Webcast #8: Look Out Below (11 minutes)

We always avoid participating in the momentum-driven stock rallies. Momentum stocks are those that seem to perpetually appreciate each day as the herd piles in, buying more and more shares as the price goes up. In last week’s blog/podcast, we discussed several companies that over the years briefly surpassed the Royal Bank to command the largest value on the S&P/TSX Composite Index (“TSX”), only to fall back down — in most cases, quite harshly. These names included Nortel Networks, Research in Motion (today known as Blackberry), Valeant, and Shopify.

Heading into 2022, everyone knew rates were expected to rise. At the end of December, the market had priced in three rate hikes in 2022 by the US Federal Reserve. However, as the calendar turned, investors began to sell their growth stocks, which get hurt most by higher rates. These same names were the momentum stocks that drove the market higher during the height of the pandemic. Because growth stocks expect sizable revenue growth in the future, upcoming cash flow is discounted back to today using a higher denominator due to a higher rate of interest. Furthermore, without revenue, growth companies issue equity and/or borrow debt to fund their future plans, both of which are hurt by higher interest rates.

The technology-dominated NASDAQ exchange is down -9.9% so far this year, much worse than the -5.6% posted by the more diversified S&P 500. By comparison, here at home the TSX is around flat, up +0.2% as of this writing.

So far in 2022, many of the momentum stocks that drove the market higher during the height of the pandemic have returned back down to earth. These names include Shopify (-36% since December 31, 2021), Moderna (-36%), Netflix (-32%), Facebook/Meta (-30%), and Tesla (-13%), to name a few. Any of these shareholders will tell you that momentum stocks are fun to own on the way up, yet painful to carry on the way down.

In 2017/18, investors were buzzing about the newly emerging marijuana sector. Personally, I didn’t put a single ticker on my screen. It had every attribute you would expect in a bubble waiting to burst. Looking at the Horizons Marijuana Life Sciences Index ETF, the price hit almost $25/share in 2018. Today, it’s $5.47, down almost 80%. I never hear questions about it anymore.

Statistics suggest that capable asset managers are correct in their selections two-thirds of the time. Avoiding a bad stock is equally as important (if not more so) than picking a good one. We look at the charts and avoid stocks that climb upwards every day. This is because of our mandate to preserve capital and avoid losses in client portfolios. All it takes is one piece of bad news for the herd to change its mind and reverse their position.