Q4 2021 Market Update
by Eric Marshall, CFA, on Jan 13, 2022
U.S. stocks finished the Fourth Quarter on an impressive uptick, with the S&P 500 Index posting a gain of 28.7% in 2021, which ranked as the 21st best year for the Index since 1926. Although every year has its unique challenges, 2021 had no shortages of uncertainties to navigate, including an ongoing global pandemic, supply chain disruptions, port congestion, labor shortages, inflationary cost pressures, and a polarizing political backdrop. Nevertheless, the market climbed another wall of worry as an abundance of liquidity found its way into U.S. equities as well as most asset classes in 2021. The bull market that started 22 months ago off the March 2020 pandemic low saw broader participation as sectors such as energy, real estate, financials, industrials, and consumer discretionary contributed to solid returns during the year. Furthermore, our relative performance in 2021 reflected a shift in market leadership that seemed to favor fundamental investing and rewarded individual stock selection.
In our opinion, the market's upward move in 2021 resulted from an ongoing earnings recovery and increased liquidity, impacting just about every facet of capital markets. Over the past year, we saw a healthy rotation of capital flowing into sectors outside of mega-cap technology, which favored stocks with improving balance sheets and whose underlying assets can produce stable cash flow and earnings. Furthermore, it is worth noting that advancing stock prices in 2021 were not driven by PE (price/earnings) multiple expansion within the major indexes. According to the most recent data published by FactSet, the S&P 500 is trading at approximately 21.2X forward earnings estimates compared to 22.6X at the beginning of the year and the five-year average of 18.5X. Although it is essential to point out that PE multiples remain highly bifurcated between growth and value stocks, the inverse of the S&P 500 year-end PE multiple is an earnings yield of 4.72%, which was still well above the 10-year treasury yield of 1.52% at year-end. Although many industries hardest hit by the pandemic have experienced a meaningful recovery, we still see opportunities for earnings improvement in the year ahead. We acknowledge that some business dislocations in response to the pandemic could be permanent, creating structural changes in the economic landscape. Although we expect many aspects of commerce to return to normal by the end of 2022, we realize structural changes will impact how we travel, provide education, work, live, and consume products and services. Such changes translate into new investment opportunities. With this in mind, the Hodges Capital Management investment team has positioned our portfolios to benefit from secular economic trends and structural changes across many sectors.
Furthermore, an unprecedented increase in liquidity over the past 22 months has supported higher stock prices and higher prices within other asset classes such as commodities and real estate. Greater liquidity has resulted from an aggressive monetary response by the Federal Reserve designed to support credit markets and significant fiscal stimulus to lessen the immediate financial blow from the COVID-19 pandemic. This money supply increase has manifested itself in higher asset prices and inflationary cost pressures in most facets of our economy. Basic economic principles would suggest that consumption cannot outpace production without long-term inflationary consequences regardless of the system's liquidity. As we have mentioned in the past, we spend little time predicting interest rates, foreign currency fluctuations, or future commodity prices. However, we pay close attention to prices and, more importantly, the pricing power that our portfolio companies exhibit within the goods and services they produce. For many businesses, inflation and logistical challenges will adversely impact profit margins and revenues in the months ahead. Companies that exhibit pricing power and a low threat from substitute products can often pass on higher costs and see profit margins benefit from an inflationary environment. As a result, we are overweighting our portfolios with both growth and value stocks that can pass on higher prices, maintain/improve margins, and inflate their earnings in the year ahead. Although supply chain dislocations and labor shortages will eventually improve, we would not be surprised to see inflation stick around as consumption and liquidity remain abundant.
As we enter 2022, we would acknowledge that investor sentiment is cautiously bullish, and some U.S. stocks now appear overbought. As a result, we would not be surprised to see one or more normal corrections (5-10%) during 2022. We would also point out that while investor sentiment suggests near-term optimism, recent fund flows into U.S. equities and overall cash levels do not indicate that investors are at a point of euphoria that would be consistent with the end of most bull markets. After speaking with senior management of more than two hundred publicly traded companies over the past couple of months, we believe the fundamental backdrop for consumption and inventory levels suggests a favorable earnings picture for most economically sensitive businesses. The big question heading into 2022 is: What will investors be willing to pay for future earnings growth, and how much earnings improvement is already priced into individual stocks? We believe the PE multiple for the broader market has no room to expand if interest rates rise. However, this is not true for every stock, as we see the potential to unlock value for many under-the-radar companies in our portfolios. As improving fundamentals materialize in the year ahead, we see further upside for active portfolio management as earnings improve for most economically sensitive sectors.
In the year ahead, we will also use periods of increased volatility to find bargains in well-run businesses that control their own destiny by relying on ingenuity and well-calculated business decisions. Investors in the Hodges Funds can be assured that we are not changing our core investment discipline, designed to seek out quality companies running great businesses with excellent management teams trading at reasonable prices. Furthermore, we see this as an ideal environment for active portfolio managers to carefully select individual stocks that we believe can generate long-term value for shareholders.
Sincerely,
Hodges Investment Team
No bull market is permanent. No bear market is permanent. There are no stocks that you can buy and forget. Remember, no investment is forever. - Sir John Templeton
Hodges Private Client is a program offered through Hodges Capital Management, Inc. (“HCM”). HCM is an Investment Advisory Firm registered with the Securities and Exchange Commission (“SEC”), is a wholly owned subsidiary of Hodges Capital Holdings and serves as investment advisor to the Hodges Funds. HCM is affiliated with First Dallas Securities, Inc, a broker-dealer and investment advisor registered with the SEC.
This discussion is not intended to be a forecast of future events and should not be considered a recommendation to buy or sell any security. Past performance is not indicative of future results. Investing involves risk. Principal loss is possible. Investing in smaller companies involves additional risks such as limited liquidity and greater volatility. No current or prospective client should assume that information referenced in this communication is a recommendation to buy or sell any security or is a substitute for personalized investment advice from your individual advisor. HCM does not provide tax or legal advice. Consult your tax or legal advisor for any related questions.
All information referenced herein is from sources believed to be reliable and is provided as general market commentary and does not constitute investment advice. This material was created for informational purposes only and the opinions expressed are solely those of HCM. HCM shall not in any way be liable for claims and makes no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information. The data and information are provided as of the date referenced and are subject to change without notice.
