By: Jeff Anderson, CFA
|Close||Weekly return||YTD return|
|US Treasury 10yr Yield||3.13%||-10.3%||160.5%|
Source: Wall St. Journal
The major US equity markets posted strong gains this week, notching gains of 6% or more. The yield on the US 10-Year Treasury Note subsided, dropping 35 basis points from its peak last week (the day before the Fed hiked interest rates). It’s been a nice reprieve from the drubbing investors have endure this year.
The University of Michigan Consumer Sentiment Index posted its lowest level on record, dropping to 50. That is lower than 2009 and 1980, when inflation was near its zenith (see chart). We’re in a dour mood for sure. Yet, the university revised its inflation expectations down over the next five to ten years from 3.3% to 3.1%. This revision, according to the Wall St Journal, “fueled some optimism that the Fed wouldn’t be as aggressive about hiking interest rates.” So, last week, the Fed hiked rates by 75 basis points vs their original intention to raise it by 50 basis points. The market didn’t love it last week. This week, the market corrected that pessimism. There are hints of optimism that inflation may come down faster. We’ll likely experience more of this flip-flopping in expectations in the coming months. Supply chain constraints and the Russian invasion of Ukraine have kept inflation stubbornly high longer than most people feared and there is no consensus when either will be resolved.
Historically, consumer sentiment peaks with market peaks and bottoms around market bottoms. It doesn’t really lead, nor lag the market. It’s more of a coincident indicator. Nonetheless, a reading of 50 is low. Very low. Having to endure a global pandemic and 40-year highs in inflation are enough to make anyone pessimistic.
So, here we are, seven plus months from the US stock market highs, and the drumbeat of a looming recession is growing louder. The first quarter’s earnings were strong, yet the market was declining. Why? The market is always 6 to 9 months ahead of the economy. We are likely in a cyclical market correction that could last the year, or longer. Earnings may have peaked. If we do in fact fall into a recession, earnings will fall. The equity markets will start moving higher 6 to 9 months ahead of the bottom in earnings. So, let’s remember to separate the two. Let’s not be confused by the market’s direction and the economy. Fixed income is starting to act rationally again. As bonds mature, they can be reinvested into higher yielding equivalent securities. And, when bear markets end, it creates higher expected returns going forward. It is nearly impossible to avoid temporary losses when investing in risk assets. Diversification is key, even when periods like now test the very definition of it.
Facebook, Netflix, and PayPal are Value Stocks:
These three companies, long the darlings of the growth / momentum bull market of the past decade have been tossed into the value camp. Netflix, the company that put Blockbuster out of business and disrupted the way we consume video content, may have run out of their ability to grow. They are no longer a disruptor. Competition is fierce and the consumer is looking for ways to cut spending. PayPal, also a disruptor in the payment space has suffered the same fate. Facebook, now Meta, the OG of social media is also under intense competition. These companies aren’t dead, but the decades long growth trajectory is likely over. Not long ago, Facebook was part of the top 10 holdings in the Nasdaq 100 Index. Now it is being added to a Value Index and politely told to leave the Growth Index. That is creative destruction. Companies can’t dominate forever. That’s how capitalism works. Do something really well, and competitors will come in droves.
So, now they trade for much lower valuations and fall into the value camp. If you own the Nasdaq 100 ETF, what does that mean? It means other companies that fit the growth definition will replace them. If you only owned Netflix, for example, its fall from its peak would have absolutely devastated your portfolio. If it was part of an ETF, it would not be nearly as bad. The underlying holdings of an ETF or Mutual Fund will change over time. Their time in the sun likely helped generate the returns of those funds but the future return of those funds will be dominated by new companies. That’s capitalism at work.
Here is a visual showing the size of Facebook and Netflix in 2020 relative to the average S&P 500 company.
Facebook’s market value currently is $460 billion while Netflix is $84 billion.