By: Jeff Anderson, CFA
Finishing the 2021 year, we experienced waning monetary stimulus with the potential of upcoming interest rate hikes. Despite the fears of inflation, the S&P 500 managed a total return of 28.71%. Further, the Nasdaq was not far behind with a gain of 27.51%. The Russell 2000, a small and mid-cap stock index, lagged the larger indexes, finishing the year at just under 15% (1). All things considered, 2021 was another strong year for domestic equities.
The MSCI ACWI ex USA Index, however, only gained 7.82%. This index significantly underperformed the US markets over the 10 years (Exhibit 1).
The fixed income sector did not experience such positive outcomes, with the US Aggregate Bond Index losing 1.54%. Bonds lost purchasing power with the compounding effects of inflation. Contrastingly, 2021 was a good year to borrow money. The thirty- year fixed mortgage rates hovered around 3% for most of the year, which allowed homes to sell for nearly 19% higher than the previous year. Cities like Las Vegas, Austin, Tampa, and Orlando experienced gains of over 20% (2).
Bull and Bear Markets:
During bull markets, stocks are expensive. During bear markets, stocks are cheap. It’s that simple. Long-term historical returns for the stock market have averaged roughly nine percent. To accomplish that average, equity markets have had to endure long periods of zero to negative returns, market crashes, and luckily, bull markets lasting years (see Market Crash Timeline).
The stock market is a discounting machine. It takes all the predictions about the future of the business cycle and the future earnings of a company and discounts it into today’s dollars. Inflationary pressures can crimp growth and margins for certain industries, while others can pass those costs on to customers.
Interest rates affect the present value of a company’s cash flows. Higher interest rates mean higher discount rates, which decrease the present value of companies’ future cash flows. Growth companies are typically most sensitive to interest rates. Consequently, we experienced this reality during the first two weeks of 2022, as growth has been lagging value.
Nobody knows where the market will be in a year from now, let alone a week from now. Consensus stock market returns for 2022 are tepid at best. After two years of well-above-average returns, it seems safe to predict lower future returns.
Though it is important to reflect on returns for 1995 through 1999, when the S&P returned 37.5%, 23.1%, 33.3%, 28.7%, and 21.1%. These returns, respectively occurred, before the dot-com market crash of 2000, when the S&P 500 fell nearly 50%, while the Nasdaq lost 80% peak to trough (3). Hypothetically, if an investor had remained invested in the S&P 500 through 2000 crash, the investor would have earned a 75% gain over that entire period.
Attempting to time the market can be dangerous for a retirement portfolio, as markets never, consistently, rise in a straight line.
Investment Climate for 2022:
Robert Carey, CFA of First Trust Advisors L.P. laid out the tailwinds and headwinds heading into 2022 (4).
- The major indices in the US are projecting solid earnings growth for this year.
- Global Speculative-Grade Bond default rates remain well below historical averages.
- Mergers and Acquisition activity remains robust.
- Stock Buybacks: 2021 saw record buybacks and Data Trek Research reported that companies have the means to further increase buybacks in 2022.
- Dividends are stable and growing.
- Wall Street Strategists are optimistic. A Bloomberg survey of nineteen equity strategists reported an average price target for the S&P 500 of $4,950.
- Mid-Term Elections: Republicans are the early favorites to take back the House and Senate. This will likely prevent further run-away spending. Gridlock is good.
- Covid-19 Pandemic should ebb, with the latest variant, Omicron, being less severe than previous strains.
- Covid-19 Pandemic could continue to disrupt economic activity.
- Inflation: CPI stood at 7.0% a trailing twelve-month basis in December, which could cut into economic growth. This reading is the highest since 1982. If inflation persists, the Fed may get more aggressive with tapering and raising interest rates, which would hurt growth.
- Supply-Chain Disruptions: Expected to persist into late 2022. Semiconductor shortages are impacting many industries and the backlog of container ships trying to enter global ports is not shrinking.
- Fiscal Stimulus: The Build-Back-Better Act has stalled. The Biden Administration cannot win enough support within its own party.
- Valuations are elevated. The trailing 12-month price-to-earnings ratio for the S&P 500 Index was 26.2 at the end of 2021, well above its long-term average of 17.2 over the past half a century.
- Stock Market Correction: Data suggests that the S&P 500 Index experiences a 10% to 20% correction every 22 months. The last one was back in March of 2020.
Finally, the Federal Reserve will try to navigate the domestic economy through an inflationary environment not seen since the 1970’s. Bond purchases are scheduled to cease by the end of March. Consequently, we could see the first of multiple interest rate hikes begin, all with the purpose of cooling inflation while attempting to keep the economy growing and unemployment low.
The liquidity created by the Fed’s asset purchases since the recession of 2009, is the third leg of the monetary stool. Given the less-accommodative measures discussed above, the Fed may be reluctant to decrease its balance sheet this year. Decreasing the Fed balance sheet would remove liquidity at a time when the economy will be adjusting to higher interest rates.
Predicting stock market returns is nearly impossible. Nobody has a crystal ball. We can only draw on history to gauge the relative direction of markets. As stated above, markets are expensive, but they have been expensive for some time. Not being in the market because it appears expensive or risky can be more costly to your retirement plans than staying invested during market corrections and fluctuations. As we note in client meetings, investors know that inflation, taxes, and market crashes are inevitable. Money is worth less in the future, taxes typically go up, and markets crash. Fortunately, the long-term direction of markets is always upward sloping.
Jeff Anderson, CFA
Chief Investment Officer,
Presidio Capital Management.
(1) Market Data provided by the Wall St Journal
(2) Forbes.com, “2021 Housing Market Frenzy Concludes with Double-Digit Price Growth”, Brenda Richardson.
(3) Wall Street Journal, “The Best Investment 2022 Stock Market Advice”, Jason Zweig.
(4) First Trust Advisors, L.P. – 2022 Market Outlook