Stock Market Outlook 2022
Will TINA still be with us?
The US stock market was up 25% or so during the past year (down from over 30% in November) and has doubled since the Covid-1 panic in March 2020. It is also up by 5x since the 2009 market bottom during the last financial crisis, for a compounded annual return of 18% or so including the reinvestment of dividends. This sort of long-term stock market performance is truly exceptional by any standard and so we have to ask: Should we expect more of the same in 2022?
Finance students will have learned how to quantify the expected future return on equities for purposes of estimating a company’s cost of capital, using models like the Capital Asset Pricing Model (CAPM). Over most of the past decade, however, these CAPM-type models would have generated estimated expected annual equity returns (for market risk companies) of 6-8%, far lower than the actual annual returns subsequently realized during this period. But students will also know that there is often a big difference between expected and realized returns and that for any given time period (particularly shorter periods) the observed (or realized) annual returns on stocks tend to be lumpy, with many or most data points falling outside the range of average returns. We should not be surprised, therefore to witness a few big up years like 2021; nor should we be surprised when we get some big down years like 2008. But a decade or more of realized equity market returns averaging over twice the expected return is nevertheless highly unusual. Why did this happen, and how should it impact our thinking about future stock market returns in 2022 and beyond?
Stock prices are volatile, of course, and when measuring periodic performance it really does matter what start and end dates one selects. The S&P 500 fell 50% during the last financial crisis in 2008-9 and it again fell 35% during Covid-1 in early 2020. The same thing happened after the dotcom collapse back in 2000-01, when the Nasdaq fell over 70% from its 1999-2000 peak levels. And so we should not be at all surprised to learn that the realized return on stocks looks very different when measured from a market bottom to a market top rather than from top to bottom. We have seen this reflected recently in the multi-year returns of institutional money managers, whose 3 and 5-year investment returns were flattered by a very strong performance in 2021.
Another big part of the stock market performance story must be the positive impact on the real economy and corporate profitability of the governmental economic policy responses to the two crises, most notably large fiscal stimulus packages passed by Congress (particularly during covid) and truly massive liquidity infusions provided by the Fed (during both the financial crisis and covid). Both actions helped stabilize and support the real economy, which was quickly reflected in increased stock prices discounting in advance an expected recovery in future economic activity and corporate profitability, which took longer to play out following the financial crisis than it has during covid, perhaps due to the larger policy response in the later years.
The price of the S&P 500 stock index is now up 50% from its pre-covid peak just two years ago, far outpacing the recovery in corporate profits which are up 30% or so in 2021 vs 2019 (following a big fall in 2020). To the extent that the value of the stock market at any point in time reflects the economic value of all expected future (not past) corporate profits in perpetuity, as we learned in school, one or two good years of corporate profits should not be expected necessarily to have a major impact on the current market value of the overall stock market, particularly in a low discount rate environment. And so something more seems to be going on here, but what is it?
In this case I think the answer is simple: the Fed and Interest Rates. As noted above, the Fed’s super-accommodative monetary policy was initially put into place during the 2008 financial crisis and it continued largely intact for over a decade, when it was ramped up again during covid. During this period, the Fed not only cut short-term rates to zero but it also purchased for its own account a net total of over $7 trillion of UST (and mortgage) bonds, driving down the yield on sovereign bonds (and mortgage loans) to all-time lows. In March 2007, just before the financial crisis, the yield on 10-year UST bonds was about 5%; by July 2020 (during covid) it had fallen to a low of 0.5%. This is a 90% reduction in the so-called risk-free rate used to value stocks. With the yield on UST bonds down 90%, should we be at all surprised that the market price of stocks went up so dramatically?
An old boss of mine liked to explain any increase in stock prices by citing “more buyers than sellers”. But why were so many people eager to buy stocks at very high valuation levels at the beginning of 2021 and at other previous market peaks? Again, I think the answer has a lot to do with the Fed and the level of interest rates. With US interest rates at 0% and 10-year UST yields at or below 1%, and with negative yields on sovereign debt in much of the rest of the world, there simply was no attractive alternative to investing in stocks for investors seeking to generate a positive return on their money. Over the past 10+ years the US and global bond market has morphed from being a market offering “risk-free returns” to one offering “return-free risks”. And much of the money fleeing dismal fixed income returns went into stocks and other classes of “risk assets”. The acronym for this widely-reported phenomena is TINA: There Is No Alternative.
I suspect that these same factors—the Fed, interest rates and TINA— also explain much of the recent market performance of bitcoin and other cryptocurrencies as well as many other recent signs of market excess, including meme stocks and SPACs. When real interest rates and sovereign bond yields are at or below zero in much of the world, and central banks have flooded the markets with over $25 trillion of excess liquidity, the distinction between “investments” and “speculation” tends to blur quite a bit. And the result has been predictable, with even relatively staid financial institutions now viewing cryptocurrencies as a suitable (even core) component of fiduciary investment accounts. And with the world’s stock markets up 20-30% in just the past year, and bitcoin up 60% during the same period, who can blame them?
Before I wrap up, let me mention one other possible contributing factor to the recent big run-up in stock prices and market valuations: the age and experience of many investors and money managers. I know that I am now a certified old geezer, and my conservative views can perhaps be attributed to advancing age and a growing tendency toward curmudgeonly thinking, but I wonder how many of the investment professionals managing customers’ money today—including those who so eagerly piled into SPACs, Robinhood and other meme stocks—were in those same positions of fiduciary responsibility during the dotcom collapse at the turn of the century or even during the financial crisis back in 2008. (I know they weren’t there during my formative years, in the late 1970s and early 1980s.) How many have lived through not just a market correction but a true bear market? I suspect the answer is “not many” or “not enough”, and this too may explain some of the aggressive “risk on” investment behavior we have witnessed in recent years.
Having said that, those investors who did pile into equities or cryptocurrencies a year or a decade ago have generally done very well and look pretty smart today, at least with the benefit of hindsight. It seems that our friend TINA delivered for equity investors big time in 2021. But will she do so again in 2022?
It is possible, of course, but the skewed risk-return dynamic of the past years may change significantly in the new year due to more hawkish Fed policy and a widely studied empirical phenomenon known as reversion to the mean. When stock prices have risen this far this fast, it is only reasonable to expect one or more periods of marked underperformance, including periods of (possibly large) negative returns, even in the absence of major market-moving developments (like a change in Fed policy). I don’t know if this will happen in 2022 or subsequent years, and neither does anyone else—not Goldman Sachs, or BlackRock or even the Fed. But if inflation continues at current levels, the Fed tightens monetary policy more rapidly than is currently expected and/or interest rates go back to anywhere near “normal” (pre-2008) levels, investors had better watch out.
Of course none of this may actually happen—leaving me alone (and wrong) again, naturally. But the current level of stock market valuations does not leave much room for nasty surprises on the downside. And in the event of a big rise in interest rates and bond yields, our friend TINA will no longer be around to bail us all out. At which point the phrase “Don’t fight the Fed” may take on a whole new meaning for investors.
But today is January 1—New Year’s Day—a day for celebrating the past year and looking forward optimistically and enthusiastically to the future, while watching football and drinking beer. And with that spirit in mind, I wish you all good health and a joyous and prosperous new year. Go Dawgs!
Link:
The Fed Pumped Up Stocks; In 2022 it May Pull the Plug, NY Times, 12.31.2021