This economic commentary comes at a year-end and, therefore, the beginning of a new year. It’s probably expected that we will recap what happened this year before commenting on the future. But this “year” end also represents the end of the second year we’ve all had to deal with Covid and the associated economic dislocations. It is important to understand how that has impacted our economy and the stock market.
From an economic perspective, there wasn’t much surprise in how this played out. Whatever opinion you have of the lockdown’s medical effects, the economic effects weren’t going to be much of a surprise. Shutting down large sections of the economy would restrict economic activity and reduce (sometimes substantially) the profits of companies nationwide and worldwide. The stock market’s primary role is the valuation of all that economic activity and profits. Accordingly, the market collapsed in the first part of 2020.
Also expected was that a recovery would come when the lockdowns and restrictions were lifted. What was not known – because there was no historical precedence for this – was how the return to normalcy would occur. Nobody knew whether, let alone how long it would take, for a shuttered factory to ramp back up. Nobody knew whether workers, once released from jobs, would return to those jobs or to any job in the same company, same region, or same industry. Nobody knew whether consumer or worker habits were permanently changed (think online purchasing and zoom meetings) or would fully return to lockdown norms. Nobody knew how government interventions would be reversed.
So while a recovery was inevitable, knowing the composition and timing of that recovery was an unknown. Which industries would survive? Which industries would thrive? Which companies would die? And which companies would be born? This was all up for grabs, and the market’s role to value the results showed the overall upward trend, but the market subjected that upward trend to increased volatility as positive and negative surprises impacted the calculations investors were making as they bid up or bid down the stock price of individual companies.
At the end of 2021, we know the recovery has been significant; but we also know that we have not yet fully returned to pre-Covid levels. There is more recovery to come just to return to the baseline. We also know that supply chains remain impacted, labor shortages abound as workers calculate the value of unemployment benefits vs. wage rates, and the money the Fed has flooded into the system has prompted accelerated inflationary price increases. The annual inflation rate now stands at 6.8% for the period ending November 30, 2021.
All eyes are on the administration, Congress, and the Fed. And that is exactly where we should be looking. The policies and actions which will come out of Washington D.C. in the months ahead will impact the pace and direction of economic activity, price levels, and stock market valuations. Within this environment, we offer several observations and projections of what 2022 will bring.
If there are no changes in policies out of D.C., we see the recovery continuing at its present slower-than-normal pace with 2.75% growth in 2022. This includes an expectation that the job market will continue to improve even as we acknowledge that the labor participation rate will remain low; some workers just aren’t going to come back into the labor market.
While we expect corporate profits to increase, we are adopting a conservative approach of assuming they remain at 3rd quarter 2021 levels. Ultimately it is profits which the market values in generating stock prices. These prices represent the best estimate of the “present value” of those future profits, and the 10-year Treasury rate is the normal “discounting” rate used to determine present value.
To be conservative with our valuation, we are assuming an increase in that rate – since the Fed has now announced it will be raising rates. Putting it all together, the continuation of these present trends indicates that the S&P 500 would be “fairly valued” (not over-valued and not -under-valued) at roughly 5,250. That is 10% higher than the level as of this writing, but it does not take into consideration any growth in profits, which would push the fair value level higher.
We also expect inflation to remain at the 4% to 5% level. This is one of the wild cards, and its impact will be felt differently in different industries and areas of the economy. Inflation throws uncertainty into all business calculations. Workers try to anticipate the increase in their cost of living as they negotiate for their wages or consider taking the job at all. Companies try to anticipate the increases in their costs from labor and suppliers, which they then build into their price increases. It is always imperfect, and some industries have the latitude and ability to do this better than others. Inflation also impacts the value of loans and bonds issued by banks, companies, and governments.
The market has anticipated inflation in its calculations, as have we in our estimate of the S&P 500. Ultimately, though, inflation is determined by the Fed, by how much money it puts into the system, or in our present circumstances by how efficiently it can withdraw excess money it previously put into the system.
There is where the Fed finds itself as we close 2021 and start 2022. It has announced that rate hikes are now on the drawing board as it acknowledges that inflation is no longer “transitory.” The Fed has the power to be one of the stabilizing or destabilizing factors in the economy and, therefore, in market valuations. Markets hate surprises, primarily because surprises distort the market’s calculations of values. If the Fed moves in anticipated ways and degrees, the market will not react. However, if the Fed moves in an unanticipated way or degree, the market will react and may react with a significant move.
100 point moves on the Dow used to be major news because they were significant. Today 100 point moves are not significant, but they still get press coverage. As all of the above unfurls, there will be 100 point moves (representing less than ¼ of a percent) and there might be 1,000 point moves (still representing only 2.5% at today’s levels). The press coverage – and perhaps the hyperbole – will be ubiquitous. Expect it, but don’t react to it.
As Warren Buffet is fond of saying, “in the short run, the market is a voting machine, but in the long run, it is a weighing machine.” What he means is that daily price moves can be “votes” similar to those cast for the prom king or queen – if that’s still done in this day and age; they are here today gone tomorrow. In the long run, the market is weighing the long-term value of profit trends in companies. Media coverage impacts the vote, but it rarely impacts true value.
There has not been a 10% correction in 2021. While a correction isn’t mandated by any of the evidence we see, it wouldn’t be surprising either. These things happen without any ability to predict them. They are also entirely unimportant. The long-run is important in the sense that you have an investment plan which meets your specific goals, not your neighbor’s, co-worker’s, or some “average” investor’s. The only things that apply to you are the ones that are specific to your unique situation. Understand that and invest accordingly. That is the path to successful investing in this environment or any environment.
We’ll close with another quote from Warren Buffet: “The most important quality for a successful investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd nor against the crowd”.