I was interviewed this week to talk markets and answer tough questions on recent volatility. The conversation is transcribed below.
Pundits are blaming rising interest rates for this selloff in growth stocks. Do you agree?
Rising interest rates are probably not, on their own, a dark omen for growth stocks. In fact, the data overwhelmingly show that periods of rising interest rates tend to be good for both growth and value. What would be more of a problem for growth stocks is if the economy stalled, but I don’t see how the Fed moving rates up from zero to half a percent or even a full one percent this year does that.
Here’s a fun fact. Right now, consumers have an extra $2.4 trillion in excess savings just sitting in bank accounts1. That’s trillions with a “t.” Add in rising wages and pent-up demand for services like travel and going out to eat, and the outlook for spending looks robust. Maybe not as good as a year ago when the government was paying people to not work, but still strong.
That being said, I do think rising interest rate fears are driving a lot of the volatility. LPL Financial recently published a report that showed the performance of the S&P 500 over the next three, six, and twelve months after the first Fed interest rate hike going back to 1980. While the performance has been a coin toss in the near-term – only 50% of the next three months were positive - investors patient enough to stay invested for a full year were rewarded 100% of the time with an average gain of 11%2. Meaning, turbulence is common during a major shift in monetary policy, but it’s also been temporary.
Why do you think it’s temporary?
The Fed raises interest rates because the economy is getting stronger, not weaker. It’s only at the very end of a rate hike cycle when the Fed is likely to screw up. More specific to growth stocks, rising interest rates tend to have little impact on the fundamentals. Sectors like technology aren’t overly reliant on debt, nor does the 10-year yield materially impact revenues.
Think about it this way. Do you think people are going to uninstall their operating systems and cancel their Netflix accounts smack dab in the middle of Ozark’s new season - while Stanford grads bypass tech to work on oilfields - all because the 10-year yield could hit 2% by March? Come on.
Fair point. But if it’s not the fundamentals, then it must be valuation, right?
Correct, and there are two theories as to why valuations have gotten hit. The first is a rising 10-year yield lowers the value of future cash flows of growth companies. That’s too technical of an explanation for times like these, and it reminds me of my favorite quote from Jim Grant:
"To suppose that the value of a common stock is determined purely by a corporation's earnings discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defense of Joseph Stalin and believed Orson Welles when he told them over the radio that the Martians had landed.”
Nice quote. And the second theory?
I think a lot of traders saw large swaths of growth stocks as being priced to perfection coming into 2022, and now they’re running for the exit at any sign of weakness. Look at what happened recently to PayPal and Facebook. They were massacred – both down over 25% in a single day – for missing expectations. Combine this with the perceived safety of value stocks as rates climb higher, and the Nasdaq corrected.
What do you mean by “corrected?”
A “correction” is a drop of 10% or more in the value of an index. A “bear market” is a drop of 20% or more. Corrections happen almost annually and stick around for a few weeks, and bear markets about once or twice a decade. I wish both happened more often because they’ve historically been phenomenal times to buy more stocks.
Thanks. Please continue…
Right, so if I’m holding growth stocks as a trade – meaning I’m less concerned with the long term and more focused on valuations today – and I’m up big over the last year or two, selling growth and rotating to value sort of makes sense. Even though value is also getting hit right now, on a relative basis it’s outperforming. So, all this chatter of a rotation from growth to value, the 164th time we’ve heard this since 2016, is once again getting airtime. Value is finally having its day in the sun!
I’m sensing sarcasm.
As David Spade brilliantly said in Tommy Boy, “Well I should hope so because I’m laying it on pretty thick.”
I just can’t see how all the innovation, earnings growth, and cash flow generation from tech is somehow rotating to other sectors. Seriously, how can anyone with a straight face argue that advancement in oil drilling or loan creation will change the world over the next decade?
If this is just a trade, when will it reverse?
At some point, those who left tech for greener pastures could eventually realize that they own some lower growth sectors that are no longer as cheap as they used to be. After a few earnings reports, they may remember that monopoly profits are more attractive than razor thin margins and debt-laden balance sheets. If so, these same investors may flock back. I think this will happen like the 163 other times before this one, but I don’t know when.
I do know that I want nothing to do with this “growth to value and then back to growth” trade because I view it as being riskier than doing nothing at all. You must sell, pay taxes, trade into “cheaper” sectors, then shift back to growth and potentially pay taxes again. But that’s not even the hard part. You must nail the timing or else.
So, is this just a dead cat bounce for value stocks? Is it time to cancel value investing?
Not at all. In fact, we own value stocks. Both styles have their place in a diversified offering, and I’ve written ad nauseum about the absurdity of pitting growth against value. It makes no sense to say a Porsche is better than a minivan without first asking what it is going to be used for.
That’s why I’m not implying growth is better than value, but rather the fundamentals of growth stocks do not appear to be shifting to value stocks. Therefore, we see little reason to participate in a trade that is solely based on predicting changes in sentiment.
Then what are you doing? If corrections are such great buying opportunities, are you “backing up the truck” as we speak?
Three points here. First, I wish we could be buying right now, but we’re already fully invested across most of our strategies. Had we kept cash on the sidelines waiting for a correction, we would have almost certainly lost out on the incredible gains over the last 18 months. Not worth it in the long run.
For example, since we’re talking growth stocks, the Nasdaq 100 is down around 9% since its last peak back in November, but it’s still up over 45% since July of 20203. Had we sat in cash waiting for a correction, it’s hard to say we could have done better.
Second, this job is about anticipating the anticipation of others. Back in June of 2020, we were talking loudly about inflation and how it was developing in a way we hadn’t seen in a long time. By the end of the year, we’d positioned our diversified strategies to prepare for inflation, even though we weren’t exactly sure when it would arrive.
The same applies to today. We’ve been preparing for rising interest rates for some time, but we take a migratory approach to adjusting our allocations because (1) the economy moves slowly, and (2) it’s a form of risk mitigation. We don’t want to get too cute and make extreme moves because we pretend we have some crystal ball.
Because if you think guessing the direction of the stock market is hard, try interest rates. Several prominent funds got hammered last year betting on the direction of sovereign yields4, so keep that in mind the next time you hear someone say they know where rates are headed. But don’t take my word for it. Peter Lynch said it best:
"If anybody can predict interest rates right three times in a row, they’d be a billionaire.”
Third, we are making adjustments based on fundamentals and put less weight into valuations. Not no weight but less weight. There’s no question that several growth stocks were expensive coming into 2022, but these corrections along the way fix that. Expectations cool while sales and cash flow keep growing, and this cycle creates the foundation for the next wave of growth.
Said another way, we focus more on cash flow news and less on discount rate news.
You’ve alluded to sitting in cash as “losing money safely.” Now that rates are rising, is this situation getting any better?
Deposit rates are based on supply and demand, and since the Fed flooded banks with so much cash in response to COVID, the U.S. banking system has trillions in excess reserves. This is cash in vaults that banks don’t need, so I don’t see them paying more for our deposits anytime soon.
Money market funds and other cash investments typically respond quicker to interest rate hikes, but after the financial crisis, these funds reduced fees to ensure that investors did not lose money in an era of rock-bottom interest rates. Now, when rates rise, so do fees. Hence, the net return probably won’t change much even if yields move higher. Oh, and then there’s inflation. Cash investments haven’t beat inflation since 2007, and that’s unlikely to change.
Speaking of inflation, can stocks continue to protect against inflation this high?
Amazon announced last week a price increase on their Prime membership, and the stock exploded. It literally was the largest single-day market cap gain in the history of the stock market5. This week, Chipotle announced it is raising prices AGAIN. They’ve raised prices so many times over the last year that I’ve lost count. The response? Stock surges over 10%6.
But not all are doing well. Clorox recently reported that they are dealing with cost pressures, and the stock tanked 14%6. That’s because they sell bleach, while Chipotle sells fresh food to mostly price insensitive consumers. So yes, stocks can protect against inflation as long as they can raise prices and keep customers.
But some of your picks haven’t been doing so well. You mentioned Facebook. Do they not have the pricing power you expected?
Facebook is a legalize monopoly with incredible pricing power, but that hasn’t saved them from “short-termism.” That’s Wall Street’s misguided preference for buying a fancy car today rather than investing for tomorrow. Those who sold Facebook last week prefer the former, while I vastly prefer the latter.
I invest in companies, not stocks. In doing so, I see one of the strongest management teams out there that is forgoing profits today to invest in its future. They’ve also got a strong track record of overcoming hurdles and executing big transformations. This mindset exposes me to the occasional “earnings report temper tantrum,” but I don’t view this as a real risk.
One more point here and then I’ll shut up. Monster Beverage is the top performing company in the S&P 500 over the last 30 years. It’s up something like 260,000%, so a $10,000 investment in 1992 would be worth over $26 million today. But you’d have had to endure an 88% drawdown that lasted 6 years and a couple more 50% multi-year drawdowns as well7.
I’m not implying that Facebook is the next Monster but rather the difference between investing in companies versus stocks.
This newsletter/commentary should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.