Before The Bell
The U.S. equity market sold off sharply yesterday afternoon following the release of the minutes from the Federal Reserve’s December Federal Open Market Committee (FOMC) meeting, which is the two-day conference of central bank leaders to vote on monetary policy. Investors did not like that the readout showed that Fed policymakers are taking a more hawkish, or restrictive, view on monetary policy. The NASDAQ Composite, which sold off on Tuesday and yesterday morning leading into the release, as rising fixed-income yields took a bite out of the higher-growth technology issues, was again under heavy selling pressure yesterday afternoon on worries about higher bond yields and forthcoming interest-rate hikes, as the central bank attempts to rein in inflation. It was the worst session for the NASDAQ index since last February 25th.
This morning, readings on the futures are mixed, showing no “bounce” from yesterday’s doldrums. A positive indicator is that the employment market remains quite strong, with new unemployment claims remaining around the pandemic-era low points and workers changing jobs at a high rate. These indicators of continuing economic strength are a counterweight to the pressure from the Federal Reserve.
Recently, the U.S. equity market has delivered a bifurcated performance, with the Dow Jones Industrial Average moving higher on the strength of its value-oriented, cyclical components, while the NASDAQ Composite, as noted, was under notable selling pressure. The equity futures are indicating a similar-type pattern when trading opens stateside this morning. All the indexes are pressured by the chance, shown in those FOMC minutes, that the pace of Fed tapering down of its bond buying program is likely to proceed at a pace quicker than most pundits initially expected. Such a move, also called reducing the Federal Reserve balance sheet, would remove liquidity from the financial system and is seen as an aggressive form of quantitative tightening. The last time the Federal Reserve made such a move was in 2018, and that led to a difficult year for equities.
The Federal Reserve’s hawkish stance, which would include the aforementioned reduction to the balance sheet, the completion of the bond-buying program tapering by early spring, and three or possibly four interest-rate hikes by year’s end, drove fixed-income yields sharply higher yesterday. Data from Automatic Data Processing (ADP) showing the creation of more than 800,000 private-sector jobs last month and the continued low weekly initial jobless claims that we mentioned (that figure came in at 207,000 this morning) is giving the Federal Reserve the platform to start removing some of the monetary support from the financial system. Later this morning, we will receive the latest reading on nonmanufacturing activity (at 10:00 A.M. EST), and tomorrow will bring the much-anticipated report on December nonfarm payrolls.
The rate on the two-year Treasury note jumped to its highest mark since March 2020, the period just before the outbreak of the coronavirus stateside, and the yield on the 10-year Treasury bond topped 1.70%, marking the highest level since last April; the benchmark rate is up again this morning at 1.74%. This pummeled the high-growth technology and small-cap stocks, with the NASDAQ Composite and the Russell 2000 both falling 3.3% during yesterday’s very bearish session.
All eleven of the major equity groups finished down, with the biggest losses suffered by the technology, healthcare, and real estate stocks. The rise in bond yields and data showing that mortgage originations and, even more so, refinancing slowed significantly last month punished the real estate stocks. Meantime, the energy and financial names held up relatively well, with the stocks of banking and financial lending institutions helped by the aforementioned notable jump in fixed-income yields and the expectation of even higher borrowing costs down the road.
Within the technology sector, we are witnessing a divergent performance. On the positive side, some of the mega-cap names, with the well-capitalized balance sheets, strong earnings growth, and steady cash flows, are holding up better than the more-speculative, high-flying technology names that have thin profit margins, are not profitable, and sport high price-to-earnings valuations. The latter group includes the likes of Spotify Technology (SPOT), Block (SQ), Zillow Group (Z), and Twilio (TWLO). The highly speculative stocks of 2021 such as GameStop Corp. (GME) felt the wrath of the nervous investor yesterday, falling notably over the last two hours of trading.
So what is an investor to do in this environment? One thing we would not do is join the panic selling. However, adding some high-quality names, particularly those with healthy balance sheets and strong earnings growth potential, may be a good near-term investment strategy. With the Federal Reserve poised to be less supportive, we think 2022 could be the year that stock-picking is given a bigger priority over broad-based sector investing. Value Line, with its stock screening capabilities, offers subscribers an easy way to identify these high-quality equities, most of which are ranked 1 (Highest) or 2 (Above Average) for Safety.
– William G. Ferguson
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.
