With the new year, not only are you inundated with resolutions, but also by predictions on what the year will be like. Market watchers are no different.
What will 2022 hold for the stock market? Well, using a price to earnings (P/E) ratio model, the S&P estimated return for 2022 is 5.24%—with a standard deviation of 15%, meaning it could be 15% more, and return 20.24% or significantly less, losing 9.76%. Why is the difference so much? Current P/E ratios for the trailing 12 months for S&P stocks is hovering around 28.8, while the historical average is around 16.5. This is also why we’ve been saying the market is overvalued for the past year.
Let’s face it, the range between -9.76% and 20.24% is quite extreme. How is that even a prediction? It’s not, and that’s the point. You cannot predict the market return for any given year, which is why we have the Ten Year Rule. The further out you forecast, the more normalized returns become. If we use the same P/E ratio model mentioned above, the 10-year annualized return is 3.59% with a standard deviation of 3.5%, meaning there is potential for a high return of 7.08% or a low of 0.9%. Notice how that estimate brings us closer to the market’s long-term average return of 10%.
Given this crazy return range for 2022, what is an investor to do? First, rebalance your high-flyer stocks. In 2021, five stocks created 35% of the S&P’s return: Apple, Microsoft, Alphabet, Tesla, and Nvidia. Keep in mind that the S&P is a capitalization-weighted index, so these companies also represent five of the 10 largest companies when ranked by market cap. Any outsized gain in these will easily push the S&P index higher. If you own any of these five, it is time to rebalance, as they have likely grown to be well more than 5 percent of your overall portfolio.
Secondly, investors should plan for inflation. Yes, inflation is here, and the Federal Reserve has admitted it is not “transitory.” That’s not news to anyone. Investors need to plan for inflation because interest rates will begin to rise, and lending will tighten. The Fed will tighten monetary policy, which will reduce investment and consumption, housing prices could fall, and ultimately, curb economic growth. Higher interest rates are not favorable for asset values and growth stock values often suffer more than value stocks. Sectors like Financials generally do well as interest rates rise, and Healthcare and Consumer Staples will likely perform better than other sectors.
For those in fixed investments, keep maturities short to limit sensitivity as rising rates means lower bond values, but short-term bonds are less sensitive to rate changes. Municipal bonds are also attractive because municipalities have money from the pandemic bailouts that they have not spent so credit risk is relatively minimal. Government spending during the pandemic fueled consumer demand, but supply chain woes have made goods hard to buy. This is the perfect recipe for inflation. Higher interest rates will be used by the Federal Reserve to combat inflation. This makes for a tough investing environment.
Overall, it’s anyone’s guess where the market goes in the short run. However, investors can pay attention to the economic cycle, interest rates, and their portfolio allocation to determine how to move forward.