If the lessons from this year have taught me anything, it is that predicting the exact moves of the market is a painfully difficult process. Every metric and variable used in these predictions is a product of the current environment, but the current conditions aren’t a constant, and the game is always changing.
With that said, there are known unknowns worth noting that will influence our investment decisions as we head into 2022.
Nobody would have predicted that 2020 would have played out the way it did at the start of the year. U.S presidential elections and China tensions were the most important thing to markets… until they weren’t.
Very few would have predicted that a 2021, promising vaccines and a return to normality would have represented so little change from a socio-economic standpoint. Yet, it provided an almost 30% return for the S&P 500.
But here we are.
S&P 500 Total Return including Dividends – 2021
Source: Y Charts
The S&P 500 hit new record highs in nearly one-third of all trading days and saw losses capped at 5%. In a year of perpetual uncertainty, we saw one of the most robust and stable market performances in the last 25 years.
Looking ahead, fundamentals remain strong, but the rip-roaring rallies powered by the reopening are a thing of the past. Growth will ease. Returns will moderate. Risks are ever-present, but opportunities remain.
Asset Class Performance 2021
Market participants were overtly ‘risk-on’ last year with the yield poverty in fixed income, drawing investors out the risk curve towards equities and digital assets.
The resurgence of strong consumer demand combined with considerable supply-side disruption resulted in significant spikes in returns across the physical commodities space (ex. precious metals). With that said, commodities still have plenty of ground to make up. Over the last 10 years, the Bloomberg commodities index is still down 32%. The case can be made for continued upside for these real assets in an inflationary environment, but volatility remains.
Fixed income yields remained suppressed throughout the year. Amazingly, with inflation running near 7%, the 10-year treasury couldn’t break 1.75%. Bonds are now a downside protection asset with limited upside, but with multiple rate hikes on the horizon, fixed income trades veer into even more complicated territory.
In what was a textbook goldilocks scenario for gold bugs, precious metals slipped. Against a backdrop of record money printing and the highest inflation in 30 years, gold failed to outperform bonds. A reminder that there is no playbook that you can follow here. The game is always changing.
Performance by Sector
S&P 500 Sector performance breakdown in 2021
Negative oil futures in 2020 led to many premature obituaries for the energy market, but lower production supply as demand came back online ensured the sector continued its comeback into 2021.
Historically low supply coupled with the current low-interest-rate environment resulted in surging real estate prices over the year. With inventory scarce, expect demand to persist.
Information technology provided strong returns with Apple, Amazon, Facebook, Google, Microsoft, Netflix, Nvidia, and Tesla, adding nearly $3 trillion in market cap in 2021.
WINNERS & LOSERS
Digital Assets
Cryptocurrencies had a standout year. Bitcoin’s 60% return paled in comparison to many of the ‘newly’ emerging cryptocurrencies and smart contract platforms like Ethereum (398%), Solana (11,178%), and Luna (12,967%).
While these growth rates are largely unsustainable, the ever-increasing market cap is sure to result in exciting new developments in the Web 3.0 and digital asset space over the coming year as more and more use cases emerge.
Electric Vehicles
Tesla entered the $1 trillion club, making Elon Musk the richest man in the world in the process. This year’s 51% growth is even more impressive when you incorporated the relentless growth it has already recorded, with Tesla now up 2,370% over the past five years.
Tesla wasn’t the only carmaker recording considerable upside over the year. Ford’s move into the EV space saw them jump 170%, while Lucid motors recorded a 305% return for the year as the EV races heated up.
Looking ahead, with the EV sector becoming increasingly crowded, some of the smaller names will need to start making considerable progress if they want to avoid being eaten by some of the more prominent players. Eventually, valuations will need to be justified.
High Growth Tech Stocks
In early December, just five stocks (Microsoft, Google, Apple, Nvidia and Tesla) accounted for 51% of the S&P 500’s return since April. This mega-cap strength helped hide the precipitous decline of some of the stay-at-home winners that rose to prominence in 2020.
In what was dubbed the Tarantino Market, the hottest stocks from last year quietly got killed in the basement while everything continued as normal in the front room.
- Docusign, Square, and Twilio all lost between 20% and 35% YTD
- Teledoc, Zoom, Beyond Meat and Zillow have lost roughly 50% YTD
- StoneCo, Pelaton and Lemonade are down between 65% and 80% YTD
ARK Innovation ETF, The poster child of the high growth sector, has now fallen over 40% from the highs as these growth tech names remain out of favour.
ARK Innovation Fund ETF – 1 Year Performance
Source: Tradingview
While Cattie Wood maintains that many of these high-growth tech names are now in ‘deep value’ territory, buying stocks simply because they have fallen, and you expect them to mean revert is a recipe for disaster.
More than 40% of all companies that were ever in the Russell 3000 Index experienced a “catastrophic stock price loss”, which we define as a 70% decline from peak levels which is not recovered.
Don’t just assume these stocks will come back. Many of them don’t.
LESSONS FROM 2021
Some of my anecdotal thoughts on the market from this year.
It’s not always logical.
The market can remain irrational longer than you can remain solvent.
– John Maynard Keynes
This year brought us the now infamous GameStop and AMC Short Squeezes, countless meme stock rallies and a 49,000,000% return for the meme coin Shibu Inu. At this point, I think it’s blatantly apparent to everyone that price and value don’t always move in tandem.
GameStop and AMC Price change 2021
Source: Y Charts
In finance, we often expect the world to behave rationally. We carefully look to quantify the probability of each individual outcome, but not everything is measurable. We naively assume logic will prevail and underestimate the persistent irrationality of man.
As, investor Jim Grant reminds us:
To suppose that the value of a common stock is determined purely by a corporation’s earnings discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defense of Joseph Stalin and believed Orson Welles when he told them over the radio that the Martians had landed.
History is a perpetual stream of mistaken opinions and unpredictable outcomes. If you’ve relied on data and logic alone to make sense of the economy, you’ve been confused for 100 years straight.
Instead of presuming everything is purely logical, it is important to realize that there are two sides to every investment: The numbers and the story.
While not always the case, in today’s momentum-driven market, ‘the story’ has consistently been more potent than the numbers. We have seen growth stocks soar off the back of compelling narratives about future possibilities with little numbers to back them up. SPAC’s, high growth stocks and altcoins have rocketed ‘to the moon’ all hitched to a promise of what could be.
This may be frustrating for many, but these market forces need to be acknowledged and understood. Blindly assuming that logic will instantaneously prevail is a sure way to underestimate the inherent risks of the market.
Crazy things happen in markets all the time. Don’t expect that to stop any time soon.
Don’t believe everything you read.
When asked what it takes to win a Nobel prize, Francis Crick said,
“Oh, it’s very simple. My secret has been I know what to ignore.”
The stock market is manipulated. Multiples are being driven endlessly higher by low-interest rates and government spending, buybacks and flows into index funds.
Narrow market breadth, yield poverty and FED policy errors have left us all in a bubble that’s about to pop.
You have likely seen some variation of this narrative repeated for the last five years as the financial media step up their scaremongering and lean into their broken clock strategy.
In a business where eyeballs are monetizable, of course, you are going to have over-sensationalized headlines that demand your attention. That’s the world we live in. However, one thing they fail to mention is the multitude of factors that have driven the current growth in the stock market.
I have written in detail about many of these factors previously, but here is a quick breakdown.
- Real GDP is at an all-time high, as are earnings
- Companies have improved their margins
- Valuation multiples have compressed in 2021 with the S&P 500 P/E ratio falling from 24x to 21x
- Demographics are the strongest they have been since the 1970s as millennials enter their prime ‘consumption years’
- Institutional investors’ cash pile of almost $3.5 trillion represents potential dry powder for markets
- Consumer demand and spending is now above pre-pandemic levels
- US household net worth has increased by $25 trillion since the end of 2019
- The equity risk premium is still an attractive 5%
- US jobless claims is at a 50-year low
- Significant growth in money supply
Now let’s dive a little deeper.
GDP Growth
Real GDP jumped 5.6% in 2021 to hit new all-time highs this year. US GDP is expected to grow by 4% next year, highlighting the economic strength despite the covid uncertainty.
US GDP has grown from less than $3 Trillion in 1980 to a record $23 trillion in 2021. That’s a 7-fold increase in just 40 years.
US Gross Domestic Product – 1948 to 2021
Source:Tradingview
Earnings Growth
While the bull market has been relentless over the last number of years, so too has earnings growth.
The decade ending 2020 saw the best-annualized earnings growth for the US stock market since records began in 1870.
Annualized Real Earnings Growth
US Stock Market 1870-2020
In 2021, contrary to mainstream media, the 27% return for the S&P 500 in 2021 was accompanied by earnings growth of 34.5%, leading to a contraction in multiples.
Percentage Change in S&P 500
Earnings and Valuations
Source: JP Morgan
Now don’t get me wrong, Market risks are ever-present, and the recent rate of growth is unlikely to continue, but positive returns can persist, supported by money supply, resilient earnings, GDP growth and expanded household balance sheets.
WHAT TO WATCH IN 2022
Fed Policy
- A policy misstep (too many rate hikes too soon) by the FED could lead to a sharp market correction as seen in 2013 and 2018.
All eyes are now on the FED as they reduce their bond purchasing program. The Feds tapering measures will reduce monthly Treasury and mortgage-backed securities purchases by $30 billion a month. The Fed’s $120 billion per month bond-buying program will be fully unwound by March 2022, giving way to the elusive next step, rate hikes.
While key indicators favour growth, pending tapering measures from the Fed and other major central banks could negatively impact equity markets over the longer term.
Equity markets have moved in lockstep with the Feds balance sheet ever since QE was introduced in 2009.
- From January 2009 to December 2014, the Fed’s balance sheet expanded at a 12% annualized rate. During this time, the stock market rose at an annualized rate of 15%.
- From 2009 to 2015, the level of the Fed’s balance sheet and the S&P 500 moved in tandem. When the balance sheet stopped expanding in 2015, so did the stock market.
- Since the start of the pandemic, the Fed’s balance sheet has grown at a 38% annualized rate. This is comparable to the S&P 500’s annualized increase of 44%.
Remarkably, the correlation between the size of the Fed’s balance sheet and the level of the S&P 500 over the last 12 years is 0.90.
Follow the Fed
Source: Federal Reserve Board, S&P
With the largest buyer of treasuries exiting the market, we could see increasing upward pressure on interest rates. Consequently, equity valuations may come under pressure as the equity risk premium falls.
While these changes won’t occur overnight, higher longer-term interest rates may offer an alternative to equities for investors looking to take some risk off the table.
Sounds just like old times.
Inflation Leads the Way
- The rate of inflation will ultimately determine the interest rate moves going forward
Following a multi-decade period of sideways inflation, CPI figures jumped to a 30-year high in 2021 due to supply bottlenecks, pent-up demand, and a sharper-than-expected rise in wage costs.
Inflation reaches highest point since 1982
Source: Y Chart
Continued inflation surprise into 2022 could sway the trajectory of the U.S. central bank’s interest rate hikes and drive both short- and long-term rates higher.
Stocks can continue to do well in a rising price environment, but corporations can only pass along higher prices for so long. Eventually, higher than average inflation becomes a headwind for the stock market.
With that said, while inflation appears stickier than first anticipated, we expect the rate of inflation to normalize over the second half of 2022 as supply bottlenecks ease and the deflationary forces of technology continue to provide downward pressure.
Value vs. Growth
Value’s resurgence is a tale that has been prophesized for years but finally looks to be on the horizon after decades of underperformance.
Higher inflation figures, a rising rate environment and a massive valuation gap, will offer more room to run for many cyclical names.
MSCI World Growth and Value Trailing P/E Ratio
Source: https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/market-insights/mi-investment-outlook-ce-en.pdf
Relative to many cyclical names, big tech has a harder climb from here. As previously mentioned – Apple, Amazon, Facebook, Google, Microsoft, Netflix, Nvidia, and Tesla added nearly $3 trillion in market cap in 2021. Dampened by interest rate expectation, a repeat performance seems unlikely.
We have already seen this value outperformance play out across the small-cap space over 2021. Small-cap value returned 28.3% last year, while small-cap growth returned just 2.8%. This disparity in results was the second-largest annual spread between the two styles since their 1979 inception.
While the mega-cap names ensured that the same dynamic failed to play out in the large-cap space, previously elusive rising rates could spur a market rotation into many of the economically sensitive names as we head into 2022.
THE FINAL WORD
We view this to be the mid-cycle of the recovery. The growth rates seen early in the cycle will slow, economic and earnings figures will be suppressed by higher inflation and less accommodative central bank policies. However, there are still opportunities for risk assets in the coming year, albeit with more modest expectations for returns.
We continue to favour U.S. over International stocks. Large-cap and high-quality stocks look set to lead the way as markets will likely favour a tilt towards value stocks.
Fixed income remains an asymmetric trade while alternatives will continue to become less ‘alternative’ as investors seek diversification in a rising interest rate market.
Risks abound, but opportunities will persist.
Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.
– Warren Buffet
Recent Comments