What’s Happening With Markets?

Markets have been falling through the year, and despite some encouraging rallies the trend so far has been decidedly negative. The NASDAQ Composite, one of the three big indexes heavily tilted towards technology companies had a -23.86% YTD return as of Monday, May 16th, a minor recovery after it had reached a low of -27% on Thursday of the previous week. The Dow Jones and the S&P 500 have YTD returns of -10.31% and -14.82% respectively. The question for investors is “what to do?” in such markets, especially after some of the best years despite the pandemic.

A closer inspection of the markets however shows that while there have been some steep sell offs reflected in the broad market, the real market declines have been far more concentrated. And while there are many different market headwinds to choose from when it comes to reasons for the recent selling action; inflation, interest rates, geopolitical strife, COVID-19, maybe even Elon Musk, the sector that has been sending markets lower has been the tech sector.

Over the past couple of years the companies posting the biggest gains in the markets have been tech companies. Apple stock (AAPL) was up 88.97% in 2019, 82.31% in 2020, 34.65% in 2021, and is down -11.6% so far in 2022. Amazon (AMZN) was up 76.26% in 2020, and has fallen -30.18% this year. Facebook, now META Platforms (FB) gained 56.57% in 2019, 33.09% in 2020, 23.13% in 2021 and has lost -38.08% in 2022. Netflix was up 67.11% in 2020, and a further 11.41% in 2021 but is down -68.74% this year. Tesla, which had an astounding 743.4% gain in 2020 and another 49.76% return in 2021 is so far down -17.36% in 2022, how long can it resist gravity? (All prices and YTD performance were collected from ycharts.com on May 6th, 2022).

I predict that we may never fully understand how the pandemic changed thinking and why stock prices climbed so much, but the reality was that many tech companies benefited from people staying home, going online and the changing priorities that coincided with not having to be in offices and commuting. Tech companies that became huge like Shopify (SHOP), which allowed traditional retailers to become online retailers, benefitted immeasurably from the lockdowns. But it too has seen its stock decline this year by -69.59%, pushing the price back to where it was in December 2019.  

Because the tech sector has become so large, particularly in the NASDAQ, the retreat of these companies carries big implications for indexes and by extension the wider market as well. As markets fall, it encourages investors to panic sell, aided and abetted by the army of computers that help multiply the effects of momentum selling. This is especially true as investors have migrated to low-cost passive index ETFs, a trend so noticeable that experts worry it might be warping the market as investors worry less about the value of individual companies and instead pile money into broad indexes with no quality filters.

Markets are facing other risks too. Inflation, which seems to be running at about 8%, can threaten economies as people buy fewer items due to cost increases. Interest rate hikes, which are meant to ultimately curb inflation by restricting monetary supply and reduce lending/economic activity have hit bond markets particularly hard. Higher interest rates mean higher borrowing costs, and its here we might hypothesize about some of the unintended consequences of the incredibly accommodative monetary policy that the pandemic introduced. That might be that investors were able to borrow to invest, and the threat of both rising interest rates and stumbling returns will only hasten the exit of money from the market by some investors. Higher borrowing costs will also have another impact on markets, as a sizeable amount of stock market returns over the past decade have come from share buy backs, funded in part by low-cost borrowing.

Having said all that, economies are still looking very strong in the present. Earnings have remained high, jobless claims continue to fall, and while we’ve seen a spike in costs the ability to address those inflationary pressures may not be something that can be easily done through monetary restricting.

There are many different sources of inflation, but two significant issues are not connected to “cheap money”. Instead we have issues that are primarily structural and represent the failure of political foresight. The first among these has to do with oil. Since the price of oil fell in 2014, infrastructure development has stalled, heavily indebted producers have retreated, and now Russia has been closed off from much of the global market. This confluence of events has unfortunately arrived as economies are reopening, global use nears pre-pandemic levels, and global refined supply is at historic lows. There is no simple solution for this, as the only remedy is time (and development). In theory, Canadian and US oil could make up much of the global need, but for a multitude of reasons neither country is in a position to rapidly increase production.

Similarly, supply chain disruption and the heavy reliance on offshore manufacturing have meant that there is no simple solution to production problems occurring in other nations. China is the key issue here, with an enormous grip on much of global supply on many items and their current insistence on a “Covid Zero Policy” China is effectively shut to global business. This means ships can’t get into port, and with-it products cannot make it to market.

Higher borrowing costs seem unlikely to handle this problem. High gas prices and lack of supply may be inflationary, but high borrowing costs can’t target those issues. Instead, higher interest rates and the threat of more in the future are hitting the parts of the market that have been pushed higher by cheap credit. The stock market and the housing market.

If markets seem to be moving independently of economies, its possible that won’t stay that way for long. As previously mentioned, higher energy prices are not controllable by higher lending rates. But higher energy prices can introduce demand destruction, a fancy way of saying that economies shrink because prices get out of control. Oil is still in high use and its needs go far beyond powering cars. In fact internal combustion engines only account for 26% of global oil need, meaning those higher prices for crude, if they get too high, can have wide inflationary impacts to the entire economy.

Higher lending rates may also lead to a substantial economic reset, especially for Canadians who have much of their net worth tied up in their homes. With almost 50% of new mortgages in Canada variable rate mortgages, home prices having skyrocketed in the past few years and with most Canadian debt connected to homes, the risk to home owners is very real. Can the Bank of Canada tame inflation, orchestrate a soft landing for the housing market and keep the economy chugging along? Such a question invites highwire act comparisons.

So what’s happening with markets? Perhaps we are simply correcting a narrow subset of the market that got too hot through 2020-2021. Perhaps we are seeing the dangers of printing too much money. Perhaps we are seeing the realities of people buying too many index ETFs. Perhaps we are witnessing people being too fearful about the future. Perhaps we are too fearful of inflation or interest rates. Perhaps we are on the brink of a recession.

Perhaps, perhaps, perhaps.

But let me offer a slightly different take. Investing is frequently about connecting your needs as an investor with the realities of the world. As Warren Buffet famously said, in the short term the stock market is a voting machine, in the long term a weighing machine. If you can afford risk, you can be risky, and with that comes the potential for significant market swings. If you can not afford risk, then your portfolio should reflect that need. If you cannot stomach bad days, potentially weeks or even months of bad news, then you need to find a way to keep your investment goals aligned with your risk tolerance.

When I started this essay we had just completed one of the worst weeks of the year, which bled into the second week of May. As I finish this piece markets are in the process of rallying for a third day, posting modest gains against the backdrop of significant losses. It would be nice if I could end this with some confidence that we’ve turned a corner, that markets had bottomed and that the pessimism that has led to so much selling is evaporating as people come to recognize that stocks have been oversold. Yet such prognosticating is the exact wrong tack to take in these markets. Instead, this is a good time to review portfolios, ensuring that you are comfortable with your risk, that your financial goals remain in sight and that the portfolio remains positioned both for bad markets, and for good ones too.

If you have any concerns about how your portfolio is positioned and need to review, please don’t hesitate to contact us today.

Walker Wealth Management is a trade name of Aligned Capital Partners Inc. (ACPI)*

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Looking Back on 2021

Its traditional that the end of a year should stimulate some reflection on the past and the future, and so in the spirit of tradition I thought I’d take some time to look over some of the stranger and more surprising aspects of 2021.

China

While 2021 brought the pandemic *closer* to an end through the distribution of vaccines, markets underwent some fairly dramatic reversals over the course of the year. For instance China looked to be the principal economy in January. Following its own strict enforcement of Covid restrictions and solid economic performance, China seemed to be an earlier winner by the beginning of 2021, and set to enjoy robust growth through the year.

By March the tide was shifting however. China’s leader, Xi Jinping, proved to be every bit committed to his past comments about protecting and strengthening the CCP over free market concerns. Several billionaires, notably Jack Ma the founder of Alibaba, disappeared for long periods before reemerging only to publicly announce that they would be stepping down from their roles.

However, even while China was shaking down its billionaires and upsetting foreign nations, a new economic threat appeared in the form of a housing bubble looking ready to burst. Evergrande, one of the country’s largest property developers announced that it could not finance its debt anymore and looked likely to default. This news was unwelcome for markets, but for China hawks it fit their long standing belief that China’s strength has been built on a mountain of unsustainable debt, with property one of the most vulnerable sectors of the economy.

The finer points of China’s housing market are too nuanced to get into here, but it’s enough to know that the property bubble in China is large, built on sizeable debt and could take some time to deflate (if it does) and no one is sure what the fallout might be. Combined with China’s ongoing policy of “Covid Zero” – an attempt to eradicate the virus as opposed to learning to live with and manage it, we head into 2022 with China now a major outlier in the Asian region.

Inflation

Inflation was probably the other most discussed and worrying trend of 2021. Initially inflation sceptics seemed to win the argument, as central banks rebuffed worries over rising prices and described inflation as transitory. That argument seemed to wane as we entered late Q3 and prices were indeed a great deal higher and didn’t seem to be that “transitory” anymore. Inflation hawks took a victory lap while news sites began to fill up with worrying stories about rising prices on household goods.

The inflation story remains probably the worst understood. Inflation in Canada, as in other Western nations has been going on for sometime, and its effects have been under reported due to the unique nature of the CPI. But some of the concern has also been overwrought. Much of the immediate inflation is tied to supply chains, the result of “Just-in-time” infrastructure that has left little fat for manufacturers in exchange for lower production costs. Bottlenecks in the system will not last forever and as those supply chains normalize that pressure will recede.

The other big pressure for inflation is in energy costs, but that too is likely to recede. Oil production isn’t constrained and prices, while higher than they were at the beginning of the pandemic are lower than they were in 2019. In short, many of the worries with inflation will not be indefinite, while the issues most worrying about inflation, specifically what it costs to go to the grocery store, were important but underreported issues before the pandemic. Whether they prove newsworthy into the future is yet to be seen.

*Update – at the time of writing this we were still waiting on more inflation news, and as of this morning the official inflation rate for the US over the past year was 7%. Much of this is still being chalked up to supply chains squeezed by consumer demand. An unanswered question which will have a big impact on the permanence of inflation is whether this spills into wages.

This political advertisement from the Conservatives ruffled many feathers in late November

Housing and Stocks – Two things that only go up!

If loose monetary policy didn’t make your groceries more expensive, does that mean that central bankers were right not to worry about inflation distorting the market? The answer is a categorical “No”. As we have all heard (endlessly and tediously) housing prices have skyrocketed across the country, particularly in big cities like Toronto and Vancouver, but also in other countries. The source of this rapid escalation in prices has undoubtedly been the historically low interest rates which has allowed people to borrow more and bid up prices.

In conjunction with housing, we’ve also seen a massive spike in stock prices, with even notable dips lasting only a few days to a couple of weeks. The explosion of new investors, low-cost trading apps, meme-stocks, crypto-currencies, and now NFTs has shown that when trapped at home for extended periods of time with the occasional stimulus cheque, many people once fearful of the market have become quasi “professional” day traders.

Market have been mercurial this past year. Broadly they’ve seemed to do very well, but indexes did not reveal the wide disparities in returns. Last year five stocks were responsible for half the gains in the S&P 500 since April, and for the total year’s return (24%), Apple, Microsoft, Alphabet Inc, Tesla and Nvidia Corp were responsible for about 1/3 of that total return. This means that returns have been far more varied for investors outside a tightly packed group of stocks, and also suggests markets remain far more fragile than they initially appear, while the index itself is far more concentrated due to the relative size of its largest companies.

Suspicious Investment Practices In addition to a stock market that seems bulletproof, houses so expensive entire generations worry they’ve been permanently priced out of the market, the rapid and explosive growth of more dubious financial vehicles has been a real cause for concern and will likely prompt governments to begin intervening in these still unregulated markets.

Crypto currencies remain the standout in this space. Even as Bitcoin and Etherium continue to edge their way towards being mainstream, new crypto currencies trading at fractions of the price, have gotten attention. Some have turned out to be jokes of jokes that inadvertently blew up. Others have been straight-up scams. But all have found a dedicated group of investors willing to risk substantial sums of money in the hope of striking it rich.

NFTs, or non-fungible tokens have also crept up in this space, making use of the blockchain, but instead of something interchangeable (like a bitcoin for a bitcoin, i.e. fungible) these tokens are unique and have captured tens of thousands, sometimes hundreds of thousands of dollars for unique bits of digital art. Like cryptocurrencies, much of the value is the assumed future value and high demand for a scarce resource. However, history would show that this typically ends poorly, whether its housing, baseball cards or beanie babies.  

Lastly, there has been a number of new investment vehicles, the most unusual of which is “fractional ownership”. The online broker Wealth Simple was the first to offer this in Canada and it has been targeted to younger investors. The opportunity is that if your preferred stock is too expensive, you can own fractions of it. So if you wanted to invest in Amazon or Tesla, two stocks that are trading at (roughly) $3330 and $1156 respectively at the time of writing, those stocks might be out of reach if you’re just getting started.

This is a marketing idea, not a smart idea. The danger of having all your assets tied up in one investment is uncontroversial and well understood. The premise behind mutual funds and exchange traded funds was to give people a well-diversified investment solution without the necessity of large financial position. The introduction of fractional ownership ties back to the market fragility I mentioned above, with younger investors needlessly concentrating their risk in favour of trying to capture historic returns.

The End

For most investors this year was largely a positive one, though markets went through many phases. But while the pandemic has remained the central news story, the low market volatility and decent returns has kept much of us either distracted or comfortable with the state of things. And yet I can’t help but wonder whether the risks are all the greater as a result. Many of these events, the large returns in an ever tightening group of stocks, the growth of investors chasing gains, the sudden appearance of new asset bubbles and the continued strain on the housing market and household goods add up to a worrying mix as we look ahead.

Or maybe not. Market pessimists, housing bears, and bitcoin doubters have garnered a lot of attention but have a bad track record (I should know!) Many of the most pressing issues feel as though they should come to a head soon, but history also teaches us that real problems; big problems that take years to sort out and lead to substantial changes are often much longer in the making than the patience of their critics. The test for investors is whether they can stand by their convictions and miss out on potential windfalls, or will they become converts right as the market gives way?

Next week, we’ll examine some of the potential trends of 2022.