Stock price performance is historically measured using the calendar year, so as of January 1st we put a frame around the prior year’s results and forge on into the unknown of the new year once again. You may have heard of the January effect: the expectation that stocks follow a seasonal pattern, rising in January with high hopes and new money coming into the market. January often brings on a spate of repositioning. This can take the form of profit-taking in some of the outperforming sectors from the prior year (real estate, large cap technology, semiconductors). It can also be a harbinger of a shift in fundamental views, investors latching on to what they believe is the new direction the market will take. This is a pivotal decision where shrewd investors do not want to get caught wrong footed.
U.S. stock investors have been riding a wave of good fortune and well-above-average annual returns for the last three years: 27.8% in 2021, 17.8% in 2020 and 30.6% in 2019 (as measured by the S&P 500). The last year with negative results was 2018 when prices fell 4.2%. Many would attribute that year’s sub-par results to a series of Federal Reserve interest rate hikes late in the year. The recent announcements the Fed intends to taper its bond purchases and hike rates three times in 2022 arguably led to the recent “correction of sorts” with an eye-opening 30-40% price drop in the average Russell 3000 stock from the November 2021 highs.
In my view nothing of any substance has changed since the end of December, though there are several things we are watching that may lead us to revise our thinking. Valuation is important and currently stocks are trading at a relatively high multiple (P/E ratio). P/E ratios are generally determined by expected earnings growth rates and interest rates. At the moment we expect sturdy growth on the earnings front and limited upside moves to interest rates.
Future earnings will need to be strong to support today’s prices. There are some Wall Street analysts forecasting earnings on the S&P 500 to be in the $240 per share range for 2022. Using a P/E ratio of 22x, this would optimistically see the S&P 500 in the 5,280 range (mile high) by year end, a roughly 10% increase from the 4,780 level it closed out last year. While this is simplistic, it paints the supportive picture for staying in long stocks while placing a lot of pressure on companies to deliver strong earnings.
There are a lot of people that have assumed interest rates, particularly the US 10-year Treasury, are about to inflect upwards. They have been thinking this for years now and have simply been wrong. The US 10-year Treasury is typically considered important for the pricing of mortgages and is assumed to reflect both core levels of economic growth as well as inflation. Short term rates (the Fed Funds rate) on the other hand, are a monetary policy tool. The Federal Reserve has announced plans to raise rates in 2022 to slow the growth in the economy and thus temper inflation and my bet is that this is causing some turmoil now, but it will not last.
I think the inflation we are seeing is solely related to the pandemic; it caused labor and supply chain disruptions no one could have foreseen. We have not seen the full extent in the changes to the makeup of the labor market, so this remains an unknown. I also think some wage inflation will sustain, as the labor market is extracting a catch up. Longer term I do not think we are facing persistent inflation.
One big concern is geo-political. Ukraine and Taiwan are hot spots. It is not clear what an upheaval would amount to, but China and Russia may be of the mind to test. The virus with the Omicron variant may be on the verge of flaming out, and the stock market behaves as though that is the case. Just the same, workers across multiple industries are calling out or opting out and schools and hospitals are far from “normal”. Whatever the potential black swan may be, we cannot effectively plan for it.
We all wish you a Happy New Year! If you have any concerns or would like to review your investments, please do not hesitate to reach out. We are working on a limited basis from the office. If you would like to meet in-person, we can arrange for that, though we are happy to safely meet via Zoom.
Please be safe out there.
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are as 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&P 500 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. This note contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.