2022 Revisited: Why the Dow Delivered and the NASDAQ Didn’t
By James Cakmak and Ryan Guttridge
[See our 2023 outlook here]
2022 was a disaster for most investors. You know it’s a tough environment when choosing cash or betting against the broader indices are the only successful strategies.
The game was turned upside down relative to 2021 as the positive earnings surprises were driven by industries that lost ground during the lockdowns. In other words, companies that didn’t benefit from Covid saw their growth rates accelerate (i.e. Dow components) versus the beneficiaries of Covid decelerating lower (i.e. tech sector).
There’s a reason why investors increasingly began to focus on more immediate measures such as earnings. It’s because there was limited consensus on where the growth rates for companies would normalize once the Covid hangover was over.
The market embarked on a PEG versus P/E debate where the P/E won out. Even Uber CEO Dara Khosrowshahi acknowledged this change early on when he told the world that Uber would focus on profitability.
Moving through 2022, things became even more complex thanks to the Fed’s historic rate hikes.
Going forward, investors are left to wonder how much of the slowdown in growth rates is a function of shorter-term cyclical factors versus an actual change in the long-term secular trends.
We believe best investment opportunities are secularly advantaged assets trading at cyclically depressed prices.
So if you believe today’s slowdown in growth is cyclical and simply masking strong underlying secular trends, today’s price levels offer an investment opportunity. Conversely, if you believe it’s a permanent change, then you should sell as valuations are bound to decline more.
We are in the former camp and believe many of the pre-Covid secular trends are very much intact.
To be sure, we may be in store for more downside in the broader market indices over the next few months until the Fed pauses or pivots. However, valuations for many of the highest quality companies have fallen to well below the Covid lows.
Reverting to the Mean
Pre-Covid, the sustainable growth curves for most companies were well understood. Covid, however, distorted those curves. In some cases, it pulled forward several years of demand into a matter of months. We wrote about this distortion in relation to mean reversion here.
With the economy firmly reopened, the winners of Covid have been falling behind their 2019 growth curves while the losers began beating theirs. Market participants chased this change, keeping the Dow well ahead of the NASDAQ for the year.
August 25 was a turning point where the Fed’s Jackson Hole added an additional gut punch.
This is when Jerome Powell declared that the Federal Reserve would “forcefully” use their tools to reduce demand. This was jarring to many because at the same time he admitted they could do little about the actual reason prices were rising (i.e. supply shortages).
If the Fed had not tried to solve a supply chain problem with interest rate hikes, we would be well on our way to being back on pre-Covid growth levels. However, investors and management teams are now putting in place austerity measures in anticipation of a recession. It is now consensus that we will have a recession sometime in 2023, if we are not already in one.
This chart from Jim Bianco is a good illustration of escalating recession fears:
Why Growth Rates Had to Fall
Looking at stocks, it was a mathematical certainty that growth rates had to fall/rise from the Covid levels after the economy reopened. And these rates would be well above/below pre-Covid levels because the lockdowns didn’t permanently change business fundamentals.
The problem investors face in determining normalized growth rates is that the Fed’s actions have pushed the trough to lower levels than they otherwise would have been.
The chart below illustrates the damage done by the Fed. Here’s a breakdown using Amazon as an example:
- Dotted line represents the pre-Covid growth expectations for Amazon at around 20%
- Due to Covid, Amazon’s growth rate got steeper and more than doubled to 44%
- In order for it to normalize back around 20%, the forward growth rate had to be well below 20%. Hence, the decline to 9% in early 2022
- Although Amazon was marching back to 20% (3Q22 was 16%), Fed policies pushed the growth rate back into single digits by crushing demand
Moreover, this pain is also evidenced in commerce more broadly. Take a look at the falling growth rates following Covid as per the US Census Bureau:
This next chart perhaps best depicts why the Dow is outperforming the S&P. The reopening of the economy led to outsized growth rates for traditional retail from easier comps, while the winners of Covid (like Amazon) gave up ground.
Again, per the US Census Bureau:
The growth of online e-commerce relative to traditional retail actually turned negative!
Flip Flopping Fed
If you want to pinpoint the problem with the Fed, it is Powell’s change of focus from the overall price level to the unemployment level.
Since Jackson Hole, he is squarely in the camp of driving monetary policy through the lens of the Phillips Curve.
As background, the Phillips Curve postulates employment rates drive inflation. Push unemployment higher and inflation falls, push employment higher inflation rises. The problem with this is that the Phillips Curve has been disproven time and again, with several economists winning the Nobel prize along the way.
Powell went from mentioning employment once in his August Jackson Hole speech to mentioning it 22 times in his September press conference.
This was disconcerting to markets because employment tends to peak right before recessions. Meanwhile, it takes a significant amount of time for interest rate increases to be fully felt.
The Fed is using a forward lagging “tool” to affect a backwards lagging statistic. It is this time mismatch that has so roiled the markets. If the Fed needs to see employment and wages decrease before they stop raising rates, they will most likely break the economy.
Meanwhile, there is a mountain of real-time measures indicating price inflation is slowing down significantly. Everything from real estate to shipping rates to gas prices are declining. Additionally, the CPI data itself has rolled over. As a result, management teams are increasingly acting as though we are already in a recession.
This juxtaposition between policy and reality has further pressured stock prices. For many investors, the impression is that the Fed doesn’t care about the consequences of their actions. Jay Powell has explicitly said he thought the Fed has the “tools” to repair whatever damage they do and that they would rather overdo it than stop too soon. This circular reasoning is frustrating and causes completely unnecessary hardships for companies and society more broadly.
The Fed’s “dot-plots” (read forecasts) make matters worse.
If you take a look at the Fed’s forecast from December 2021 it was completely wrong. Given that track record, the current forecast is likely to be completely wrong as well.
We are in this mess because of an out-of-touch Fed, plain and simple. Greenspan can be criticized for causing a bubble in 2000, but at least he did things like check in with the Fedex CEO regularly to gauge real-time demand versus government produced lagging indicators.
For “growth companies” these forces have created a concern that there might be a secular growth issue. While in reality, the Fed-induced cyclical slowdown has simply exacerbated the slowdown that was necessary to return to “normal” off of lockdown sugar highs.
While the Fed’s “we’ll fix it after we break it” attitude is scary (financial crisis scary), longer term, it doesn’t change a thing.
Yes it can be argued that many growth companies are much larger and more mature so the days of hyper growth are gone. But, if pre-Covid growth rates are still relevant, the recovery will only be steeper, albeit taking longer than it otherwise would have.
A Glance Ahead
Unfortunately, that is bound to happen only after the economy gets worse from here and consensus earnings estimates come down. As it stands, there is a 10%-15% downside to current S&P estimates which can peg the S&P somewhere around 3300.
What we are witnessing right now is the mother of all mean reversions being exasperated by lagging cyclical pressures. Buying secularly advantaged business at cyclically depressed levels has always been a winning strategy historically speaking.
If investors have the ability to withstand the volatility, the opportunity today should be similar to those available in other times of duress, such as in late 2008 and early 2009.
Invest accordingly and buckle up.
[See our 2023 outlook here]
Clockwise Capital is an asset management firm with a private equity approach to the public markets. We focus on the meaning of time and the role it plays in people’s lives. We believe the essence of a great investment resides in the ability of a company to either save their customers time, or improve its quality. We understand how technology evolves to drive these two factors, which we believe define human progress. As a result, we search for securities with cyclically depressed valuations whose companies save time, thus using secularly advantaged industries to build a concentrated portfolio. With each series of investments our goal is to optimize edge, maximize return, while also minimizing correlation. This allows our portfolio to maintain a liquid, low duration fixed income balance, ready to capitalize on market volatility, while still generating market beating performance.
