It Makes Complete Sense Now: Bad is Good and Good is Bad

It Makes Complete Sense Now: Bad is Good and Good is Bad

January 05, 2022
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2021 was the year of a continued virus, rising inflation, and the promise of higher interest rates from the Fed. Not a trifecta of great things, yet the market had its best year out of the last three really good years! So that means that bad is good, right? Does that mean that now that we have an idea on the new virus being a quick catch-and-release without a rash of calamity in its wake? And even though Fed chair Powell tells us that growth is so good, the labor market is becoming so tight that he might be forced to raise rates sooner than expected? This must be bad for the markets, right? I believe that the end of the year was met by hedge fund profit taking and portfolio rebalancing, hence some of the big names of the S&P 500 and NASDAQ were a source of funds as they can be transacted in large quantities of value and facilitate quick and easy portfolio adjustments without moving their prices dramatically. I went into some detail on this point last week. The economic news of last week (as this was about all that was going on of substance) was that retail sales increased by 18.2% in November while "quits data" from the Department of Labor was down to 2.8% from a low 3% the month earlier. Post-Christmas, numerous surveys show that consumers may have some concern about inflation, but they still found the right place to go spend to their liking. 

Yet the surveys of both major investment firms and retail investors show that neither one is feeling particularly good about the stock market right now. Both reference the problem with how “good” the markets have been, not concerns about earnings progression or economic expansion globally. The latest American Association of Individual Investor’s sentiment survey shows that the percentage of bulls remained below 45% for a fifth straight week, despite the S&P 500 trading above its rising 50-day moving average. When that has happened in the past, the S&P 500 has consistently booked a gain of almost 5% over the next 3 months. But now that 2021 is in the books, there is a very interesting fact that sobers up even the most zealous negative commentators. The index's gain last year roughly equaled its rate of earnings growth, suggesting that not only is it not overvalued, but even after an approximately 25% up-year, it didn't get any more expensive than when it started the year. So, what are we looking at in front of us in 2022?

  • Further increases in corporate earnings, which should achieve new record levels, supported by rising revenues and high profit margins.
  • Prospects for a gradual decline in inflation pressure, which should peal this winter as the global supply chain gradually recovers from the pandemic-induced congestion.
  • A gradual reduction in the highly accommodative monetary policy, which has provided excess liquidity to the financial markets during the pandemic. 

As a result of these three (just to name a few), I go back to what drives the markets. As always, it is the economy. If the economy is strong, labor is stable and interest rates have not encountered bouts of tightening — yet the equity markets should continue their ascent. Should they rally as they have since the COVID lows? Probably not. Even still, a nice solid follow-up to a very grand last 18 months would be welcome, and far better than the press has indicated over the last few weeks about analyst opinions.

So how do I measure the health of the economy? My primary fear is impending recession risk, which has been the primary cause of most market contractions. So, let's look at our five key pre-recession indicators to see if a contraction might be on the horizon:

  1. Accelerating Inflation: The current wave of inflation is driven by the high level of consumer demand supported by the recent elevated level of fiscal stimulus in a goods-focused pandemic economy, along with the widespread product shortages spawned by supply chain issues. The combination of high demand and supply chain issues has broadened the level of price pressure in recent months. It should take time for these supply chain issues to ease to a point where annual inflation can return to the 2-3% range. We expect consumer demand to moderate during 2022 as the fiscal stimulus impact dissipates, and supply chain dynamics gradually improve by the end of the year. 
  2. Payroll Growth: While there is a shortage of qualified workers, there is no shortage of available jobs. The number of openings now stands at the second-highest on record, at slightly over 11 million, as labor demand continues to strengthen. These tight labor market conditions have placed upward pressure on wages, especially for those in lower-paying sectors. The number of people working part-time for economic reasons (the underemployment rate) declined to 7.8% which is within one percentage point of its low since the year 2000.
  3. Rising Unemployment Claims: Initial claims for unemployment insurance declined by 8,000. The four-week average fell to 199,250, tracking close to the lowest level since 1969, as labor market conditions have tightened significantly while companies retain their employees. 
  4. Inverted Yield Curve: The slope of the yield curve provides an indication of the health of the economy. Yield curve inversion occurs during the latter stages of economic expansions and usually precedes a recession. Over the past half-century, every extended yield curve inversion has led to a bear market within two years. This doesn't appear to be in the cards currently. 
  5. Leading Economic Index: The rate of change of the LEI is 4.6% and strength among the index components remains widespread. The LEI continues to indicate an above-trend period of economic growth continuing well into the calendar year 2022. Pent-up demand was apparent during the holiday season as Mastercard reported U.S. retail sales increased 8.5% from November 1 through December 24. Yields remain tame with the 10-year Treasury rate at 1.51% and the 30-year rate at 1.9%. 

This week we enter 2022. Last year, the S&P 500 generated very strong returns, the NASDAQ even stronger! The 10-year Treasury generated negative returns, and the foreign markets were on the low end of the middle. What could core bond investors expect in 2022?

  • Fixed income investors aren’t used to negative total returns for core fixed income (as measured by the Bloomberg U.S. Aggregate Bond Index) but that is exactly what happened in 2021.
  • The index was down -1.5% for the year, which was only the fourth negative returning calendar year since the index’s 1976 inception—and the first since 2013.
  • Interest Rate Returns are only part of the equation with bonds, though. Capital preservation, liquidity, and diversification benefits of core bonds still make the asset class an important one within a diversified asset allocation.

The only thing that was close to US Equities was the commodities market. Definition: too much money chasing too few goods! I can't imagine a more transformative year than the one we are starting. After two years of unprecedented government actions, the winds of change are blowing hard. The economy has been buffeted by short-term factors since 2020; this year, long-term fundamentals should re-assert themselves as the most important drivers of economic and financial performance. The year could certainly end with a massive change in the political balance as frustrated citizens across the country rethink the persons they put in office. Even Joe Manchin wouldn't support the latest funding package that was attempted to be pushed through. With the midterm elections coming late in the year and big changes seemingly being ready to happen, tax hikes seem to almost certainly be out of the picture. If the Fed doesn't have to hike rates then the economy, left to its own devices, could muster up another one in the plus column. This probably won't be without some type of scare that could shake out investors for a period, but the end result appears that it could be another good one. 

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Important Disclosures: 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy. 

Investing involves risks including possible loss of principal.

The Standard & Poor's 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.

The Nasdaq-100 is a large-cap growth index. It includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.