Is Unprofitable Growth Dead?
It may not be as apparent from the overall stock index, but over the last couple months high growth companies that are not yet profitable have gotten killed as well as other Risk On Assets. There has been a general rotation to valuing low risk profitable companies, and energy.
Performance Nov 1 2021 - January 16th 2022
S&P 500 stock index (1%)
S&P 500 energy sector (10.8%)
S&P 500 Consumer staples (7.2%)
Kroger (21.4%)
Ark Innovation ETF ( -56%)
Bitcoin (-40%)
GoldmanSachs NexGen Index DX Software Growth (-60%)
Clover Health (-60%)
Zoom (-42%)
The main reason behind this is likely the Feds talk of rising interest rates.
Interest Rates
Currently there’s a large concern of inflation with the CPI rate rising 7% yoy in December. Prices are determined by current supply and demand as well as expectations of future supply and demand. The supply side is determined by what goods / services we are capable of producing, and the demand side is determined by how much money people have to purchase those goods and services and their expectations of future supply and demand.
An example to illustrate this is the price of used cars up 37% yoy.
Current Supply Side
The pandemic caused major automotive manufacturers to build less new cars. They poorly predicted how fast demand would rise as things opened, and then when they tried to ramp production they hit a chip shortage. This is caused by chip facilities being shut down from the pandemic, the rise in demand of computing devices to work from home, and a drought.
Current Demand Side
The government printed a lot of money to stop total economic collapse during the pandemic. This allowed folks to still have money whether that be through a direct stimulus cheque or not being laid off as their company was directly or indirectly supported by stimulus. Folks had previously held off on purchasing a new car as they weren’t using them in the pandemic, so now they need a car and have money to spend. Also if you need a car now, you may be unable to wait.
Expectation of Future Supply
Future expectations are different to different folks and hard to predict, but generally it seems predictions are that the chip shortage won’t end until deep into 2022 or 2023.
Expectation of Future Demand
It’s generally expected that the worldwide demand for vehicles will continue to grow.
Eventually car manufacturing will ramp up to match demand, the chip shortage will end, and folks won’t be willing to pay nearly as much for a used car. However, right now they are hard to get and are expected to be hard to get for some time. Therefore, the price is high.
It’s not great if prices of basic essentials are increasing quickly. To combat this, either supply or expectations of supply have to be increased or demand or expectations of demand have to be decreased. The Fed has limited control over increasing supply or supply expectations; they can't make companies build more cars faster. Therefore they go after demand and demand expectations. In theory they can reduce current demand by reducing the amount of money in circulation and demand expectations, by communicating how they may act in the future.
In theory they reduce the amount of money in circulation by raising interest rates. The theory is that if it’s more expensive to get a loan less people will, thus reducing the money supply and personal and company expenditures. This also incentivizes folks to save their money instead of spending it. This leads more folks to buy government bonds instead of other assets therefore reducing speculation and risk taking in the stock market. It’s arguable that this succeeds in slowing overall money supply growth as the government then has to print money to pay these higher interest rates on the bonds unless there’s a very significant tax raise. However, If that money stays in those bonds instead of circulating in the economy it’s possible to have continued money supply growth and lower inflation by lowering the velocity of the money.
What’s also important is the Feds effect on future demand expectations. It doesn’t particularly matter if raising interest rates actually reduces demand as long as people believe it does. If folks' future demand expectations are lowered because they believe the Fed is going to raise interest rates they may be less willing to pay higher prices in the short term helping combat inflation.
In this way the Fed hopes to get people to speculate less, and be less willing to pay higher prices until the supply side can catch up and we can effectively make enough stuff for everyone whether that be food, cars, or houses.
So why does that crash growth stocks
Companies are generally valued based on all future cash flows of the company discounted back to the present value of that cash. Future money isn’t as valuable as money today. An increase in interest rates makes the future cash flows of these growth stocks less valuable and more risky as they may have issues raising capital. This makes it more potentially more appealing to own stocks that make money today.
So how do I look at this
I just see this as an opportunity to buy exciting companies at cheaper prices. Not all of these companies will succeed, but in 10 years from now I’m going to be happy that I got the opportunity to get more ownership of these companies at cheaper valuations. I don’t believe now is the time to follow the herd and rotate into low risk asset categories. Instead I plan on the reverse and to start rebalancing my portfolio towards riskier investments.
Personally I’d be surprised if we ever see high interest rates 5+% based on how much government debt there is and the increase in money supply paying those rates would cause. I’d rather own fast growing companies / limited supply assets than ‘low risk’ assets.
Generally it’s basically impossible to time the market. These growth stocks could keep falling for months or years to come. Raising interest rates or taxes might crash the entire market, So it’s never wise to make sudden moves, but instead of panicking I’m working towards buying more.
What do you think is going on in the market?
Disclaimer: This does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this article should consult with his or her advisor.