Know the animal you are riding: Five capital market observations so far in 2022
The rough market highlights the strength of value stocks and the importance of staying the course
The first couple months of 2022 have been a long overdue reminder about the volatility of capital markets. Through the end of 2021, save the short-lived COVID-19 downturn, equity markets went on an unprecedented bull market ride. Fixed-income markets benefited from an extended period of declining rates, causing prices to rise significantly.
However, through the first four-and-a-half months of 2022, both equity and fixed-income markets displayed a familiar pattern: an uncomfortable pullback after a period of prosperity. There are many lessons to be learned during times of market stress and it is especially important to base investment decisions on first principles to ensure that investors stay the course and do not fall into market-timing traps.
Here are five observations about 2022 year-to-date performance:
1. There is nowhere to hide
Capital markets across geographies, asset classes, size segments, style segments, etc. have provided little cover against the global downturn. In fact, the vast majority of major asset classes and sub asset classes are down year-to-date through mid-May. Exhibit 1 illustrates this for various asset classes in the Vise asset allocation tree.
Exhibit 1. Year-to-date asset class performance, through May 16, 2022
Everywhere we look, outside of commodities, we have observed negative returns year-to-date.
2. Investing in companies with strong profitability and cheap relative prices has worked very well
Valuation theory and academic evidence tells us that companies with strong profitability that can be purchased at cheaper relative prices (“value stocks”) should have the highest long-term expected return. While this holds in theory, the past few years have tested this philosophy, as relatively expensive, low-profitability companies (“growth stocks”) have outperformed the rest of the stock market.
2022 disrupted this trend. Traditional value stocks have outperformed traditional growth stocks by about 17% (Jan 1 - May 16, 2022). But we can go even further in identifying value or growth characteristics. Empirical evidence suggests that we can define better measures of value and growth by adjusting for intangible assets that do not get reflected normally on balance sheets (assets such as a company’s patents, copyrights, etc.).
Vise performs this analysis as part of its investment strategy, and our intangible adjustment to defining value has added incremental value — intangible-adjusted value stocks have outperformed intangible-adjusted growth stocks by about 19% year-to-date, beating the 17% outperformance by traditional value stocks.
When addressing the investable market, Vise categorizes securities by their expected return by measuring size, value, and profitability characteristics. Exhibit 2, below, shows the expected return percentile rank of each stock in the Vise US Large Cap Universe on the left side, and each stock’s year-to-date performance on the right column. The observed data is in line with valuation theory and academic evidence: buying high-profitability, low-relative-price companies should lead to higher expected returns.
Exhibit 2. Vise US Large Cap universe, beginning of year expected return ranking and year-to-date returns
Investing is complex, but it can also be deceptively simple: Focusing on strong companies with low relative prices should lead to better long-term returns, and 2022 has seen this relationship play out.
3. Valuations still remain above historical long-run averages
Much of the 2022 drawdown in equities can be attributed to valuation multiple contraction, i.e. a contraction in the ratio between the price investors are willing to pay for a company and the company’s earnings. Why might this occur? One reason is that rising interest rates have resulted in future earnings, especially future earnings expected further into the future, being discounted more, resulting in lower prices.
In other words, investors are willing to pay less money for future earnings than they were at the beginning of the year. Exhibit 3 shows the price-to-earnings ratio for US large cap value and growth stocks through time.
Exhibit 3. Price-to-earnings ratios through May 16, 2022
While the sharp downturn in price-to-earnings ratios so far in 2022 has been notable (especially in the growth segment of the market), P/E ratios still remain elevated: the P/E of the Russell 1000 Value Index is currently 21.3 with a long-term average of 18.4, and the P/E of the Russell 1000 Growth Index is currently 37.7 with a long-term average of 28.0. The P/E of the overall Russell 1000 Index is currently around the 80th percentile historically.
While there is little evidence that valuation levels can help investors time markets, there is significant evidence suggesting that they are useful in planning, as they can help understand expected returns going forward. Even given recent value outperformance, we still expect value to outperform going forward. Now is a great time to be a value investor, even if you are not already.
4. SPACs and recent IPOs have suffered
SPACs (Special Purpose Acquisition Companies) and IPOs are hot topics in recent years, with many trendy companies going public and capturing the attention of markets. The growth in SPAC transactions grew significantly during the pandemic, peaking at the beginning of 2021 at over $35 billion dollars in monthly volume.
Recently, many companies taken public through SPAC transactions or IPOs have suffered greater drawdowns than the broader US stock market. Exhibit 4 shows the year-to-date performance of SPAC and IPO indices.
Exhibit 4. Year-to-date performance of SPACs and IPOs, through May 16, 2022
Year-to-date, both SPACs and IPOs find themselves down over 30%. The observed correlation between the returns of SPACs and the returns of IPOs is intuitive, as the characteristics of companies taken public via SPAC and those taken public via traditional IPOs are likely to be similar.
The lack of historical performance data on SPACs causes us pause as we evaluate the types of securities we look to include in our portfolios. Further, there is significant empirical evidence suggesting that recent IPOs (and for structural reasons, we can likely extrapolate the data to make similar statements about SPACs) underperform the broader market for a period of time after the public offering. Vise chooses to remove both SPACs and recent IPOs from our investable universe, which has benefited our strategies year-to-date.
5. Commodities have gotten up off of the mat
The past decade has been very difficult for commodities investors. Through May 13, 2022, the iShares S&P GSCI Commodities ETF (ticker: GSG) has lost 24.18% cumulatively over the last 10 years, an annualized return of -2.73% per year. While these results are disappointing, they hide the fact that commodities had been down 47% at the end of 2021. A sharp start to 2022 has erased about half of this cumulative drawdown, with commodities up over 40% year-to-date.
Exhibit 5. Cumulative performance of iShares S&P GSCI Commodities ETF, May 14, 2012 to May 13, 2022
Commodities strategies tend to perform well during periods of significant inflation, and, after poor performance during a relatively low inflationary environment to start the trailing 10 years, they have held up their end of that bargain during the high inflationary start to 2022. Through the Vise platform, advisors can choose to include commodities exposure in client allocations.
Knowing the animal you are riding is one of the most important factors in determining how well you are able to endure the journey. For investors, knowing what is happening in the markets and how this affects portfolios can provide comfort during volatile times. It is important to remind ourselves that achieving financial goals is not a linear, always-up-and-to-the-right journey; it involves roadblocks and setbacks. However, if investors can remain steadfast in their investment strategy, weathering periods like the one we find ourselves in now, we can maximize the probability of achieving those goals.
*Nothing contained in this article constitutes tax, accounting, regulatory, legal, insurance or investment advice. Neither the information, nor any opinion, contained in this document constitutes a solicitation or offer by Vise or its affiliates to buy or sell any securities or other financial instruments, nor shall any such security be offered or sold to any person in any jurisdiction in which such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction. Images shown are for informational and illustrative purposes only, and may not reflect actual performance. Decisions based on information contained in this document are the sole responsibility of the advisor. *
Vise AI Advisors LLC ("Vise") is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of Vise by the Commission.
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June 6, 2022