What Did We See?
- U.S. Large Cap stocks, or the S&P 500 index, were up about 11% in Q4.
- The developed market of Japan was down about 1.7%.
- Europe and the U.K. were up about 7% and 4% respectively.
- Emerging Markets and Asia (Ex-Japan)were down more than 1%.
- Global fixed income returns ended the quarter mixed.
Where Do We Stand?
- The market ended a very strong year with another impressive showing in Q4.
- Valuations remain stretched and by some measures are at 20-year highs.
- The time horizon for a correction is nearer than markets are anticipating.
- I remain in a position to weather the volatility while taking advantage of dislocations as they present themselves.
The developed world’s equity markets continued to rally in the last quarter of 2021. This brought to a close the third consecutive year of strong positive returns. This impressive equity performance has been driven by positive earnings growth. The world learned to grow within the confines of a pandemic stretching into its second year. While the emergence of the Omicron mutation of the virus led to higher volatility, it has done little to derail the markets so far. The risk of another major shutdown seems to have lost it’s teeth the more we learn to live with this virus.
Bonds were flat to lower as the market digested higher inflation and a softening of easy money policy from global central banks. Fears over a softening of growth prospects as we look out to 2022 and beyond are likely to continue to weigh on markets. Whether or not those fears are realized, the markets seem poised to continue being volatile. Omicron, inflation threats and lower levels of fiscal and monetary support being the main culprits.
Prediction Theory
Predicting the future can be a loser’s game. That is why I always stress the benefits of diversifying one’s exposures to differing asset classes. No one truly knows what the future holds. The longer out in time one tries to predict, the more likely they are to be wrong. This theory has been scientifically proven numerous times.
One of the better books on prediction, written by Philip Tetlock in 2006, is called Expert Political Judgement. In his research he asked a group of pundits and foreign affairs experts whether the Soviet Union would break apart by 1993. When he reviewed the answers in hindsight (The Soviet Union dissolved in 1992) he found that the “experts” were no better at predictions than a group of “dart-throwing chimps”. It didn’t matter how qualified the “expert” was or what their political leanings were. Other studies have shown that Meteorologists are the most accurate predictors of the future and their predictive ability was only accurate to 3 days. After 3 days, the accuracy fell to a coin flip.
Diverse Opinions
As further proof that predicting the longer term future is futile, predictions for the S&P 500 next year amongst Wall Street Analysts are some of the most diverse we have ever seen. The range of estimates for the index closing price for 2022 are as low as 4,400 and as high as 5,300. That is a 20% spread, the second highest spread in a decade. With the S&P 500 closing the year at around 4766 that means the stock market could be down about 8% or up about 11% depending on which “expert” you ask. So, what does the main street investor do under such a scenario?
Be Open Minded
Although Tetlock didn’t uncover the holy grail to making good predictions, he did uncover a style of thinking that was beneficial when considering making predictions. That is, those who actually considered multiple smaller differing possibilities in their predictions did far better than those who focused on a single big possibility. By blending together several explanations, we can be better at predicting the future! Put simply, more open minded individuals make better predictions. Applying that to the markets, one needs to consider all the good possibilities while they consider all the bad possibilities.
The Good
In the face of lockdowns and unpredictable events (elections, political unrest, etc…) corporations here and abroad have managed to grow. Technology has allowed economies around the world to adjust to new information faster than ever before. Economies can grow with people working from home. Economies can recover quicker than ever before from shocks. The resilience is outstanding. Furthermore, governments are now faster at reacting to shocks. Whether it be fiscal or monetary stimulus based.
Earnings growth is the great driver of market returns. Earnings took a big hit in the first lockdown of this pandemic and recovered admirably. Some analysts expect earnings to continue this momentum into 2022 and beyond. If true, stock prices will follow suit. Further driving the continued recovery has been jobs. Jobs are recovering. While still not at the pre-pandemic levels, employment is now only 3.5 Million people below. In the height of the pandemic we were more than 22 Million below that level. At the same time job openings have more than doubled since the height of the pandemic.
The Bad
The markets have not had a meaningful correction since the initial shock from the pandemic in March of 2020. The S&P 500 was down close to a correction in September and again in October of that year. There was another pullback in October of 2021. Technically, we are coming up on 2 years since a meaningful correction. As stated in previous updates, markets like to take breathers (in the form of a correction) every 18 – 22 months. We are at 22 months now.
While earnings are predicted to grow in 2022 and beyond, the uncertainty is high for those predictions. With current pricing pressures driven by supply issues, the durability of that earnings growth is questionable. Furthermore, current tax and policy uncertainty leads to more earnings unpredictability going forward.
Valuations are something we have discussed in depth for the past few updates. The valuation multiple for the S&P 500 remains at elevated levels. In fact, by some measures the P/E (Price to Earnings) multiple of the market on a trailing basis is at 20 year highs. The higher the multiple, the harder it is for the market to go higher.
Lastly, we come to the bond market. The bond market is telling us that interest rates are going higher. That is to be expected knowing the levels of money that have been pushed into the system during this pandemic. This has led to inflation which must be contained at some point if we expect to protect our economy. That day of reckoning is closer today than it was 12 months ago.
Stay the Course?
As long as one’s time horizon is long enough, the best advice is always to stay the course. While I tend to increase cash levels in client accounts the closer we get to market euphoria, the majority of accounts will often be invested. That is because one’s portfolio can recover if we have the time. Timing the markets can be a fool’s errand. We don’t want to be on the wrong side of that exercise but at the same time we like to ensure a certain level of asset protection. Walking that fine line is usually the best course of action.
Conclusion
The spread of the Omicron variant will likely be challenging for economies around the world in the first half of 2022. Staying broadly diversified is a good way to ensure that the volatility that is likely to come can be mitigated. If the variant wreaks more havoc than we expect, it will be good to be diversified with higher cash levels than normal. If the variant and it’s economic effects are short-lived it will be good that the majority of one’s portfolio stayed the course. However, the risks bear watching.
If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.
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