Markets Winter 2022

Despite recent slowdown in economic growth related to Omicron effects, the U.S. economy remains in expansion mode. The CNBC Survey of Economist is projecting a median 4.3% real economic growth in 2022. A peak in Omicron cases and effective viral vaccines could bring about yet another Spring re-opening phase. Supply bottlenecks and shortages are a work in process that eventually fixes itself resulting in a moderation of inflationary pressure. Inflation pressures are peaking but will linger. Investors should consider high quality companies with pricing power offering dividend growth. Prepare for higher market volatility stemming from Fed tightening, geopolitical risks (Russia), slowing China economy, and the midterm elections. The period before midterm election is known for corrections due to uncertainty of outcomes. I would be a buyer in any midterm election correction.

U.S. Large-cap stocks, measured by the S&P 500, returned 26.9% for 2021 – an uncommonly strong year. History shows that annual stock returns of greater than twenty percent are followed by 9% return 74% of the time according to CFRA research looking back to 1945. Growth stocks beat Value stocks, and Large-caps outpaced Small-caps. Developed Market Equities and Emerging Market Equities trailed U.S stock returns. U.S. Bond market, measured by the Aggregate Bond Index declined 1.6%.

After three years of higher returns do not expect stock markets to deliver double digit returns this year. Expect a modest single digit results accompanied by above average volatility as the Federal Reserve tightens. Uncertainty of Mid-term election results will also add to market volatility. Moreover, historically high equity valuations limits future returns especially under a monetary tightening regime. Stock multiples are compressing under the specter of rising yields. Even so, Stocks, in a volatile year, should outperform Bonds based on a backdrop of above average real economic growth and normal earnings growth.

For stock investors, the speed of the increase in interest rates is key to whether the S&P 500 Index takes a path higher or lower. If the tightening cycle is not gradual, then S&P 500 Index moves lower, and recession risks rises in late 2023. The Fed does not want to engineer a recession by hiking more frequently than each quarter this year. However, the Fed is behind the inflation curve skewing the risks towards a faster tightening cycle. A slowing economy should moderate inflation easing pressure on the Fed for faster monetary tightening.

Current year earnings and sales growth for S&P 500 projected to normalize from lofty levels in 2021. FactSet projects earnings growth of 9.4% and sales 7.6%, figures associated with a Bull market. Despite concerns about inflation, supply shortages, higher energy cost, and labor shortages, net profit margins are at record levels. Earnings growth is supported by a backdrop of historically easy financial conditions, low unemployment, low debt service levels, household wealth, historically low interest rates, and so on. Consistently high ISM readings suggest corporate earnings announcements will meet expectations.

Economists are trimming their economic growth forecasts partly due to Omicron variant hit to the economy. Goldman Sachs said each one percentage point drop in GDP growth would roughly reduce S&P 500 earnings per share by $7. The latest retail sales report disappointed thanks to Omicron’s impact on demand and supply. The peak in Omicron variant is critical to consumer demand and stock prices. Following past peaks in COVID-19 variants, pent up demand surged in sectors of economy held back by it. I expect an economic rebound this Spring and Summer. Still weighing on markets will be higher cost of labor adverse impact on profit margins.

Its looking like a “Sell in May and Go Away” year given Midterm election is coming coupled with Fed tightening regime. The period from late-April through the end of September in year two has seen the largest drawdown on an average basis of the entire cycle. Midterm elections tend to cause higher market volatility during election years. LPL research reveals that the S&P 500 Index declines on average 17% going into Mid-term election day. After election results are in the S&P 500 Index generate above average returns over next twelve months.

There is no alternative to stocks (TINA). This year’s projected earnings should deliver, and real assets such as stocks typically perform well with inflation accompanied by economic growth. Cash is not keeping up with inflation and neither are bonds. I think dividends will play a bigger role in stock returns this year. I think this environment favors investing in companies with underlying fundamentals that permit dividend growth. Dividend growers are very profitable companies with high quality earnings and financial statements. Seek out high quality dividend paying companies that can raise prices at this point in the market cycle.

After the initial shock of Fed tightening announcements, investors do well on average, despite the negative impact on equity valuations. Research by CFRA shows that the S&P 500 Index has risen eleven times in the past twelve tightening cycles since 1950 with an average annualized rate of 9%. Moreover, during tightening cycles when intermediate yields rose 1.5 percentage points since 1950, the S&P 500 Index averaged an annualized gain of 12%. History suggests buying the dip could be a profitable strategy this year sometime before October. Until then a more balanced strategy between short-term bonds with a tilt towards quality equities is the way to navigate 2022 markets.