I hope everyone has had a good start to the year. Mine started with a bout of Omicron. I was patient zero in our household and then we went 6 for 6. Nothing serious but it did put me on my back foot to start the year…thus you are receiving this a few weeks later than we’d like. We appreciate your patience.
2021 was an interesting year for the stock market. The major stock indexes logged yet another double-digit year of growth. There were reasons for the markets to be optimistic. Corporate earnings were good, consumer demand was up, unemployment was low, money was loose, and the economy posted strong enough GDP numbers to bring us back to the long-term trendline of economic growth. These factors are all tailwinds for stocks and 2021 proved to be a good year for many companies.
A good year for many but not a good year for all
For some time now though, we have noticed disparity in different parts of the market. In some places, like traditional growth, valuations are high but not obscenely so. In other places, valuations appear to be reasonable. There are also areas of the market that have been downright speculative. In our 2021 Q2 commentary, we pointed to the speculative behavior occurring in certain areas of the market: SPAC’s, meme stocks, crypto-currency, FinTech, innovative tech, and non-profitable tech. These areas of the markets had received huge inflows of capital since the pandemic which had driven the price of many companies to lofty levels. About halfway through 2021 though, the gains started to reverse. By the end of the year, roughly 40% of the companies in the Nasdaq index had a share price that was 50% lower than their 52-week high.
The chart below has some notable names that experienced heavy losses in 2021. If I had continued this chart into 2022, it looks worse, but need something to talk about next quarter.
At the surface level of the market, this was barely noticeable. In fact, the Nasdaq 100 continued a steady upward climb through the end of the year. That begs the question, how is it possible that almost half the companies in an index can drop by 50% and yet that index still goes up in price?
The answer: Big Tech. With their earnings perceived to be destined to grow forever, capitalism and passive fund flows have rewarded the Big Tech companies handsomely. Google, Facebook, Microsoft, Amazon, Apple and Tesla have now grown to the point where they make up 45% of the total value of the Nasdaq 100. 6 companies = almost 50% of the market. They are so big that their combined market capitalization is twice the Gross Domestic Product of every country in the world, excluding the US and China. They’re big. Really, really big. Historically big. Andre the Giant big. The performance of these 6 stocks heavily influences the direction of the index, nearly to the point of domination. If they are performing well, a lot of other securities in the index can be performing poorly and you won’t notice it on the surface. That is exactly what happened in the latter half of 2021. Big Tech was stable, other areas…not so much.
The chart below shows % drop-off from the highest price of several Ark Invest Funds. Ark managers focus on investing in what they believe to be life transforming innovations. Their funds are a good proxy for the types of companies who had their share price drop in 2021. They performed excellently the last few years and, arguably, for good reason. Many of these companies have extraordinary ideas and extraordinary products. They may very well may change the way we interact with the world. Areas such as FinTech, robotics, genome science, biotechnology, and the metaverse to name a few, all have the potential to deeply affect the way we live and interact with one another.
The world has seen several life altering innovations in the past couple of centuries: the automobile, trains, oil, electricity, and the internet, to name a few. In his book, Engines that Move Markets, Alasdair Nairn examines market behavior during these cycles of innovation. In each cycle, speculative market bubbles developed when innovation was coupled with what he calls a rare combination of coincident conditions. Let’s look through this list of coincident conditions and make some very brief notes (in parenthesis) on whether each of these conditions exist today:
- The emergence of a new and potentially transforming technology about which extravagant claims can be made with apparent justification (Yep…quite a bit of it out there)
- A climate of relatively easy money and credit conditions (let’s see here…lowest interest rates ever, multiple stimulus checks directly deposited into consumers accounts, and the largest increase of M2 money supply on record. I think this one is covered too)
- General investor and consumer optimism (I’m feeling pretty good)
- A wave of new publications promoting the merits of the new technology (um…yes. Also, Reddit)
- An efficient and productive supply machine, capable of creating a host of new companies to meet investor demand (SPAC’s; ETF’s, Coinbase, Robinhood. There is nothing bad about any of them but it does illustrate that the finance supply chain is alive and well)
- Suspension of normal valuation and other assessment criteria (I could go on about this one for a long time)
It looks like all the conditions that marked prior market bubbles are present today. While I would stop short of calling what has developed a bubble, the price of many securities did get expensive, very expensive. Fueled by government stimulus, time on their hands, new ways to speculate, and encouraged by the promise of a changing world, the market drove the price of these securities higher and higher. Eventually people woke up to the fact that, for instance, there are a limited number of people who will spend $1,500 on a stationary bike from Peloton. As always happens, the market then reversed many of the gains that had been realized over the last three years. As it is often said, trees do not grow to the sky.
While these speculative movements only happened in relatively small corners of the investing world, they are important to note for a couple of reasons:
First, it may mean that investors are turning a more discerning eye to where they invest their capital. The investing world has been seemingly oblivious to fundamentals for some time, focused on investments of promise rather than investments of profits. If people are growing concerned about the truly speculative corners of the market, they also may start turning a more discerning eye to the price of the rest of the market. In the last few weeks of the year, it looked like even Big Tech was susceptible to some price reconsideration.
Second, it is a reminder that “the market” is a diverse place. We think this is a really important point as we look to the years ahead. The stock market certainly faces mounting challenges: inflation, rising interest rates, geopolitical tensions, a slowing economy, etc. There is also a lot of talk of the US market being over-valued. I could quote any number of investors, many of whom we have great respect for, that say the market is over-priced and due for a correction. There is certainly an argument to be made there. But 2021 was a good reminder that “the market” is more diverse than we often give it credit. It may look expensive, there may be speculative areas, but there are also reasonably priced opportunities with the potential for good long-term growth. From our vantage point, there is more diversity in the price of securities today than we’ve seen for a decade. As such, we will continue to look for opportunities to invest capital at an acceptable level of risk.