“Babylon is burning”

Babylon's burning, you'll burn the street

You burn your houses, with anxiety

With anxiety, Babylon's burning, Babylon's burning

With anxiety, Babylon's burning, Babylon's burning

Babylon's burning, you burn the street

You burn the ghetto, with anxiety

With anxiety, Babylon's burning, Babylon's burning

With anxiety, Babylon's burning, Babylon's burning

Babylon's burning baby, can't you see?

This single by The Ruts captured the mood of the time, as riots swept Britain in the summer of 1979, my first year at university. It is one of my all time classic punk rock songs. It's an anthem.?The Ruts?were also heavily involved in anti-racism causes.?

So, the stock markets Babylonians have been burning with anxiety since the beginning of the year.

The?growth company orientated?Nasdaq?Index?officially dropped into “correction” territory (meaning down 10%+ from the most recent high).

Meanwhile, the?broader?S&P 500 has fallen 7% from its recent high, and the Dow?Industrial, about 6%.

It suddenly seems like the end of the growth and particularly technology company world.?Markets?usually?drop faster than?upward?market rallies, giving rise to the often-used phrase that markets ‘take the stairs up, and the elevator down’

Is the decline related to the?prospect of rising interest?rates, rising inflation,?or?Omicron causing?further delays in economic recovery? Or is it?a natural retracement?or correction?following?the big gains of 2021? Although this is probably a combination of all four factors,?I believe?the connection with?interest rates?is?difficult?to ignore.

The news last week on U.S. interest rates confirmed rate rises are on the way.

The?Federal Open Market Committee (FOMC)?released the following:

With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.”

It?appears?not?to be?planning on more than four rate?rises?in 2022, but it’s not taking the option off the table.

If?investors from 15 years ago could see us worrying about?interest rates heading towards 2.5%, they would think we were crazy.?

We have become?used to easy money, and what worries investors today is how much higher rates might constrain growth?and, consequently, company profits and share prices.

The central fear today is?that?“rising rates will doom shares.” That’s a false?assumption.?

What?equity?markets?don’t like?is “too much, too fast” when it comes to?interest?rates. But measured increases actually correlate with strong?equity?market returns.

Investors?have rotated out of riskier?growth?assets?such as technology, biotechnology, cutting edge software companies?in recent months.

Former “Poster boy” Netflix being a great example.

The company beat both?sales?and?earnings?estimates, but is down a whopping 25% because of?company?guidance suggesting slower growth.?

The company added?8.28 million?new?subscribers?last quarter, higher than the 8.19 million expected and nearly double the net additions recorded in the prior quarter.

But the company forecast?2.5 million new subscribers next quarter versus the nearly 4 million it added in the same quarter a year ago.?That’s the disappointment, only 2.5 million new subscribers!

However, when I looked in a bit more detail, I noted that their new content releases are very much scheduled for the end of the next quarter. For example, the second series of the hit show “Bridgerton”.

This is what panic looks like.?But as you can read, this may be short sighted. Particularly given Netflix has also raised its prices. An extra $1 to $2 per month across monthly subscription packages?add up in a big way, increasing profit margins and cash flow immediately.

Netflix has pricing power. Subscribers want their content and they can’t get it anywhere else.

Then we had Microsoft report fourth quarter results. Revenue rose 20% and beat analyst estimates.

Microsoft’s cloud computing software, Azure grew by an impressive?50% year?on?year to $18.33 billion in revenue.

Most tellingly,?Microsoft’s finance chief, Amy Hood, told investors that demand is still strong.

Yet, this January, Microsoft shares have?experienced?their?worst month since 2010, down over 14%.?

Microsoft were followed by equally impressive Apple quarter results.?Sales of $123.94 billion were up 11.2% from a year ago and beat analysts’ expectations by $5.4 billion.?Earnings per share?beat?analysts’ expectations of $1.89 by 11.3%, coming in at $2.10 and growing 25% year?on?year.

Further,?Apple CEO Tim Cook noted during the?results presentation?that the company’s supply chain issues were improving.

76% of the?U.S.?companies that have released results so far have exceeded estimates.?

As we have said many times over the last few weeks,?you don’t normally get?bear markets when?you still have?earnings growth?and short term,?it looks likely that earnings will be up 24% in the fourth quarter.

They?could be even higher.

This is from?FactSet:

Based on the five-year average improvement in earnings growth during each earnings season due to companies reporting positive earnings surprises, it is likely the (S&P 500) index will report earnings growth of nearly 30% for the fourth quarter, which would be the fourth consecutive quarter of (year-over-year) earnings growth at or above 25%.

So, we have what should be strong earnings,?with?healthy?company?returns in a rising rate environment.

Given this, the question?is, “when will the bottom be?reached?”

Fundamentals?don’t always matter.

In the words of folk singer Sheryl Crow, "No one said it would be easy, but no one said it would be this hard."?

So, what will change sentiment?

First would be?we do indeed get those?strong earnings, reminding?investors?of?the actual strength?of company earnings and their financial strength.?

Second?would be related to Central Banks, and largely the U.S.?If the?U.S. Fed signals more patience about raising rates considering the effect of Omicron,?investors?are?more likely to start buying equities again and quickly.

Every year, the financial analysts at JP Morgan release a very long presentation containing a recap of the current conditions of the global financial markets, plus some brief notes on what to expect.

In this year’s edition they report that historically,?most years,?end?with?positive?returns, but almost all of them have had a medium to large pullback during the year.?They?expect the same to happen in 2022 as well, since there are no exceptions.

And there have also been six crashes of?greater than?30% in the last 40 years, so you can reasonably expect a similar amount for the next decade. Fasten your seatbelt and don’t sell in panic.

I would additionally point out the 2022 is?a midterm election year?in the U.S., with members of Congress up for re-election in November. Historically, stocks don’t tend to perform well in a midterm year,?and the stock market often experiences 15% corrections at some point during that year.

But the?good news is that?U.S. stock markets?tend to rebound strongly the next year, which??at least this bodes well for a strong market rebound in 2023.

I would not be surprised if?the?stock market remained volatile for several more months, if not for the entire year.?But I don’t believe we are in a prolonged bear market.

That's because bear markets typically coincide with recessions. With 2021 GDP?in the U.S.?expected to come in at 5.9%, the fastest growth rate in 37 years, that's?not?a recession.?

And with?U.S.?GDP in 2022 projected at 4.0%, with 2023 projected at 2.2%, there?would appear to be no recession in the?foreseeable future.

Assuming continued volatility and move away from the technology sectors,?markets?always offer?different, sometimes obscure, ways to profit.

For example, the three following trends?could be the ones to follow in 2022:?

1. Crude Oil's "Swan Song". The transition to a carbon free?world could?be interrupted by?soaring crude prices.?No matter how "doomed" crude oil may be over the long term, it could deliver?some spectacular short-term gains.?In?the today,?demand?for oil during the last?several months has been rebounding sharply. As it continues to rebound,?so the oil price could go higher.?Furthermore, oil and gas companies have been slashing the exploration budgets for many years.?Global investments in oil and gas exploration and production have plummeted by about 65% since 2014.?A tightening oil market, coupled with a rising inflationary trend, provides ample reason to expect oil?and gas shares?to deliver?strong performances?in 2022.
2. Borrow money now because interest rates could be?going up.?Re-arrange mortgages and possibly look to fix. Buy that new house, new car, extension, etc. before the mortgage or loan costs more.
3. The Revenge of Caution/Value.?Unlike 2021, the "character" of the?stock?market?could continue to?shift from a "risk-on" bias to "risk-off."?

I expect investors to behave more cautiously than they did in 2021.?Generally speaking,?we might expect?relatively cautious investments to outperform their relatively?more?risky counterparts.

Valuations don’t always signal tops or bottoms, but they are useful for projecting long-term returns. With where we are today,?I believe that simple investing in a broad index will not deliver great returns. Rifle shots?will be the key.?That lends itself to a disciplined active management approach consistent with your risk appetite.

Legendary investor, Jim Grant, has a great quote:

‘’To suppose that the value of a common stock is determined purely by a corporation’s earnings discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defence of Joseph Stalin and believed Orson Welles when he told them over the radio that the Martians had landed.’’