Top Headline for Q4: The Market Bulls Win!

After a rise in risk sentiment to close the 3rd quarter, one was left to wonder if we had seen the stock market peak for the year; however, the Bulls were not finished. After a strong rally in October, the US equity market had fully recaptured its drawdown and again achieved new all-time highs. In general, equity markets around the globe enjoyed positive returns for the year. The Vanguard Total World Stock ETF (Ticker: VT), which is a blended portfolio of equities spanning domestic and international markets, ended 2021 +18.3%. After some late November and early December volatility, the market saw its biggest 4-day surge of the year before stabilizing to close the year within 1% of another all-time high. In fact, the S&P 500 Index closed at all-time highs on over 25% of all trading days in 2021. This marks the highest total recorded since 1995. Client accounts saw an increased level of rebalancing during the quarter as we rebalance “opportunistically,” instead of specific times during the year (monthly, quarterly, etc.).

What’s quite remarkable about the recent performance is that the macro-level news has not been favorable. For example, in Q4, thanks to the Omicron variant, we endured a resurgence of COVID; the Federal Reserve announced an acceleration of the tapering of their bond buying program; and inflation figures soared, which suggests rates hikes are almost a certainty in 2022. US equity investors shrugged off all of the news and appeared fearless to close the year. And, why not be fearless? The indices spent most of the year hovering at/near all-time highs; the market did not see a drawdown greater than 5% in 2021; and the Federal Reserve, despite the “taper” talk and change of pace, is still “easing” by buying billions in bonds monthly. Yet, as we enter 2022, we’re reminded of Buffett’s famous quote, “Be fearful when others are greedy and be greedy when others are fearful.”  As we will later discuss, some caution is warranted as we enter into 2022.

General Market Update

US Equities:  The S&P 500 Index surged in the quarter finishing up a whopping 10.6% for Q4 and nearly 27% for the year. The Nasdaq Composite was up 8.3% in the quarter (21.4% for the year), and the Russell 2000 Index climbed 1.9% in the quarter (13.7% for the year). The US equity market performance has been nothing short of stunning. In recent years, the US indices have crushed other major developed market indices. It is noteworthy that some weakness is finally emerging in pockets of the market. Specifically, some of the high-flying performers from recent years (e.g., recent IPOs and “profitless tech”) are down from 2021 peaks and are trending poorly. Moreover, the US market has been led higher by a minority of mega-cap positions. As you may recall in a previous quarterly commentary, we highlighted the fact that about 27% of the S&P 500 Index is comprised of seven mega-cap companies (Apple, Microsoft, Amazon, Tesla, Alphabet, NVIDIA and Meta).   

International and Emerging Market Equities:  The Schwab International Equity ETF (SCHF), which holds stocks of developed markets excluding the United States, was up 2.8% in Q4. SCHF finished up 11.4% for the year - an obvious divergence from major US indices. This divergence can be traced to the growth/tech bias of the US indices (i.e., the segments that have most benefited from “easy money” federal bank policies). The Schwab Emerging Markets ETF fell 0.7% for both the quarter and year. Emerging market equities continue to be hurt by weakness in China. Looking ahead, we believe this recent underperformance presents an intriguing opportunity.    

Fixed Income and Credit: Like Q3, the 4th quarter was a quiet one for the bond market. Both short and long bonds were generally flat for the quarter. With most of the damage being done in the 2nd quarter, 2021 proved to be a rough year for the bond market. It’s hard to see 2022 being much better as the set-up for bonds (i.e., Federal Reserve tapering, planned rate increases and inflation concerns) are big headwinds moving into 2022. We continue to view most segments of the bond market as a buffer for volatility in more conservatively allocated portfolios.

Commodities, Precious Metals, Inflation: Some of the COVID driven inflation is proving transitory, but the general trend in commodity prices in 2021 is up with particular strength in industrial metals related to the “green revolution” (e.g., copper and nickel). Precious metals have been range-bound for much of the year despite favorable conditions (e.g., substantially negative real interest rates). All eyes will be on these sectors in 2022 as price changes will have substantial policy implications.     

A Look Ahead

2022 is shaping up to be a very interesting year. The US equity and bond markets are going to be facing headwinds that they haven’t seen in a long time. Specifically, the Federal Reserve’s bond buying program is expected to terminate in Q2. Moreover, interest rate hikes are expected following the tapering of the bond buying program. In general, rising rates are not favorable to the equity market because it raises the cost of capital and causes renewed interest in credit investments. Despite the bond buying taper and expected interest rate increases, both being well telegraphed by the Fed, it would not be surprising to see the market temporarily react unfavorably. An increase in volatility from 2021 is almost a certainty given the unpredictable impacts from what is coming and the above-average current equity market valuation levels. Historically, Value segments of the market tend to outperform during rising interest rate environments. While client portfolios are always well diversified across asset classes, they enter the year with a slight “lean” into Value over Growth. And, as clients know, we like to also express sector market views through our “tactical overlay” to portfolio management. This tactical overlay has a Value overweight through sectors such as Materials, Industrials, Energy and Financials.

To further add to a potentially volatile cocktail, political pressure is intensifying ahead of the 2022 midterm elections. Inflation is soaring and consumers are angry. Anti-corporate sentiment is rising in conjunction with concerns over wealth concentration. Elected officials are pointing fingers and demanding changes which may accelerate any Federal Reserve Bank rate increases. The Fed is supposed to be “independent” of these types of pressures, but it feels less so these days than in the past.

While the year-over-year changes in inflation are certain to fall from current levels, above-average inflation gains continue to feel like a good medium to long-term bet. One of the most unexpected by-products of COVID is that soaring equity markets and bleak working conditions pushed millions of older workers into early retirement. This post-COVID shift left a massive shortfall in the labor force and contributed to the start of wage inflation. Moreover, there are other, more secular, pro-inflation trends including an extremely low level of investment by traditional energy producers and commodity producers in recent years. The government has some control here through the money supply, bank liquidity and interest rates. However, given potential adverse market impacts, will the government use these tools and to what degree? On a more positive note, the widely-covered supply-chain issues that are wreaking havoc on key industries, such as car manufacturing, are likely to see improvement in 2022.   

In summary, it’s a very difficult environment for forecasting. We now have conflicting agendas (i.e., what is good for solving issues like inflation and wealth concentration is not generally good for the equity and bond markets). We see volatility in our future as agendas compete for support. It’s been a long time since we’ve seen a substantive drawdown of greater than 10% in the equity markets, but we would not be surprised to see one sometime in the first half of 2022. In any case, volatility brings opportunity to add value through rebalancing portfolios, and we’ll be watching closely. We wish you and yours a very prosperous 2022.