While we generally do not focus on short-term performance, given the heightened market volatility to start the year, we wanted to offer some perspective. The S&P 500, which is representative of US stocks (and widely used in passive portfolios), is down almost 9% from all-time highs, and down almost 8% to begin the year. Tech stocks, as measured by the NASDAQ, are down over 15% from all-time highs and almost 12% in the first 2 weeks of the year.
While these may seem like large moves, and they are in such a short period of time, we wanted to re-frame this with a 3-year time horizon. Over the last three years through the end of 2021, the S&P 500 was up over 90%, a stunning 24% on an annualized basis (per year). The NASDAQ was up 137% over the same period of time, or approximately 33% on an annualized basis. These are unusually large returns and 2-3 times higher than what is expected of stocks over longer periods of time.
Throughout 2021, we continuously discussed that the large overall return of the stock market was NOT representative of what was actually happening. If you look at the constituents of the S&P 500, the top 10 holdings represent nearly 30% of the index. This means that the remaining 490 companies represent 70% of the index. This is fairly concentrated for what is supposed to be a broad measure of the US stock market.
Moreover, the attribution of performance has continued to be led by a handful of stocks, namely Microsoft, Alphabet (Google), Apple, Nvidia, and Tesla. These 5 stocks represented about a third of the overall 29% total return of the S&P 500 in 2021. When you review a broader sample of stocks in the index, there was significant negative performance, particularly in high-growth technology and biotechnology stocks. Our view was that this dynamic was both misleading and unhealthy and that we would need to see a correction.
The primary catalyst for the recent volatility has been significant changes in policy from the Federal Reserve. In the face of high inflation (the latest CPI reading was 7%), the Fed is raising interest rates, perhaps as soon as March. The market is reacting accordingly. In the first 2 weeks of the new year, the rate of the 10 year US Govt bond, a widely used benchmark of medium-term interest rates, rose from 1.5% to end 2021 to a peak of 1.9% before retreating. While this may not seem like a “large” move, it is actually very significant relative to history, particularly as measured by the speed of the move.
Technology stocks and other high-growth sectors such as biotechnology have been among the hardest hit. Stocks are valued based upon their future cash flows, discounted by current interest rates. When interest rates rise, like they have this year, the farther out those cash flows are, the less they are worth today. Given that growth stocks derive their value from the future, they have been hit the hardest. On the other side of the spectrum are oil companies, banks, industrial companies, and material companies that derive higher cash flow in the near term, and have outperformed to begin the year. As a reminder, we specifically take out traditional energy (oil and gas) exposure in our client portfolios, in favor of an allocation to clean energy.
So while none of the actual market action is all that surprising, the speed of these moves has been. We continue to be constructive on stocks given the positive economic backdrop, but would not be surprised to see continued volatility. Ultimately, we view this correction as a positive. It will likely lead to a more healthy market that allows for more broad-based gains, beyond a few stocks.
As we mentioned earlier, recent stock index returns are very high relative to longer-term averages, and we do not expect these kinds of index returns going forward. This is why we believe it makes sense to be tactical during times of volatility and to diversify across other asset classes. We used this as an opportunity to selectively re-balance our portfolios, trimming positions in positive performers such as emerging markets, gold, silver, and bank loans, while adding to negative performers such as big technology, small-cap stocks, biotechnology, and digital assets.