what I see

In mid-February of this year, the ARK funds, emblematic of the swing-for-the-fences school of investing and already epic winners in 2020, were all wildly ahead of the S&P and NASDAQ (I haven’t tried to figure out exact numbers, but the chart I’m eyeballing says 20+ percentage points or so up on the S&P). For the record, I’m an owner of several ARK ETFs and still hold almost all of what I initially bought (but I have switched much of the rest of my portfolio out of ARK-like names).

Then came a considerable period of sharp underperformance, in which ARK lost all those gains and another 15-20 percentage points as well (the ARK Genomics ETF appears to have lost around double that).

As I see it, the largest components of this slide, in descending order, were:

–relative valuation

–hints that the pandemic might be coming under control

–the ARK managers’ unwillingness/inability to play defense.

One might reasonably suggest that I’m mistaken in my third point and that the ARK folks simply misread the lay of the economic landscape. My reply would be that we’re nine months past the peak but there’s no sign I can discern that the ARK group has adjusted its strategy. Ex possibly ARKG, however, the group appears to have stabilized.

Anyway, the important point is that while the US stock market continued to rise, its tone changed dramatically.

since the September downturn

Over the past month or so, stocks seem to me to have progressed beyond the general notion that the worst is behind us to beginning to discount the near-term earnings performance of individual stocks vs. expectations.

In a traditional market there would be an asymmetry between the performance of the stocks of companies reporting positive earnings surprises and those reporting negative surprises. In a bullish market, the rise in a stock’s price after a positive surprise would typically be relatively strong, while the decline after a negative surprise would be relatively subdued. In a market with a bearish tone, the reverse would be the case.

In contrast to tradition, in today’s market, as I see it, the reaction to both positive and negative surprises has been extreme. My guess is that initial reactions are being driven by AI, with human analysts/portfolio managers following the computers’ lead.

My take is that this marks a further step away from the highly concept-driven market that prevailed during the worst of the pandemic. In particular, I read the greater attention being paid to earnings as prompted by recognition that world governments are beginning to withdrew the extraordinary monetary stimulus of the past two years. Put a different way, valuation is starting to count. For us as stock market investors, this means that the only defense against anticipated rising interest rates will be surprisingly good earnings results.

where to from here?

I find it unusually difficult to say. My base case is that the overall stock market moves more or less sideways, with outperformance/underperformance coming mostly from whether individual stocks in the portfolio belong to the positive/negative earning surprise camp.

I apparently don’t think this will be the only game in town, however.

I recently started a small position in Intel, despite the company’s recent announcement that it’s results will be sub-par for a considerable time. In fact, the announcement is the reason I bought some–with the idea that the company’s value resides in its physical assets and its intellectual property rather than in near-term earnings growth. For me, then, INTC is a value stock with a catalyst for change. It’s in the portfolio for defense. I think INTC won’t go down a lot while new management is refocusing the company back to engineering excellence. If so, it’s a hedge against the possibility that my assessment of a flat market proves too optimistic.

My native optimism, which translates into the assumption that the market will be flattish as the Fed tightens, is one risk I see.

the bigger question mark

A bigger imponderable, though, is how fixed income investors will react to the ending of a 40-year bull market in domestic bonds, driven by ever lower interest rates. According to Investment Company Institute figures, despite the enormous bull market in stocks in the US since the 2008-09 financial crisis, domestic investment money flows have by and large been out of stocks and into bonds. What has saved this flight to safety from being a disaster for refugees from stocks, in my view, has been the march of interest rates to zero, which has created capital gains for holders of long bonds.

We’re now at a point, however, where the dividend yield on the S&P is almost equal to the interest yield on the 10-year Treasury note (in fact, the dividend yield has been higher than the interest yield at certain times this year). The earnings yield (i.e., 1/PE) of the S&P–which is the more common measure of equivalence–is about twice the dividend yield on Treasuries.

This relative value situation was common in the first half of the last century. Chalk that up to the Great Depression and the sketchy nature of publicly-traded companies’ financial disclosure back then. I can only remember once in my working career, however, in the depths of the brutal bear market that followed the internet collapse twenty years or so ago, where I’ve seen stocks and bonds with equivalent payouts (instead of stocks having much lower payouts). And that was in the UK, not the US.

Add to this that the last big down period for Treasuries was forty years ago, and I don’t have the faintest inking what holders will do as interest rates begin to rise. Yes, professional bond managers will presumably continue to move as much money as they can into the short end. But will clients be ok with that or will they take their money back? …if the latter, where will they redeploy it? Presumably either into stocks or cash, but who knows what the proportions will be. Could the flows out of bonds and into stocks be large enough to dampen any stock declines?