Quarterly Market Review and Outlook
2021 Market Re-Cap
The U.S. stock market (as represented by the S&P 500) continued to post strong returns in the 4th Quarter of 2021 and returned over 20% last year.[i] While this headline number is certainly impressive, it should be noted that the S&P 500 is weighted towards the biggest stocks by market capitalization. In fact, the top 10 S&P 500 companies comprise 26% of the value of the index! Said plainly, a small group of big firms (mostly technology companies) carried a significant load in producing those returns.
As we look beyond the largest U.S. companies, small cap stocks produced returns more in line with historical norms and were positive by approximately 15%.[ii] International stocks produced slightly less than a 7% return in 2021.[iii] This is a continuation of a trend over the last 14 years where the U.S. stock market outperformed most international markets—that does not appear to be reversing course any time soon.
The story in the bond and fixed income market was very different in 2021. For only the second time in the last 10 years, the U.S. bond aggregate produced a negative return.[iv] The international bond market also posted a negative return last year.[v] Fortunately, creative use of non-traditional bonds and fixed income securities allowed most of our clients to earn a positive return.
2021 was unique in that it was only the fourth year since 1977 in which stocks produced positive returns while bonds declined in value.[vi] It is also interesting to note that this is a somewhat recent phenomenon as all four of these years occurred since 1999.
2022 Q1 Outlook & Beyond
Up, Up and Away!
No, we are not talking about the 1960s song by The 5th Dimension, but the price increases in fuel, food, housing, automobiles, and many other goods and services. The Consumer Price Index data from November 2021 shows that prices have increased at their fastest pace since 1982.[vii]
There are many culprits for raising inflation over the last 12-18 months. The most noted and obvious are supply chain disruptions. Certainly, this can be traced to transit of goods from manufacturing to consumers. However, it also has to do with production. Unfortunately, U.S. Industrial production has still not returned to pre-COVID levels.[viii] It turns out there are implications of the government shutting down the economy.
We would also be remis if we failed to mention the incredible amount of money that has been printed and put into circulation over the last few years. The Federal Reserve calculates the M2 money supply to be $21.44 trillion as of the end of November 2021—the November 2019 number was at $15.25 trillion! The classic definition of inflation is too much money chasing too few goods.
Moving forward, the issue is not necessarily “the why” inflation is present, but what will it look like moving forward?
Currently, there are two basic schools of thought. One group says that inflation is transitory and, with Fed tapering, will settle into a historically normal range. The other is more convinced that this inflation cycle has a chance to last longer and potentially evolve into a more significant problem and to even rival the hyperinflation of the late seventy’s.
We tend to believe that inflation is not transitory, but it won’t turn into hyper-inflation either. We believe that the current inflationary issues are not going to disappear in the short term and may be more persistent than the Fed currently admits. First, we see it as unlikely in the short term that the demand for goods and services will diminish. To the contrary, as people get more comfortable with COVID and its side-effects, we would anticipate demand to increase. Further, as unemployment and wages improve, we would anticipate people spending those dollars. We also think it will take time for the supply chain to work itself out.
We do not see the Federal Reserve changing their strategy and escalating interest rate hikes faster than anticipated. The Fed Funds Future currently projects 2-3 hikes in 2022.[ix] To provide a little context, we have inflation running at levels not seen since the early 1980s, but the 10-year Treasury yield is almost 14% lower than the early 1980s.[x] Different time, different Federal Reserve and different policy response.
The good news is that in the short-term, higher inflation should serve as a tailwind for stocks. As we have said before, money must be invested somewhere. The four basic asset classes are stocks, bonds, cash or alternatives. Bonds just experienced one of their worst years in the last 20 years, offer sub-inflation yields, and cash earns nothing in the long term. Additionally, even if the Federal Reserve increases rates in 2022 as excepted, it is unlikely that the yield curve will invert and cause economic red flags to emerge.
There are very few instances in modern history where persistent high inflation is a positive. At some point, either interest rates must increase to combat inflation, or the price of goods and services becomes too great for consumers to bear. History shows that neither of these scenarios end well for the economy and for investors. The timeline for this to play out will take a while—we will be watching this closely and act accordingly as necessary.
Employment & Jobs
It is possible that inflation will stabilize as the employment picture improves. The U.S. Bureau of Labor Statistics published in December that there are eleven million job openings (the second highest on record) as of the end of October.[xi][xii] Businesses want and need to hire people. If a substantial amount of these openings are filled with skilled and efficient workers, then production could improve easing supply chain issues. Diminished supply chain issues lead to, generally speaking, lower inflation.
Also, it is our hope that as time goes by, COVID will be less of a disruption than it has been over the previous 18-24 months. Over the last six months, the pace of vaccinations and immunity has accelerated in the U.S. Additionally, biotechnology companies are continuing to develop therapeutics to combat the effects of COVID. So far, Omicron has proven to be quite contagious but not very deadly. We pray that trend continues.
The counter to this is that more workers and higher wages can lead to both higher costs and demand for goods and services. It is entirely possible that as more people return to work that everything is essentially a wash. That is our hope.
Whatever happens with inflation, we have positioned portfolios to perform in an inflationary cycle. For example, we have introduced Treasury Inflation Protected Securities (TIPS) into most client bond portfolios. TIPS are bonds issued by the U.S. Treasury Department whose principal increases or decreases a measurement of the Consumer Price Index.[xiii]
Stock Market Valuation & Volatility
A significant issue following a great year like 2021 (above average returns with little volatility) is that the road ahead can be bumpier. Since 1980, there have only been 8 years in which the S&P 500 was positive and did not experience at least a 7% pullback at some point during the calendar year—2021 was one of those years.[xiv] In nearly every instance, the year following experienced a return of significant volatility. High volatility does not necessarily mean negative returns—it just means the ride is bumpier. Beyond historical examples, common sense dictates that markets cannot go up forever.
As we mentioned above, in the short term as interest rates remain low and the economy continues to pick up steam, stocks should still experience a solid tailwind. Further, S&P 500 companies continue to report very strong earnings. During the 3rd Quarter, roughly 95% of companies in the S&P 500 reported revenues more than 3% above the consensus forecast.[xv] Generally speaking, the share price of companies on the S&P 500 appreciates when they report very good numbers.
Further, as it appears that a tax increase is less likely to get passed, corporations should feel more confident that their tax rates will remain as they have been since the Tax Cuts and Jobs Act of 2017. Continued high profits, low taxes and potentially increased productivity should make the fundamental picture look attractive for stocks in 2021.
With that being said, we do anticipate volatility to increase in 2022. We think the stock market, particularly certain sectors, are a bit ahead of themselves. A correction can add value back to those sectors, making them attractive for purchase—remember we want to buy low and sell high. We have recently positioned portfolios to hold more cash—we think of it as dry powder to use at a more attractive entry point when better opportunities are available. We continue to stress that short-term corrections are normal and should not be justification for major alterations to long term investment strategies.
Planning Topics for 2022
As the beginning of the year is often a time for reflection, planning and resolutions, it seems appropriate to discuss a couple of financial planning topics to consider for the year ahead.
First, we would remind clients that while planning for long term goals, it is prudent from time to time to make certain your estate plan in is order. A will, possibly a trust, and other legal documents are part of a plan. Some folks need those documents drafted for the first time—some of you have made those plans but need to revisit them to make certain they are up to date. For many, life insurance is a critical part of that estate plan. If you need to review your estate plan and your life insurance, do not hesitate to call us.
Second, the beginning of the year is a prudent time to consider if you are contributing adequately to your financial goals. The IRS typically adjusts retirement plan contribution limits every couple of years. For 2022, participant contribution limits for 401(k)s, 403(b)s, most 457 plans and Thrift Savings Plan will increase to $20,500—more if you are over 50. [xvi] The limits for Roth IRA and traditional IRA remains unchanged for 2022. Whether you are saving inside or outside a retirement plan, make sure you develop a regular and disciplined habit of saving and investing money.
We welcome a conversation regarding any aspect of financial, retirement, and estate planning for you and your family.
In closing, we would like to include the opinions of a few economists and market forecasters that we have followed closely over the years.
Brian S. Wesbury—Chief Economist at First Trust: “Our year-end 2022 call for the S&P 500 is 5,250… and we expect the Dow Jones Industrial Average to rise to 40,000.”[xvii]
Bob Brinker: “Although we expect a higher level of stock market volatility in 2022, based on our estimated price/earnings ratio range of 21 to 22 times forward operating earnings, the S&P 500 Index has the potential to challenge the 5000-level going forward.”[xviii]
BlackRock Investment Institute: “We keep our overweight on equites on the strategic horizon. We see the combination of low real rates, strong growth, and reasonable valuations as favorable for the asset class.”[xix]
We tend to agree with these—we expect elevated volatility in 2022 relative to 2021, but see more tailwinds than headwinds for stocks. We will continue to monitor the situation and advise accordingly should our thought process change.
As always, thank you for your continued trust and confidence. We hope that you and your family have a great and blessed 2022!
[vi] BlackRock Investment Institute. “2022 Global Outlook”. Page 3. BlackRock, Inc. December 2021.
[vii] Brinker, Bob. “Bob Brinker’s Marketimer”. Volume 37. Number 1. January 5, 2022.
[xii] Brinker, Bob. “Bob Brinker’s Marketimer”. Volume 37. Number 1. January 5, 2022.
[xiv] J.P. Morgan. “Market Insights: Guide to the Markets®”. Page 16. J.P. Morgan Asset Management. 1Q 2022.
[xv] Brinker, Bob. “Bob Brinker’s Marketimer. Volume 36. Number 12. December 3, 2021.
[xvii] Wesbury, Brian S. & Stein, Robert. “Monday Morning Outlook”. First Trust. December 13, 2021.
[xviii] Brinker, Bob. “Bob Brinker’s Marketimer”. Volume 37. Number 1. January 5, 2022.
[xix] BlackRock Investment Institute. “Weekly Commentary”. BlackRock, Inc. December 13, 2021.
Securities offered through First Heartland Capital ®, Inc., member FINRA/SIPC. Advisory Services offered through First Heartland ® Consultants, Inc. Walker, Higgins & Associates, LLC and Walker, Higgins & Associates Wealth Management, LLC are independent of First Heartland Capital ®, Inc. and First Heartland ® Consultants, Inc.