Three 2021 Market Lessons for 2022
In many ways, 2021 was a good year for the markets. It also reinforced some basic market lessons that are hard to learn, even if they are not new. As we launch into the New Year, we’re highlighting three 2021 market lessons that we think may matter for 2022: 1) equity valuations alone are a poor timing mechanism, 2) structural forces have a large influence on interest rates and may keep them relatively low, and 3) politics and markets don’t mix.
2022 will provide its usual mix of ordinary market behavior and unexpected surprises. At the same time, markets have patterns that tend to repeat, even if the emphasis is different from year to year. As we head into the New Year, we’re taking a look back at 2021 and drawing out three lessons that we think will matter for 2022.
VALUATIONS ALONE AREN’T A SHORT-TERM MARKET TIMING MECHANISM
At the start of 2021 we heard concerns that broad U.S. markets were overvalued using many traditional valuation metrics, such as the price-to-earnings ratio (PE). In addition, compared to the U.S., international stocks (both developed and emerging markets) looked relatively cheap. As shown in Figure 1, the S&P 500 surged higher in 2021, performing well above its historical average, while international equities lagged behind the U.S., with weakness in emerging markets in particular. Once again, valuations were a weak short-term timing mechanism. At the start of 2021, the PE for the S&P 500 was historically elevated at almost 22.5 on forward earnings according to FactSet data. At the same time, interest rates were extraordinarily low, which makes stocks attractive relative to bonds and increases the present value of future earnings. On top of that, an extraordinarily strong year for corporate earnings helped stocks “grow into” their valuations, with the PE actually falling to nearly 21 by the end of the year despite strong stock market gains.
Sentiment is often the primary culprit for allowing valuations to remain elevated, and it did play a role in 2021, however market fundamentals were even more important. If investors favored stocks in 2021, it was more about a sizable upside surprise in earnings growth than elevated optimism.
The underperformance by international equities this year reminds us that valuations are not a timing tool. International stocks have been more attractively valued than U.S. stocks for quite some time and yet, they’ve underperformed consistently for over a decade. We believe valuations should be used in combination with technical analysis, which helps measure both sentiment and captures collective market wisdom to help inform investment decisions. Signals from the charts have helped us side-step some of that performance drag.
Also, keep in mind that Europe and Japan are more value-oriented markets than the U.S., so growth-style leadership here at home makes it very difficult for these international markets to keep up. We continue to favor the U.S. over developed international markets for 2022 because of the relatively healthier U.S. economic growth outlook and strong U.S. dollar. International equities may become increasingly attractive as COVID-19 restrictions are removed globally.
STRUCTURAL FORCES CONTINUE TO WEIGH ON INTEREST RATES
It’s true 2021 wasn’t a very good year for core fixed income investors— although that was largely to be expected. Coming into the year, interest rates were still amongst the lowest they have ever been and we thought they were headed higher—and they did. As such, returns for core fixed income investors, as measured by the Bloomberg U.S. Aggregate Bond Index, were negative for the year for only the fourth time in the index’s history dating back to 1976. However, after a 70 basis point (0.70%) increase in the 10-year Treasury yield by mid-March, which led to one of the worst starts to the year ever for core bonds, yields have largely remained range bound.
One of the main reasons interest rates have stayed as low as they have this year was the amount of foreign interest in our markets. Despite relatively low yields in the U.S., many foreign investors are still better off investing in U.S. fixed income markets. With approximately $13 trillion in negative yielding debt globally, even modestly positive yielding debt is an attractive option. This has certainly helped keep interest rates from moving significantly higher—a likely headwind to higher rates in 2022 as well.
So what is the key takeaway from 2021? Besides inflation, there is still a huge global demand for safety, income and liquidity in portfolios and that has kept interest rates (and spreads) from moving much higher. While yields for U.S. core fixed income may seem low, the role it plays in portfolios is still an important one.
POLITICS AND INVESTING DON’T MIX
This is one lesson we likely knew before the year began. 2021 provided another strong example of why politics and investing don’t mix, both for broad markets and for the market impact of more specific policy.
Speaking more broadly, stocks have done extremely well over the past decade with little regard or correlation to which party has held the White House or Congress. As midterm elections begin to dominate the news cycle in 2022, we believe investors will do well to remember this point. It’s not that policy prognostications are incorrect or that policy doesn’t matter. Rather, when it comes to markets there are larger economic forces in play that typically matter a lot more.
WHAT LIES AHEAD IN 2022
We do not expect 2022 to simply be a repeat of 2021. We’ve moved further toward the middle of the economic cycle. The policy support from central banks and governments that have helped global economies bridge the economic fissures left by COVID-19 will likely begin to fade, leaving the economy to stand increasingly on its own two feet while putting more emphasis on the aggregate decisions of businesses and households.
To learn more about what's ahead, we encourage you to join us for our upcoming virtual event, 2022 Market Outlook event on Tuesday, January 11th at 4 pm ET.
We expect some important lessons learned in 2021 to matter in 2022 and as the year evolves, we’ll continue to monitor and share the market signals that will help shape the market environment in the New Year.
If you have specific questions related to your own investment strategy or financial planning needs, we welcome you to call us at 302.234.5655 or email us at contactus@covenantwealthstrategies.com to set up time to discuss further.