Eye on the Markets - 2022


2022 - The Year of Regime Change

By Ketu Desai

One of the most common questions during this pandemic rally has been, how is the stock market up so much, when so much of the economy is suffering? I think 2022 will result in the opposite question, why is the stock market not up more, when the economy is doing so well. To understand the answer to both questions is to understand what drives the S&P 500.

The S&P 500 is a market capitalization weighted index, meaning that the biggest companies have the biggest weights. The biggest companies are seven tech companies that make up more than a quarter of the index and largely determine index performance. Apple, the largest, is now the equivalent of McDonald's, Walmart, AT&T, Philip Morris, Berkshire Hathaway, Proctor & Gamble, JP Morgan, Starbucks, Deere, and American Airlines combined. These tech companies were the unquestionable winners of the pandemic as we relied heavily on technology to get through the pandemic. They received a further boost from quantitative easing, which resulted in multiple expansion. Low rates made it so that paying high multiples was fine, because they were still relatively attractive.

Many of these tailwinds are likely to become headwinds in 2022, at a time when earnings growth is likely to slow for many of these names. For instance, Apple is expected to have less than 2 percent earnings growth this fiscal year, while its multiple is 50 percent higher than its historical average. The removal of accommodation and higher rates will likely mean that the market can't rely on multiple expansion and will have to shift to an earnings' driven market. This will likely cap returns for the broader index. S&P earnings growth is expected to be in the high single digits for 2022. Returns will be determined by how rates behave. Can we hold the current multiple or do we have multiple contraction?

The economic backdrop for 2022 is more encouraging, driven by the potential for an improvement in virus trends, a global consumption boost from pent up savings, a new capital expenditures cycle, and inventory rebuilding. Domestic growth is expected to come in above trend at about 4 percent. European growth should come in about the same. Emerging market growth should come in around 4.9 percent, while global growth is expected around 4.5 percent. Differences in monetary policy around the world are also likely a major driving factor in 2022. The Fed is in the process of removing accommodation and likely to start a rate hiking cycle. Inflation will drive how many times the Fed will hike. The market is currently expecting three hikes next year. The ECB said that it is unlikely to hike rates in 2022. While China recently cut rates and there is talk of stimulus. These differences in policy will likely mean investors will want some global equity exposure in their portfolio.

Since the Great Financial Crisis and through most of the pandemic period, the environment has been defined by low rates and deflation fears. Investors paid any price for growth in this environment. Valuation and profitability didn't matter much. This was to the benefit of tech and growth stocks at the expense of most other parts of the market. As we look towards, hopefully, a post-pandemic period, we will likely be in a new regime. A regime in which inflation is a greater fear than deflation, and higher rates more likely than lower rates. 2021 was largely a transition year for this regime shift, which got muddied by the continued variants. The virus risk led to a narrow market in which investors crowded back into the large cap tech stocks at the expense of pretty much everything else. In this new regime, valuation and earnings will matter. This will favor energy stocks (10.8x earnings), bank stocks (12.4x), materials (16.1x), industrials (19.6x), healthcare (16.3x), European and Japanese stocks (14.1x), and emerging markets (11.8x). These are all at a significant discount to the S&P at 22.8x and 28.3x for the Nasdaq 100.

These cheaper areas of the market are either smaller parts of the S&P or not in the S&P all together in the case of the foreign stocks. This combined with S&P's reliance on the large cap tech names will make for muted S&P performance. Bank of America estimates, based on earnings and valuation, that over the next decade, large caps are set to return only 1.7 percent annualized, compared to 8.8 percent for the broader Russell 2000. With the 10YR at just 1.5 percent, and negative on an after-inflation basis, it might make for challenging times for the passive 60/40 portfolio. After over a decade of languishing, 2022 is setting up to be the revenge of active investing and value stocks.

Looking forward, the market will focus on the virus, the latest out of Washington and the Fed, and take in fourth quarter earnings and economic data.

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Ketu Desai is the Principal of i-squared Wealth Management Inc. ( www.isquaredwealth.com ), an investment management firm based in New Jersey. ketu@isquaredwealth.com