February 17, 2022:
A year ago, we wrote a piece expressing the view that US growth stocks had entered a major speculative bubble. We didn’t know when that bubble would reach its peak, because that can only be known in hindsight. But we did suggest that it would peak at some point, and would probably suffer the gruesome fate that awaits most bubbles. And this seemed like an important risk to keep on our radar.
As it turns out, some of the bubblier corners of the market did peak around then. For example, IPO and SPAC companies (which we featured in our article) topped out a couple weeks later and have since fallen 40% and 48%. But US stocks as a whole continued onward and upward for the rest of the year.(1)
That changed quite abruptly at the start of 2022. US growth stocks have declined by 14% since the start of the year, dragging the overall US stock market down by 8%. Bonds have defied their safe haven status by falling at the same time, with the US bond market having lost 4% year to date.(2)
Fortunately, the more reasonably priced areas of the global markets where we have most of our exposure have held up a lot better, with some still in positive territory for the year. Additionally, our alternative investments, which detracted from performance in 2021, have been a big help so far in 2022.
Inflation is not cooperating
It’s always tricky to speculate about what’s causing short-term market moves, but in this case it’s pretty clear that stubbornly high inflation is playing a major role.(3) Investors are concerned that the Federal Reserve will have to aggressively raise rates to get inflation under control, and some areas of the market are selling off as a result.
We discussed this risk at length in our last article, “What’s Going on with Inflation?” We suggested that markets weren’t allowing for the possibility of higher rates, and that if this changed, richly-priced growth stocks could be very vulnerable.
The market did end up changing its tune on rates. Since our inflation article in December, the Fed funds futures market went from pricing in very little chance of a 1.25% rate hike in 2022, to it being a near certainty.(4)
US growth stocks dropped hard as rate expectations increased, and there may be more to come. Core inflation was over 6% in February, its highest annual pace since 1982.(5) If inflation doesn’t moderate on its own pretty quickly here, there is a good chance that the Fed will be forced to raise rates even faster than the market is now pricing in, which could further punish growth stocks.
Is the bubble bursting?
So is this it for the US growth stock bubble? We wish we could say for sure, but we don’t think anyone can know the answer to that in real time. Here’s what we do feel pretty confident in saying:
- We have experienced a major speculative bubble
- That bubble may be starting to falter
- It’s fighting a backdrop of 40-year high inflation and a Fed that’s just getting started with what could be a very aggressive tightening cycle
The situation is… interesting. OK, it’s more than interesting. In fact, we think there’s a good chance this period in the markets will be talked about and studied for decades to come.
Here in the present, we’re sticking to the approach we’ve outlined over the past year:
- Concentrating our stock exposure in the non-bubbly, reasonably valued areas of the global markets that are less vulnerable to rising rates. This includes some resource stocks, which are unusually cheap vs. the market and have outperformed in past inflationary periods.
- Leaving some room to add to our stock exposure if valuations improve.
- Investing in alternative strategies that are mostly uncorrelated with stocks and bonds (including the value-growth convergence strategy we described here).
- Avoiding long-term bonds.
If markets shake off the recent decline and continue upward, we’d expect to participate, as we still have meaningful exposure to areas of the market outside the bubble.
If markets continue downward – and especially if the bubble bursts in earnest – we’ll probably participate in that too, at least to some degree. It’s not realistic to expect that our stock holdings will keep going up through a protracted market decline. (And trying to avoid the downturn altogether would be too risky in our view, as we described in an article last year). Our goal is to weather any downturn that comes along, and to take advantage of it by picking up cheap investments that have been caught in the crossfire of a general market selloff.
But the short term is always murky. Longer term, things are more clear. We feel pretty strongly that at some point there will be a major repricing in the markets, and that value-focused investors will be well positioned to benefit from it.
- Source: stockcharts.com, symbols IPO, SPAK, SPY.
- Source: stockcharts.com, symbols VUG, SPY, AGG.
- Fears of a Russian invasion in Ukraine have rattled markets as well, but we believe the selloff so far has mostly been related to inflation and the prospect of tighter Fed policy. The big market moves coincided with inflation news or changes in the rates markets, which are more concerned with Fed policy than geopolitical news. Additionally, the more rate-sensitive growth stocks have fared worse than the overall market.
- Source: CME Group. On 12/2/21, markets priced in just an 8% chance that the Fed funds rate would reach 1.25% by the end of 2022. As of 2/16/22, the probability has increased to 96%.
- Source: Federal Reserve