Equity markets ended the year on a high note as all of the major indices posted positive returns for the month of December. For December, the S&P 500 gained 4.36%, the NASDAQ underperformed with a 0.69% gain, the Dow Jones Industrial Average added 5.38%, the Russell 1000 Value outperformed the rest of the indices with a 6.12% gain & the Russell 1000 Growth rallied 2.06%. With December’s strong performance, every one of the major indices posted double-digit gains with only the Dow Jones Industrial Average failing to cross the +20% threshold.
December Stonemark Market Commentary
Leading equity markets higher were the Consumer Staples (+9.95% for December), Real Estate (+9.74% for December) & Utilities (+9.74% for December) sectors while only one sector Consumer Discretionary (-0.31% for December) had a negative month. Given the strong performance that equity markets saw in 2021, it is only fitting that we end the year on an equally strong note. Looking at the graphics below, the S&P 500 recorded 70 record closes in 2021 – the 2nd most record closes in a single year going back to 1929. While 70 record closes for the S&P 500 is clearly impressive, what is almost more astonishing is the frequency that we were seeing these record closes, with the longest stretch without a new record close coming in at 33 trading days between September 2nd’s & October 21st’s record closes. Furthermore, with 252 trading days in 2021, 70 record closes for the S&P 500 translates to a new record closing high once every 3.5 days & there were certainly stretches in 2021 where it felt like we were hitting a new all-time closing high every day. As CNBC notes, the S&P 500 has posted at least one new record close every month since November 2020.
Build Back Better D.O.A.
As we discussed in our November Monthly Commentary, Congress was able to pass President Biden’s $1.2 trillion “Infrastructure Investment & Jobs Act” (“IIJA”) on November 5th. However, President Biden’s “Build Back Better Act” (“BBBA”), which included funds for clean energy & universal preschool, in addition to a multitude of other projects & was supposed to go hand in hand with the IIJA, came to a screeching halt in December when Senator Joe Manchin (D-WV) rejected the latest iteration of the bill. With Democrats holding the slimmest of majorities in the Senate (50-50 with Vice President Kamala Harris being the tiebreaking vote), Democrats needed full partisan support of the bill in order to advance it through Congress. So, as a result of Manchin breaking with party lines, the BBBA was essentially dead-on-arrival. Here is Manchin’s official statement on the BBBA:
With President Biden’s largest piece of legislation, his pride & joy that he campaigned on, essentially on life support, we will have to wait & see if Democrats are willing to make even more concessions to the bill in order to appease their own party members. While Manchin has remained steadfast in his position on the bill, all but asserting that there are no concessions that can be made in order to regain his vote, the BBBA appears very unlikely to pass ahead of 2022’s key midterm elections.
4th Quarter Earnings Preview
With December coming to a close, over the coming weeks we will start to receive corporate earnings for the 4th quarter, which analysts, for the most part are expecting to come in much better than 2020 earnings. According to CFRA & the graphic below, analysts over there are expecting huge year-over-year earnings growth for the Energy & Industrials sectors, which for the Energy sector shouldn’t come as much of a surprise given the extremely low (negative) earnings results that we saw in the sector in 2020. CFRA is forecasting that the Real Estate sector will be the only sector to see negative year-over-year earnings growth for the 4th quarter but will still have solid double-digit year-over-year growth on an annual EPS basis.
Should 4th quarter & full-year 2021 earnings be in-line with CFRA’s estimates of $50.74 & $205.20, respectively, that would imply a 12-month trailing EPS multiple of 23.2x, which is well above the 16x historical P/E multiple for the S&P 500. With CFRA forecasting 2022 S&P 500 earnings to come in at $220.77, the S&P 500 closed 2021 trading at a 12-month forward P/E multiple of 21.5x, which is still above the 5- & 10-year average 12-month forward P/E multiples of 18.5 & 16.6, respectively. As a result, we will need to see 2022 earnings to come in better than expected in order to justify the S&P 500 trading much higher in 2022 given the fact that multiple expansion is going to be difficult in a rising interest rate environment.
What’s In Store for 2022? – The Fed, Interest Rates & Inflation
One of the biggest macroeconomic themes that we will be keeping an eye on as we head into 2022 is inflation & how the Federal Reserve (“the Fed”) plans to combat the soaring prices. Inflation has been on investors’ minds for most of 2021, so, while this is not necessarily a “new” theme heading into 2022, the Fed announcing a series of policy steps they plan to take in 2022 to combat inflation is new. Following the final Federal Open Market Committee (“FOMC”) meeting of 2021, the Fed announced that while they were not raising rates at the present time, they were going to start reducing the monthly pace at which they have been buying Treasury & mortgage-backed securities (“MBS’s”). More specifically, the Fed’s statement read, “In light of inflation developments & the further improvement in the labor market, the Committee decided to reduce the monthly pace of its net asset purchase by $20 billion for Treasury securities & $10 billion for agency mortgage-backed securities.”
Turning to interest rates, one of the many tools the Fed has at its disposal to combat inflation, Wall Street professionals anticipate that the Fed will raise short-term interest rates 2-3 times in 2022 & another 2-3 times in 2023. Looking at the graphic below, which is the Fed’s “dot-plot”, members of the FOMC (each “dot” represents interest rate expectations for each member) are justifying Wall Street’s expectations with the majority of them expecting interest rates to finish the year at the 0.75-1% targeted range.
However, the timing of when the Fed will begin hiking interest rates remains uncertain. One thing that is almost 100% certain is that the Fed will provide ample forewarning to the markets before it starts raising interest rates. That being said, some investment professionals believe that Fed tapering & interest rate hikes don’t necessarily go hand-in-hand & believe that the Fed will only start raising rates after it has completed the tapering of its balance sheet. Others, such as analysts at Goldman Sachs, are calling for the Fed to speed up its tapering so that it can start raising rates sooner. With that said, the emergence of the omicron variant of COVID-19 & the uncertainty surrounding how it will impact economic growth has led Goldman Sachs to forecast rate hikes starting towards the 2nd half of 2022 with expectations of rate hikes at the May, July & November FOMC meetings.
With the expectation that the Fed will raise interest rates anywhere from 4-6 times between now & the end of 2023, we wanted to discuss what sort of impact this will have on the equity markets. For the last two years, equity markets have benefited significantly from interest rates near 0% & extremely accommodative monetary policy out of the Fed. As we have discussed in the past, low interest rates are very conducive for corporate growth because it allows companies with little to no profit (and even companies that are losing money) to borrow money in order to fund & expand their operations. As a result, the astronomical price-to-earnings multiples (“P/E multiples”) that we have seen the markets trade at can be justified by these historically low interest rates. According to FactSet’s “Earnings Insight” publication, as of December 17th, 2021, the S&P 500 was trading at a 12-month forward P/E multiple of 21.2, which is above both the 5- & 10-year averages of 18.5 & 16.6, respectively. As a result, with the prospect of three interest rate hikes this year eroding the justification for unusually high P/E multiples, in order for the S&P 500 to maintain its current level, we are going to need to see corporate earnings growth & for these earnings to beat analysts’ expectations.
Additionally, how we view the release of economic data is going to change now that the Fed is expected to raise interest rates 2-3 times in 2022. What we mean by this is that good economic data should now be positive for the financial markets while bad economic data should now start to have a negative impact on the financial markets. Over the last two years, with extremely accommodative monetary policy, the markets have seemingly benefited from weaker than expected economic data & have stumbled from better-than-expected data. The reason behind this was that when we received economic data that missed analysts’ expectations, the financial markets saw this as a reason for the Fed to maintain its extremely loose monetary policy. On the contrary, positive data was interpreted as a potential greenlight for the Fed to start rolling back their accommodative monetary policy & to start raising interest rates.
Finally, with the S&P 500’s 16.26% & 26.89% gains in 2020 & 2021, respectively, we would caution that a reversion to the mean return (roughly 10% annualized for the S&P 500) could be a more likely outcome than another year of 15-20% growth. Looking at the graphic below, Wall Street professionals are forecasting fairly modest growth in 2022 with the average Wall Street price target for the S&P 500 coming in at 4,985, which, based off of the S&P 500’s December 31st, 2021, closing price of 4,766, would represent just a 4.5% gain over the next twelve months.
While we would expect 2022 to be a year that we return to “normal” returns, given the forecasted tightening of monetary policy, there are certainly sectors of the market that could stand to benefit from rising rates & tighter monetary policy. For example, companies within the Financials sector of the S&P 500 have historically outperformed other sectors during periods of rising interest rates. As we have discussed in the past, Financials generate a large portion of their revenue from what is called the net interest margin (“NIM”), which is the difference between what they pay to borrow money in the short-term & what they charge to lend in the long-term. The interest rate they pay to borrow in the short-term is typically less than the interest rate they charge to lend in the long-term & the “spread” between these two interest rates is a bank’s NIM. In addition to financials, Consumer Staples & Healthcare names typically hold up better during a rising interest rate environment because companies within these sectors typically provide goods & services that are needed regardless of the economic or interest rate conditions.
While inflation & interest rates will be at the forefront of investors’ minds in the coming year, there are certainly other catalysts to look forward to in 2022. Most importantly, in November 2022 we will have the mid-term elections, which will see a total of 469 seats in the U.S. Congress (34 in the Senate & all 435 in the House of Representatives) up for election for the November 8th vote. With Democrats gaining a net total of three seats in Senate & still holding a 9-seat majority in the House of Representatives despite a net loss of 10 seats during the 2020 elections, Democrats controlled all three chambers of Congress. However, President Biden’s handling of the COVID-19 pandemic, the economy & international affairs has made the 2022 mid-term elections arguably one of the most important & potentially one of the most contested mid-term elections in recent history. Should Republicans gain the majority in the Senate & the House of Representatives, the next two years of Biden’s presidency will most likely be filled with gridlock & limited passage of legislation.
Although interest rates, inflation & political uncertainties will undoubtedly create some volatility in the equity markets, as the graphic above shows, out of the last 14 times since the 1950’s that the S&P 500 has had a 20%+ annual returns, 12 of those years have been followed by another positive year of returns. While past performance does not guarantee future results, history has shown that years of large gains in the S&P 500 typically bode well for the following year. With all of that said, we will continue to monitor any & all catalysts & will keep everyone apprised of developments that warrant bringing to your attention. Towards the end of 2021, we did raise our cash levels slightly & will be looking for opportunistic entry points to deploy some of that cash into names that pass our investment criteria. We will continue to screen for new names that should theoretically perform better in a rising interest rate environment & will use opportunities of broad market weakness to initiate positions in new companies or add to our position in existing companies. Finally, despite the growing list of uncertainties heading into 2022, we remain cautiously optimistic that 2022 will be a year of modest economic & market growth.
As always, please feel free to reach out with any questions or concerns.
Stay Safe, Stay Healthy & Happy New Year!!