Market Update January 2022 – It’s Not Just What You Buy, But What You Pay
First, a warm welcome to 2022 what surprises might you have in store for us? As we move into the new year, sentiment will undoubtedly be a significant factor shaping the path taken by risk markets during 2022. In one corner will be optimism, supporting a continuation of rising equity markets since the spring of 2020. And in the other corner will be skepticism, promoting that equity markets can’t produce outsized gains forever. But this tension may just work out to everyone’s benefit.
In many cycles, the prevailing optimistic sentiment overshoots reality, unsupported by wavering fundamentals, resulting in a reversal. But there is no rule that defines the time-limit of an economic expansion or contraction and if investors believe there is further economic and earnings growth ahead, markets can continue to advance. While there are no defined limits for economic growth and rising security prices, history confirms that investors often times push the prevailing trend too far. Yet history also suggests that many investors become uncomfortable when the strength of a trend is strong and long-lived, even in an era with healthy fundamentals. Where are we today?
Trends rarely die due to longevity. Rather, a catalyst enters the equation, changing the economic and/or financial environments, resulting in a move to the next era. In today’s markets many investors are concerned that rising interest rates pushed by inflation could be this catalyst. Particularly, if it’s coupled with a slowdown in demand due to the ongoing COVID era. But this does not appear to be the case. Economic disruption continues to abate with each COVID flare up as businesses increasingly adapt to the challenges faced. And, with interest rates having been held artificially low by monetary officials for some time, there is likely room for interest rates to rise back to normalized levels commensurate with current economic strength.
If these conditions, including further economic expansion, persist into 2022, the relationships may serve to further equity market gains rather than cause the end of this bull market. And a very plausible scenario for equity markets in early 2022 would be: (1) economic strength persists, causing interest rates to move marginally higher; (2) in the midst of a changing interest rate regime, equities experience an increase in volatility, resulting in a choppy, sideways phase with moderating valuations as investors adjust to the rate changes; (3) earnings results for 2021 Q4 come in strong, coupled with forward guidance reiterating expected further improvement ahead; and (4) with sentiment having become more cautious on the back of higher rates, equity valuations have moderated and investors re-up their equity interest, moving markets higher once again.
Fundamentally, the case for higher equity markets in 2022 is based upon the current rising trend in economic growth and the expected earnings gains that would follow. But caution is warranted when investors become comfortable with the economy and markets. With rising interest rates, inflation concerns and political disruption, the path is unlikely to be smooth and may provide a list of concerns (some old – COVID, and some new – inflation) in 2022 that will test investors’ metal as market volatility picks up. But the saying that “the market climbs a wall of worry” exists for a reason and 2022 may just fit the bill.
CHART OF INTEREST: It’s Not Just What You Buy, But What You Pay.
After 2021’s strong returns in the US equity markets, what should be expected in 2022? Should an investor expect mediocre returns following a year with outsized gains? This may turn out to be the case for the broader market, but that doesn’t mean all market sectors will follow suit.
2021 saw a large gulf between the largest sector (Technology +35%), the best performing sector (Energy +55%) and the lowest returning sector (Utilities 18%). It also left a large divergence between the fundamentals of each sector. 2021 was also another year with significant support from the fiscal and monetary authorities, an investment environment that tends to be less sensitive to fundamentals. Now, with much of the monetary stimulus beginning to wind down, investors are likely to again place greater value on fundamentals as they make investment decisions.
The chart below takes a look at three basic measures of fundamental expectations for the S&P 500 Index sectors in 2022: earnings, cash flow and growth rates, using Bloomberg analyst estimates (“BEst”). For context, the first two columns show the sectors’ weights and P/E ratios as of prices on 12/31/21. The following columns look at the same price relative to estimates for fundamental measures in 2022, such as earnings and cash flow, along with price-to-earnings v. earnings growth (PEG ratio). In each of these datapoints, green depicts “less expensive”, and the red depicts “more expensive” when compared to the top row index averages (as represented by SPDR S&P 500 ETF Trust (SPY).
While this table contains much data, the story is quite simple. Despite the strong gains in 2021, there continues to be selective opportunities in particular sectors. And, not surprisingly, many of these opportunities represent sectors having greater sensitivity to economic conditions. During the recovery investors have tended to be cautious about these sectors until confidence in economic growth strengthened. Now that the economic data continues to improve, markets are seeing this rotation to economically sensitive sectors.
Of course, a word on inflation is appropriate in today’s environment and, not coincidentally, a number of the sectors in green typically realize some benefits from an inflationary environment. But as many investors know, “inflation is never a problem, until it is”. And if inflation hits “is”, the investment paradigm may very well shift again.
Quantitative Advantage, LLC (QA) is an investment advisor registered with the Securities and Exchange Commission and is a limited liability company organized in the state of Minnesota. Registration of an investment advisor does not imply any specific level of skill or training. QA Wealth Management is a division of QA.
This information has been prepared by QA, is provided for informational purposes only and does not constitute investment advice. It contains general information, is not suitable for everyone and is subject to change without notice. The views and opinions expressed in this report are solely those of QA and are current as of the date of writing. While the content is provided in good faith to provide a general commentary of current market factors and conditions, the views and opinions expressed are limited in scope and QA makes no representation or warranty as to the accuracy or completeness of the information provided. Past performance of the global investment markets is not a guarantee of future results.
The index performance results referenced in this report represent past performance and are not a guarantee of future performance. Investment returns and principal value will fluctuate and are subject to market volatility, so that a client’s investment, when sold, may be worth more or less than the original cost. Indices are unmanaged and investors cannot invest directly in an index. An index’s performance does not reflect the deduction of transaction costs, management fees, or other costs which would reduce returns.
The S&P 500 Index is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the New York Stock Exchange or the NASDAQ Stock Market. For more information regarding this index, please refer to the sponsor website at www.standardandpoors.com. SPDR S&P 500 Index ETF Trust (SPY) is designed to track the S&P 500 Index.
For more information about QA, its investment programs, fees, and the risks associated with the investments which QA may make or recommend, please review QA’s Form ADV disclosure brochure, which is available at www.QAwealthmanagement.com, or upon request from QA’s compliance department by telephone at 866-767-8007, by writing to 10400 Yellow Circle Drive, Suite 303, Minnetonka, MN 55343, or by email to compliance@QAwealthmanagement.com. Please review the Form ADV disclosure brochure carefully before or at the time you enter into an agreement with QA.