Market Update

The S&P 500 lost 1.9% last week and finished at 4620.64. The Dow lost 1.7% and the tech-heavy Nasdaq fell 2.9%. The S&P finished a tick above its 50-day moving average. It is 2.6% below its all-time high. A close below 4495.12 would put a double top in place, which would signal more short-term downside. The stock market may remain under pressure into year-end as institutional managers rebalance. Strong stock performance and weak bond performance means selling stocks and buying bonds. There is support from 4300 to 4500 that could limit any serious downside. There is also the traditional Santa Claus rally. The already significant selling of stocks other than the FAANG gang might limit further downside as well. 

J.P. Morgan strategist Marko Kolanovic notes that the broad-market Russell 3000 index is up about 21% in 2021. Meanwhile, the average U.S. stock is down 28% from its highs. The Generals are the last to capitulate in Wall Street lore. The troops take damage first. The broad index holds up for a time thanks to the Generals. Eventually, the Generals join the sell-off, and the broad index falls. In this case, Kolanavic writes that “Such a divergence is unknown to us, and indicates a historically unprecedented overshoot in selling smaller, more volatile, typically value and cyclical stocks in the last four weeks.” He is referring to the wide gap between the Russell 3000 index’s gain year-to-date and the average stock’s decline from its highs.

Norwood Economics’ base case is for a flat market next year. We think a 15% decline at some point during the year is quite likely. Rising interest rates, a slowing economy, slowing earnings growth, and Covid makes a correction highly probable. Continued economic growth, a strong jobs market, and large excess consumer savings make a recession and bear market unlikely in 2022.

By comparison, the S&P 500 should close near 4909 next year, according to the average of 15 Wall Street strategists’ forecasts. The gain amounts to 6.2% from Friday’s close. That’s not too far off the average gain of 8% over the past 94 years, according to Janus Henderson portfolio manager Aneet Chachra. Of course, most Wall Street strategists are loath to predict no gain or, heaven forbid, a loss for stocks. Norwood Economics is bullish on its stocks but believes the market will make little progress in 2022.

Economic Indicators

I’m at my parent’s for a visit. Going to shorten the newsletter this week. Economic data will return next week!

Investing in Energy

Norwood Economics has significant exposure to energy stocks. Our portfolio weighting is far above the Energy sector’s weighting in the S&P 500. We bought seven energy stocks in October of 2020, a week before the Pfizer vaccine was announced. The timing was lucky. The five months of research before buying those positions was time well spent. Now we find ourselves in an unusual position for us. Norwood Economics is an old-school value investor. We buy good companies when they are on sale. We sell them when they return to fair value. Now we find ourselves contemplating holding on to our energy stocks even though five of the seven have returned to fair value.

We find ourselves thinking about holding the positions even though we are expecting a period of retrenchment for the stocks. It is likely that a stronger dollar and Covid fears this winter will send the price of oil back into the $60 per barrel range for a period. Our energy holdings will likely lose 20% to 30% if oil does fall to those lower levels. Yet, we also believe that oil will move higher over the next few years, possibly above $100 per barrel. Our energy stocks will move higher from their current prices if oil does rise to $100 or more. It is also possible that oil will not drop much in price, and neither will the stocks.

The safer course is to take our profits early next year. A conservative move since none of the stocks are overvalued. Some haven't even returned to pre-Covid levels. All have strong balance sheets. All are paying a well-above-average dividend. All have strong cash flows. All would be profitable with oil in the $40s. All will move higher with higher oil prices over the next few years. And all are cheap relative to the market. In fact, Morgan Stanley analyst Devin McDermott points out that energy stocks are trading at a 65% discount to the S&P 500 index, twice their historical discount, according to Barron’s.

I’m not sure what we’ll do yet. It's possible we'll incorporate our macroeconomic view on oil into our stock selling decision and hold the stocks for the next few years. Certainly, like the Federal Reserve, we will be data-dependent.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist