February 2022 - "Buy the dip" investment may have had its day
In a bull market investors are well rewarded for “buying the dip”. As a share market sets new all-time highs, as most global share markets did through 2021, the bulk of equity investors experienced good gains but those that invested more in all the market dips experienced significantly enhanced returns. Hence the mantra of a bull market – “buy the dip”. And January 2022 has kicked off with a real solid dip in global shares, as I write this article, the S&P500 is down 11% while the tech heavy NASDAQ is down 15%. So, we have a dip but should investors still “buy the dip”? Renowned investor Jeremy Grantham, founder of GMO the Boston based value manager, weighed into this discussion with an emphatic “no”.
This month Grantham has predicted that the S&P500 will fall nearly 50% to 2,500 from its recent all-time high of 4,818. This is clearly a bearish outlook for equities! And such sell-offs have occurred in the past but they are rare events especially in the context of a broader market index such as the S&P500.
At this point, it should be noted that it has become something of annual ritual in recent times for Grantham to start the year by calling for the arrival of a bear market. Devout value investors do have a distinct tendency to call for the end of multi-year bull markets.
However, there is a third option, a type of share market that is neither bull nor bear, the range bound sideways market. And there is a decent chance that this is indeed the next phase of share markets and that it lasts until the emergence of a more settled global macro environment. In such a scenario there is likely to be rotation between sectors and asset classes, or put another way, a lot going on under the hood that largely cancels out at a headline level, creating a choppy but essentially sideways market.
There can be little doubt that some segments of the market do require a major sorting out. A prime example for this being the technology and innovation sectors of the market which performed in stellar fashion through 2020 and most of 2021. This was an entirely rational response to zero interest rates that were deployed to battle the effects of the pandemic. Zero interest rates made potentially large future earnings far more valuable relative to moderate but reasonable current earnings. The valuation pendulum had swung to an extreme extent to sit massively in favour of companies with long duration earnings.
The flaw in that otherwise perfectly rational response to zero interest rates was that to deliver great long-term returns, it required interest rates to stay at zero for years into the future. That flaw in reasoning was increasingly exposed through the second half of 2021 as it became ever more certain that inflationary forces were going to force central banks to abandon quantitative easing and increase interest rates. Culminating in the recent and public pivot by the US Federal Reserve, that they were essentially committed to multiple interest rate hikes in 2022. The consequence of these higher rates is that the valuation pendulum swings back towards companies that have decent current earnings and away from those that offer an uncertain pot of gold in the future.
The chart below captures that swing of the valuation pendulum perfectly. For the initial period of the chart the hare that is the ARK Innovation fund literally explodes upwards, zero interest rates are high octane fuel for its favoured type of company. Within 12 months that fund rises 200%. Meanwhile the tortoise that is the Berkshire Hathaway had barely managed to claw itself back to pre-pandemic levels. Owning real businesses that generated current earnings and paid dividends from free cash flow made little sense in zero interest rate environment. Which is why in February last year, the gap in performance between these two investment funds was close to touching a scarcely believable 200%.
Chart showing the tortoise reeling in the hare
Jumping forward to January 2022 and what a difference just a few months can make. Berkshire Hathaway went on a strong run, generating a just over 30% return for its investors, as the pendulum swung back to real cash generating businesses. But the pendulum swinging away from you is also a powerful force and ARK Innovation felt that force, dropping over 50% from its peak. And just like that the hare has been caught by the tortoise.
Looking ahead, if the markets are moving into a sideways period it’s likely to see a continuation of the rotation out of investments like the ARK Innovation fund, into the likes of a Berkshire Hathaway, as investors return to a more normal setting of the valuation pendulum. That scenario places much more emphasis on what specific companies investors own rather than merely allocating to the market and blindly “buying the dip”. Ultimately, a rangebound sideways market with big winners and big losers, suits a “buy selectively” approach.