Let's face it: the stock markets have been on quite a run since the depths of the Covid-19 Pandemic, with the S&P 500 now up more than 75% and the tech-driven NASDAQ up over 100%, since the March 2020 lows. Make no mistake, a great contributor to these successes has been the nearly $6 trillion in government stimulus injected into the US economy. ⁽¹⁾ This government-fueled binge is the largest in modern history and the hangover effects are yet to be fully understood.

As we conclude 2021 and peer cautiously into 2022, we've identified four hurdles the markets may face in 2022 and recommend one New Year's resolution in response.

Hurdle #1:
The Rush from Covid Relief Programs is Fading

Although Congress enacted trillions of dollars in pandemic-related relief programs over the past two years, their effects fade more and more each day. As a result, we project a radical downshift in "government sponsored-income" for nearly anyone who makes less than $75,000 per year. Thankfully consumers amassed record savings during the pandemic and have shown continued signs of eagerness to spend. Most analysts see scant risk of a recession in 2022.

However, inflation pressures could change consumer sentiment and affect future spending. Next year's U.S. GDP growth, which is projected between 3% to 4%, might feel tepid after an estimated expansion this year around 6%. ⁽²⁾

Hurdle #2:
Tighter Federal Reserve Policy

Beginning in March 2020, in an effort to prop up the economy during the pandemic shutdown, the Fed cut its benchmark interest rate to near zero (today the Fed Funds Rate stands at 0.00% - 0.25%) and began large purchases of government bonds. Since bond yields move in the opposite direction of bond prices (see December 2021 White Paper), Fed bond purchases artificially depressed yields, making it cheaper for everyone to borrow.

Inflation, as we all know, has been surging in recent months and has surpassed 6% on an annualized basis. The Fed finally admitted in November that inflation had moved from "transitory" to a more persistent problem and subsequently announced the reduction in the pace of its bond buying program (often referred to as tapering). In fact, as recently as December 15th, the Fed accelerated the tapering process from $15 billion less in bond purchases per month to $30 billion less in bond purchases per month, highlighting the very real underlying pressure from inflation on the US economy.

Once tapering is complete (meaning the Fed stops purchasing government bonds altogether) in March or April of 2022, the next step for the Fed to take will be to raise the Fed Funds Rate (the benchmark inter-bank lending rate) from its current range of 0.00% - 0.25% in an effort to further tighten monetary policy.

These policy changes remove a large amount of liquidity from the financial system, hopefully slowing inflation but at the cost of slowing economic growth as well.

Hurdle #3:
Corporate Profit Growth May Lose Steam

Corporate profits—a key ingredient in investor enthusiasm for stocks—surged significantly in 2021. That growth has propelled the market. However, virtually every company will experience some form of cost pressure (rising wages, soaring freight costs, higher material prices, etc.), which could erode profit margins, as only so much can be passed on to the consumer. ⁽³⁾

Hurdle #4:
Market Valuations Are Lofty

Finally, the S&P 500 closed the year with a trailing P/E of 23.2x, which places it 6th highest since 1988, and indicates an uncomfortable level of optimism when compared with the average year-end P/E of 18.8x.

Investors tend to ignore such red flags and willingly take on risk when underlying conditions are favorable. However, with inflation possibly lingering and the Fed draining liquidity from the economy, investors may decide that stocks are overly expensive and begin to invest elsewhere.

Summary Thoughts

In 2021 the S&P 500 finished higher by +28.7%. This follows a 18.4% return in 2020 and a 29.5% return in 2019. Truly, three exceptional years that far surpassed the historical average of 9.4% (since WWII).

Sam Stovall of CFRA Research tracks how the market has fared on a rolling basis in past decades. The data shows that strong stretches usually are followed by more-lackluster periods. Based on how the market has been performing in recent years, CFRA has a year-end 2022 S&P 500 price target of 5,024, representing only a 5.2% projected price appreciation from the closing value on December 31, 2021. ⁽⁴⁾

The markets may prove less resilient in the face of new shocks, such as the possible emergence of a more virulent variant of Covid-19, without the unprecedented amount of Fed stimulus. So, while there's a chance that 2022 could be a "back to average" year for stocks, any virus flare-ups could reintroduce more volatility than investors are accustomed to. We witnessed that first hand around the Thanksgiving holiday with the news of the Omicron variant.

The lack of real returns in many asset classes (e.g., US Treasuries, corporate bonds, etc.) have forced investors to seek out more "risk-on assets", such as stocks or high yield bonds, over the past several years and exchange calmness for volatility.

The New Year's Resolution

This is an excellent time to visit with your financial advisor and discuss how 2022 and beyond will impact you personally. A good starting point is asking whether your portfolio is positioned so you can endure a heightened level of volatility, while still achieving your return objectives, or whether it's time to make a strategy adjustment. Either way, what's important is to make a plan and stick with it.

Regardless of the outcome of discussions with your advisor, we remind you of the importance of staying invested with a long-term perspective. Remember, WE BELIEVE it's time in the market, and not market timing, that leads to wealth accumulation.


Sources

1. US spending on COVID-19 relief poised to hit $6T with passage of Biden stimulus bill
   foxbusiness.com
   
   
2. The Conference Board Economic Forecast for the US Economy
   conference-board.org
   
   
3. Investors are paying up for stocks where company profit resists squeeze from inflation, says strategist
   marketwatch.com
   
   
4. Email from Sam Stovall Chief Investment Strategist at CFRAResearch.com