The end of year is time for reflection. For most investors 2021 is a year of frustration as the major indexes racked up new highs and portfolios struggled to make gains. It was a year that disproved the benefit of diversification and asset class models.
A brief visit to the hypothetical offices of Hindsight Capital, LLC. can help us understand the split personality of Mr. Market during the past year. At Hindsight Capital, managers have perfect forward vision.
At the beginning of 2021 with early signs of inflation, Hindsight Capital managers’ omniscience recognized the traditional role of precious metals was being replaced by crypto currency. With the year-end CPI at 6.8% and PPI at 9% investor reliance on historic returns of gold or silver generated losses rather than gains.
Similarly, reliance on bonds for risk management was upside down as fixed income volatility rose generating losses in the traditional haven of safety. This was particularly frustrating for retirees where standardized industry advice increases allocation to bonds with increasing age. Bond portfolios increased risk and reduced returns! Really.
The bond market’s volatility index rose while the volatility in equities rewarded concentrated risk exposure with the VIX index falling 25%. As Mortimer Snerd would say, “Who’da thunk it?”
Hindsight’s managers recognized the consumer shift developing from the side effects of “confinement frustration” due to the previous year’s broadly implemented Work From Home policies.
At the end of 2020, retail malls were priced to be bulldozed for greater and better use. Home entertainment stocks were priced for spending the rest of our lives indoors. In 2021, the home entertainment sector fell while Bloomberg’s regional mall index rose 83%. Only Hindsight Capital saw that coming.
The major emphasis on Environmental, Social and Government policies by major financial firms, corporate boards and government agencies has been a major investment theme for years. Hindsight’s portfolios won big being investing in natural gas and avoiding falling solar energy stocks. “Who’da thunk it?”
Without access to Hindsight’s prescience data last January, investors were allocating across asset classes and applying diversification to manage risk consistent with Modern Portfolio Theory. By not focusing on returns from capital weighted large cap indexes, 2021 was a frustrating, poor performing year.
Small caps generated half the return of larger companies. While returns were good against long-term averages, they still lagged. Worse was the often-mandatory inclusion of international assets in portfolios. Even worse was the year of major banks touting opportunity in emerging markets. China created “dead capital” for any emerging market exposure.
Following all basic portfolio construction rules, investors missed the benefit of a very narrowly focused market. Some of Mr. Market’s anomalies have been developing for years with well-known large caps attracting investors while the businesses are struggling to maintain earnings growth. Earnings “growth” has been sustained through stock buyback commitments while revenues have moderated or fallen. Investor focus on mega-cap stocks hasn’t been as concentrated or obvious since the late ‘90s as the tech bubble expanded.
Unfortunately, Hindsight Capital has implemented tight security, locking its door, and prohibiting access to the 2022 data. In our opinion, a major pullback is long overdue, but we can only be on guard watching for its arrival. Deep pullbacks corrected the exuberances of the tech bubble, the ’08 financial bubble and the run up to Covid. Deep pullbacks are a normal market event that is not attached to a calendar date or any particular market cycle. They just are and will be, again.
Returning to inflation, we know the Fed has repressed interest rates and is not making material changes to address the inflation problem. The current yield of 1.5% on the 10-year Treasury which has historically fluctuated with inflation – until the Fed intervened. The Fed’s plan to raise its benchmark rate to 2-2.5% within three years seems timid.
By many measures the market is overvalued, but investors continue buying with an Alfred E. Neuman attitude. “What? Me worry?”
Inflation is generally positive for commodities which is evident in the very issues that are causing household and corporate concerns – food and energy. Costs are rising much beyond the recent 10-year 1.5% interest rate.
A move to new market highs requires improved broad market breadth. Market breadth is a measure of stocks with new highs versus the ones posting new lows. As the red line in the chart illustrates, this measure of a healthy broad market has not advanced in six months and remained weak at year end.
There is so much political adjustment to government data, we view much of it with the same anticipation we had as kids watching for the next Burma Shave signs on road trips.
As we begin 2022, we rely on our process and charts to identify strength and weakness in asset classes, sectors and industries. Predicting investor demand is not possible. Tracking it and adjusting to changing conditions is our objective.
We appreciate your expression of confidence in our work and the opportunity to stay engaged with you.
May we all have a happy new year.
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