EARLY THOUGHTS ON 2022
Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial
Ryan Detrick, CMT, Chief Market Strategist, LPL Financial
With the fourth quarter underway—historically the best quarter for stocks, by the way—2022 is fast approaching. While a lot can still happen between now and the end of 2021, we don’t think it’s too early to start thinking about what stocks might do next year. We see a favorable economic environment for stocks in 2022, consistent with prior mid-cycle expansion years and bolstered by continued earnings growth. The gains may not come easy, however, with a number of risks such as COVID-19-related supply chain disruptions, inflation, and higher interest rates.
WE START TOP DOWN
As 2021 winds down, we are starting to look ahead to 2022. As a starting point to begin forecasting stock market performance next year, we want to first assess the economic growth outlook and where we are in the economic cycle. If we are approaching the middle of an economic cycle that has at least a few more years to go (our view), then we believe the chances of another good year for stocks in 2022 are fairly high. Mid-cycle simply means we do not believe a recession is likely anytime soon—nor do we expect the big equity gains typically seen when the economy emerges from recession (those came last year). Looking back at the past 50 years, the S&P 500 Index was up an average of 12% during the 27 mid-cycle years we identified, with gains in 81% of those years.
We also acknowledge that stocks are up a lot and valuations are elevated (more on that below). The S&P 500 is up 16% year-to-date and 95% since the March 2020 low, which to us means the probability of another big up year in 2022 is relatively low. However, with the economy poised to grow (we expect above-average gross domestic product growth in 2022) the chances of solid gains remain high.
EARNINGS ARE A KEY PIECE OF THE PUZZLE
A growing economy is a great start, but stocks fundamentally derive their value from their earnings stream and earnings start with revenue. The environment for companies to grow revenue next year should be excellent with above-average potential economic growth and some pricing power from elevated inflation.
Historically, S&P 500 revenue growth is well correlated to nominal gross domestic product (GDP) growth. Nominal GDP growth is real GDP growth (inflation adjusted) plus inflation. Hypothetically, 4% GDP growth next year (consensus forecast of Bloomberg-surveyed economists) plus perhaps 3% inflation (consensus forecast for the increase in the Consumer Price Index) puts a 7% revenue increase in play. Without any change in profit margins (probably too rosy but let’s keep it simple) and some share repurchases to lower the share counts—a near 10% increase in earnings in 2022 looks to be within the realm of possibility, which is reflected in current consensus estimates shown in Figure 1. Significant earnings momentum is also bullish, with estimates having been raised significantly by analysts over the past six months, also shown in Figure 1.