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Jan 06 2022

Research Preview: Style Swings In 2021

  • Jan 6, 2022

Despite elevated uncertainty over pandemic developments and expected policy tightening, and in the face of aggressive valuations, the S&P 500 still managed to gain a delightful +28.7% in 2021. Even more noteworthy, in our opinion, is that this advance came with nary a single correction of more than 10%.

We wrote in the latest Green Book that a breadth indicator that should be more well-known than it is—the High/Low Logic Index (or HLLI)—had moved to “maximum negative” right at the cycle high in the NASDAQ Composite on November 19th. Specifically, the 10-week moving average of this indicator showed a perilous internal condition in which too many NASDAQ stocks were reaching 52-week New Highs and New Lows simultaneously. That’s the very definition of a “fractured” market, and has preceded some important NASDAQ declines. There have also been a couple of premature warnings, as in the summers of 1996 and 2019.

 

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The CPI numbers suggest inflation is broad-based and less transitory than expected. Our Scorecard starts to tilt a bit toward a cost-push inflation regime, caution is warranted. Watch the yield curve closely.

 

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As bond yields climb to their highest level of the recovery, we are all getting a glimpse of our portfolio future. 

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As the new year begins, the Federal Reserve has taken center stage. Fears swirl around “when,” “how fast,” and “how much” the Fed may raise interest rates in 2022.

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As shown in the accompanying chart, since the very start of this pandemic, every significant change in the U.S. COVID-case count has “moved” bond yields in an inverse fashion. That is, until the last couple of weeks?

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After years of underperformance, Value was finally productive—it was the best factor we track. In general, overall factor performance was good, but worked much better within small- and mid-caps compared to large-caps. Value was especially superior outside of the large-cap universe.

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We know our view on this is controversial, but we like the relative prospects for Small Caps—even though we still believe the broad stock market is currently the most speculative one in U.S. history. 

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When we entered the business in 1990, our grandmother mailed us a decades-old clipping from a Minneapolis newspaper featuring a columnist’s cryptic take on a hand-rendered chart. He coyly claimed to have found it in “an old desk”—and it wasn’t until the internet age that we’d learn of its unattributed source.

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Numerologists will be disappointed to learn that longer-term time cycles don’t line up for a prosperous 2022 for stocks. However, the historical “hit rates” aren’t high enough to justify running for cover if you have no other fundamental stock-market worries. 

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If January is the 21st month of the recovery, then time has elapsed in “dog years.” And that might put this “canine” recovery at around 12 years—just shy of where we might be had COVID never occurred! 

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Market revelations were certainly not in short supply in 2021. We believe some of those surprises will continue to have a huge impact on markets in 2022. We have updated our time-cycle composites to provide an idea of what a “typical” 2022 could look like.

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You’ve likely heard of “shrinkflation,” the practice in which a package of M&M’s is reduced from 40 pieces to 32, while the price per bag is unchanged. Publicly-traded companies have been engaged in similar schemes for awhile.

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We take a look at our historical analysis of industry-group portfolios to see how the “Dreams” and “Nightmares” from 2020 fared in 2021. The industry composition of the 2021 Dream and Nightmare portfolios is also presented.

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Bond mutual funds had a stellar 2021. With data available through November, this subset has already amassed YTD net-cash inflow trumping 2009’s all-time record.

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During the last year, real GDP growth was among the strongest of the post-war era, job creation was spectacular, wages rose by one of the fastest clips in almost 40 years, and annual retail sales grew by an astounding 18%. On top of that, housing activity was on fire, core capital-goods orders rose to a record high for the first time in more than 20 years, and corporate profits were unprecedented.

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Read this week's Major Trend. 

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As the Omicron variant ravages the country, we begin the New Year with a resigned realization that COVID is likely a part of our lives forever. We are vaxxed, masked, tested, distanced, and saddened by our shocking loss of loved ones! We are resolved to finally move beyond and pursue a new post-COVID normal, practice appropriate ongoing caution, and expect additional hardships. But we are also determined to return to our routines and again embrace aspirations, interactions, and the business of fulfilling lives. Although COVID will still be with us this year, Americans are poised for the pandemic to become endemic!

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It’s once again that time of year for what our founder deemed the great “thermal pollution.” Market pundits and prognosticators will divine, guess, and predict all that the market will bring in the new year.

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The S&P 500 is flirting with new all-time highs, and the news gets even better for followers of seasonal patterns: The Santa Claus rally has yet to officially begin!

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This year, the U.S. dollar played a significant role in the financial markets (Paulsen’s Perspective, December 10, 2021), and its movement in 2022 will likely prove equally important.

Forecasting the dollar is extremely difficult, and many would say it is a fool’s game. My personal experience predicting the greenback has not been particularly good, but a “fool” is rarely discouraged from trying again. Traditionally, U.S.-dollar outlooks are based on relative economic-growth rates (i.e., expected real U.S.-GDP growth compared to overseas), anticipated inflation rates, a comparison of relative monetary policies, and excess long-term yield spreads.

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Read this week's Major Trend. 

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Since September, the stock market has been periodically battered by renewed pandemic fears (Delta and now Omicron), increasing anxieties about pending Federal Reserve tightening, selloffs among popular new-era stocks, and ongoing concerns about high valuations and inflation. This has taken a toll on investor sentiment, as highlighted by several survey measures and market indexes.

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With the most speculative year in U.S. stock market history drawing to a close, we could probably all use a rest. How about a rest that lasts 12 months?

The year 2022 on the Jewish calendar is a Shmita year—historically considered to be a year of rest, or sabbatical, following six years of work. Unfortunately, markets have frequently taken this suggestion quite literally! There’s been a major financial disruption in seven of the eight Shmita years dating back to 1966:

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As the Federal Reserve turns more hawkish and expectations for higher interest rates mount, investors are lowering exposure to growth stocks. Typically, growth stocks exhibit a higher duration than value stocks because a larger proportion of their cash flows won’t be received until the distant future. Consequently, like longer-term bonds, growth stocks are generally expected to struggle when yields rise.

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Extremely loose monetary and fiscal policies during the pandemic have created distortions and disequilibria throughout the economy. The most visible bubbles may be in financial markets, evidenced by the boundless valuations applied to visionary startups and the speculative fascination for digital assets of all types. This report examines a bubble of a different kind; not a financial bubble but rather a real-world bubble in “fun”. Producers of recreational goods are flourishing during the pandemic, posting massive sales gains and a tripling of net income, yet selling for miniscule valuations.

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Read this week's Major Trend 

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The stock market has been stressful of late. First, the S&P 500 had a rough autumn, declining by more than 5% from September to early October; after a brief recovery, stocks hit another sudden air pocket in late November. Both times, the VIX™ Volatility Index spiked above 20, and broader-market stocks suffered even steeper declines (e.g., small caps, cyclical stocks, and international investments).

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To maintain sanity and protect fragile psyches, investment managers share a code. If results are good, it’s due to extraordinary foresight and skill. Whereas bad years are simply the product of unpredictable “bad luck.” In 2021, however, whether thanks or blame is deserved, “King Dollar” drove investment returns—as the following chart pictorial demonstrates.

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October and November’s readings both signal that monetary stimulus is now doing more harm than good. The Fed policy pivot from supporting the labor market to fighting inflation has begun. Gains in consumer prices have resulted in a headline CPI value not expected until the middle of 2024 under the pre-pandemic trend.

 

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It’s easy to misread where the true “consensus” stands on any financial forecast. Here’s a disconnect we see in current consensus thought: The “crowd” seems broadly bullish on commodities, yet the same crowd (previously known as Team Transitory) thinks consumer price inflation is near a cycle high.

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The NBER informs us that the economic expansion is only in its sixth quarter. That’s good to know, but we don’t think investors should be positioned nearly as aggressively as such a statistically-youthful recovery would normally mandate. 

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There has been a torrent of new policies coming out of China recently. The goal of this report is to disentangle these seemingly random or even nonsensical policy moves and present a clearer roadmap of what China is thinking and doing.

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There should be a name for the syndrome suffered by foreign stock investors over the last decade or so. “Groundhog Day” doesn’t quite cut it, because that event repeats only once a year. It seems like this time of year we always feature a chart showing a healthy YTD double-digit gain in the S&P 500, along with a bond-like gain in EAFE, and a bond-like gain or loss in the MSCI Emerging Markets Index.

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We think 2021 has earned its place in the books as the wildest and most speculative year in U.S. stock-market history, eclipsing even 1929 and 1999. That doesn’t mean 2022 will bring a panic or a crash, maybe just a degree of sobriety.

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While retail spending has boosted staples and durables alike, we believe that discretionary durables have been the prime beneficiary of changing lifestyles and spending patterns, with skyrocketing sales and inventory outages that may not reach equilibrium even in 2022. 

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As shown in Chart 1, the relative one-year-forward Price/Earnings (P/E) multiple of the S&P 600 Small Cap index is near the lowest level ever recorded since it was first introduced in October 1994. It is now as low as it was at the height of the dot-com mania when everything outside of tech stocks underperformed.

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With all the crosscurrents weighing on the economy and financial markets, it is easy to get lost in the weeds attempting to figure out what the stock market may do in the coming year. Will Omicron force another economic shutdown, bringing a serious market decline? Will inflation prove the Fed is correct in retiring its “transitory” tag, forcing monetary officials to speed up tapering and perhaps raise rates sooner than expected? Will high valuations finally catch up with Tech stocks?

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Headline inflation reports, including the Consumer Price Index and wages, continue to run disturbingly hot! As a result, investors worry that ongoing inflation pressures will eventually contract equity valuations, push bond yields higher, and force the Federal Reserve to act much sooner and more aggressively than planned.

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