I hope this letter reaches you in good health and that you enjoyed a peaceful holiday. 2021 was both rewarding and challenging in many ways. It brought both big gains in investment prices, and continued stress in everyday life. Many may be glad it is over.
Before I discuss the ongoing speculative market with its headwinds and tailwinds, I want to raise some key observations that give context for the future. We believe that, at this point, it is fair to characterize US equity markets as a collection of speculators, short-term traders and computer algorithms who all compete for ‘performance’ and have driven many stock prices to levels that are completely detached from fundamental reality. At some point, that reality will make its presence known again.
There has probably never been a moment where so much capital is speculating in securities of companies both public and private that do not generate income or cash flow and have no evident value. In the long run, future cash flow determines an investment’s worth, and its worth relative to its price will drive your future investment returns. Period.
The S&P 500 finished 2021 with its 3rd consecutive year of double-digit gains closing at 4766 -- making mockery of those who perform fundamental analysis and putting to shame the price forecasts issued at the beginning of the year. For entertainment purposes, here were the 2021 S&P 500 year-end forecasts made by big banks one year ago: Goldman Sachs - 4300 UBS - 4100 Credit Suisse - 4050 Barclays - 4000 Deutsche Bank- 3950 Morgan Stanley - 3900 Wells Fargo- 3850 -SocGen - 3800 Citigroup - 3800 Bank of America – 3800. So much for forecasting.
Year-end price targeting has once again proven to be a loser’s game. And the futility of fundamental analysis or diversification strategies in a Fed-fueled market came into sharp relief in 2021. That reality is probably best reflected by the large underperformance of most hedge funds, which, as a collective, returned just 10% according to Hedge Fund Research1.
What caused stock prices to be so detached from reality? The Federal Reserve and its unabated hyper-stimulative policies of liquidity injections, direct lending, bond purchases and interest rate suppression. At the end of the day, huge amounts of Fed-sponsored cash and credit flowed to the hands of speculators and juiced up the stock prices of the biggest companies, which have now grown to unfathomable sizes (as of Dec. 31, 2021): Apple - $2.9 tn, Google - $1.9 tn, Microsoft - $2.5 tn, Amazon - $1.7 tn, Tesla - $1.1 tn. In other words, the stocks with already stretched valuations continued to be bid up in 2021, simply because they were the largest stocks. This is a reflection of mass-migration to index strategies, not thoughtful/careful investing. It is also a reflection of a misperception that those companies, and indexes in general, are not risky. These phenomena define today’s long-term risk/opportunity set.
The rest of the market floundered and corrected underneath the largest companies’ stocks with the NASDAQ ending the year with 62% of its components below their 200-day moving average. This despite traders’ heroic attempts to markup performances in December (‘traders’ being largely algorithms because trades are mostly driven by computers, not people). The NASDAQ without the five largest stocks (AAPL, FB, MSFT, GOOG, AMZN) declined over 20% for the year as of Dec. 6 (see chart below). With this massive divergence in price movements, one might argue that the credit bubble may be in the process of bursting.
So, while the 2021 financial headlines kept showing record high after record high in the indexes, the truth is that there has been significant corrective activity taking place beneath the indices. As I have written about in the past, artificial Fed-sponsored cheap credit and easy terms has warped investors’ incentives and behaviors, and wrought excessive speculation, large capital misallocations and mispricing within markets. It has also financed the largest expansion of government since World War II (see next chart):
Previous periods of very concentrated market leadership, i.e., the Nifty Fifty market of the early 1970s and the internet bubble of the late 1990s, did not end well. That is not to imply that a crash is imminent, but simply to provide historical context and encourage you to consider the unusual investment climate within which we operate. There are still great opportunities in ignored and unloved investments…because those tend to do well during and after bear markets in the major indices. The next correction/bear market is as uncertain in its timing as it is inevitable.
Financial media will want to tie 2021’s market performance with double-digit earnings growth. Let me dispel that notion: The S&P 500 produced double-digit growth in 2019 when there was zero earnings growth, and it produced double-digit growth in 2020 when there was double-digit negative earnings growth. The last year the S&P 500 showed a down year was in 2018 when earnings growth was positive. The only discernible constant that influences market direction has been the US Federal Reserve, not earnings. The Fed’s directional influence has come with the consequence of ever-rising multiple expansion (record high prices relative to earnings and prices relative to sales…see chart below). I’ve highlighted this point for a long time, and I will do so again today as it is so incredibly important for understanding the current environment.
The overwhelming liquidity coming in from the fiscal and the monetary sides of the government has also kept any corrections limited. Indeed 13 months of consecutive new monthly record highs on the S&P 500 matched the 13 months of consecutive new highs of the Fed balance sheet (see chart below):
The only time any correction has occurred was during times when the Fed balance sheet either temporarily dropped or paused. The last time the Fed balance sheet failed to make new highs on a temporary basis was the fall of 2020 coinciding with the last 10% correction in the S&P 500. Hence the S&P 500 can be considered, in essence, a Fed balance sheet tracker.
I have been harping on the risk of stimulative monetary policy for years, and now my view is part of the official record as evidenced by this quote by ECB Executive in charge of market operations, Isabel Schnabel: “QE is inflating asset prices. Benefits of central bank’s bond buying program are ‘fading’, while it may cause ‘excessive risk taking.”
In 2021, excess liquidity created a problem – inflation. Inflation has been really hurting the poor, working classes and retirees, which are large in number and who vote. Hence, the 2022 market will have to contend with a Fed trying to finesse a reduction in inflation and the ultimate cessation of artificial liquidity flows. Just like the late 1990s tech-led speculative stock market had to deal with it when Fed chairman Alan Greenspan withdrew liquidity after Y2K. A lot of people, unaware of market dynamics and caught up in CNBC, got hurt.
It is important to be aware that after Y2K, when tech stocks crashed 80%, the Fed once again lowered interest rates and pushed in liquidity to assist the economy and investors’ wrecked retirement plan balances. But this time value stocks, foreign stocks, and resource producers, which had been unloved for the 14 years prior, skyrocketed and led the market for 10 years. Large company growth and technology languished. A reality that almost no one forecasted. Certainly not mainstream investors or Wall Street firms.
Since 2019 the Fed has added $5 trillion to their balance sheet, the ECB added $4.5 trillion for a combined $9.5 trillion. On the back of this cheap Fed- and ECB- sponsored credit, private lending in both the traditional and shadow banking systems exploded, adding fuel to the credit expansion and driving up most asset prices. Therefore, the rising prices we have observed in megacap tech stocks, NFTs and other speculations do not reflect fundamentals, but rather reflect 1) liquidity; 2) the career incentives of institutional investors; and 3) high levels of speculation by retail investors who are suffering declines in real wages and drive them to trade stock options on the side.
It is an additional concern, to me, that our central bank has, in effect, financed large government expansion (exploding debts and deficits that future generations will pay), consciously destroyed the wages of the poor and working classes, and destroyed the savings of many retirees who have no way to offset 7% cost of living increases in CDs and savings accounts. And it has enriched speculators as well as Wall Street and Silicon Valley firms that benefit from large-scale speculation.
Perhaps more alarmingly, the Fed itself has completely disregarded the incoming data. The once self-proclaimed ‘data-dependent’ Fed has ignored all data and ended up not only relentlessly continuing its balance sheet expansion, despite rapidly exploding inflation and very tight labor markets, it also has kept rates at 0%… entirely disconnecting its policy rate from all historic precedence in its relationship to inflation (see chart below).
The obvious analogy is that it keeps throwing fuel on the fire while insisting that the fire is ‘transitory’, a term that Jay Powell had to abandon and opt for a more rapid tapering in 2022 – and opening the prospect for rate hikes sooner than expected.
Let there be no doubt: The Fed flooded the system with money. Not only in 2020 during the depths of the Covid crisis, but it kept printing money like never before…even in 2021 when 1) inflation data was exploding higher, 2) US equity markets continually produced new record highs (71 new highs during 2021); and 3) as jobless claims dropped to their lowest in 50 years.
Let there also be no doubt as to the consequences: First, the largest disconnect of the relationship between asset prices from the economy ever, closing the year at a record 210% market cap to GDP -- Warren’ Buffett’s favorite measure (see chart below):
And second, the other important consequence -- the most distorted wealth inequality ever… with inflation devaluing the meager savings and wages of the poor and working classes. And people at the top of the wealth spectrum enjoying investment prices explode higher. This dynamic has heightened the risk that reigning in the credit bubble has set the stage for the next recession as the Fed is now forced to fight the entrenched inflation that it has denied existed in the first place.
We believe the 2020s, overall, will be a challenging decade for the investors who are still positioned in yesterday’s winners, and who actively ignore fundamentals and valuations. Challenging as well for those who are blissfully unaware of the situation in which the Fed finds itself. Adding to the risk in yesterday’s winners is the fact that the majority of both amateur and professional investors simply chase performance and do not understand or care about the risks they own.
As such, there are now phenomenal opportunities for investors that focus on value. Highgate advocates a practical approach that emphasizes fundamentals within a geopolitical and historic context. To this end, for the companies in which we invest, we focus on asset quality, economics of the business, corporate governance, growth strategies and finally the price we pay. At the moment there are many stocks that trade cheap and carry huge upside potential with limited long-term price risk.
The advantage of an investment process like Highgate’s is that because our focus is on safety of principal and the value of what we own, we believe we get the double-benefit of 1) not having to sacrifice returns; and 2) carrying significantly less risk than most investors who closet-benchmark or chase performance. When markets become adverse, we are not likely to suffer the painful declines that those who own the most popular and expensive stocks will. And if we can limit declines, we will have much higher average returns.
Thank you for considering Highgate Securities Investments to help meet your investment goals. We can be reached at 303-968-1230, or by email at email@example.com. You can also visit our website at www.highgatesi.com. We are happy to perform a no-obligation, objective portfolio evaluation for you.