segments such as energy, materials, and industrials turned a horrible 2020 into the biggest winners of 2021.
It is also worth noting the stocks that performed well in both 2020 and 2021. Stocks such as Microsoft and Goldman Sachs were able to perform in vastly different market environments due to their strong balance sheets and business models coupled with pricing power and exposure to all the right areas of the economy.
As we look to the year ahead of us, investors must be ready to allocate in a rising interest rate environment. The Federal Reserve made it extremely clear that throughout the first two years of the pandemic, their most important mandate was full employment, even if that meant higher levels of inflation. Two years of aggressive additions to its balance sheet have kept rates low to subsidize the recovery. Now that the US has achieved full employment at the cost of six percent inflation, the Federal Reserve has announced they will accelerate the taper timeline as well as potentially raise interest rates four times in 2022.
Simply put, a rising rate environment is less favorable for equities than a low-rate environment for a few reasons. For starters, many managers of pensions, endowments, and mutual funds have specific mandates for a fixed percentage of their total allocations to equities and fixed income. When interest rates rise, bond prices decrease, meaning the fixed income portion of a portfolio is now a smaller percentage of the total portfolio. This forces many managers to sell equities to rebalance their portfolios at the end of every quarter. We saw the exact opposite of this phenomena going into the second quarter of 2020 as stocks had decreased so much in value in the quarter prior and bond prices soared.
Another reason a rising rate environment is less favorable for equities is the simple, yet ever important present value of future earnings. Stocks that are priced to earn more money in the future have smaller present values with higher interest rates. Intuitively, investors can afford to be more patient with stocks that do not generate earnings with low interest rates. However, if interest rates are higher, investors are less likely to patiently wait for high-valuation stocks to earn money in the future.
There are many stocks that perform well in a rising rate environment. Allocators still have specific equity mandates they need to meet whether rates are rising or not. Because stocks with high multiples become less attractive with higher interest rates, stocks with strong earnings and healthy balance sheets become more attractive. Stocks like GM, JPM, and MSFT are financially sound and can perform with higher interest rates. Bank stocks perform better in a rising rate environment due to growth in their lending divisions. Even a stock such as FB is extremely attractive in this environment. FB has a below-market multiple but is still growing like many of its tech peers. Lower multiple stocks with strong balance sheets make up the groundwork for our 2022 portfolio.
As of the writing of this letter, the market is down nearly 10% from its highs and technology is seeing even greater losses. Large market weights such as NVDA and TSLA are down 32% and 24%, respectively. Our investment committee is looking at this correction as a necessary course for the market after seeing two years of above average performance. It is important to remember that corrections always need a trigger to occur, even if a correction might be overdue. Corrections are healthy market events that historically occur once per year. The trigger for this correction was rising interest rates coupled with challenging comps for the upcoming earnings season.
While our investment committee welcomes this correction, it is important to note that we believe the market dynamic will shift after this selloff. Given that this correction was triggered by higher interest rates and earnings season, high-valuation stocks with no earnings will not return to their highs for a significant period, if at all. Our investment committee tends to stay away from pre-earnings companies, such as Peloton, because their lack of financial stability can lead to steep selloffs. As a result, our investment committee prefers iron-clad balance sheets and growth at a reasonable price. These are the stocks that will withstand volatility and see positive performance in 2022.
Our investment committee is especially emphasizing diversity in 2022. The S&P 500 has become dominated by a select few companies whose exponential growth has led to these companies dominating the weightings of the index. While the comparison to the S&P 500 is something often cited by investors of all sophistication ranges, our investment team is beginning to shift further away from using it as a relative benchmark. What was once a well-diversified, healthy market thermometer has become a tainted measure of overall market health. The S&P 500’s top 5 stocks make up over 20% of the index. The NASDAQ 100 is even worse- the top 10 stocks make up 46.7% of the weighting of the index. Moreover, stocks such as MSFT, GOOGL, AAPL, NVDA, and TSLA accounted for 51% of the market’s return since April and one third of the 2021 S&P 500 return. This lack of diversity needs to be considered when evaluating risk-adjusted returns of a portfolio like ours.
Global conflict is also on our radar given the circumstances in Taiwan and Ukraine. An act of aggression on either sovereign nation would have rippling effects across global markets. While we cannot predict the actions of adversarial nations, we are confident that our high conviction names would not be materially impacted by these events relative to the rest of the US equity market.
Finally, we are also in a midterm election year. The markets are preliminarily predicting a red wave which could lead the federal government into a lame duck state for the next two years of the Biden Administration. Our team does not have an immediate opinion on the effects of the election, but we will keep a close eye on the current administration’s legislative and regulatory agendas, especially anti-trust scrutiny, as we proceed throughout the year.
Our team believes that there will be volatility in the first part of the year as markets digest the new interest rate environment and the continued reopening of the economy that has been delayed due to new COVID variants. Investing in strong, proven business models is the best way to invest in a market that is not conducive to robust performance in hyper-growth stocks.
It is important to remember that investing is a marathon and not a sprint. Geopolitical uncertainty, earnings seasons, and changing market climates come and go but quality companies do not. We are confident that the broad market volatility will lead to positive recoveries in the strongest US businesses. As always, if you would like to discuss our investment thesis further, we would be happy to schedule a meeting. Thank you for your continued confidence in our ability to manage your capital.
The CEA Investment Team