Brian Dress, CFA — Director of Research, Investment Advisor.
2022: It’s been a year to remember and, more accurately, a year to forget.
After a bull market that lasted for more than a decade since the Global Financial Crisis of 2008-09, markets experienced a massive pullback. Whether you were a conservative investor with a concentration of high quality bonds, or an aggressive investor with the most go-go of tech stocks, you are nursing losses. In fact, this year was just one of five in the last 100 years where both U.S. Treasuries and the S&P 500 finished in the red. To say we are excited to see the back of 2022 is an absolute understatement.
For the last newsletter of the year, we wanted to give you our take on the year in review: what worked and what didn’t work, both from a sector and an individual security perspective, along with the major investing themes that played out over the last 12 months.
What largely drove the bull market between 2009 and 2021 were a few separate, but related themes: explosion of revenue growth in high flying sectors like information technology and communications services, low inflation, and a very prolonged period of low interest rates, coming out of the financial crisis. Persistently low interest rates not only resulted in a low cost of capital for companies in growth mode, but also caused investors to give very high multiples to companies who delivered high sales growth rates. In most cases, these companies were and are far from profitability.
This year marked a dramatic change in investor psychology. For years, but particularly since the start of the pandemic, the old standby valuation metric of price/earnings was far out of favor and the more ethereal price/sales dominated the narrative. Late in 2021 and more so in 2022, this growth mindset at last fell out of favor, quickly collapsing some of the nosebleed valuations in pandemic-darling stocks like DocuSign (DOCU), Teladoc (TDOC), Roku (ROKU). Even mega-cap names like Meta Platforms (META, the artist formerly known as Facebook), Amazon.com (AMZN), Alphabet (GOOG, GOOGL), and Tesla (TSLA) experienced dramatic declines in share price. As we move through the year in review, we will examine in greater depth what happened in markets in 2022.
With that all being said, let’s get into it! We are excited to offer you our thoughts of the year in review.
Duration is a fancy financial term that measures the sensitivity of an asset’s price to a change in interest rates. In low or falling interest rate environments, we want to own assets with high duration, as they tend to rise in price most as interest rates fall. Examples of these are long term bonds or the ultimate long duration asset: growth stocks. Additionally, the lower the coupon rate on a bond, the longer the duration.
When interest rates do begin to rise, long duration assets experience the most dramatic falls in prices. This is precisely what we experienced in 2022. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index Exchange-Traded Fund (ZROZ) is the longest-duration bond exchange-traded fund (“ETF”) available in the market, with a maturity of longer than 25 years and a coupon rate of zero. This ETF has lost more than 37% in value in the last year.
In the stock arena, many of the longest duration assets reside in the Invesco QQQ Trust (QQQ) ETF, which tracks the NASDAQ-100 index has lost more than 30% of its value in 2022, at the time of writing. The net result is that long duration assets bore a disproportionate segment of the selling in 2022, which should come as no surprise, with interest rates reaching levels unseen since the late 2000s. The question of whether it is time for investors to wade back into long duration assets is something we will address in the first article of next year in a preview of 2023.
What is/is not Working?
In every newsletter for 2022, we have furnished you with this section, which is the starting point for our weekly research process.
For the Year in Review, we zoom out and provide our findings for the whole of 2022, both from a sector perspective, as well as regarding individual stocks. The following sections will start at the sector level and I will acknowledge top and bottom performers underneath those headings. We will start, naturally, with “What’s Not Working” for 2022, given the overall negative tilt of market action.
Information Technology/Communications Services
These related sectors were the 4th and 1st worst performing sectors for 2022, respectively. Information technology stocks from the S&P 500 were down 27% for the year, while communications services stocks were down more than 40% in 2022.
Within the communications services segment sit three of the four components of FANG, META, GOOGL, and Netflix (NFLX), all of which lost more than 35% in stock value over the past year of trading.
As we mentioned above, stocks in these two sectors were some of the most affected by the move away from long duration assets. Over the 2010s and especially in the post-pandemic world, we saw growth stocks in these sectors experience extreme multiple expansion. When interest rates are low, money chases high growth assets, but the theme reversed rapidly in 2022. In retrospect, IT and Communications Services stocks trading more than 15-20x price/sales ratios (and higher!) represented a bubble. It may be some time before market psychology around these stocks returns to a bullish state.
Within this category, we also saw a major pullback in the semiconductor chip stocks. Ultimately this is a highly cyclical industry, which had benefited from a major shortage during the pandemic. As supply constraints begin to wane, we saw a violent sell-off in these stocks, with the VanEck Semiconductor ETF (SMH) down more than 30% year-to-date (and that’s after a nearly 20% rally over the last two months!)
As we take a look at the worst performing stocks in the S&P 500 that come from these two areas, we note quite a few well-known and heavily owned names: PayPal (PYPL), Tesla (TSLA), Advanced Micro Devices (AMD), Salesforce.com (CRM), Micron (MU), Nvidia (NVDA), Etsy (ETSY), Qorvo (QRVO), and Adobe (ADBE).
Inflation had an impact, not just on the arithmetic behind stock prices, but also profoundly on the profitability of the underlying businesses. This was most apparent in the consumer discretionary sector or, as normal people say – retail. Retail stocks were the 2nd worst performing sector of the 11 in the S&P 500, losing nearly 38% in 2022.
We saw inflation impact this sector in two major ways. First, inflation hit the consumer directly, particularly in the non-discretionary items of food and energy, where prices spiked and caused major economic pain for virtually all members of society. With food and energy prices hitting the pocketbooks of consumers worldwide, the amount of available discretionary income decreased throughout the economy. Couple this with the diminishing income associated with the end of pandemic-era fiscal stimulus programs and companies selling consumer goods were some of the most affected over the past year.
Not only was there a demand problem for these retailers, but we saw issues from the supply side. Of course, supply chain constraints have been an issue since 202, making it difficult for companies to keep inventory in stock. In fact, companies like Target (TGT) were unable to keep the right inventory to match changing tastes among consumers, resulting in heavy losses. Couple this with reopening society in 2022 and the overnight shift of consumer demand from goods to services and travel, and it not surprising that this was one of the worst years on record for retail.
A third issue plagued retail in 2022 – inflation in labor costs. A number of factors have led to wage inflation, including a number of workers leaving the workforce post-Covid, reduced levels of immigration, and more. The net result is higher labor costs, where wages were up more than 5% year-over-year as of September 2022. Whatever the reasons for cost pressures in this area, retailers have been put in a difficult position of either having to raise prices and destroy demand or to eat the higher costs and suffer lower margins. Retailers were unable to make the best of this hard choice and performed quite poorly over the past year.
Notable poor performances in this spectrum include VF Corp (VFC), Carnival Cruise Lines (CCL), Amazon.com (AMZN), Bath and Body Works (BBWI), and Advanced Auto Parts (AAP). From these names, you can see that the pain was not limited to any particular corner of retail; the damage was widespread.
2022 was one of the worst years in memory for both bonds and stocks, a fact that nobody can deny. But even worse was the performance of “alternative” “assets,” namely crypto. Of course, assets like real estate, stocks, bonds, and virtually everything else, benefitted from the long-term regime of low interest rates. However even more so, crypto may never have even existed without the low interest rate environment.
Cryptocurrencies from Bitcoin, to Ethereum, to Dogecoin (and beyond) hit their all-time highs in 2021, as the U.S. Federal Reserve delayed in raising interest rates. That all came crashing down in 2022, almost correlated perfectly to the decision of the Fed to begin moving rates off the zero-lower bound. As we dig through the worst performing ETFs in our ETF list numbering more than 325, five of the worst 6 performers came from the crypto space. The worst performing security in our list was the Grayscale Ethereum Trust (OTCQX:ETHE), which lost more than 82% in value in 2022. Bitcoin itself, long considered the “safe” crypto, fell by more than 75%.
With inflation elevated and a Federal Reserve that remains committed to getting the price level back in line with the historical norm, we think it is highly unlikely that crypto will find a resurgence any time soon. This is exacerbated by fraud and abuse that has come to light, as the prices of crypto assets have fallen precipitously. None has been worse than the fraud uncovered at FTX in November 2022. We think this should be a lesson to investors that trafficking in unregulated markets and assets like this is very risky and highly dangerous. Our empathy goes out to those investors that lost everything due to unsavory behavior from actors like Sam Bankman-Fried.
We now move to the more positive side of the ledger for 2022. Of the 11 sectors in the S&P 500, just one has posted a positive return for the year and that is energy. At the time of writing, the energy stocks in the S&P 500 were up a collective 53% for 2022, an astonishing outperformance compared to the 20% loss for the overall index.
A number of factors had contributed to more than a decade of underperformance for energy stocks. The first factor was a lack of capital discipline: for decades, the ethos of the energy industry has been to drill for new discoveries at all costs. This created a violent boom-bust cycle that last resulted in a spate of bankruptcies back in 2016, as oil fell to $26/barrel. Oil as an investment has also fallen out of favor due to the spread of the Environment, Social, and Governance ((ESG)) investment framework that many institutional investors have adopted in recent years. Such a framework has led many large market participants to avoid energy investments entirely.
The tide for energy really turned in 2021, as societies started to rebound from the pandemic and freedom of movement came back into play. Energy stocks, as tracked by the Energy Select Sector SPDR Fund (XLE), rose by more than 100% in 2021.
This year, we saw a new theme emerging in the oil/gas business: capital discipline. In previous business cycles in this sector, we have seen a furious response from oil companies to drill, drill, drill when commodity prices are high. At Left Brain we spend a lot of time reading earnings conference calls. As we have read the earnings calls from the energy sector over the past two years, the tone has definitely changed. Management at these companies bear the scar tissue of previous busts in this business and no we hear time and time again that the capital allocation plan is to limit investment in new drilling discoveries.
We have been vocal all year that we like the way that business is being conducted in the energy patch. Beyond the capital discipline, there has been a clear shift to return capital to shareholders. Many of these companies have used their windfall cash flows over the past two years to pay down debt, raise dividends, and stock buybacks. Many investors have taken notice, but energy comprises just 4% of the S&P 500 even after this enormous run, far below the historical figure of 7%. We think there still may be plenty of room to run for energy stocks. Note also that of the top performers in the S&P 500, 7 of the 10 come from the oil/gas space and the top 12 performers of the 1,000 stocks we follow at Left Brain were energy related. In a year of negative news, energy was one clear bright spot.
In the mid-2000s, solar energy stocks always did well in the times when oil/gas stocks did well. That relationship was less than solid in 2021, but we saw a return to that dynamic in 2022. The 5th best performing stock in the S&P 500 this year was First Solar (FSLR), up 80% year-to-date, while the 12th best performing stock this year was Enphase Energy (ENPH), which itself gained 63% in stock price value. Humankind’s march toward renewable energy marches on apace, and solar was a major beneficiary of this continued progress in this area, as the world works to combat the issue of climate change and scarce natural resources. We continue to be impressed with Enphase in particular, which has parlayed its line of microinverters into a full suite of solar power services, including batteries, software, and more. If you are a long-term investor, keep an eye on this space.
A major investing theme for us this year has been healthcare. Healthcare is the ultimate non-discretionary expense and has historically been a defensive sector of the market. The healthcare components of the S&P 500 have lost just over 3% of value in 2022, which we think is admirable given the overall weakness in the market and compares favorably to the 20% loss in the overall index.
What we like about healthcare is that it does provide that defensive ballast to a portfolio, while also providing some opportunity for growth, particularly in the biotech and pharmaceutical sectors. Some of the best performing stocks on the board come from this space this year: healthcare services provider Cardinal Health (CAH; up 56% YTD) and generic pharmaceutical giant McKesson (MCK; up 54% YTD). One of our favorites has been health insurer Cigna (CI; up 45% YTD) and we’ve seen very strong moves out of the pharmaceutical space out of Merck (MRK) and Eli Lilly (LLY).
Innovation continues to occur, particularly in the biotech space. For investors looking to find growth in a defensive sector, healthcare may be the best place to put funds to work. In the last six months health care has been a top performer, with the Health Care Select Sector SPDR Fund (XLV) gaining nearly 10% in that time:
We don’t have enough space in our final newsletter to cover every sector that showed promise this year, but there were a number of areas that showed relative strength. Those include sectors where expenditures are non-discretionary and companies have pricing power: consumer staples, insurance, materials, defense, and industrials. These areas appear poised to remain strong into 2023, a theme we will cover in our preview next month.
Takeaways from this Year
It feels good to have 2022 in the rearview mirror. In some ways, this year has brought investors back to the basics of demanding businesses with strong and predictable profits, trading at reasonable valuations, as the markets shifts its gaze from growth to value. We’ve learned a lot in 2022 and we hope you have too, from this newsletter.
IT and communications services stocks suffered greatly in these radically changing market dynamics, along with retail and crypto. On the other side of the ledger, traditional value sectors like energy, healthcare, defense, etc. shone. We expect this dynamic to remain in place for some time. Please note that we are moving to a monthly format beginning in 2023 and we hope that we can provide you with additional impact per word written next year. Look for our 2023 preview early in January.
Thanks again for your continued support of the Jarvis Newsletter.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.