Not even the emergence of a new variant of Covid 19 could stall financial markets in the final quarter of 2021. Although stock markets initially fell sharply lower when Omicron was discovered, as most Americans were finishing Thanksgiving dinner, stock indexes quickly resumed upward momentum.  This resulted in a strong December, a strong 4th quarter, and a very strong year.  Once again, the best performing index of the year was the Standard and Poor’s 500 Stock Index (S&P 500).  This popular benchmark finished the year 28.68% higher than where it started.  It was also the top index for the 4th quarter with a 9.75% three-month return.  However, nearly every major index posted solid returns for the trailing twelve months.  The Russell Large Cap Value index (26.43%), NASDAQ (22.21%), and Dow Jones Industrial Average (20.95%) all generated above average returns for 2021. The returns for small cap stocks (14.74%) and international stocks (11.86%) were only soft by comparison. 

In other financial markets interest rates were little changed, gold stacked higher, and oil prices gained slightly.  Investor’s attention has turned to interest rates as the Federal Reserve indicated it would begin to eliminate buying bonds in the open market (quantitative easing) and evidence of rising inflation continues to mount.  With the reduction of bond buying (tapering), it appears that the Federal Reserve’s raising of the federal funds rate (interest rates) will not be far behind.  For now, rates have remained nearly unchanged as the 10-year Treasury Note went from yielding 1.48% at the beginning of the fourth quarter to yielding 1.51% at the end.  Precious metals, such as gold, continue to be caught in a demand battle between being a store-of-value hard asset and competition from cryptocurrency investors.  Historically, gold has been held as a hard asset to asset to help hedge against inflation.  However, to the younger generations and market speculators cryptocurrency is seen as a more modern hedge.  For the fourth quarter, gold was able to increase from $1,758 to $1,829 a troy ounce.  Oil prices increased just 2.61% for the final quarter of 2021 but were 59% higher than when the year started.  On December 31, 2021, a barrel of West Texas Intermediate crude was $76.99.

The “silent killer” of concentration risk continued to mount in the fourth quarter as major indexes behaved more like a six-stock portfolio than a diversified index.  Inactive managers remained indifferent as exchange traded funds (ETFs) and index mutual funds reached record levels of company specific risk.  The D’Arcy Capital FAANGM Multiple Ratio was the highest it has ever been (inception 6/30/2019).  This ratio calculates the average weighting of a FAANGM component (Facebook, Apple, Amazon, Netflix, Google, Microsoft) relative to the average weighting of all other stocks within the S&P 500.  The average weighting of the 6 FAANGM position is currently 25.58 times higher than the average weighting of the 501 remaining stocks in the S&P 500 (yes, the S&P 500 has 507 stocks currently). This risk has been masked by consistently strong performance in the S&P 500 (3-year annualized return of 26.03%).  However, greater performance of the S&P 500, the greater the risk is elevated.  Investors have ignored this volcanic shaped risk developing in inactive funds that replicate the S&P 500 Index.  Many people erroneously believe that successful investing is as simple as putting everything they own into one index without regard to the underlying holdings.

Looking Forward

The debate to determine the best portfolio management approach between Active investing and Inactive investing (index funds, ETFs, and closet benchmarks) has raged on for decades.  Inactive investment management could arguably claim victory during the roughly ten-year period between the end of the Great Recession (2009) and the beginning of the Global Pandemic (2020).  The frequency of active managed portfolios exceeding the S&P 500 was low.  Compounding the problem was that many mutual funds that claimed to be active managers were building a portfolio that was invested exactly like the index (closet benchmarks).  Additionally, this 10-year period experienced an abnormal return relationship between large company stocks and small company stocks.  Historically, small cap stocks outperform large cap stocks (1926 to 2010 – small cap stocks averaged 12.1% while large cap stocks averaged 9.9%).  However, in the 10-year span indicated previously, small caps averaged 11.36% compared to 13.36% by large cap stocks.

Why is this so important going forward?  The reason is that both anomalies began reversing during the global pandemic.  This rotation back to historical relationships (Active over Inactive and Small Cap over Large Cap) is only beginning and will probably last a long time.  The problem is most investors are overweight large cap (specifically growth) stocks within Inactive strategies.  The success of Inactive strategies in the previous decade was the result of multiple factors coming together to form a “perfect storm.”  The outperformance of Inactive management is undeniable.  But equally undeniable is how preposterous it is to believe that it does not matter what stocks an investor is purchasing and the relative weightings they are held in the portfolio (Inactive approach). 

There is still time.  Investors should review their stocks, mutual funds, and ETFs carefully.  Determine if there is concentration risk within an investment or within the overall portfolio.  Understand if a portfolio manager (or team) is responsible for constructing the portfolio or if it is an Inactive algorithm.  Make sure all the holdings are diversified by size, style, and geography.  What has worked the last ten years will not be the same approach that works for the next 10-years.  By creating broad exposure to many types of investments, investors will have the best chance in participating in the next major trend.

The three economic concepts D’Arcy Capital is focused on for 2022 are increasing interest rates, rising inflation, and FAANGM concentration risk.  D’Arcy Capital currently favors value over growth and small caps over large caps.  As inflation germinates and interest rates bloom, it is important to have stocks that can adjust with price increases.  These include the energy, financial, and consumer discretionary sectors.  Sectors that struggle to pass on price increase such as utilities and consumer staples should be underweighted.  D’Arcy also favors inflation protected bonds (TIPS) and municipal bonds within the fixed income complex.   

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