January 2022
Key takeaways
► Another outstanding year for US stocks
► Bad news for bonds will probably continue
► A more challenging year begins
► Headwinds and tailwinds
► Stick with stocks
US Stocks Continue to Amaze
In 2021 stocks faced numerous obstacles: slowing growth, rising inflation, supply bottlenecks, labor shortages, political gridlock in Washington, the coming end of Fed stimulus, and new variants of Covid. But the US stock market managed to deliver double-digit returns for the third straight year. The S & P 500 index logged 70 record highs in 2021, ending the year up 28.71%. And the S & P 500 index beat the Dow (+18.7%) and Nasdaq (+21.4%). Investors are in a good mood going into 2022.
A lot went right in 2021. The year started with much optimism. Covid vaccines became widely available, and the end of the pandemic looked near. Many expected to be back in the office by Memorial Day. Corporate earnings continued to beat forecasts, and the Fed remained accommodative and rates low. But as new Covid variants – Delta and Omicron – appeared, inflation marched higher and the Fed announced the end of easy money, stocks barely withered. You can see the damage Delta (September – November) and Omicron (December) have done in the US stock market chart below. Fortunately, recovery time for stocks is shorter and shorter with every new Covid variant. Energy was the best performing sector (+ 55.7%) followed by real estate (+38.3%).
On the other hand, the outlook for bonds is more challenging. Most bond markets posted negative returns for the year – a pretty rare occurrence. Economic factors favoring stocks are not good for bonds. And yields are still meager. The 10-year US Treasury ended the year yielding 1.50%. With inflation running close to 7.0%, your real yield is negative 5.5%. Something has to give. Yields have a lot of catching up to do, even to come close to inflation. Hence, bonds aren’t expected to do well this year (bond prices move in the opposite direction of yields). But as I’ve often stated before, keeping an appropriate amount in bonds is essential despite low rates and fears of inflation. Bonds are like ballast in a portfolio. They provide income and protection in a stock market collapse.
What’s ahead for stocks
Making predictions is folly, and Wall Street is often famously off course. So instead, let’s look at various possible headwinds and tailwinds for stocks in 2022.
Headwinds
2022 begins with the world in a different place. Enthusiasm about a return to a normal, post-Covid environment has waned. The US economy is past its Covid vaccination spurt (though GDP is still projected to be up a quite strong 3.9% this year). Inflation has ticked up dramatically, and the world seems like a more dangerous place, with all kinds of tensions from Russia vs. Ukraine to a more assertive Chinese President Xi clamping down on China’s private sector.
High valuations for stocks. Stocks are not cheap. The Price/Earnings (P/E) ratio is a standard measure of value in the stock market. The P/E ratio indicates how many years of profit it will take to recoup an investment in the stock. The P/E ratio for the S & P 500 index ended the year at around 29. The average is approximately 16. It reached 44 just before the dot-com bust in 2000. While high, ironically, the P/E has fallen in the last year. Corporate earnings climbed higher than stock prices. An argument in defense of high P/E ratios today is that interest rates are historically low, meaning that a dollar of earnings is worth more today since what you can earn in bonds (or at the bank) is quite low.
Inflation is back. You have to go back to 1982 (remember 18% interest rates on CDs?) to see inflation as high as it is today. The Consumer Price Index (CPI) rose 6.8% in November, its highest reading in 40 years. Is it “transitory?” It seems like even the Fed has dropped that prediction. Even though most economists expect inflation to moderate to around 5% this year and even lower next year as supply bottlenecks recede, higher prices seem to be baked into the economy. Higher rates entice investors and can be competition for stocks.
Tighter Monetary Policy has arrived. The days of easy money may be over. While monetary conditions are still relatively lax, the Fed has signaled that they will end pumping money into the market – taking away the proverbial “punch bowl” from the party. Instead, the Fed will stop buying bonds and begin to raise rates. When and how fast is in question. Any surprises will surely hurt stocks, especially large growth stocks which performed spectacularly in the past ten years.
Tailwinds
Stocks always climb a “wall of worry,” and 2022 shouldn’t be different. Look at this list of worries from last year:
- Delta and Omicron
- Slowing economy
- Supply chain bottlenecks
- Inflation
- Fed tightening
- Fed tapering
- Low labor market participation
- The “Great Resignation”
- Geopolitical tensions in Europe and Asia
- Oil price rise
- Political gridlock in Washington
While many of these concerns are with us in the new year, stocks can also enjoy various tailwinds. Some of which are:
A strong economy continues to recover from pandemic lows – thanks to massive government spending and the miracle of Covid vaccines. Though beginning to slow, by most estimates, the US economy is mid-cycle in its expansion, meaning we have yet to see peak output. A recession is not in the forecast. 2022 GDP is forecasted to be 3.8% before moderating further into the low twos next year. Corporate earnings should continue to increase with such a robust economy. Fiscal stimulus may also continue if President Biden can pass some version of his Build Back Better plan.
Healthy consumers are buying and buying. Consumer spending accounts for 69% of the US economy, and the US consumer looks quite resilient. Wages are rising, the unemployment rate is inching below 4.0%, and Americans still have a comfortable savings cushion. Savings grew during the pandemic when stimulus checks and lockdowns prevented eating out, travel, and even commuting. The personal saving rate in the United States is 7.3% – relatively high by recent history. Many of us have stayed home enough and are eager to get out to eat, travel, meet friends and family.
Low rates will be around for a while. Though rising, interest rates are still historically low. Low rates act as a floor for stock prices. The Fed has signaled that the days of easy money are over, but it’s going to take a long time for rates to come close to inflation. The current Fed funds rate is 0.25%. Even four quarter-point increases (only three are predicted for 2022) bring the rate to 1.25%. Meanwhile, inflation is clocking in at over 6%. Hence, the real cost of money is still negative, especially supportive of US growth stocks.
A Wild Card? Geopolitical tensions. I think many underestimate how dangerous the world is nowadays. The US is mired in angry partisanship and political gridlock while the world’s autocrats chase their ambitions. Russia is amassing troops and armor at the Ukraine border. Putin threatens an invasion if his demands aren’t met. Chinese President Xi threatens Taiwan with military incursions into Taiwanese space and continues to expand its military. How many nuclear weapon tests will North Korea make this year? Any of these regional skirmishes could quickly escalate and threaten stocks.
Any alternative to stocks?
Stocks always climb a wall of worry: slowing growth, rising inflation, supply chain disruptions, political gridlock, the end of Fed stimulus, new Covid strains, and ambitious despots all hang over the market.
The “easy money” has been made. Nevertheless, stocks will likely continue their march forward (albeit modestly), propelled by a strong economy, strong growth, robust corporate earnings, low interest rates, and, hopefully, continued progress on beating back Covid. Our economy is only mid-cycle (at most) in its present expansion. There’s plenty more rebound from 2020 to go. Inflation and what the Fed may do about it remain key risks. Hopefully, inflation will moderate as supply chain issues and pent-up demand abate. But it’s hard to imagine the Fed raising rates aggressively anytime soon. And bonds remain unattractive as their yields are negative after inflation. Remain diversified with a tilt toward stocks, particularly cyclical stocks in value sectors in small-cap and international. Continued low interest rates mean you don’t want to give up on your large growth stocks either. We will monitor President Biden’s ability to navigate his social infrastructure plan through Congress as its passage will provide a significant boost to the economy. In addition, remember that, despite low rates and fears of inflation, it is essential to keep an appropriate amount in bonds. Bonds are like ballast in a portfolio. They provide income and protection in a stock market collapse.
Please let me know if you have any questions or concerns.
Happy New Year!
Sincerely,
Henry
Henry Gorecki, CFP®
HG Wealth Management LLC
10 S. Riverside Plaza, Suite 875
Chicago, IL 60606
312-474-6496
henry@hgwealthmanagement.com
