The chart of the S&P 500 shows stocks with the wind at their backs heading into the new year.
Positive momentum is usually a good thing. But after two strong years of market gains, many investors are downbeat about the potential for a three-peat of double-digit gains. The market might have tough comparisons on several fronts, but that doesn’t mean stocks can’t perform well. In the year ahead, the economy will transition to the middle of the expansionary cycle (i.e. mid-cycle), where growth starts to slow to more average rates, and valuations begin to matter more. In this transitionary period, stocks can continue to outperform their own historic average. But that doesn’t mean the gains will come easy.
In thinking about the year ahead, it’s easy to point to the known risks: the Fed reversing stimulative measures, inflation uncertainty, the supply chain mess and corporate earnings that are returning to more normal levels. Those items will make the market a little more difficult to navigate this year. But there is still a lot that could go right.
Real Risks: The Fed and Inflation
Let’s start with the stuff keeping most investors from believing in the three-peat. It’s no secret inflation has run hotter than most of us are used to for the better part of the past year. It’s eating into consumer purchasing power, and no one seems to know when it will subside, including Fed Chair Jerome Powell.
To be sure, the Fed is positioning itself to do its part in curtailing runaway inflation. However, there are both supply and demand issues that are driving inflation. The Fed can cool demand with higher rates, but the pandemic-induced supply chain issues are not as easily controlled by the central bank’s policy. The good news is that market expectations for inflation have come down, though they still remain elevated versus history. Additionally, there are signs that the supply chain pressures may be easing. For example, shipping container costs are off their peaks and backlogs are declining. Wage growth and higher housing costs will provide clues to inflation’s staying power in the year ahead. Ultimately, I’d expect inflation to moderate from the high levels experienced in 2021, with the rate averaging out to something that is more tolerable.
The Fed is now projecting three rate hikes in 2022. Given the improving economic environment, which is supported by an improving health situation (increased vaccine/booster use, treatment and testing availability), 2022 feels like the right time for Fed lift-off. Still, the speed of the rate hikes will impact how the market reacts. Typically, the market performs better when the Fed moves at a more gradual pace. Raising rates at every other meeting would be an example of a timeline the market could accept.
These known unknowns will keep us on our toes as the first half of the year unfolds.
Not as Bad as Feared: Earnings and Valuation
On the bright side, GDP is still expected to grow solidly above average in 2022 at a rate of 4%, according to the Federal Reserve. The housing market has been resilient as prices continue to move higher on limited levels of inventory. Manufacturing continues to expand with prices beginning to decelerate despite supply chain disruptions. Services are picking back up with non-manufacturing PMI setting another record in November. Consumers are shifting spending to services from goods. The workforce participation rate is improving, and job openings are plentiful. While there is still work to do on the jobs front, overall, the consumer is financially stable.
This is a good set-up for corporate earnings in 2022. As things currently stand, the S&P 500 is projected to reach a new record for earnings of $220 per share, according to S&P Capital IQ. That equates to growth of 7.5% annually. Going back to 2009, annual earnings growth averaged 7.7%, making the estimate for this year sound pretty reasonable.
Many fear the risk of inflation and rising rates on profitability. So far, companies have easily managed the inflation risk in the second half of 2021. Price increases have driven sales growth and close management of controllable expenses have resulted in the highest quarterly margins (based on earnings before interest and taxes) since 2007. Notably, margins have rarely come under pressure in periods of economic expansion.
While interest rates haven’t yet impacted corporate financial statements, anticipation of higher rates is weighing on valuations. The forward price-to-earnings (P/E) ratio of the S&P 500 has fallen to 21x, from a peak of more than 25x in the early part of the pandemic. Slowing growth is also weighing on valuation, but there is concern that rates could have a greater negative impact in the year ahead, especially as many sectors continue to have premium valuations versus their history.
Contrary to what most believe, when rates are rising from low (or near zero) levels, valuations have been more likely to rise than fall. A study by BlackRock shows that since 1995, in months when the 10-year treasury yield rose by more than 50 basis points, over the following three months the S&P 500 posted a price gain of 3.2%. This relationship is even stronger when considering real interest rates (taking inflation into account). Speed of rate hikes will likely play a large role in this dynamic, but should the Fed move at a steady and moderate pace, valuations shouldn’t crash. It is possible the market will continue to carry a premium multiple versus the long-term average of 16x, as rates are expected to remain low by historical standards in 2022.
Upside Potential: CapEx and Buybacks
No doubt companies and investors have much to contend with this year, but with record earnings and piles of cash, corporations will do their part to support the market through spending on capex and buybacks.
The pandemic may have created supply chain disruptions, but it also accelerated the use of technology and shed light on areas of underinvestment in the last cycle. Combined with increased demand, this is expected to lead to increased spending on operational improvements. By some estimations, capex is expected to exceed pre-pandemic spend by up to 20%. Like the past three quarters, growth in technology investment is likely to outweigh equipment investment.
In addition to capex, there has been a return of buyback programs. When the final numbers are in for 2021, it is expected share repurchases will exceed pre-pandemic levels by about 17%, reaching $850 billion. The amount repurchased has steadily increased each quarter since Q2 of 2020, as cash flow stability reemerged. Many technology and financial companies have already committed to large buyback programs for 2022. This natural buyer of stock will help support the market in the year ahead.
Additionally, the number of companies buying back large chunks of their shares remains low versus pre-pandemic levels. This could change if confidence in prospects for economic and cash flow growth improves. Of course, this would be icing on the cake, helping to push earnings estimates higher and aid market upside.
The Bottom Line
A third year of double-digit gains is a tall order for the market. There are plenty of risks and uncertainties that will test investors’ patience in 2022. Volatility is probably not going anywhere. However, if margins can be managed, interest rate increases come gradually, and there is a step-up in corporate spending, stocks could still be one of the best games in town.
Happy New Year and happy investing in the year ahead!
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Lindsey Bell, Ally’s chief markets & money strategist, is an award-winning investment professional with a passion for personal finance and more than 17 years of Wall Street experience. Bell’s unique ability to connect the dots between data and real life and craft bite-sized money ideas that people can use and apply stems from her deep background as an analyst, researcher and portfolio manager at organizations including J.P. Morgan and Deutsche Bank. She is known for demonstrating why and how an understanding of all things money improves a person’s finances and overall well-being. An ongoing CNBC contributor, Bell empowers consumers and investors across all walks of life and frequently shares her insights with the Wall Street Journal, Barron’s, Kiplinger’s, Forbes and Business Insider. She also serves on the board of Better Investing, a non-profit focused on investment education.
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