This past year was an exceptional year for investment returns on an absolute basis. Overall asset prices benefitted from a unique market environment where monetary and fiscal policy worked in tandem at levels never seen before. The influence of low interest rates and quantitative easing combined with trillions of dollars in stimulus powered markets through unprecedented uncertainty as the global economy continued to rebound from the depths of the pandemic.
The S&P 500 led all major equity indices finishing the year with a total return of 26.9%, easily outpacing its own 10-year average annual return of 10%. While annual returns this high may seem a bit egregious, they are more common than one may think. In fact, since 1928 the S&P 500 has generated annual returns of more than 20% 36 times and of more than 10% 55 times. Looking at the last nine times the S&P 500 returned more than 20% in a year, each subsequent year the annual return also ended positive.
Within the S&P 500 there was quite a bit of volatility underneath the surface. Stylistically Growth and Value posted similar 12 month returns but leadership rotated multiple times throughout the year. From a sector perspective Energy (+54.6%), Real Estate (+46.2%) and Financials (+35.0%), all which underperformed in 2020, led the way albeit each for different reasons.
While the S&P 500 posted a banner year, on a relative basis the rest of the major equity indices lagged while still holding their own in absolute terms. In comparison, other domestic large cap indices (i.e., Nasdaq +22.2% and Dow Jones Industrial Average +20.9%) stood out while several asset classes were more muted. Small cap indices continued a 5-year streak of underperformance with the Russell 2000 (+14.8%) returning roughly half that of the S&P 500.
Outside of U.S. equities, International Developed returned +11.8% while Emerging Markets finished -2.2%. Following a strong 2020, bonds and gold had a rough 2021. Perhaps most interesting was the rise of digital assets into the mainstream. The implications of this are far reaching and not straightforward but we would be remised not to call out how far the risk spectrum has widened across the investable universe. With the type of volatility and returns recently experienced in cryptocurrencies such as Bitcoin (“BTC”) and Ether (“ETH”), the once “risky” stock market has become boring to some. My how times have changed.
With fiscal policy rolling off in 2022 (falling from 11% of GDP in 2021 to only 2.2% in 2022) and monetary policy tightening to stem surging inflation, excess liquidity can no longer be counted on to push markets higher. Traditional market fundamentals, such as profitability and sales growth, will be used to separate the winners and losers. However, consensus earnings growth estimates are expected to fall year-over-year from 45% in 2021 to only 8% in 2022.
Inflation became a real problem in 2021. Historically the magic annual number for inflation is +4%. This is the threshold where valuation multiples in the equity markets begin to compress. The hard part is gauging whether more than +4% is sustainable beyond the next few quarters and the Omicron surge certainly won’t make the data any clearer. If inflation persists, we’ll need better than expected economic growth as most asset classes look stretched at current valuation levels.
"Stocks have become "boring" to some, with cryptocurrencies gaining traction in the investments world"
The good news is that there is a chance earnings could blow past current expectations if:
1. Omicron and vaccinations get us closer to herd immunity or at least to a state where most people are no longer altering their behavior in fear of getting sick.
2. China alters their “no-covid” policy and accepts the reality that they won’t be able to control the virus, which has led to intermittent lockdowns across the country.
3. Consumer sentiment picks back up after multiple years of double-digit drops leading to a release of pent-up demand and increased spending on discretionary goods and experiences.
4. Interest rate hikes are inline or less than expected because inflationary pressures begin to subside in the second half of the year, while the unemployment rate remains above the long-term natural target.
5. Corporations stick with some of the changes that supported historic profit margins throughout the pandemic.
Michael is the founder of Fire Capital Management.