Market Update

The S&P 500 rose 0.9% last week. It hit a new high Thursday reaching 4808.93. The index beat the Nasdaq on the year, returning 26.9% excluding dividends. The Nasdaq returned 23%. It is the first time the S&P 500 has beaten the Nasdaq since 2016. It is the third year in a row of double-digit returns for the S&P, a rarity. The index trades at 21.9 times 12-month forward earnings. Price is the primary determinant of future returns. Bank of America expects large-cap U.S. stocks to earn only 1.7% annually for the next decade. Small-cap stocks should outperform over that period. Small stocks are trading at 15.5 times forward earnings. BofA securities strategist Jill Carey Hall writes that small caps should return around 9% per annum over the next 10 years.

It is 2022, the start of a new year. Time for a few forecasts. Norwood Economics expects the S&P 500 to return zero percent, plus or minus a few percent. We also expect increased volatility in 2022. A 10% to 15% correction is overdue but requires a catalyst. Norwood will continue to look for good companies on sale, using any sell-off as a buying opportunity.

A bear market is unlikely. Dr. Jim Paulson of the Leuthold Group thinks the S&P 500 will finish 2022 around 5,000, a gain of 5%. He thinks the S&P will climb above 5,000 during the first half of the year. He’s expecting a difficult second half of the year. Paulson thinks the Federal Reserve’s rate hikes and slowing earnings growth might be the triggers to a sell-off.

Norwood expects 2% to 3% GDP growth in 2022. Inflation will finish the year between 3% and 4%. The 10-year Treasury will end the year between 1.5% and 2.0%, although it could move to 2.5% before falling back. Real interest rates will be negative at year-end 2022 if we’re right about inflation and the 10-year Treasury bond. Negative real rates are a positive for stocks and commodities. U.S. large-cap stocks will underperform, especially high P/E growth stocks. Emerging and International markets will outperform the U.S. and small-cap stocks will outperform large-cap stocks. Commodities will continue to shine, including oil. Norwood will continue to underweight bonds. We agree with Citi Private Bank that bonds will lose money in 2022. Citi is forecasting negative 1% to flat.

Final forecast: it will be a stock picker’s year. Buying good companies on sale that pay above market dividends will continue to work well. Buying the market will not.

Economic Indicators

Home prices continue to rise rapidly. The Case Shiller U.S. home price index climbed 19.1% in October. Pending home sales fell 2.2% in November after climbing 7.5% in October. Jobless claims were below 200,000 again, coming in at 198,000. The labor market is strong. The Chicago PMI was 63.1 in December up from 61.8 in November. Numbers above 60 are strong. Economic indicators continue to point to a growing economy in 2022. Consumer Confidence does not.

The University of Michigan Index of Consumer Sentiment dropped 13% to 70.6 in 2021. It is the lowest end-of-year reading since 2008 during the Great Recession. Double-digit drops in Consumer confidence are often a prelude to recession. Norwood isn’t forecasting a recession for 2022, but consumer confidence bears watching. The lack of confidence hasn’t translated into a lack of consumption yet. Consumption is 70% of the economy. A pullback in consumer spending commensurate with the drop in confidence would likely tip the U.S. into recession. We don’t expect it but can’t rule it out either.

Extreme Risk Aversion

I had conversations with two clients last week that are worth reviewing. Both clients are sitting on large amounts of cash. Neither is comfortable investing the cash. They are losing 6% in purchasing power annually at the going rate of inflation. They would rather lose 6% than risk the stock market. Their fear is a large, permanent loss of capital. They both talked about stocks crashing. Neither seemed aware that stocks are a claim on part of a company’s profits. Instead, they referred to stocks in the abstract, unconnected to real companies.

A stockholder shares ownership in a company with others. Owners are entitled to a share of the profits. Companies can do three things with excess cash flow (profits). It can pay a dividend to its owners. It can buy back stock, which increases the remaining owners' share of future profits. It can invest profits back into the company hoping to increase future profits for its owners. A company’s value to its owners is based on future profits, not the price of the stock. A stockholder’s return equals the dividend yield plus earnings growth. The stock price will follow the earnings growth, assuming the price-to-earnings multiple doesn’t change. That last bit is important. Pay too much for earnings and your return as an owner will lag a company's earnings growth. It is the reason that value investing outperforms growth over the long run by 4.3% on average annually.

I pointed out to both of my clients that we don't own the expensive stocks. Our stocks tend to trade between 8x and 12x earnings. Yes, the market is expensive but that is due to around 50 stocks that make up 25% of the S&P 500. Those 50 stocks are trading at high price-to-earnings multiples. We don't own any of them.

What we do own are real companies with real profits. Companies that are integral to modern society. Energy companies, healthcare companies and food companies among others. What would it take for these companies, most trading at less than 12 times earnings, to lose most of their value permanently?

The U.S. economy would need to implode. The electric grid is gone. Running water is a thing of the past. Grocery stores no longer have food to sell. Modern civilization is destroyed. A diversified stock portfolio of profitable companies is not going to zero. It would take the end of life as we know it.

My clients had not connected the dots. They hadn't thought about the businesses they owned. They are losing purchasing power to inflation out of a vague fear that stocks will crash. It is important to remember what a stock signifies, ownership of a company. Could their portfolios decline by 30% to 40% for a time? Of course! But remember that a drop in the stock price doesn't change the value of the company. A company's value depends on its earnings and its earnings growth not its stock price.

The U.S. stock market has never gone down over a twenty-year period. The S&P 500 has only had two 10-year periods with negative returns. Why? Because corporate earnings have continued to grow along with the American economy. My money is on the American economy and corporate earnings continuing to grow.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist