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How many times have you heard now that the market is going to correct 10 - 20% because of Fed policy next year?
I am willing to bet a lot, in fact it has become consensus at this point. Nearly every fund manager is beginning to advise AGAINST holding the “untouchable” stocks which include small caps, Cathie Wood stocks, or really anything with growth. This is becoming extreme and sentiment seems to be pricing in the worst case scenario for 2022. So, the question becomes, is this the first time main stream consensus is universally right?
I doubt it. There’s a new scenario emerging and it’s emerging quickly.
The Thesis Behind a New Scenario
Recently, I’ve witnessed nearly everyone going back and fourth on how to treat growth or small caps. More importantly, the popular consensus appears to be that we’re going to correct heavily or crash. This is raising some serious contrarian indicators. Puru, I appreciate you but this is becoming a daily occurrence where you flip back and fourth. Also, it’s not just very smart money managers that are saying this.
If you look on YouTube, the narrative spreads here as well. I listened to Meet Kevin today as well and he said, “why don’t you just dump your small cap names and then rotate back into them after they reverse? Everyone else is dumping their money into Apple, Microsoft, and Nvidia, why shouldn’t you?”
Today I turned on CNBC and a fund manager said that he’s holding a 20% cash balance! This is insanely high for a fund to be 20% cash. It’s obvious popular consensus on the street is saying that anything with growth, or risk, should be avoided and it’s time to buy “quality companies”.
In other words, literally everybody is saying the same thing.
Because of this new narrative and realization, I am going to back peddle on my market outlook that I posted about in the link above. It appears that it is MORE LIKELY that the market trades sideways to slightly up (in between 8% -11% with no major market correction greater than 15% in 2022 and small caps/Cathie Wood stocks heavily out perform.
Previous market outlook
New Market Outlook
ARKK Innovation ETF Outlook
The Current Narrative Explained
The current market narrative is completely shrouded with inflation concerns. Because of these inflation concerns, many pundits are drawing conclusions to the 1970’s. The way inflation was controlled in the 1970’s was by purposefully crashing the markets, hiking rates aggressively, and provoking an economic recession. Thus, killing inflation. Consensus has it that a 1970’s approach will need to be done again. A few reasons why people think this:
Inflation is at 40 year highs. The last time we saw this was at the beginning of the 80’s. The Fed’s policy response back in those days were very aggressive interest rate hikes. People are afraid inflation is not transitory and the Fed has to do something similar. This will certainly crash the markets.
The Fed has printed nearly 50% of all U.S. Dollars in circulation, doubling their balance sheet through Quantitative Easing. M2 money supply increased from $15T to $21.4T since the bottom of the pandemic.
Supply bottlenecks resulting from unprepared demand caused by the pandemic and stimulus
There are three rate hikes expected in 2022 with some Fed members substantially more hawkish than usual. Target federal funds rate below:
Inflation, Fed policy and Supply Chain bottlenecks have created a massive risk-off environment. Essentially, Fund managers are positioning themselves for more rate hikes and for inflation NOT to abate and to NOT be transitory. They have concentrated their portfolio’s into Mega-Cap tech companies and cyclicals for a risk off trade and in some cases, positioning themselves for a major stock market crash.
Why the Calls for a Market Crash are Wrong
When you think about it and really assess the trade that’s happening in the markets you begin to realize this narrative toward rate hike fears and QE ending fears have plagued us since February of 2021, 10 months ago. This risk-off trade of abandoning Cathie Wood stocks and small caps is not new or out of the ordinary. Essentially, this has become a crowded trade. More importantly, there’s a few key things to know here.
Large caps have absolutely crushed small caps this year and have been since February. We’re just now getting to extreme levels and we’ve been in a Bear Market for small caps and growth stocks.
This trade is crowded and everyone is following the trend of dumping small caps and heading toward FAANGM. This is most apparent in Apple’s valuation with a forward P/E of 32 and 10% growth projected over 3 years. This is all multiple expansion and has little to nothing to do with what is going on at Apple. If it was, analysts would update their revenue and earnings expectations but they’re not. Essentially, Apple is running on safety and the idea of stock buy backs. This historically does not work for long.
There’s a ton of liquidity on the sidelines. If the purpose of QE is to inject more liquidity into the system but if liquidity is already at historical levels in both bank reserves and reverse repo’s, this means there’s a chance this capital is waiting for a significant dip in the stock market. More importantly, this goes back to what I mentioned before about how fund managers are CASH HEAVY! If they are cash heavy, this further strengthen’s the argument that we wont see as aggressive of a pull back in the major index’s.
Inflation could actually be transitory and we could see it abate in the months ahead. Everyone right now is positioning their portfolio’s toward inflation not being transitory as consensus has it continuing to be high, after it’s already run up to historical 40 years highs! Nobody is asking, “what if it slows down?”
To summarize, there’s Trillions of dollars on the sidelines that institutions and banks are not using. This is enough capital to prevent any sort of major stock market correction because institutions will likely buy the dip heavily due to the excess liquidity that’s already in the system, despite QE ending. Small caps and “Cathie Wood Stocks” have been beaten down this year with billions of dollars of outflows.
Sentiment/consensus has three rate hikes priced in with an over emphasis of QE ending. This means the worst is priced in to (and currently still being priced in to) small caps, growth stocks, “Wood Stocks” and many other risk assets. However, what’s not priced in is that inflation does come back as transitory, supply chain issues resolve, and the Fed doesn’t hike rates 3 times next year. If this happens, growth stocks and small caps will catch bid as their multiples are already contracted to historically bearish levels.
What is Likely to Happen
Using contrarian indicators, it seems likely that large caps will trade sideways to slightly up next year. There could still be a correction as some sort of self fulfilling prophecy but there’s too much liquidity and bond prices are still historically low. Institutions and, now, retail find themselves positioned long Mega-cap tech and short small-caps after the trade has been going on for 10 months. This is likely to flip, quickly, and there could be an underlying risk-on-rally as valuations normalize.
Small Cap Stocks I like
Some small cap stocks are trading at insane valuations and not even on a revenue basis. There are a few stocks I see that are trading at a price to book ratio of 1x, meaning you’re essentially buying their assets on a 1:1 basis paying no mind to future cash-flows the business will generate. All of these stocks here, I believe, are positioned to out perform the market in 2022
FuboTV $FUBO
A once FinTwit darling, this has a special place in my heart. Fubo is growing extremely fast and they have big plans for the future. The biggest concern here is that they are tight-ish with cash on hand and they need to raise more capital. If their share price does not go up, investors face a big dilemma of being heavily diluted so the business can stay afloat. They must show improving operating margins or the stock price will never move.
If they show improving operating margins on their next call and that their Sportsbook and latest acquisitions are going well, this stock could take off like a Fubo Rocket-ship. Buy-zone: $13/share
Agrify $AGFY
Officially trading at a 1.5x Price to Book ratio, they’re expected to be earnings positive within 2 years. More importantly, they already have a lot of their work already booked for 2022 and they’re expected 200%+ growth this year. This Ag-Tech stock has the ability to disrupt indoor cultivation as we know it and shape the Canna-industry’s indoor grow farms. Their biggest risk is competition and execution. They are a very new and small company, so there’s a chance it doesn’t work for them. However, if they execute successfully based on analyst expectations, this could be a major winner for a lot of portfolios.
Buy-Zone: Here at $9/share.
PubMatic $PUBM
Let me say that it’s kind of dumb to even see PubMatic be disrespected like it has all year. I assume it’s being grouped into the small cap growth category, therefore institutions don’t want it. On the contrary to their popular opinion, there are few stocks this year that have CRUSHED expectations and earnings on both the top and bottom line more than PubMatic has.
They operate as a supply-side AdTech company and they are growing organically by 50% YoY. More importantly, they run 30%+ EBITDA margins with 70%+ gross margins. This means they are very profitable and they are growing nicely, taking market share, in a competitive market. Buy-zone: $30 - $35.
Brilliant Earth $BRLT
I have been following this one since IPO and I have fallen more in love with this stock over time. This one is simple and a classic “Peter Lynch Stock”. They’re an online first e-commerce jeweler that’s running a similar show room & e-commerce approach as LoveSac $LOVE who has seen their share price appreciate 140% since 2018’s IPO. More importantly with $BRLT, they’re growing revenue steadily and they’re doing it profitably with 9% net-income margins. They have a strong balance sheet and strong business fundamentals.
They’re clearly taking market share and they’re catching a generational trend of buying everything online. They’re leading the “tech capabilities” in this market by instituting digital twins technology and block-chain diamonds. It’s a no brainer, they have a massive runway for growth and they’re executing extremely well, profitably. Buy-zone: $15 - $17
Summary
The markets are likely to be very good in 2022 for the right type of investors who know where to look. Basically, what we’re seeing is that growth and small caps are completely “out” and everything else is in. This positions the growth trade to have a good year despite expected macro head winds. More importantly, macro projections are almost always WRONG. Inflation could begin topping out soon and all of the sudden, the Fed decides it doesn’t need to hike rates too soon. We don’t know what we don’t know but we do know which sector has been beaten down.
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I got a ton more content for you guys in 2022!
Stay tuned, stay classy
Dillon
Great read. I do tend to agree. We don't know for certain, but in most scenarios sectors tend to revert and continue to cycle. That's not to say indexes and large caps will crash (small correction most likely in my opinion), but if you look at the gains of 2020 for small-mid cap growth, 2021 should not be too surprising. I'm not saying it was easy to predict, but after a steep correction small-mid cap growth is poised to rebound nicely.
I don't think interest rates at the projected levels for 2022 pose much of a risk for companies with strong revenue growth and profitability (or a strong path to it). It's important to note that major FED policy shifts since 2008 has significantly changed market dynamics, and the use of historical comparisons beyond that are less telling than they once were.
As Always a Great Read Dillon ... I enjoy and appreciate your view on the Market ...
Many thanks ...