The stock markets have had another very strong year with the Dow 30 Industrials, S&P 500 and Nasdaq up 18.7%, 26.9% and 21.4%, respectively. Over the past three years the S&P 500 has almost doubled by increasing 90% with gains of 29%, 16% and 27% from 2019 to 2021. Over the same timeframe the Dow is up 56% and the Nasdaq has risen the most at 137%.
The Dow had the smallest rise of the three major Indexes in 2021. It hit its all-time closing high last Wednesday at 36,489 and intra-day high on Thursday at 36,679.
The S&P 500 notched 70 record highs during the year with a closing high point of 4,793 this past Wednesday and an intra-day high of 4,809 just a day ago.
The Nasdaq’s all-time closing high was on November 19 at 16,057 with an intra-day high of 16,212 on November 22. While the S&P 500 and Dow closed less than 1% off their closing highs by 0.6% and 0.4%, respectively, the Nasdaq was off by 2.6%.
While there are a number of factors that could keep the bull market running and overcome what is a perennial wall of worry, there are numerous headwinds that could keep the markets from moving higher. Some could have a larger influence, such as the Federal Reserve’s tightening, while others would probably be less, such as Congress going after big tech companies. Below are many of the major factors that could put a damper on the market’s performance in 2022.
GDP growth, unemployment and inflation to slow while interest rates rise
To provide a quick overview of the economy this is a chart from the Federal Reserve’s December economic projections. What it shows is that the economy will still grow but at a slower rate with the unemployment rate and inflation decreasing while the Fed funds rate will start to creep up. Note that while there is a fairly sharp drop in GDP growth predicted by the Fed, it is not surprising that it settles in around a more long-term 2% rate.
Federal Reserve slowing then ending its bond purchases and raise interest rates
There is a stock market adage of, “Don’t fight the Fed” which means if the Fed is pumping money into the market by buying bonds or lowering interest rates, the equity markets will rise. However, if the Fed tightens by increasing interest rates that is bad for stocks. Since late 2008 when the Great Recession hit, the Fed has grown its balance sheet from under $1 trillion to almost $9 trillion. This has been an unprecedented move that has helped to fuel stocks. It is really unknown how much an impact ending its bond purchases and raising rates in 2022 will have on the markets.
Interest rates have been on a downward trajectory since 1981 when the Fed raised them to fight inflation. This has helped the stock market as investors have opted for stocks over bonds. While investors are not expecting any large rate hikes in 2022 or 2023, if the Fed or the market deems that they should rise faster than expected it would be negative for stocks.
Inflation remains at a higher level for longer than expected
While inflation has bubbled up to rates not seen since March 1982, a good portion of the increase is due to Covid-19 mucking up supply chains in various ways. While the rate of inflation is expected to decline due to supply chains getting better and year-to-year comparisons being “easier”, there is a risk that inflation remains at a higher level longer than expected.
Even when the more volatile food and energy costs are removed, the 5.0% rate reported last month has not been seen since the middle of 1991.
Note that U.S. Treasury Series I bonds are paying a 7.12% annualized rate for six months. While the rate will probably decrease in May, there are a number of advantages to buying them outlined in this article.
Earnings led the way in 2021 but slower growth in 2022
S&P 500 earnings are on track to increase 46.3% this year per John Butters at FactSet, but the better comparison is the 26.0% increase from the pre-pandemic year 2019. Earnings growth allowed the markets to hit new highs even as the Index’s P/E multiple contracted a bit.
Earnings growth is expected to slow to 8.7% to 223.48 for the S&P 500 in 2022. Investors tend to like accelerating growth, so slower growth could be a headwind next year.
Valuation multiples decrease
The S&P 500 was able to smash record after record in 2021, even with the market’s earnings multiple declining, as earnings growth more than made up for the slightly lower valuation. It isn’t surprising to see the Index’s P/E multiple decline for the year as the Fed finally announced it would slow its bond purchases and signaled raising interest rates next year.
If P/E multiples could stay the same in 2022 the market increasing 9% would be considered very solid, especially after such a strong performance this year. However, the biggest risk to the market’s equation of earnings times the P/E ratio to provide a value for the Index is the current 21x multiple falling.
Job growth could slow
After the economy lost 9.5 million jobs in 2020 it came roaring back with over 6.1 million created in the first 11 months in 2021. The unemployment rate has dropped from a high of 14.8% in April 2020 (and it was probably higher due to data gathering limitations) to 6.7% in December 2020 to 4.2% as of November 2021.
While the rate could drop further, the gains will be smaller as there are fewer people looking for a job. The labor force participation rate has rebounded from 2020’s depths, but is about 1.5 percentage points below where it was pre-pandemic.
One reason that the participation rate probably won’t rebound to pre-pandemic levels is the number of “Excess Retirements” that are believed to have occurred due to the pandemic. Economists at the Federal Reserve Bank of St. Louis published an analysis that shows there are potentially 2.4 million people who retired earlier than planned. If that is the case there will be fewer people to rejoin the workforce and receive wages that could be spent.
Excess savings have been spent
Over the past 18 months the Federal government has provided trillions of dollars to people in Covid relief. This allowed millions of people to stay afloat with money for rent, food and other essentials. There were also millions of people who were able to save this money as can be seen in the chart below.
There has been a lot written about how this additional savings would flow back into the economy and from the looks of it the savings has pretty much been spent. Since there isn’t anything of this magnitude being queued up by the Federal government this extra boost to spending won’t be there in 2022 or beyond.
Tom Lee points out a few more risks
Tom Lee is the Head of Research and co-founder of Fundstrat Global Advisors. On a client call last week he included a slide that includes a number of the above headwinds and has a few more such as military conflicts in Taiwan (would be very impactful to the markets and especially technology stocks) and Ukraine (not good but probably doesn’t have the same impact).