Here we are suddenly in the final month of 2021. There is a lot to be grateful for but in many ways nothing more so than medical science and the remarkably fast development of COVID vaccines and therapies. Science has, in effect, saved the day and a direct beneficiary of this medical innovation has been the stock market. Stock prices measured by the S&P 500 dipped a bit in November, falling 0.83%, but remain up a solid 23.18% year to date. For some context, stocks returned 17.8%, 30.6% and -4.2% in 2020, 2019 and 2018 respectively.
Volatility began to pick up at month end, as intra-day price swings of > 1% became a regular thing (carrying over into the first days of December). This in some ways is a good sign, indicating less complacency by investors; a little fear can be a good thing. The increased tension is related to the emergence of the omicron variant and what looks like monetary indigestion – the beginning signs the Fed will move towards a more hawkish stance given the persistence of the inflation data and the strength of the labor market.
Interest rates remain historically low and even with a more hawkish tone out of the Federal Reserve, I would not expect a dramatic upward shift in the yield curve. The nominal yield on the 10-year US Treasury bond, a rate often considered a guide or benchmark for home mortgages, is 1.43% and has been falling ever since it peaked September 30, 1981 at 15.8%. Pundits have been foretelling the bottom of this slide for over 20 years now.
Since its prior peak in 1979, inflation has also been trending lower. Deflation in many respects is a more pressing (unsolvable) concern in aging economies. Global supply shortages and shipping bottlenecks have led to temporary price spikes. This is supply shock – think about microchip shortages leading to limited availability of new cars causing a spike in used car prices. Supply chain issues will normalize. The U.S. consumer is economically healthy and spending; with jobs available, higher wages and an excess of savings the demand side of the equation is in good order. Inflation will begin to dim as a headline issue with supply chains stabilizing, and the labor markets digesting some of the cultural shifts ignited by the virus.
The labor market, with unemployment in the 4% range, is coming back into equilibrium after the multiple dislocations caused by the virus. More people are employed at substantially better wages. One can argue that this great labor and wage catch up is an unintended consequence of the virus and it is resolving a huge issue the corporate world and politicians did not have the courage to address.
In my opinion, 2022 will bring a continuation of the stock market’s recent trend, with earnings remaining the most critical factor. The market’s returns this year have hung on a near 30% increase in earnings, offset to a modest degree by some multiple compression. Expectations for continued strong earnings growth into ’22 and ’23 are supporting the market’s price levels. Since the late 1980s there have been 5 periods when earnings have fallen (for periods between one and three years). This will happen again at some point, and we remain attentive to early signs of change.
Our approach is to continue to own high quality stocks with above-benchmark return potential. We utilize screens to sort by factors, including strong earnings growth, high free cash flow, and dividends. We focus primarily on traditional growth names and stocks that will benefit from the extended reopening. As is often said, it’s a stock picker’s market. The median stock value in the S&P 500 is roughly 19x (JP Morgan Asset Management) while the valuation spread is 2x the average for the last 25 years – meaning there are a lot of stocks with considerable hidden value, and equally many likely to disappoint.
Please let us know if there are any year-end details we can sort out for you. We always look forward to catching up with you if we have not been in touch recently. If you have an IRA and take distributions, be aware that we are in the process of making sure you’ve taken your required amount for 2021. Otherwise, all of us here at Hotaling Investment Management wish you and your family a safe and healthy holiday season and a happy new year. Be safe out there.
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S & P500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation.