KCS Quarterly Market Review for Q4 2021
January 24, 2022
2021: A Year to Remember (or Try to Forget?)
Who would have thought that a year that began with a storming of the US Capitol and featured several waves of COVID-19 variants (despite intensive vaccine rollouts) would end up being one of the best years for stocks in the past decade? During the final quarter of 2021, the MSCI All Country World Index (the “ACWI”) jumped +6.7%, capping an +18.5% increase for the full year.
Bonds, meanwhile, did not fare so well, with the Bloomberg Barclays Global Aggregate index ending 2021 down a hefty –4.7%, something rarely seen in the fixed-income market. Rising interest rates were to blame, as the 10-year US Treasury rate rose from 0.9% at the start of last year to 1.5% at year-end (and since then, the yield has shot up to 1.8%).
Hiding within the veneer of the major global indices, however, were great divergences in performance and a lot of turmoil. For example, while US stocks finished the year up +28.7%, emerging markets fell by –2.5%, the largest disparity in at least 15 years. Differences in sector performance were also wide, with leaders Energy (+36.0%) and Technology (+27.4%) easily trouncing laggards Consumer Discretionary (+9.0%) and Utilities (+10.1%). Similarly, large stocks handily bested small ones, and just 5 of the very biggest companies—Microsoft (MSFT), Google (GOOG), Apple (AAPL), Nvidia (NVDA) and Tesla (TSLA)—accounted for over half of the S&P 500’s return since April of last year.
As a result, even though equity indices finished within 1% of their record highs, investors felt pain in thousands of individual names by year’s end. For example, over half the companies in the Russell 2000 index of small stocks finished the year down at least –20%, and in the NASDAQ, nearly 1 in 3 stocks ended the year down by –50% or more from their recent highs. Clearly, 2021 was not a year when throwing darts at the stock market page was a successful approach to picking stocks.
Bonds experienced similar deviations. Against this backdrop of rising rates, longer-term, “safe haven” assets were particularly vulnerable, while bonds with shorter maturities and higher yields managed to eke out small gains.
Fortunately, last year’s environment was ripe for KCS’s valuations-based approach, as our individual stock models were helped significantly by our stock selections. We avoided the year’s biggest blowups as we stayed clear of “meme” stocks and other questionable names, while diversifying globally and avoiding overconcentration in the largest US companies, as index investing currently requires.
Position limits on the largest stocks, however, can sometimes prove to be a double-edge sword: while we own several of the mega-cap equities that were strong performers last year, we don’t own them to as high of percentages as capitalization-weighted benchmarks such as the ACWI and S&P 500. The result is that a KCS portfolio is in many ways more diversified than the indexes, but in years like 2021, when a few huge companies drove a large part of index performance, this approach can temper returns while limiting risk should one of these mega-caps (or any individual stock) suffer a sharp decline.
We are confident that by not overweighting the very largest stocks, our long-term performance will benefit. Even in 2021, our strong stock selection more than offset this “mega-cap” effect. And in the early weeks of 2022, our approach is very clearly showing its mettle in relative performance.
Similar disparities in returns among the different sectors of the fixed income market also played well with KCS’ investment style, with performance aided by our allocation to high yield bonds as well as by our individual security selections. We are proud that in a particularly difficult year for the bond market, KCS portfolios weathered the storm well.
A Look Ahead
2021 was clearly a year of both highs and lows. Some of the lows we remember well: the January 6 insurrection; “meme” stock mania; “coins” named after dogs; the blowup of a $15 billion family office; alpha, beta, delta and now omicron variants infecting hundreds of millions of people worldwide.
There were some highs as well: nearly 10 billion vaccine doses were distributed globally; most people were back at work and unemployment is low again; with few exceptions, economies have largely reopened; most people have higher savings today than before the pandemic. In other words, despite turmoil and several viral surges, the world gradually moved closer to normal last year.
As we enter 2022, we remain optimistic about the year ahead, both for the world in general and the markets in particular. Below, we discuss the key themes we expect to unfold.
- The Economy Will Continue to Recover
After a –3% plunge during pandemic-stricken 2020, real global GDP is estimated to have increased by about +6% in 2021. This brings us back above pre-pandemic levels, but still below the prior trend. Thankfully, we still see a lot of low hanging fruit to boost the economy as coronavirus restrictions continue to loosen and people become progressively more comfortable congregating with others. There are signs that demand is much stronger than supply right now, putting a bit of a cap on economic activity, but ultimately, we think supply challenges will be worked through. As supply bottlenecks continue to loosen, we expect the economy will finally feel like it is booming, with at least 4% real growth in global GDP this year. Given our optimism, we would expect economic recovery names to continue to outperform in the year ahead.
- Omicron Won’t Stop This Train
COVID fears reemerged at the start of December as the Omicron variant rapidly spread across the world. This strain was particularly concerning because of a large number of mutations that render it both more contagious than delta and better able to evade antibodies from vaccination or prior infection. This combination of features enabled it to quickly become the dominant variant of COVID-19 while infecting large numbers of people—including many who are vaccinated—in a remarkably short span of time. Despite being less severe than prior variants (although unvaccinated/non-immune individuals can still become very ill or die), the sheer number of cases is overwhelming many hospitals, again forcing people to defer necessary medical care.
But Omicron also brings good news. Its lesser severity means much lower infection fatality rates, closer to influenza than previous variants. Its extreme infectivity means that large numbers of people are rapidly being infected—many with no or minimal symptoms–creating meaningful population immunity. And so far, the rapid rise in case counts is being matched with almost equally rapid declines in cases in those areas that have already peaked. In sum, this wave is looking to be really tall but mercifully narrow. And there are some early suggestions that this may at last be the variant that helps convert COVID-19 from pandemic to endemic, allowing us to finally live with the virus in relative normalcy.
New York City’s recent COVID spike was short-lived
There’s a lot more we could say about COVID and Omicron, but for now suffice to say that we are hopeful that 2022 is the year when most of the world will finally see the pandemic in the rearview mirror. And there’s no question that people will relish this development. Economically, this implies continued expansion and a potential boon for companies most impacted by the pandemic.
- Inflation and Interest Rates Are Moving Higher—But not too high
Inflation in the United States is currently running at 7% annually. This has been matched by similar, uncharacteristically high readings in other major economies such as Europe (+5.0%) and Canada (+4.7%). By now, “transitory” inflation is starting to feel more permanent, and both central banks and markets have taken notice. Here in the US, we have seen the 10-year US treasury hit a yield of over 1.8% in the first three weeks of the year, up from 1.5% at the end of 2021. The Federal Reserve is reducing its bond-buying program more rapidly than previously anticipated, and their latest forecast points to several interest rate hikes in both 2022 and 2023.
Inflation recently topped 7% in the United States
Is this sudden spike in inflation temporary or permanent? We believe it’s some of each. High demand coupled with supply chain challenges is naturally leading to higher prices. Over time, both of these will likely normalize and relieve some of the price pressure. Similarly, once wage increases reach equilibrium, wage cost pressure will abate. These represent the transitory component.
But the longer term may still see some inflation pressure as the astounding increase in the money supply since the start of the pandemic continues to reverberate. Many more dollars (and Euro and Yen) chasing only a bit more goods will naturally lead to price inflation and along with it, higher interest rates. The latter will be helpful in unwinding some of the excesses and imbalances of the last few years, and also provide savers with more income. However, the shift will not be kind to expensive growth stocks or long duration fixed income assets. Shorter-term bonds and value stocks with good cash flow will likely do well in this environment. As a result, we continue to keep our bond maturities on the short side and avoid the priciest stocks.
We don’t think that the persistent component of inflation will be all that high, and almost certainly well below the current 7%. Rather, we see inflation rates over the next few years at 3% or less, as there are other secular factors, such as technology, the aging of the population and income disparities that tend to keep inflation at bay. This suggests that the current concerns over long-term inflation and much higher interest rates may be overblown.
- Equity Returns Will Become Less Concentrated
What do you expect the stock market to return over the next five years? We think most of our readers would guesstimate a figure in the 8%–12% range, as that not only jives with history, but also with what we’ve heard from prognosticators for most of our lives. And over the last five years, that’s mostly what we’ve seen: international stocks returned 9.6% per year; emerging markets rose 9.9% per year; small cap US stocks grew 11% annually; and equal weighted large caps have done slightly better, earning about 13.9% per year. But these all pale in comparison to the returns of the 500 largest US companies, weighted according to their size: the capitalization-weighted S&P 500 trounced the competition, generating returns of 18.5% per year for the last 5 years.
We question the sustainability of those returns going forward. And while we like several of the largest securities in the S&P 500 (e.g., Microsoft, Alphabet, Apple), we realize that ultimately, either competition and/or governments will prevent monopolies from lasting forever. For this reason, we strongly advise against putting all your eggs in the mega-cap US basket. Interestingly, we may already be seeing signs of reversion—year-to-date, non-US stocks have outperformed the US by more than 5%.
The two graphs below illustrate how the S&P 500 has become progressively more concentrated in the stocks of just a few very large companies. The first graph shows that, by the end of last year, the 10 largest companies in the S&P 500 index accounted for 30.5% of the index, leaving the other 490 companies with the remaining 69.5%. Put another way, the average “Top 10” company accounts for a bit over 3% of the index, while the average “bottom 490” each account for only 0.14% of the index—that’s a difference of 22 times!
Meanwhile, the earnings of these mega-caps have not kept pace with the growth of their stock prices. At their peak, they accounted for over 1/3 of S&P 500 earnings, a percentage that makes their large weight in the S&P 500 seem reasonable. But during the second half of 2021, while their stock prices kept rising, their contribution to S&P 500 earnings fell precipitously to 25.8%. We believe their share of S&P 500 earnings will continue to fall over the next few years, not because these companies are making less money, but because the earnings growth of the other 490 will be considerably more rapid. The big get bigger—but not forever.
- Be Wary of Tail Risks
Of course, there are always risks worth watching for. The biggest risks are those we can’t predict, but there are some knowable ones we are keeping our eyes on. Geopolitical issues seem to be particularly likely as a source of potential sell-off, with troubled hot spots including Taiwan, Ukraine, and more recently, Kazakhstan. Other potential problems we are watching include prolonged semiconductor or labor shortages. And of course, there’s always the possibility that yet another COVID variant shows up and again disrupts life. Where feasible, we are striving to reduce risk in our portfolio from such potential adverse events.
In sum, we think that 2022 will continue many of the trends from 2021. The global economy will remain strong, especially as backlogs and shortages are worked through. COVID will likely become endemic and hopefully finally fade out as a major impact on our health and daily lives. Inflation will be higher than we’ve become used to over the past decade, and interest rates will continue to move higher, but probably not as high as some people are now forecasting. Markets returns will broaden well beyond US mega-cap stocks. Geopolitical tensions heating up and a still-unpredictable virus throwing a curveball are the most obvious wildcards.
How is KCS positioning portfolios for these scenarios? In equities, we continue to look for and find high-quality companies priced to provide potential double-digit annual returns. We find these mostly in the value space, although recent selloffs in tech and growth stocks are providing good entry points into some previously overvalued companies. In fixed income, we think 2022 will reward investors who focus on credit quality instead of chasing yield, and although speculative debt has worked well over the last few years, we worry about owning these in a rising rate and higher cost environment. Thus, we have targeted a barbell approach: shorter duration, investment grade securities make up the bulk of our bonds, but these are boosted by higher yields on the other end from investment-grade preferred stocks and unique convertible security situations.
We have no doubt that 2022 will provide us with several surprises, but overall, we foresee another good year for investors, despite the recent choppy start. A bear market is clearly in our future, but we feel comfortable in predicting that it is unlikely to happen in 2022.
The KCS Investment Team
KCS Wealth Advisory is a registered investment adviser. Our services include discretionary management of individual and institutional investment accounts, along with personalized financial, estate and tax planning services.
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 Coincidentally, Netflix (NFLX) is down –24% as we write this. We do not own this stock in our models.
 Since 1900, US stocks have returned about 10.0% per year