When doves turn into hawks

By David Nelson, CFA CMT
Important themes as we head into 2022 – At the top of any investor list has to be the pace of the taper and the terminal rate expected at the end of the Fed’s hiking cycle. In the face of the highest inflation numbers since the early 80’s the Fed is moving aggressively to ramp up the taper pulling the dot plots forward. At least 50% of respondents now expect the first hike as early as March. The question that looms, is that soon enough? When doves turn into hawks you can bet the FOMC has fallen behind the curve.

Data by FactSet
The above begs the question how will stocks hold up as the Fed moves from friend to foe? Stocks can deliver during a heightening cycle, but the question is which stocks? A few weeks ago, I published 2022 – Flat is the new up in part referring to the indices dominated by large cap secular growth and an increasingly tech heavy index whose weighting rivals that of the dot.com bubble. 
Some of the largest stocks on the planet i.e., Alphabet (GOOGL) and Meta (FB) we’re moved out of Tech and into the communications sector in 2018. We can debate if Facebook is a technology company or a user of technology, but most investors look at Alphabet as a tech play. Add the fact that consumer discretionary giant Amazon (AMZN) gets 12.5% of its revenue from its cloud services division Amazon Web Services (AWS) you can see that technology as a percentage of the S&P is likely understated. Some analysts are suggesting it could be as high as 40%

kryptoniteRising rates can be Kryptonite to uber-growth stocks and in part explains some of the epic swings from one side of the lifeboat to the other in the last week. While a giant like Apple (AAPL) might be rich by historical standards at 30x forward earnings and 8x sales it is a relative value when compared to a universe of cloud stocks judged mostly on revenue with earnings are all but invisible.

Banks Challenged by Fintech

Financials are always the go to sector when the Fed starts raising rates but today this sector faces some significant headwinds. Traditional banks and card companies are being challenged by Fintech as consumer tastes change. Back in April JPMorgan Chase chairman and CEO Jamie Dimon listed fintech as one of the “enormous competitive threats” to banks in his annual shareholder letter.

The Shape of the Yield Curve

Data by FactSet

What’s the shape of the curve going to look like once the Fed blasts off? In a week where the FOMC all but guaranteed a more hawkish tone the long end of the curve continues to flatten suggesting economic activity may not be as robust as many firms suggest.  

S&P 500 Estimates

Data by FactSet

Most investment houses are projecting double digit returns for the S&P 500 next year. Even if you’re a bull it’s hard to make the math to work. Consensus earnings growth for next year is just shy of 9% and yet the median price target for 2022 is +14%. The multiple expansion needed to hit the bogey seems a stretch with valuations as rich as they are and the Fed gearing up to drain liquidity.

S&P 500 Target

Data by FactSet

I think the real story is far more nuanced. Investors are going to want some food on their plate in the form of earnings, cash flow and or dividends. Stock returns next year will be less about the indices as investors move down the valuation curve looking for something more than just revenue growth. In the end stocks are more than just a sexy story or crowd driven performance. It’s a contract giving the investor their pro rata share of earning’s and or dividends. 

Yes, stocks are one of the best investments to outpace inflation, but the tide is unlikely to lift all boats in 2022. 

“Only when the tide goes out do you discover who’s been swimming naked” – Warren Buffett

*At the time of this article some funds managed by David were long AAPL, GOOGL, FB and AMZN