The equity market, like the economy, is cyclical. It goes through long periods where certain macroeconomic or business trends lead to meaningful performance differentials for various market sectors and companies.
After a long bull market, driven by low interest rates, technological innovation, high profit margins, and lush corporate profits, the economy and the equity market seem to be in a transitionary period driven by changes in the economic environment. Meaningful changes in the relative performance of various sectors of the equity market have developed over the past year, and they seem poised to persist.
After many years of disruptive change, driven by technology, globalization and extraordinary monetary policy (negative interest rates and enormous bond buying), 2022 has been a year that can be characterized as a reality check or a return to the old normal.
After more than a decade of extraordinarily supportive financial conditions, global central bank policies have changed dramatically to a much more restrictive stance in order to combat the economic challenges presented by surging inflation. Sharply higher interest rates have been the material catalyst driving dynamic change in the stock market, not just in terms of eliciting a general bear market, but also in terms of changing market leadership and dispersion of returns.
A time of change
Highly accommodative monetary policies, disruptive technologies, and a global pandemic set the stage for some very new, if not strange, developments. Interest rates not only fell to levels that had not been seen in hundreds of years, but, in many countries, fell to negative levels that investors had never experienced before. Valuations for many growth companies, regardless of profitability, ballooned to levels that were equally hard to comprehend.
Valuations for some small, struggling companies that caught the attention of social network investors (aka “meme” stocks”) went to absurd levels, while the multitude of crypto-currencies and non-fungible-tokens (NFTs) spiked to soaring values that seemed to be driven less by financial conventions than by trend-following and FOMO (fear of missing out).
Interest rates and bond yields are now valued at a more normalized level given the realities of inflation. Valuation for the stocks of many mega-cap, high-growth companies have been slashed, leading to sharp price declines. Finally, the rose-colored metaverse goggles that many investors had been wearing have been removed, showing that prices for many assets related to the burgeoning crypto financial industry had been supported by augmented reality.
As interest rates and bond yields rose, investor expectations also changed, but to a lower, more risk-averse attitude. This has led to key dynamic stock market trend changes which are likely to persist into the new year and beyond:
- Corporate earnings expectations are now declining. The realities of inflation and a possible recession, with their combined impact on corporate profitability, are slowly being factored into earnings estimates. Higher wage and input costs are expected to pressure profit margins and earnings. Companies are now shifting from a growth mentality to a cost-management mentality. Uncertainty over earnings will be a discordant theme going into the new year. Diminishing earnings expectations will be a muting influence on overall equity market returns.
- Stocks of companies that exhibit old normal factors related to value, lower volatility, return on equity, and higher earnings and dividend yields have vastly outperformed the broader market in 2022. With higher interest rates and economic uncertainty (risk of recession), this trend will likely continue until rates sustainably roll over.
- The long bull market concluded with an increasingly concentrated group of stocks that were driving broader market returns. The extreme narrowness of the market proved to be a problem when some very large companies, such as Netflix, Meta (aka Facebook) and even Amazon, suffered price declines of 40 to 70%. Recently, market breadth has improved, and a much more diverse group of sectors and companies have begun to outperform the broader market.
- The Technology sector has decidedly relinquished the equity market leadership mantle it has enjoyed for more than a decade. After years of lagging relative performance, stock market value sectors, such as Energy, Consumer Staples, and Industrials, have performed dramatically better than the overall market over the past year. More recently, even as bond yields have declined (which typically benefits the high growth technology sector), these value sectors continued to significantly outperform the growth-oriented sector of the market. They have also been joined by other value sectors such as Financials and Utilities. In short, the shift in investor attitude toward more reasonably valued diversified industrial sectors, rather than a singular focus on technology and growth, seems to be a longer-term persistent theme.
- Small and mid-cap stocks have been outperforming large cap stocks over the course of 2022. However, this improved performance may be due more to industry composition and a domestic focus rather than size. Still, after years of lagging large capitalization stocks, this trend of small and mid-cap companies generating more attractive relative returns seems poised to persist, but only for those companies with proven and sustainable business plans that generate a compelling return on capital and maintain solid balance sheets.
- International stocks, and especially emerging market stocks, have offered exceedingly disappointing returns for a number of years. A key reason for this has been the dramatic appreciation of the U.S. dollar relative to other global currencies, as well as fundamental economic and market problems abroad. However, both the value of the dollar (very high), and the relative value of international stocks (very low), have reached extreme levels. Recently, the U.S. dollar declined sharply, while international stocks fell to valuation levels that are difficult to ignore. Investor attitudes toward the international sector appear to be changing, with relative returns for this more volatile sector of the market improving throughout the year.
Equity markets tend to go through long cycles as economic, business and investor behaviors change. These cycles seem to persist for about a decade and tend to conclude in some form of excessive speculation. Subsequent new cycles are usually characterized as a return to traditional business and financial virtues. They often involve a renewed focus on sectors or companies that have solid long-term fundamentals, visible earnings, clear policies of returning capital to shareholders, and rational valuations.
Although transitions from one cycle to another can be unnerving in the short run for investors, they are good for the long-term health of the markets and the economy. They are also good for investors who exhibit the time-honored virtues of patience, discipline, broad diversification – and who remain committed to a plan, even during turbulent times.