State of the
Market | Take Refuge in Fundamentals | Stories of Note
 |
| Riding the roller coaster of the stock market in 2022 hasn’t been this much “fun” in fifty years (statistically-speaking, of course!)! Thrilling, scary, and gut-wrenching are good descriptors for this ride. [Image ©artisticco/ Adobe Stock. Modified for The Ignorant Investor: www.theignorantinvestor.com] |
The investment emotions of the last six months have certainly reflected the best and scariest roller coaster rides The Ignorant Investor has ever experienced! And did anyone truly expect that anything could rival the dark months of 2020 (from an investment perspective, that is)? Deep, terrifying selloffs that never seem to end. Breathtaking rallies (a la energy and certain “quality” growth names). Boring yet profitable range-bound trading. And yet more uncertainty ahead. Or is there? The stock market is usually a forward-looking thing, after all, and while no person alive – whether investor, analyst, or economist –may be able to accurately predict what will happen by next week, let alone next month, the next year is slowly becoming clearer. But before we look ahead, let’s quickly summarize what is behind us.
The damage to the stock market - stemming from a plethora of concerns - has been quite substantial over the last six months. From the beginning of the year to the end of June, the S&P 500 fell almost 21%. The Russell 2000 fell nearly 24%. And the perennial outperformer, that champion of growth, the Nasdaq fell 30%. Peruse the stock market wreckage more closely, and we can find numerous lockdown darlings have been recently trading at 70%, 80%, and even 90% below their 52-week highs. This isn’t to say that other risk assets performed any better- after all, bitcoin is down about 55% over the same period.
Many of The Ignorant Investor’s stalwart indicators flashed buy signals for many months even as the market this time around ignored them and turned every lower. While not something we typically favor, stop-loss orders can be quite helpful in select situations! We now find ourselves in an unfamiliar environment for a large percentage of analysts and investors. After all, inflationary pressures have been almost nonexistent since the so-called dot-com selloff at the turn of the millennium. Anyone under the age of fifty will have limited experience of market volatility and tendencies in a rising interest rate environment like the one we are facing today. Still, as this last week’s market activity has shown, stocks are cheaper than they have been in years and great “diamonds in the rough” opportunities – perhaps even generational opportunities – abound. This doesn’t mean that this whole beaten-down market is a buy; merely that select companies in select industries look quite appealing to The Ignorant Investor.
Per the usual, some (many?) analysts have been lagging the market quite broadly this year with their company assessments, downward-revising price targets following stock price declines as they adjust their core investment theses [“Oh, hey guys, you know that company that just sold off sixty percent from the level where we issued our buy recommendation? Yeah, we think you should sell that.”]. Perhaps some of those “sell” calls on quality companies may actually be a contrarian buy? Good investment advisors will be able to help identify some of these opportunities.
Inflation is Driving Fed Action: Take Refuge in Fundamentals
 |
| Fundamentals are key when uncertainty abounds! [Image ©Funtap/ Adobe Stock. Modified for The Ignorant Investor: www.theignorantinvestor.com] |
Remember in the 2020 and 2021 boom times, The Ignorant Investor continually lauded the wartime level of Fed support as being a big driver of the stock market action? Well in 2022, we are seeing the results of the Fed unwind that same action- steadily hiking interest rates and reducing the balance sheet as it strives to shrink the money supply and slow economic activity. Thankfully, the USA has benefited from an extremely tight labor market – with some estimating that nearly two jobs exist for every unemployed American – which has allowed the Fed to directly tackle rampant inflation through interest rate hikes.
Inflation, then, is the driver of Fed action and the primary culprit behind US market declines. Inflation is a thief that benefits no one. High inflation pressures both consumers and companies: consumers by reducing their spending power and eating away at their savings; companies by forcing prices higher while pressuring margins and hence moving profitability lower. But the driver of inflation here is a combination of changing consumer spending behavior, supply chain pressures as well as high energy/food prices. Supply chains are very slowly sorting themselves out (remember the former chip shortages, anyone?) and high energy prices will eventually move lower should peace return to Europe or production increase meaningfully; these drivers of inflation are indeed transitory. This means that the dirty secret here is that the Fed is in the unhappy position of forcing changes to consumer demand by basically destroying excess consumer demand to better match current beleaguered supply. The Fed’s tightening policy is currently driving investors back down the risk curve (see the recent crypto market collapse, for example), but ultimately, this painful process will at least achieve in the desired effect of taming inflation.
For now, the Fed remains “behind the curve” and some market participants expect the Fed to overcorrect (raise interest rates too fast and too far) in its efforts to dampen inflationary pressures, which could result in recession. This raises questions. Are we in a recession since economic activity, as measured by GDP estimates, may well have fallen for the past two quarters? Is recession coming now that Treasury yields have once again inverted, with the 2-year hovering above the 10-year? How can we possibly be at the cusp of a “real” recession when the employment market remains incredibly tight and neither consumers nor businesses appear to be struggling to meet financial obligations? This is why authors of financial articles are divided: some arguing we are in a recession; some say a recession will come later this year; or others that a recession will arrive in 2023. And what if Putin were to shut off gas supplies to Europe as a byproduct of the Ukraine-Russia conflict? US markets surely would not be immune to contagion effects.
Uncertainty is outside of our control. But as investors in a forward-looking market (ie the stock market), we need to look beyond the uncertainty and try to identify companies that will be more valuable a year from now than they are today. And if our thesis is correct, then the company’s corresponding stock price should also increase in value as the next year approaches. Yes, earnings estimates may be close to peaking, but sectors of the market still appear to hide value relative to historic valuations by various mainstream metrics. Yes, a recession may indeed come. But the entire stock market has sold off, and there surely is value among the rubble. A year from now, when inflation is falling and the Fed is less hawkish, then The Ignorant Investor is willing to posit there may well be strong performance from these beaten-down names.
All this can be summarized by saying that life goes on, and companies with strong balance sheets, solid income, and a compelling story will likely still be around next year and the year after that. Finding quality names that will withstand potential downturns, while perhaps speculating on some of the quality “story” names with slightly shakier fundamentals, will likely pay off quite handsomely, if not in 2022, then in 2023 or 2024. We are investors after all, not traders!
And again, as always, if you are interested in unlocking this value, be sure to coordinate closely with your financial advisor to come up with a buy list of quality companies that may be on sale today!
Stories of Note
More Acquisitions Ahead
Not so much a story as a potential theme. Elon Musk makes a tentative offer of $44 billion for Twitter before expressing a strong desire to renege on said deal (a messy lawsuit and court ruling will determine what happens next). Merck nears a purported $40 billion agreement to acquire Seattle Genetics- erm, excuse me, I mean Seagen. From way back in January, Microsoft bought up Activision Blizzard for nearly $70 billion. Each of these companies (and in the cases above, one person) are making these acquisitions for a variety of reasons, but at the core, the acquirer sees more value in the company than the stock market does- which is why they pay a premium to own said companies. These disconnects are more common than you might guess, but an acquirer is necessary for an acquisition to take place- cash rich companies are likely on the hunt in the rubble of the current stock market and will likely move quickly once uncertainty around inflation and the economy starts to clear up.
The Buffett Effect
Several years ago, The Ignorant Investor took note (in a previous article on this blog), of the highly favorable terms Warren Buffett received from Occidental Petroleum in return for staving off hostile bidders and shoring up the company’s financial position during crisis. There is no doubt that Berkshire profited handsomely from the deal. Now, since the beginning of 2022 (and even more so since energy pulled back from recent highs), Berkshire has again revisited the energy company. Berkshire this time is operating on the public equity side of things by buying up nearly 20% of the company through the first week of July. Speculation has been growing that as oil and gas producers spew out huge amounts cash – with a potential runway of many months to come – and continue to trade at relatively cheap (ie low) multiples, buyouts may be coming. And perhaps Warren Buffett through Berkshire Hathaway has his eye on Occidental Petroleum.
