David T. Mayes
Despite brief setbacks in September and November, investors’ appetite for riskier assets remained strong in the fourth quarter, putting its full-2021 return at just under 29% and lifting the l index, or number of years with a positive return, at 74% since 1926.
The Index’s annual average returned to 10%, but to achieve this average return, investors had to build confidence despite three corrections of 5% per year, one correction of at least 10% per year, one correction of 15% once every three years and a bear market (correction of 20% or more) once every six years, on average.
Bear markets coincide with recessions, so equity investors are constantly weighing the likelihood of a near-term recession when deciding whether a stock’s current price is fair valued. For now, the outlook for growth is solid with earnings growth expectations of 9% for S&P 500 companies in 2022. Assuming investors’ risk appetite does not change, this would translate into a another year of near double-digit returns for equities.
A key economic variable for 2022 will be inflation, which has reached record highs in recent months. This raises two questions. First, will high inflation persist? If so, what could be the impact on the economy and stocks, which of course depends on how the Federal Reserve reacts with changes in its interest rate policy.
One view of the current inflation picture is that it has largely been driven by COVID-related disruptions in the supply chain. That is, there are enough goods being produced to meet the demand, they just have a hard time getting to the right place due to disruptions in the transportation system. This is undoubtedly part of the problem, but the massive amount of stimulus money that governments have injected into the economy in the wake of COVID surely plays a role as well. These two factors suggest that higher inflation should be temporary once the imbalances disappear from the system.
That said, the Fed noted that the high inflation readings had continued for several months and signaled that it was ready to abandon its bond-buying program and set the fed funds rate near zero. . These two actions helped keep interest rates low to support the economy. To control inflation, the Fed will raise interest rates, although its efforts may be somewhat hampered by low interest rates abroad.
Higher rates will likely trigger greater stock market volatility, but a bear market is not inevitable. On the contrary, stocks have tended to rise during periods when the Fed has raised rates. It is when the Fed pushes short-term rates above long-term rates that stock markets run into trouble, because such tightening of credit conditions usually precedes a recession.
Bond investors should expect lower yields as higher rates mean lower bond prices, all else being equal. Positioning for a rising bond yield environment means favoring shorter-dated issues and those with higher income payments. However, caution should be exercised about rising high yield bonds, as these carry credit risk that exposes investors to significant declines at the onset of a recession. Floating rate notes carry the same caveat regarding credit quality.
With stock and bond markets appearing near market highs, investors may be wary of putting money to work in the stock or bond markets these days. Such anxiety is understandable since the logical recipe for better investment returns is to buy low and sell high. But the fact that the markets are making new highs doesn’t really give us any indication that the next move is likely to be down.
A recent article by Dimensional Fund Advisors Vice President Weston Wellington demonstrates that this anxiety is misplaced. Looking at the 94-year period ending in 2020, Wellington finds that buying stocks at all-time highs produced similar returns over subsequent one-, three-, and five-year periods compared to a wait-and-see strategy. to buy until after a 20% decline. So while we may be worried about seeing short-term losses after investing near stock market highs, we better stick to our well-designed investment strategy by continuing to put money to work. and to rebalance as needed when yields push our stocks and bonds. allocations far from our objectives.
David T. Mayes is a CERTIFIED FINANCIAL PLANNERTM Professional and IRS Registered Agent with Three Bearings Fiduciary Advisors Inc., a fee-based advisory firm in Hampton. He can be reached at (603) 926-1775 or by visiting www.threebearings.com.