2022's Great Rotation Has Begun

Jan 4, 2022

2022’s “Great Rotation” Has Begun (and the Santa Rally is over)

Capital is flowing out of tech, but where’s it going?

This week we explore:

• Why Santa Claus has left the building and growth investors are left holding the bag

• How the “Great Rotation” has begun in earnest out of tech and into value (and where that value is)

• Why present cash flows become worth far less in an inflationary world and why it’s time to reset the portfolio.

“Strive not to be of success, but of value”

― Albert Einstein

The Santa Claus rally is officially over.

The “Santa Claus Rally” is an annual market spike that covers the last week of December and the first two trading days of January.

Today was the last official day. It’s now time for 2022 and the true start of the Great Rotation, best defined as a long-term shift from “growth” to “value.”

The good maxim for investors has always been “own great companies,” but that’s not as black and white one would hope these days, especially given the change in the economic landscape we’ve seen over the last 18 months.

Here’s the bottom line. While there are a lot of good companies out there, there aren’t a lot of great stocks to own, especially at current valuations.

This change is exactly why technology stocks have dominated the market for the last 10 years, and why investors may be leaving them behind in favor of value.

Over the last five years, the Russell 2000 Index, which is the most widely quoted measure of the overall performance of small to mid-cap stocks, has risen 60%. Meanwhile, the Nasdaq is up 182%.

The big question to ask is “why” has tech tripled the performance of value companies?

In normal times, there is generally a correlation between company and stock performance, but clearly, we live in anything but normal times.

A great company can make tons of revenue while its stock drops in value year over year. A great stock can soar in value while losing money hand over fist every quarter.

It all comes down to future expectations regarding inflation. Today’s market valuations are based on present values of cash flows and expectations about their future value and growth. In a deflationary environment, present values are worth the same or even more down the road. It means that today’s cash is worth even more tomorrow.

However, in an inflationary environment, tomorrow’s money is worth significantly less than today’s value.

Think of it this way…

If I have $100 today, and we have no inflation, that $100 in 5 years will be worth… $100.

In a deflationary environment, that $100 in 5 years could be worth $120.

Naturally, in an environment where interest rates remain incredibly low, technology stocks have been the high flyers. This is because we value their future cash flows at a much higher level. This explains why in recent years we have seen companies like Peloton, Uber, and Expedia all continue to see share prices rise while their actual revenues are flat or are falling. Wall Street is valuing their future cash flows in a low inflation environment.

But now inflation is surging, and we are witnessing a rotation that will likely drastically affect investors, the market, and stocks – especially tech stocks.

However, if we are entering a 5% inflationary environment (the last CPI numbers had inflation at 6.8% so this is being conservative), that $100 compounded annually is now worth less than $75 five years from now.

Once future cash flows account for inflation, we can recognize that current valuations are far too high.

Many experts believe we could see up to a 50% drawdown in technology stocks in the coming years as the Federal Reserve stays behind the inflation curve.

If you think this sounds outrageous, remember this is precisely what occurred in the Dot-Com bubble. As the Fed stayed behind the inflation curve tech stocks got hammered and value stocks overperformed.

This is why we anticipate and highlight that we are witnessing a Great Rotation out of growth (future payouts) and into value (real earnings).

Value stocks have underperformed over the past five years as inflation has remained muted.

But that’s changing.

It’s no longer about what ‘might’ become, it’s now about what is.

And we believe that what is valuable is a return to real. Today’s performance in equity markets offers a glimpse of this future.

A total of 76 of The Nasdaq 100, a composite of 101 top Nasdaq stocks (heavily concentrated in technology), dropped in today’s trading.

Meanwhile, the Russell 2000 Index rose 1% on the day.

We believe today’s results are a microcosm of future trading. Capital is flowing out of tech and into value as these small and mid-cap stocks, which are reliant on profitable revenues for success, are far more appealing to investors anticipating an inflationary world.

Never forget that Wall Street models are based on “projections” and “earnings” over a certain time frame and certain sets of assumptions, one of the most important of which is inflation (or the lack thereof).

While we don’t believe we are headed for hyperinflation today, we are of the opinion that the US is headed for a long-term inflationary cycle and that the Fed will continue to remain far behind the inflation curve.

The Fed has manipulated interest rates to zero percent for over a decade and now seems hell-bent on raising rates. What this has meant is that ever since the housing market bubble collapse of 2008, investment capital has flowed into equities, paper markets, and financial assets and taken advantage of this deflationary period.

As a result, the Nasdaq, which opened in 2009 at 1,632.21, opened this year’s trading at 15,732.50 – nearly 10X growth in just over a decade.

But this growth can only be maintained in a world where inflation remains muted and why we believe a rotation is unavoidable.

A rotation!

From growth to value…

And from deflation to inflation…

And a return to real.

Buckle up and get ready for a particularly interesting and volatile 2022 as the market reprices the new inflationary world.

Best,

Adam Baratta

Editor-in-Chief

Brentwood Research