Below is an excerpt containing this quarter's market commentary. To download a copy of our full quarterly newsletter, click the Download Article link.
So that was 2021. Huh. It’s fair to say it wasn’t quite what we were expecting. A year later and, despite vaccines and other therapies, daily COVID–19 cases are at all–time highs. Businesses are going back to remote work when possible, and many countries are reinstituting lockdowns and other measures. Instead of the much–hyped and widely–anticipated return to normal we had all been hoping for, we find ourselves living in a quasi–normal world where social interaction remains limited, distancing and mask wearing remain recommended, and nothing is quite back to the way it was. Rather than a grand reopening, we’re in the midst of a grand congestion of sorts – yes, of noses, but also of ports and railways and any other way of getting goods from one place to another. The result has been a sharp increase in prices that has left many people feeling worse off now than they were last year.
It brings to mind the climactic scene from the 2005 film, Star Wars: Episode III – Revenge of the Sith, when Obi–Wan Kenobi faces Anakin Skywalker on Mustafar. To paraphrase Obi–Wan’s words (with our own twist): “You were the chosen one, 2021! It was said that you would destroy the COVID, not join it! Bring balance to the world, not leave it in darkness!” Alas, we must now turn our eye toward 2022 – a new hope, a Luke Skywalker for us all.
There is reason to believe 2022 will be better. Early data on the omicron variant from South Africa and the UK suggest the virus is becoming less deadly even as it becomes more infectious. Though it is too early to tell, a weakening virus could change the math for those weighing the personal health risks versus the social, mental, and economic benefits of reintegrating into everyday life. Indeed, many people have learned to live with COVID, if packed football stadiums across the country this fall have been any indication. Still, COVID’s resurgence places further strain on a healthcare system already at or past its breaking point. As doctors and nurses, whose ranks have been depleted by attrition, illness, and other factors, stare down a third year of this pandemic, there is no guarantee that even a mild form of COVID won’t continue to wreak havoc and drive uncertainty.
It is this uncertainty that the Federal Reserve is trying to navigate, and the Fed’s choices in 2022 will likely have a meaningful impact on both bond and equity markets, not to mention everyday things like inflation, jobs, mortgage rates, etc. Over the past decade, via a series of policy decisions that could be described as anything from “loose” to “ultra, ultra loose,” the Fed has forced itself into an avoidance– avoidance conflict. It must now choose between two undesirable scenarios: 1) It can continue its accommodative stance in an effort to drive the unemployment rate down further, which will likely fuel inflation and asset price bubbles or; 2) it can begin raising interest rates to curb inflation, even if this has the potential to deflate asset prices and risk the nascent economic recovery.
At its December 15th meeting, the Fed largely chose the second scenario – combatting inflation – when it decided to double its reduction in bond buying from $15 billion to $30 billion per month. At this renewed pace, the Fed’s asset–buying program should end in March. Then, with bond buying off the table, the Fed should have a clear runway for interest rate increases throughout the rest of the year. Presently, a majority of Federal Open Market Committee (FOMC) members expect three rate hikes of 0.25% apiece throughout 2022. Markets generally agree with this outlook and are pricing in a two–thirds likelihood that the first rate hike happens in March. If inflation remains high throughout the year even in the face of higher rates, it is possible the Fed could enact four interest rate hikes. Conversely, if the economy starts to wobble, then the Fed might only raise rates once or twice.
For much of the fourth quarter, broad markets shrugged off the looming specter of higher interest rates. In our last market commentary, we discussed the market’s penchant for climbing a wall of worry, and that’s exactly what happened through the end of the year. Led by a resurgent Apple (AAPL), the S&P 500 Index fought back from a dismal September and made it through a choppy holiday season to finish the year up a whopping 28.68% on a total return basis. This showing bested both the Nasdaq Composite Index (22.21%) and the Dow Jones 30 Index (20.95%) – just the third time since 2010 where the S&P 500 outperformed the Nasdaq.
These attention–grabbing, broad–market returns, however, belied much volatility beneath the surface. As 2021 wore on, investors shifted, abruptly at times, from the growthiest areas toward higher quality names. Due to this underlying volatility, roughly 92% of S&P 500 stocks had experienced a drawdown of 10% or more by the fourth quarter, with the average drawdown being 18%. Among Nasdaq–listed companies, 89% had experienced a double-digit price decline, with the average decline a whopping 40%. The story was even worse among small cap stocks, as 98% of Russell 2000 companies experienced a decline of 10% or more throughout the year. Thus, in more ways than one, 2021 was a year of challenged expectations. It would be reasonable to assume, in a market up 20% or more, that all boats would rise in a rising tide. But a majority of stocks had a challenging year, as companies struggled to meet unrealistic comparisons to stellar 2020 operating performances.
Now, a week into the new year, this dynamic has persisted. After a strong first trading day, market chop has resumed. On January 5th, the Nasdaq declined 3.1%, its worst single-day performance since March. The Nasdaq wasn’t alone, as the S&P 500 lost 1.9% and the Dow dropped 1.1%.
Ostensibly, markets were spooked by the Fed’s December meeting minutes, within which certain Fed members floated the possibility of reducing the Fed’s balance sheet sooner rather than later. This sentiment was unexpected and would imply a more hawkish Fed stance than has been seen throughout much of Chairman Powell’s tenure. Thus, it is possible that markets are finally waking up to the potential negative impact of tighter monetary policy on stock prices. Our view remains that it takes very little to upset the apple cart when valuations are as stretched as they are, and the Fed minutes are just one example of a bump in the road. We are likely to experience more bumps, and so investors should understand that 2022 could be a volatile ride. Fortunately, it comes on the back of three consecutive strong years for markets.
As always, we’re happy to answer any questions or concerns you might have. Now that we are in a new tax year, for example, it might be worth looking at your appreciated securities with an eye toward trimming the biggest winners. Until next time, we wish you and yours a very Happy New Year. May the next few months keep you warm and healthy.