The stock market corrected from all time highs recently, after inflation worries seem to have spooked markets.
Inflation and stock valuation
For one, the US 12-month core inflation rate jumped to 3%, the highest since 1995.
Many high growth stocks and ETFs like Cathie Wood’s Innovation ETF ARKK fell more than 33% since its peak in March, and has not shown any signs of reversing.
The reason for such drastic price correction can be attributed to how growth stocks are priced.
Since many growth stocks do not exhibit profitability and have little to no cash flows today, and many of these cash flows are expected earnings in the future, when valuing growth stocks using the discounted cash flow model, the expectations – and valuation – of growth stocks tend to take a much larger fall compared to their value counterparts when interest rates rise.
Market volatility has also trended upwards in recent days. The VIX – a real-time market index representing the market’s expectations for volatility over the coming 30 days – spiked as high as 27 before tapering off slightly.
There were also some negative surprises. For example, while 1 million new job openings were expected in April, only 266,000 were added.
Volatility should persist at market highs
Stock markets are still in extended territories by many measures and have priced in many of the COVID recovery that we expect to see. Any negative surprises (e.g. resurgence of COVID, larger surge in inflation expectations) would have a negative impact on stock prices.
However, the macro backdrop has been rather supportive. Continued fiscal stimulus by governments around the world and loose monetary policy can be expected for a little longer, although personally, I’d expect fund flows to continue rotating from growth into value rather than out of equities.
Avoid selling out of equities but consider hedging/diversifying
Personally, bonds and cash returns have been ludicrously low and are unlikely to change any time soon. Taking too little risk will be costly for your portfolio growth as inflation (which is expected to increase) eats into your returns.
Take too much risk and you can expect a huge portfolio value dip as investors rotate capital out of expensive assets in relation to the macroeconomic environment and expectations of the future.
Since there are no good alternatives outside equities, I still think it’s good to remain invested in a diversified portfolio of mainly equities. I previously wrote about VWRA and why it is the best portfolio to own.
Let’s look at VWRA’s (using VT as a proxy since it tracks the same index) performance in recent months compared to a growth oriented portfolio like QQQ and ARKK.
As you can see, while ARKK (in red) showed super growth in early 2021, it had all its gains wiped off in recent months, even underperforming VWRA/VT and QQQ on a year-to-date basis.
VT/VWRA (in blue) demonstrated less volatile returns, but still managed to squeeze out positive returns. VT/VWRA returned 8.54% while QQQ returned 2.77% year-to-date as investors rotated out of growth stocks into value stocks.
But that’s not to say that QQQ and ARKK are bad ETFs just because of their recent underperformance. Zooming out the chart all the way back to 2017 showed how much ARKK has outperformed the other two by more than 4x.
The key is understanding where you are in the macro cycle and where capital is expected to rotate towards if you’re taking a more concentrated approach to investments.