New Year, New You, Same Old Market

By Crest Capital Advisors on January 7, 2022

Dow: (0.29%) to 36,231.66
S&P 500: (1.87%) to 4,677.03
Nasdaq: (4.53%) to 14,935.90
Russell 2000: (2.92%) to 2,179.81
10 Year Yield: 1.77%
Outperformers: Energy 10.61%, Financials 5.36%
Underperformers: REITs (5.00%), Technology (4.69%), Healthcare (4.65%)
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We find ourselves entering the new year with an ongoing market tantrum (not necessarily noticeable in the headline averages) that started back in late November. The catalyst for the recent turmoil in markets has been a cacophony of investor cries over the now supposedly more hawkish federal reserve, due in large part to stubbornly high inflationary readings. The story goes, a hawkish Fed will be forced to deal with high inflation by removing monetary accommodation and embarking on an aggressive campaign of tightening financial conditions. Much quicker than was anticipated just a few short months ago. This in turn is considered bad for stocks (and the economy) so hence the significant shift in investor risk tolerances for certain asset types. The beneficiaries of this vicious market rotation are companies perceived to have high-quality earnings potential (e.g. the top portion of the S&P 500) and the losers in this environment are long-duration growth assets (think innovation, emerging growth, and small-cap stocks).

So for the first week of the new year, we saw this continuation in trend occur as stocks on balance fell, with the lower market capitalization and growth indices (e.g. Russell 2000 and Nasdaq respectively) relatively underperforming on the week, as they have done for the past few months. And the large-cap Dow Jones Industrial Average (the largest of the indices in terms of capitalization) was only off by a minor -0.29%. Bonds also fell in value this week as Treasury yields rose fairly significantly from 1 month ago levels of just 1.34%, with the 10-year treasury now back to 1.77%…now at the highest level since before the pandemic.

You might think we are being overly dramatic given the limited declines we’ve seen in the S&P 500 and Dow Jones Industrial Averages, but, according to our friends at Strategas Research Partners, the average S&P 500 stock is now down -11% from its 52 week high, whereas the S&P itself is only down -2.3%. More pronounced down the capitalization spectrum, we note the Russell 2000 benchmark for small-cap stocks is down -10.1% from its high, but the average stock within the index is down a whopping -32.6%!

In addition to the ongoing style and sector rotation under the market surface, the main headline event on the economic front was the December payrolls report which rose 199,000, missing estimates for over 400,000. Private payrolls of 211,000 also missed the consensus of 390,000. The unemployment rate declined (0.3%) to 3.9% beating the consensus of 4.1%. Average hourly earnings rose 0.6% beating the 0.4% consensus. The annualized average hourly earnings growth now stands at 4.7% also above the estimates of 4.1%.

Our Obligatory Market Outlook – Bookmark This CMD!

In short, we see gloomy sentiment setting the stage for another solid year in which all surprises will be on the upside. The Omicron case-wave may have already crested, IF South Africa is a template. Its low virulence is minimizing panic and acting as an impromptu vaccine. There will be no more draconian lockdowns or significant consumer withdrawal from economic activity. Equity valuations, according to one of our equity risk premium models, begin 2022 precisely where it began in 2021. (See chart below)

The reality is that equity valuations, at least valuations relative to bonds as expressed in our S&P 500 equity risk premium model, are starting this year virtually exactly where they were a year ago – literally just a 1 bp difference.

This year’s forward earnings upgrade momentum is well above average, but not at last year’s extraordinary pace, pointing to an above-average year for stocks, but not a repeat of last year’s stellar returns. A low bar has been set for this earnings season when sufficient surprises could reignite a new upgrade cycle. The yield curve is discounting Fed lift-off at the May FOMC meeting. If growth and labor market recovery continue as they have, which we expect, lift-off won’t be tightening, but only an appropriate policy adjustment. But we expect statistical inflation rates will cool so the Fed might wait as an insurance policy, in which case we would expect only two hikes this year. Oil prices are key, having been a major contributor to current inflation levels; that contribution will wane, as we expect oil will be flat to lower this year. Long-term yields will drift higher, but we don’t expect a growth damaging backup.

The inflationary twists and turns will remain, but they will evolve. Higher prices on goods and services have led to investment spending on capacity. This year’s dramatic increase in semiconductor equipment spending is a top example. Big-spending ramps are occurring across many industries and businesses currently. As new capacity comes online, spiking price moves will normalize, and double and triple orderings will end. We wouldn’t go betting that used car prices will jump another 29% in 2022. In fact, we wonder what are the odds that they are a double-digit percentage lower this year?

Housing prices will be a question mark for 2022. Right now, the market for housing inventory is low while prices continue to rise. Apartment vacancy rates are also quite low so we do expect the housing component of the CPI to rise. Labor prices are the $64,000 question. Jobs are plentiful and the availability of labor is very uncertain. Those who want to work should expect to get paid nicely. Meanwhile, millions of other Americans continue to re-evaluate their priorities and may quit for a different job or for no job at all.

Following is a short summary of some of our predictions for 2022:

Covid-19 risks will meaningfully abate.Yes, omicron is spreading like wildfire. But the stats on the variant are actually a long-term positive, as omicron is proving to be much less severe than previous variants. This means the virus is mutating in a way that is making it more contagious but less severe – which also means it is mutating in a way that makes it less of an economy-stopping threat to society. In most countries, the era of lockdowns will become a thing of the past in 2022. We believe society will continue to move toward a more “normal” state next year.
Global supply chains will be restored.The biggest economic positive of the retiring of lockdowns and restrictions in 2022 will be the restoration of supply chains, which have been severely disrupted in 2020 and 2021 by restrictions that have led to production shortfalls and labor shortages. We fully expect supply chains throughout the globe to come back to near 100% capacity by mid-2022.
Inflation will fall back to the 2% range by the end of the year.Inflation is running red-hot right now because of a huge, global supply-demand imbalance. Consumer demand has been robust, and supply is short, which is pushing prices higher. But consumer spending, particularly on pull-forward goods (think Pelotons, computers, etc) will slow meaningfully in 2022 and supply chains will come back online in a big way. Therefore, today’s supply-demand imbalance will begin to balance itself out in 2022 – leading to a situation where inflation cools dramatically. We expect the global supply-demand dynamics to improve throughout the year, creating a situation wherein we exit 2022 with core inflation rates in the 2% range. As this could be construed as one of the more controversial of our opinions, we want to unpack this a bit further. Simply the cessation of continuing inflation in a few key categories – especially motor fuels and motor vehicles – should easily bring overall inflation back to target. For instance, for motor fuels to repeat their year-over-year contribution to today’s alarmingly high CPI inflation, oil would have to go to $160 per barrel! That could happen, but it’s not going to happen. All oil has to do is stay unchanged for a year and inflation comes down by something like 1.6%. And, if motor vehicles and other categories where prices have been inflamed in the post-pandemic recovery actually reverse their gains, we could be looking at CPI prints that appear to be downright deflationary. Ask yourself if you think it is likely that the market for used cars, USED cars, will increase 29% as it did in 2021? That’s just a crazy stat for a depreciating asset! Just take these factors out of the CPI and you see that we can quickly get down to more manageable levels.
The Fed will not hike rates three times.The Fed “dot plot” is currently forecasting three rate hikes in 2022. That forecast is based on the assumption that inflation will remain well-above acceptable levels. That won’t happen. Inflation will dip below 2% by the end of the year. Amid a rapid deceleration in inflation throughout the year, this historically ultra-dovish Fed will do very little to adjust monetary policy. We believe the Fed will hike rates once or twice – but later rather than sooner and certainly not 3 times.
Long-duration Treasury yields will remain generally low.Most investors believe the 10-year Treasury yield will rise above 2% and make a run toward 3% in 2022 as the Fed hikes rates. But, as stated above, we don’t see the Fed hiking rates all that fast. Consequently, we don’t see the 10-year Treasury yield moving higher by all that much either. We think the 10-year Treasury yield will finish 2022 perhaps in the 2% to 2.5% range, and numbers closer to 3% are very unlikely. If we’re wrong, the yield will be lower than our target range, not higher.

Risks To Our Views:

As with any set of predictions, there are always risks that we may be wrong. So here is a shortlist of factors we see that could cause our views not to materialize.

Lockdowns In China. Continued lockdowns in countries like China affecting supply chains and inflation trends could negate our view that supply chains and inflationary pressures will resolve on their own in 2022.
New More Harmful Variants. Any negative development on the Covid front could obviously call for renewed economic retrenchments, and certainly cause more strain on global supply chains.
Aggressive Central Bank Tightening. Chair Powell has already taken us through one period (2018) where he became overly hawkish and caused a market calamity, if he continues on the path the market fears he is on, he could repeat history in 2022. Though, it’s notable to us that this current market tantrum has already front-run much of the severity we saw in 2018.

Concentration Risk

Conventional wisdom argues that one should just buy the S&P 500 market ETF and call it a day. After all, it’s purportedly highly diversified…the 500 largest companies in the US. But what many don’t realize is how the index is compiled. It’s a capitalization-weighted index…meaning, the largest companies comprise the largest weights. And after years of top-heavy outperformance, the weighting of the top 10 issues in the S&P 500 now comprises nearly 30% of the overall index, making it more top-heavy than ever, with the historical average being closer to 21% based on data from 1980. Furthermore, the 6.9% weight that Apple carries makes it the largest single-issue ever in the index. Investors have to go back to the mid-1980s to find an issue besides Apple that has made up more than 6%.

So, the S&P 500 is not quite as ‘diversified’ as one might think. However, as long as the top 10 names (influenced mainly by Apple, Microsoft, Google/Alphabet, Facebook/Meta, Amazon, Nvidia, and Tesla) continue to outperform, it’s doubtful many will care.

Intra-Year Drawdowns are Normal

2021 was NOT a normal market year. The largest intra-year drawdown in the S&P 500 from peak to trough measured just -5%. Along the way, the S&P 500 posted 70 all-time highs during the year, the most record-high closes in a calendar year since 1995. This grind higher market action of 2021, characterized by limited drawdowns along the way, is only surpassed by the extremely anemic -3% drawdown we saw in 2017 and again a -3% drawdown way back in 1995. Typically, investors should expect larger drawdowns intra-year on the path to long-term accumulation. It’s the cost of achieving the returns we all have come to expect from markets. After all, without risk, there would be no reward!

The chart below shows each calendar year’s intra-year drawdown dating back to 1987. As you can see, a typical average is more or less in the -10% range. While this is not a prediction, we would not be surprised to see more normal market action in 2022. Notably, this is not a call to panic or make radical changes to one’s portfolio, but more or less a ‘be prepared’ and maintain perspective reminder.

Crazy Stat(s) of the Week

Here are this week’s crazy stats:

2021 Total ETF inflows were over $900 Billion. This is larger than both 2019 and 2020 flows combined. Equity inflows were nearly $700 Billion…greater than the sum of 2018, 2019, and 2020 combined. The charts below show the magnitude of fund flows.

In addition to ETF inflows, venture capital also saw record-breaking activity. Overall US venture capital funding topped $329 billion in 2021, nearly doubling the previous record.

Quote of the Week

“While we acknowledge that absolute equity valuations are elevated, this is true for all major asset classes relative to history. We expect global earnings to grow 8% in 2022; this should support a reasonably strong year for equity markets overall and our targets in each region imply about an 11% total return in global equities.”

– Goldman Sachs

Calendar of Events to Watch for the Week of January 10^th

We’re expecting a very busy week ahead with lots of headline events to drive markets. First, we kick off the unofficial start to Q4 earnings season with major money center banks reporting results on Friday, though we do have some notable earnings as well earlier in the week to get things started.

On the conference calendar, the marquee event of the year for healthcare (JP Morgan Healthcare Conference) will take place with lots of pre-announcements, company updates, and maybe even some M&A expected to go along with it. Unfortunately, the buzz of the conference will be a bit more muted as it is once again ‘virtual’ rather than in-person.

On the economic front, inflation will get outsized scrutiny as we get CPI and PPI on back-to-back days Wednesday and Thursday, but not before inflation becomes the major focus in Congress during Fed Chair Powell’s confirmation hearing in the US Senate. It’s going to be nothing but inflation, inflation, inflation for 3 straight days. We hope market participants can remain calm

Monday 1/10 – US Wholesale Inventories for November are expected to show a 1.2% month-over-month increase.

Tuesday 1/11 – No major economic reports due today. Fed Chair Powell and Vice Chair Brainard will be in front of the US Senate for their confirmation hearing.

Wednesday 1/12 – One of the highlighted reports of the week will be the release of the December Consumer Price Index (CPI) data. Economists are forecasting a 0.4% month-over-month pace and a 7.1% year-over-year headline rate. The core (ex-food & energy) data is expected to show 0.5% and 5.4% respectively.

Thursday 1/13 – The Producer Price Index (PPI) data for December is expected to show a 0.4% month-over-month rate and a whopping 9.7% headline rate on the year-over-year data.

Friday 1/14 – US Retail Sales for December is expected to show a modest 0.1% month-over-month increase. We’ll also get Export/Import Price Index data (both expected to modestly contract at -0.05% and -0.2% respectively) as well as Industrial Production data for December which is expected to be roughly unchanged a 0.4% rate.

Source: FactSet