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| The twelve members of the Federal Open Market Committee hold incredible power over the stock market’s 2022 performance. They next meet on March 15th and 16th and are expected to modestly raise interest rates and provide a blueprint for reducing the balance sheet. [Image ©bas121/ Adobe Stock. Modified for The Ignorant Investor: www.theignorantinvestor.com] |
What kind of glib entry can we start this post off with today? The world has become a grimmer place with social media images of a Russian tank crushing a civilian car – with the civilians inside, no less – and urban street battles between Russian and Ukrainian armed forces. Then that ominous smoke following an attack near an active Ukrainian nuclear power plant just several days ago. Yes, this is 2022, but the entire outlook of this bright “new normal” has changed, even as mask mandates are being lifted across US cities. Let’s address the elephant in the room (Ukraine) at some later point. For now, let’s focus on the stock market.
The stock market has suffered from months of weakness starting in December of last year as the darlings of the huge Covid-19 stock market boom (ie growth stocks) sold off (*gasp*) as sky high inflation stoked now-realized Fed “triple threat” fears (more on that below). If you look across an array of Nasdaq-listed companies, you’ll find a boneyard of stocks that are thirty, forty, or fifty percent off their 52-week highs! Of course, this doesn’t mean there aren’t outperformers. The S&P 500 component leader from 2021 has been a shining star, a bright green sector in a sea of red as a Who’s Who of energy companies move ever higher in sympathy with higher oil prices and matching supply fears. The Ignorant Investor has started putting sidelined cash to work in *select* companies (yes, even some quality growth names) on the suspicion that the heavy selloffs are perhaps overdone as may well be evidenced in the second half of the year.
Let’s look at the broader market conditions that will influence 2022 performance.
2022 Themes: First Half of the Year
“It’s the dollar, stupid!”
Or, in this case, a shrinking supply of many billions of dollars as the Fed’s “triple threat” is realized: supportive stimulus measures cease, interest rates are raised, and the bloated balance sheet is offloaded (note that in talking about the Fed, we are also directly talking about those Treasury yields you keep hearing about on financial talkshows!). This is likely the primary driver to the stock market selloff, with the Ukrainian conflict initially acting as a smokescreen and excuse for market weakness (this is fluid and has been changing in recent days as commodity/sanction risks resulting from the Ukraine invasion spill over into other markets and the real economy). After all, the spectacular stock market gains of the last two years have been on the back of incredibly strong monetary support coupled with some stimulus spending. The music has now stopped playing and investors face a world with 1) inflation near 40-year highs 2) a Fed aggressively shrinking the money supply to combat that inflation. All those stalwart growth stocks that have been the big winners over the past several years begin to look a whole lot less appealing against that backdrop. A good illustration of this can be seen in recent earnings reports: tech stocks that beat expectations have been flailing and tech stocks that miss have been crushed by steep selloffs a la Snowflake.
“Inflation is taxation without legislation”
These wise words courtesy of Milton Friedman emphasize why high inflation really is problematic. And the guardians of our money supply (ie Fed) work diligently to keep inflation low- although this hasn’t really been a challenge for the past twenty or so years. However, inflation readings hovering stubbornly around the 7% range (annual reading and near 40-year highs) will only be further exasperated by the higher energy prices sparked by the Ukrainian conflict. Of note, those wage gains we’ve been seeing in employment reports have been less than inflation numbers, indicating that the average worker seeing a five percent and change raise because of tight labor market conditions is still losing buying power every year. High inflation readings are also bad news for parts of the stock market as demonstrated by “smart money” fund flows away from growth and into cyclicals in recent months.
“Speak softly and carry a big stick”
Winston Churchill’s advice worked well in WWII and has continued to be the mantra well into 2020. The only difference now is that multiple adversaries now carry big sticks and big chips on their shoulder (Europe will soon be expanding their military capabilities as a result of recent Russian action). This is just another way of saying that geopolitics are here to stay and must be carefully considered by investors allocating their capital across markets. Until more clarity is available, The Ignorant Investor is quite content to stay invested in domestic-facing US companies. Economic data remains quite solid after all. Do keep in mind that cyberwarfare is to be expected- and note that “Russia” briefly compromised even the Nasdaq stock exchange twelve years ago (see one of our earliest posts on the topic here; this has now been mitigated on all major exchanges through air-gapped daily backups of positions of all market participants).
“Be fearful when others are greedy and greedy when others are fearful”
As stated by none other than Warren Buffet (who lives out his advice- he or his lieutenants apparently took a $5 billion position in Occidental Petroleum last week). Following such heavy and indiscriminate selling of recent months, The Ignorant Investor suspects that incredible value can now be found in many areas of the market. Many fears remain, however. For sake of brevity, we will gloss over some of the big ones which include:
- Skyhigh energy prices leading to stagflation and global recession
- Nuclear security degrading in Ukraine through the fog of war
- Contagion of geopolitical conflict should European weapon systems flowing into Ukraine from the West substantially damage Russian military
Volatility feeds off all these potential scenarios, explaining the massive daily – and intraday – swings in US equities. The Ignorant Investor is very careful in even trading positions as the factors driving market actions remain highly fluid. This fear should subside by the second half of 2022 as clarity across the spectrum improves.
A brief look at energy markets
Energy security is suddenly at the forefront of everyone’s mind as Russia, the third largest oil producer and a member of OPEC+ no less, faces increasing sanctions. Should the country decide to taper back fuel supplies to Europe, or should the West decide to sanction Russian energy supplies, then Europe will face a near-impossible situation of trying to find alternative fuel supplies in the waning winter.
While the broader commodity markets have been upended by the Ukrainian conflict (fossil fuels, the price of foodstuffs like wheat, and even metals like aluminum are moving around), let’s focus on energy producers. The underlying energy company stocks themselves have had a more muted reaction. Part of this is institutional investor wariness- they have been burned again and again by energy companies behaving badly over the past decade (executives demonstrating poor judgment by spending wildly in BOTH the boom-and-bust times which led to widespread bankruptcies and underperformance in the sector). Another part is that if oil prices get too high, demand destruction occurs as some industries are priced out or move on to substitutes. This doesn’t mean that opportunities don’t abound for the discerning investor working in close consultation with their financial advisor, however. Also, some of those quality renewable energy companies that have seen nothing but selling for months now suddenly look darn appealing!
A Deep Dive into the Russia-Ukraine Conflict
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| The end of a beautiful day as the winter sun sets over the city of Kyiv, the capitol of Ukraine [Image ©slava2271/ Adobe Stock. Modified for The Ignorant Investor: www.theignorantinvestor.com] |
This is 2022. Why would a powerful sovereign nation invade a small sovereign nation at its border, unprovoked and without a prior attempt at dialogue to resolve differences? Europe struggled to find a rational answer and many people and nations across the globe are perplexed and appalled by the Russian invasion of Ukraine. Are the Russian actions predictable and understandable? The answer here may well be yes. Does this make it justifiable or right (especially without trying diplomacy first)? The answer is almost certainly no.
In January, The Ignorant Investor fielded numerous queries from various acquaintances and working professionals about whether Russia would invade Ukraine. My answer was invariably “quite likely”; this primarily due to absolute European dependence on Russian gas in the dead of winter (yes, the US has some small imports, but Europe would likely face outright “war level” energy shortages if Russian gas imports were halted), a hesitance from the US to create potential conditions for WWIII, and an aggrieved Russia seeking to make its historic alliances “whole” again. After all, Russia has openly telegraphed its displeasure with a westward expansion of NATO for more than twenty years- even acting militarily on that displeasure on two previous occasions in Georgia and Ukraine (Crimea), respectively.
The response? A united front of global countries unleashed severe sanctions against Russia, including the somewhat controversial move to freeze Russia’s extensive FX reserves. But absent broader conflict stemming from mass killing of civilians by Russia or the West unilaterally sanctioning Russian energy, the Ukrainian war will have little effect on US companies. Russia will of course feel the need to retaliate against the US and Europe as its citizens will lose access to global assets and will struggle to even travel outside its borders (currency exchange and bank and credit activities have been halted for Russian citizens, remember) and this will likely be in the cyber realm. Hacking activities could be used to devastating effect but will likely be limited to reduce the chance for tit-for-tat Western retaliation (in a hail back to the early days of this blog, here is a post about how Russia likely planted a digital bomb capable of taking down the Nasdaq in a proof-of-concept hack; the hack was fully implemented in 2010 but never executed).
A Walk Through Time
The Ignorant Investor is an avid student of history, holding to a strong philosophy that we as humans are not nearly as smart as we think we are (myself included), and that events that have occurred in the past are quickly forgotten and often repeated because of that forgetfulness. With this backdrop, I thoroughly enjoyed “Munich: The Edge of War” in a viewing last year and found the parallels to February 2022’s flurry of diplomatic activity uncanny. Once again, the great powers (in 2022, Russia, United States, European Union; in 1938, primarily Germany and England) sat around a table discussing the fate of another small nation (in 2022 this was Ukraine; in 1938, Czechoslovakia) without any representation from that small nation. The larger aggressor in 1938 ended up swallowing up the smaller nation as the rest of the world watched. All sorts of treaties and agreements in both cases created a web of confusion, but the result this time around will likely be a similar fate for the smaller nations, although unlikely to result in a world war (the actual events around the military buildup, Great Powers negotiations, and invasion appeared to parallel history).
