– 2021 ended with a bang, with the S&P posting a 27% gain on the year. This appreciation occurred with the markets were facing a trifecta of rising interest rates, an unknown coronavirus variant backdrop, and the Federal Reserve tapering. The major indices reached unprecedented territory breaking through all-time high after all-time in what seemed like a daily occurrence throughout the year until the back third of the year rolled around. The September correction was a harbinger that valuations do matter, albeit October saw a huge reversal to the upside. Then came the November/December bifurcation in the markets, along with extreme bouts of volatility. Despite the back third of the year, the S&P 500 posted a 27% gain, placing the index in rarified air across many valuation metrics.
As interest rates, fed taper, and the pandemic gripped the markets, a sea change occurred. This sea change started to take hold back in November and December of 2021 while really accelerating in the first week of January 2022. As a result, technology names experienced heavy selling, specifically in stocks with high beta and/or rich valuations. This massive rotation came out of technology companies that are unprofitable with proof of concepts and into value-oriented companies that are well-capitalized, profitable, and pay dividends. As 2022 continues onward, this theme will lead the charge in the markets until the uncertainty surrounding the pandemic and the interest rate environment is settled out.
The Dow Jones and the Nasdaq have moved in opposite directions as of late. The first week of 2022 knocked the Nasdaq down over 4.5%, while the Dow Jones was only slightly negative by 0.3%. This is a massive divergence from 2021, where all major indices moved higher in lockstep for most of the year. Overall investor enthusiasm has cooled, especially in the more speculative momentum stocks in cloud software, SPACs, and recent IPOs. High growth, pandemic-driven, and proof of concept names have seen their valuations more than cut in half in just a matter of weeks. Money has flowed into companies that are generating profits, paying dividends, and making tangible products. This will likely be the theme throughout 2022 as valuations begin to matter and are placed in check.
Vicious Selling Continues Into 2022
As of the beginning of December, a third of the S&P 500 is off at least 15% from its high, and nearly one in eight Nasdaq stocks logged a new 52-week low. Furthermore, the CNN Money Fear & Greed Index, a composite of market-based indicators that gauge risk appetite across stocks, bonds, and options, dropped to its 2021 lows, seen during previously equity pullbacks. It has only tended to plunge below this when the market is in near-crash mode, such as December 2018 and March 2020. The markets did bounce during the proverbial Santa Claus rally to negate some of this downtrend; however, we are right back in the same conversation after the first week of January 2022.
As such, financial technology, certain software stocks, e-commerce apps, fading trends, sports-betting plays, and stay-at-home plays have been absolutely decimated by 20%-70%-plus. PayPal (PYPL), Block (SQ), Robinhood (HOOD), Docusign (DOCU), Peloton (PTON), Beyond Meat (BYND), and Twitter (TWTR), to name a handful of stocks in this bucket.
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Deutsche Bank noted, “The equity sell-off since last over the two-week November/December transition remained modest, in keeping with regular 3-5% pullbacks that have occurred every 2-3 months historically. However, this was accompanied by the sharpest weekly decline in equity positioning since the collapse back in March 2020 at the beginning of the pandemic.”
In general terms, when overall earnings are expanding, so far, the consensus for 2022 is for 8.8% growth; stocks tend not to suffer deep and lasting downturns. The first hike tends not to end a bull market. Years when the S&P 500 has been strong heading into November typically add to gains, and fourth-quarter seasonal tailwinds tend to blow unless financial conditions are tightening. I think markets are over-reacting to the omicron backdrop, and stocks are primed for a bounce after this excessive sell-off.
When the Fed Tapers and Inflation Hits
As the Consumer Price Index (CPI) continues to push higher in conjunction with better-than-expected employment numbers, the Federal Reserve is compelled to put through rate increases. Although interest rate risk disproportionally impacts fixed-income investments such as bonds and annuities, stocks are undoubtedly being impacted already. This is especially true for highly leveraged companies such as tech and super-charged growth companies.
This pivot in monetary policy by the Federal Reserve sets the stage for reducing asset purchases and downstream interest rate hikes for 2022. As this pivot unfolds, risk appetite towards equities hangs in the balance and has already seen a massive hit to valuations. The speed at which rate increases hit the markets will be in part contingent upon inflation, employment, and of course, the pandemic backdrop. Inevitably, rates will rise and likely have a prolonged negative impact on equities.
Apparently, valuations do matter, especially once the fiscal and monetary stimulus is removed, inflation rears its ugly head, and markets inevitably turn lower. As 2022 unfolds, it’s going to be a tug-a-war between inflation, interest rates, and the pandemic backdrop. CPI reports will become more significant as these readings are used to identify periods of inflation and will influence monetary policy. As investors grapple with the prospect of downstream rate increases, pockets of vulnerabilities throughout the market have been exposed, with rate hikes on the horizon. Technology names experienced heavy selling, specifically in stocks with a high beta and/or rich valuations because of impending rate hikes. This massive rotation came out of technology companies that are unprofitable with proof of concepts and into value-oriented companies that are well-capitalized, profitable, and pay dividends. As 2022 continues onward, this theme will lead the charge in the markets until the uncertainty surrounding the pandemic and interest rate environment is settled out.
As valuations moderate, there are many high-quality names at steep discounts, such as Microsoft (MSFT), Adobe (ADBE), Chipotle (CMG), Netflix (NFLX), Nvidia (NVDA), PayPal (PYPL), Starbucks (SBUX), and Block (SQ) that may be great entry points for the long-term investor.
Disclosure: Stock Options Dad LLC is a Registered Investment Adviser (RIA) firm specializing in options-based services and education. There are no business relationships with any companies mentioned in this article. This article reflects the opinions of the RIA. Any recommendation contained in this article is subject to change at any time. No recommendation is intended to constitute an entire portfolio. The author encourages all investors to conduct their own research and due diligence prior to investing or taking any actions in options trading. Please feel free to comment and provide feedback, the author values all responses. The author is the founder and Managing Member of Stock Options Dad LLC – A Registered Investment Adviser (RIA) firm www.stockoptionsdad.com defining risk, leveraging a minimal amount of capital and maximizing return on investment. For more engaging, short-duration options-based content, visit Stock Options Dad LLC’s YouTube channel. Please direct all inquires to [email protected]. The author holds shares of AAPL, AMZN, DIA, GOOGL, JPM, MSFT, QQQ, SPY, and USO.
Source: Apparently, Valuations Do Matter