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Rates, Russia and Reflation: A Recipe for Volatilty

Rates, Russia and Reflation: A Recipe for Volatilty

| February 20, 2022

2022 has been a difficult one for stock investors. 

Yet, strong economic expansion has resulted in robust earnings growth. In fact, results have been above analysts' expectations for more than three quarters of the companies.  This is usually a factor that pushes share prices higher, but such expansion has been accompanied by inflation and the prospect of rising interest rates. For those concerned about inflation, we hear you.  But we also remind you that stocks are among the better hedges against inflation, especially those firms who have pricing power. The recent earnings surprises provide some evidence of that.

Unfortunately, investors in 2022 also have to contend with an aggressive Russian military massing troops along the border with neighboring Ukraine. When combined with a transition to a rising rate environment, you have a recipe for a market decline.

We won't try to predict the outcome of diplomacy to diffuse the situation, although we surely wish the very best outcome for the Ukrainian people.  We'll just say that stocks have survived wars, financial crises, recessions, pandemics and more. They may not be higher in the short term, but they have always ended up higher.  It's hard to remember this when we are in the "heat of the moment", but it is likely not long term investors who are net sellers of stocks, but those who seek short term profits at the possible expense of achieving their long term objectives. (Remember, there are two decisions to make -- to sell, and when to buy back in.)

As the old adage says, "It's not about timing the market, but about time in the market."  Stay the course whenever you can.


Having lived through dozens of corrections and bear markets, the signs of a rapid rotation among market leadership (or more correctly, lagger-ship, for the underperformers) is looking familiar.  While the underperformance of one sector surely doesn't usually presage a bear market, the rotation that one strategist called a "circular firing squad" reminds us why we have diversified portfolios in the first place.  Rotation out of market "darlings" has often been brutal, while the broader averages have declined much more modestly. (As of this writing, the S&P500 is down 8.76%, excluding dividends, year-to-date.)

Among the first companies to show price weakness were the companies that profited most handsomely from pandemic consumer trends (think Zoom (NYSE: ZM) or Pelaton (NYSE: PTON).  Such shares rose sharply in 2020 only to retrace a large portion of those gains in 2021.  Investors rightly began to question whether or not those large sales gains were sustainable in a world where we are more free to move about. Those who bought in late were badly burned.  Each company's shares have declined by more than 70% over the past twelve months.

Then, in late 2021, a whiff of inflation and higher interest rates precipitated weakness in the shares of high growth (but profitless) startups.  Among the hardest hit were the new crop of electric vehicle firms (such as Rivian (NYSE: RIVN) and Lucid (NYSE: LCID), each down about 50% over the past three months. So-called "disrupters", including Lemonade (insurance) (NYSE: LMND) and Affirm Holdings (consumer finance) (NYSE: AFRM) have lost some investor interest, declining by more than half over the past year.   

This weakness has now spread to the broader market.  The lesson we take away from this?  Chasing performance might work in the short run, but POMO (fear of missing out) is not an investment strategy.  We have missed many trends and will likely miss many more.

Contrast "performance chasing" with the philosophy of a fundamental investor.  At the portfolio level, firms like Boardwalk care about diversification, financial quality and having diverse drivers of success (including less dependency on stock market returns wherever possible.)  And at the stock selection level, such investors care most about cash flow that will ultimately find its way to the shareholder. It is with this cash that a company can do great things for its owners -- pay dividends, reduce indebtedness, buy their own shares or make accretive acquisitions.  We care about the quality of a company's balance sheet because it is this foundation on which a company can survive more difficult times. And, of course, we care about the company's growth prospects and management's ability to exploit those opportunities.

Investors who care about sustainability also believe that companies who are more efficient users of resources often have higher profit margins.  Those who treat employees with respect are less likely to have turnover issues, with the higher costs that come from that.  Firms with tighter management controls often value transparency, worker safety, and seek to reduce risk of fines from environmental mishaps.  And while there are no perfect companies, in the end, these principles are usually rewarded with a higher share price.

Markets will have cycles, and geopolitical issues will occasionally rise in importance, but for investors who understand why they invest in growing enterprises, challenging times are part of the environment that we must accept if we wish to profit on the other side.

We welcome your thoughts and would enjoy having a discussion if you are unsure about your current portfolio positioning.