The nice thing about the investment profession is that creativity is more important than striving for perfection. Striving for a perfect world runs the risk of chasing the market. By selecting investments in which all the good news is discounted, a portfolio is created that structurally lags behind the market.
The disadvantage of too much creativity is that occasionally things can go wrong. That does not matter, as long as the pluses are greater than the minuses. The way to avoid mistakes as much as possible is to think carefully about investment decisions beforehand and to learn from them afterwards.
1. Valuation was a pitfall
The first lesson from 2021 is that valuation says nothing about short-term returns. While this is not a new phenomenon, it has again proved true in 2021. The most expensive market was also one of the best performing markets in 2021. The special thing about valuation is that it actually has a major impact on long-term returns. In the short term, factors such as the economy and liquidity prevail. A year ago, there were plenty of warnings about the overpriced US equity market. Equity markets outside the United States were relatively cheap. Anyone who decided not to invest in the United States on that basis was very wrong last year.
At the beginning of 2021, the price/earnings ratio of the S&P 500 was 22.5, according to FactSet. Interest rates were extremely low, so the risk premium on equities was historically high. The low interest rate meant that future cash flows were much more important than past performance. On top of that, the strong economic recovery also led to a sharp increase in profits. As a result, the valuation of the S&P 500 has now dropped to 21. Use valuation only for long-term forecasting returns, not for short-term investment decisions.
2. Historically extremely negative real interest rates
The main reason why equity markets performed so well in 2021 was that interest rates remained low despite soaring inflation. It was regularly speculated during the year that US ten-year yields would be above two per cent by the end of the year, but despite rising inflation, which even reached 6.8 per cent, ten-year yields did not exceed 1.5 per cent. This resulted in an extremely negative real interest rate of 5%, also in the eurozone.
People had to invest in order not to lose part of their purchasing power. There is still about 12 trillion euros worth of bonds around the world with negative interest rates, and they did not react to rising inflation either. Even the central bank turnaround at the end of the year could not move the bond market. Structural factors are at play here, which simply means more demand than supply.
Firstly, central banks are the biggest buyers in the bond market. Furthermore, there are many institutional investors who do have to invest in bonds. Even private individuals are more or less forced to invest in bonds under the guise of a buffer function and/or portfolio risk reduction, despite the fact that all that is left of bonds is risk and no return. Given the large turn away from bonds towards equities, the market is starting to learn that in the coming years there will continue to be a real negative interest rate on savings and on bonds.
3. Top ten tech as pseudo-bonds
So many dollars have been printed that there is a shortage of US government bonds to park those dollars in. The US economy is about 24 per cent of world GDP, about 16 per cent on a purchasing power parity basis. The total size of the world economy is USD 88 trillion. The world market capitalisation is clearly above that at about $100 trillion. The market value of the NYSE and Nasdaq together is about 50 trillion dollars, so about 50 percent of the total.
The weight in the MSCI world index is even higher at 63 per cent. Index investing is popular and creates a strong demand for dollars due to the heavy weight of US stocks. European bond investors see US bonds as an alternative and flee into the dollar. The laggards are hit three times. First, they have to pay interest instead of receiving it. Then the euro falls because of the money flow towards the dollar. Finally, the falling euro causes more inflation.
In their search for a liquid, safe alternative, they end up with the top 10 largest tech companies in the United States. These 10 companies thus acquire the status of pseudo-bonds, just as Warren Buffett was happy to park his money in shares like Johnson & Johnson in the past. The lesson is that safe havens do not last forever and depend on the situation.
4. Inflation is not dead
For a long time, central banks assumed that inflation would be a temporary phenomenon in 2021. Although the Federal Reserve has now admitted that this is not the case, its policy still assumes that inflation is temporary. The fallacy being made is that quantitative easing after the Great Financial Crisis did not lead to inflation and that this would also be the case now. The difference is that there were big holes in the financial system back then and China was the exporter of deflation to the rest of the world. China stopped doing that quite suddenly and too much money is flowing into the real economy, resulting in inflation.
The Fed’s balance sheet has doubled in recent years to 9 trillion. The US national debt has risen from $6 trillion in 2000 to over $20 trillion today. That will not be reversed with a few interest rate hikes. In 2022, the inflation debate will continue for some time, with the ultimate result probably being that inflation will remain structurally higher in the coming years. Investors will have to relearn how to deal with rising inflation, something we have not seen for more than a generation.
5. New investors irrationally exuberant
In 2021, many new investors have joined, with a preference for crypto-currencies, electric vehicles and meme stocks. In December 1996, Alan Greenspan spoke of “irrational exuberance” and this expression fits perfectly with current market behaviour. In times like these, investors are all too quick to forget that stable growth stocks are usually preferable to very fast unprofitable growth stocks.
Within the Nasdaq, there was a large yield gap between profitable tech companies and unprofitable tech companies in 2021 as a result of a bout of common sense during the year. One of the lessons that current investors should learn from these new investors is that today, a relatively small group can cause large movements in the market. Due to the growing group of passive investors and other market participants who trade regardless of price, much of the liquidity in the market is apparent. This could result in larger price fluctuations in 2022.
Han Dieperink is an independent investor, consultant and knowledge expert for Fondsnieuws. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is currently active as chief commercial officer at Auréus Asset Management. Dieperink provides his analysis and commentary on the economy and markets. His contributions appear in Dutch on Fondsnieuws.nl on Tuesdays and Thursdays and in English on Investment Officer Luxembourg from time to time.