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DON’T EXPECT THE FED TO END THIS BULL ANYTIME SOON

Jeff Buchbinder, CFA, Chief Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

The Federal Reserve (Fed) has engineered a massive hawkish shift, causing a bit more stock market volatility recently. But how worried should investors be? Here we take a look back at historical performance for stocks before, after, and much after initial Fed rate hikes to help reassure any nervous investors out there. We also take a quick look at what the Fed pivot could mean for growth/value and large cap/small cap trends given the maturing business cycle.

MASSIVE HAWKISH SHIFT

With the recent pivot by Jay Powell and Company at the Fed, rate hikes have been getting a lot of attention. And rightly so, given the bond market has gone from pricing in one 2022 rate hike just a few months ago to now pricing in three to four. That’s one of the most dramatic hawkish shifts by the Fed in a short period of time that we’ve ever seen, so some market jitters are not surprising.

HOW MUCH SHOULD WE WORRY?

A look back at history may help calm some investors’ jitters around the start of Fed rate hikes. As we wrote in our Outlook 2022: Passing the Baton, stocks tend to do well leading up to initial Fed rate hikes. There we highlighted the average 15% gain during the 12 months ahead of the initial hike of an economic cycle, including gains in all nine cases back more than 60 years. This makes sense given it takes a strengthening economy to create the job gains and inflation the Fed needs to see to take away the punchbowl. We see the first rate hike coming in either March or May, and with the S&P 500 Index up nearly 20% since March of 2021, and more than 10% since May 2021, those gains may already have occurred.

Looking beyond the initial hike, on our LPL Research blog last week we looked at how stocks performed during various periods after the Fed starts to hike rates. The story is similar, with the S&P 500 up an average of 7.5% six months later and 10.8% over the next 12 months historically. Stock were up all eight times one year after those initial hikes going back to the early 1980s. So based on history, the start of a rate hiking campaign by the Fed should not be too worrisome for investors.

LOOKING OUT LONGER TERM

But what does the hike mean further out, say 2023 and beyond? In Outlook 2022, we noted that initial Fed rate hikes can help us mark where the economy is in its cycle. The start of rate hikes typically happens in the early-to-middle stages of the cycle, where stocks historically see solid gains as we are forecasting for 2022.

But we can extend this exercise further and look at how stocks have done from the initial rate hike of a cycle until the end of the accompanying bull market, as we have done in [Figure 1]. Those first rate hikes have been followed by an average gain of 67% before the subsequent bull market peak. For those keeping score at home, that would take the S&P 500 to over 7,700 (no, that is not a forecast) before the next 20% or more decline.

On average, after rate hikes start, bull markets have run for about three to four years (or 40 more months) before peaking, with the longest in the late 1990s at six years (72 months) between the 1994 hike and the bull market top in March of 2000.

CAN CORPORATE AMERICA KEEP IT ROLLING?

Jeff Buchbinder, CFA, Chief Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial      

Corporate America has been on quite a run. Coming into 2021, S&P 500 Index companies were expected to generate less than $170 in earnings per share. As 2022 begins, it looks like that number may end up higher than the latest LPL Research estimate of $205, one of the biggest earnings upside surprises ever and a big reason why stocks did so well last year. But 2021 earnings are not yet fully in the books. We have one more quarter to go, which we preview here.
 

BIG BANKS KICK US OFF

Fourth quarter earnings season kicks off this week with earnings from several big financials, including BlackRock, Citigroup, JPMorgan Chase, and Wells Fargo reporting on Friday, January 14. This week just seven S&P 500 constituents report, but another 40 will announce results the following week (January 17-21) and 99 the week after that (January 24-28).

We welcome the shift from the macro to the micro where companies can continue to showcase their ability to effectively manage through the pandemic challenges, notably the supply chain disruptions and labor and materials shortages that are pushing costs higher.

WHAT TO EXPECT

We expect another good earnings season overall in which companies continue to beat expectations in aggregate and produce solid growth. Consensus estimates are calling for a year-over-year increase in S&P 500 earnings in the fourth quarter of about 22% [Figure 1]. The long-term average upside surprise of around five percentage points makes 27% a reasonable target, but given earnings beat estimates by 12 percentage points last quarter, the number could be higher. Earnings growth approaching 30%, though slower than the third quarter’s nearly 40% clip, would be impressive given the challenging operating environment.

We see several reasons to remain optimistic for this earnings season. First, estimates have been rising. Since the end of October 2021, the consensus estimate for fourth quarter S&P 500 EPS has increased 3.3%.
 

THREE 2021 MARKET LESSONS FOR 2022

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

In many ways, 2021 was a typical year for markets, but it also reinforced some basic market lessons that are hard to learn, even if they are not new. As we launch into the New Year, we’re highlighting three 2021 market lessons that we think may matter for 2022: 1) equity valuations are a poor timing mechanism, 2) structural forces have a large influence on interest rates and may keep them relatively low, and 3) politics and markets don’t mix.

Welcome to the New Year for markets, when year-to-date returns all reset to 0% and the year ahead is still a blank slate. No doubt, 2022 will provide its usual mix of ordinary market behavior and unexpected surprises. While these surprises can’t be forecasted, we can say with near certainty that we’ll have some. At the same time, markets have patterns that tend to repeat, even if the emphasis is different from year to year. As we head into the New Year, we’re taking a look back at 2021 and drawing out three lessons that we think will matter for 2022.
 

VALUATIONS AREN’T A SHORT-TERM MARKET TIMING MECHANISM

At the start of 2021 we heard concerns that broad U.S. markets were overvalued using many traditional valuation metrics, such as the price-to-earnings ratio (PE). In addition, compared to the U.S., international stocks (both developed and emerging markets) looked relatively cheap. But as shown in Figure 1, the S&P 500 surged higher in 2021, performing well above its historical average, while international equities lagged behind the U.S., with weakness in emerging markets in particular. Once again, valuations were a weak short-term timing mechanism.

At the start of 2021, the PE for the S&P 500 was historically elevated at almost 22.5 on forward earnings according to FactSet data. At the same time, interest rates were extraordinarily low, which makes stocks attractive relative to bonds and increases the present value of future earnings. On top of that, an extraordinarily strong year for corporate earnings helped stocks “grow into” their valuations, with the PE actually falling to nearly 21 by the end of the year despite strong stock market gains. Sentiment is often the primary culprit for allowing valuations to remain elevated, and it did play a role in 2021, but market fundamentals were even more important. If investors favored stocks in 2021, it was more about a sizable upside surprise in earnings growth than elevated optimism.
 

HOW MUCH HIGHER CAN TREASURY YIELDS GO?

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial
 

We expect interest rates to move modestly higher in 2022 based on near-term inflation expectations above historical trends and improving growth expectations once the impact of COVID-19 variants recede. Our year-end 2022 forecast for the 10-year Treasury yield is 1.75–2.00%. An aging global demographic that needs income, higher global debt levels, and an ongoing bull market in equities may keep interest rates from going much higher.
 

Most of this content was taken from Outlook 2022: Passing the Baton

Coming into 2021, we expected Treasury yields to move higher from their very low levels and they did. Higher inflation expectations, less involvement in the bond market by the Federal Reserve (Fed), and a record amount of Treasury issuance were all reasons we thought interest rates could end 2021 between 1.50% and 1.75%. For 2022, near-term inflation expectations above historical trends and improving growth expectations once the COVID-19 variants recede are reasons why we believe interest rates could move moderately higher from current levels. In 2022, we expect the 10-year Treasury yield to end the year between 1.75% and 2.00%. However, an aging global demographic that needs income, higher global debt levels, and an ongoing bull market in equities (which potentially means more frequent rebalancing into fixed income) may keep interest rates from going much higher in 2022. While we don’t expect interest rates to move much higher next year, because starting yields for core fixed income are still low by historical standards, returns are likely to be flat to the low single digits in 2022. Not a great year, but we should see an improvement over the negative fixed income returns we have seen in 2021.

The role of fixed income

With long-term interest rates close to what we think will be cycle highs, it’s important to revisit the case for fixed income within a broader asset allocation. Core bonds have historically provided capital preservation, diversification, and liquidity to portfolios, which we think are important portfolio construction objectives and help clients remain committed to their investment goals. With the economy likely transitioning to mid-cycle, the need for high-quality bonds increases in our view. Moreover, the need to offset potential equity market volatility remains an important role for core fixed income.

Bonds, particularly core bonds, have been less volatile than stocks and have historically provided ballast to portfolios during equity market drawdowns, which as we know, are normal occurrences from time to time. The maximum drawdown for bonds, in any given month, has been dramatically less severe than stocks [Figure 1]. While the worst drawdown in a month for equities was -28%, the worst bonds have done during a month was down 6%, and those losses were quickly reversed. So, when combined with equities, bonds help reduce total portfolio volatility, which makes for a smoother investment experience for investors.

STOCK MARKET OUTLOOK 2022

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Jeff Buchbinder, CFA, Chief Equity Strategist, LPL Financial

We expect solid economic and earnings growth in 2022 to help U.S. stocks deliver additional gains next year. If we are approaching—or are already in—the middle of an economic cycle with at least a few more years left (our view), then we believe the chances of another good year for stocks in 2022 are quite high. We believe the S&P 500 could be fairly valued at 5,000–5,100 at the end of 2022, based on an EPS estimate of $235 for 2023 and an index P/E between 21 and 21.5.
 

Most of this content was taken from Outlook 2022: Passing the Baton

We expect solid economic and earnings growth to help stocks deliver gains in 2022. When forecasting stock market performance, we start with the economic cycle. We believe we are currently approaching—or are already in—the middle of an economic cycle with at least a few more years left. Historically, if this holds true, then we believe the chances of another good year for stocks in 2022 are quite high, which is an important added factor for our positive outlook for stocks next year [Figure 1].

ECONOMIC OUTLOOK 2022

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial

We believe pent-up demand, gradual improvement in supply chain challenges, solid labor force growth, and productivity gains will all contribute to another year of above-trend economic growth in 2022. COVID-19-related risks remain and the potential for a policy mistake may be elevated as the economy moves towards normalization, but we think the overall environment will be supportive of business growth and ultimately equity markets.

The U.S. economy bounced back from its worst year since the Great Depression in 2020 with one of the best years of growth in nearly 40 years in 2021. A combination of record stimulus, a healthy consumer, an accommodative Federal Reserve (Fed), vaccinations, and reopening of businesses all contributed to the big year.

In what amounted to the shortest recession on record, only two months in March and April 2020, the economy came roaring back to produce what is currently expected to be over 5% GDP growth in 2021, more than making up for the 3.4% drop in GDP in 2020. Of course, there have been hiccups along the way. You can’t shut down a $20 trillion economy and then expect it to get going again without warming up first. Supply chain backlogs, materials and labor shortages, and higher prices all held the economy back to varying degrees. The good news is, demand is still very strong, and as the backlogs unwind (which could take years in some cases), we expect above-trend economic growth and see low risk of a recession in 2022.

As the U.S. economy moves more to mid-cycle, our 2022 forecast is for 4.0–4.5% GDP growth in 2022 [Figure 1]. While a slowdown from 2021, it’s still a very solid number. We expect inflation to tame from 2021 levels to a potential run rate under 3% by the fourth quarter with core inflation numbers lower, a step in the right direction, although it may still be on an upward trajectory the early part of the year.

Globally, Europe and Japan were hit especially hard by the pandemic in 2021. But as COVID-19 cases potentially fall globally, those areas could be ripe for better economic growth in 2022. Meanwhile, emerging market economies may disappoint as growth in China could be constrained by regulatory crackdowns.

WILL OMICRON RUIN THE SANTA RALLY?

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Jeff Buchbinder, CFA, Equity Strategist, LPL Financial

Historically, December has been a great month for stocks, but now we have the Omicron variant causing major volatility and uncertainty. Still, we remain optimistic that the new worries will subside over the coming weeks and stocks will finish 2021 on a solid note.
 

THE LATEST ON OMICRON

First things first, we are very excited to announce that tomorrow (Tuesday, December 7) we are set to release Outlook 2022: Passing the Baton. This will have all of our views on where we think the economy, stocks, and bonds are headed next year. Because the Outlook is coming out tomorrow, this week’s Weekly Market Commentary is shorter than normal, but hopefully just as impactful.

After 29 consecutive days without a single 1% move higher or lower for the S&P 500 Index, news of Omicron broke the Friday after Thanksgiving and as a result, five consecutive days saw at least a 1% move up or down. Clearly Omicron and the uncertainty it brought with it showed everyone that stocks can’t stay calm forever.

Although we do expect this volatility to continue, it very well could be a buying opportunity. We’ve been living with COVID-19 for more than 20 months now. We’ve seen several variants and managed to move forward, and we expect a similar playbook to work once again. Admittedly, we don’t know how effective current vaccines are against Omicron, or how transmissible it is, but we do know that the appetite for another nationwide shutdown is quite low and that these questions should be answered over the coming weeks. We remain optimistic that the medical community will quickly create booster shots against the new variant if needed, paving the way for this economic recovery to move forward early next year.

WILL SANTA STILL COME IN 2021?

December started off a little rocky, but we are still optimistic that the usual December bullish season will take place. For starters, the S&P 500 has gained 1.5% on average during the final month of the year, with only April and November better. But no month is more likely to be higher, with December up close to 75% of time.

As shown in Figure 1, it turns out that the majority of the gains tend to take place during the second half of the month, so we could see a continued choppy market until we have more clarity over Omicron, which would match the typical strong second half of December action.

Where things get interesting is after a negative November (like we saw this year), December does even better, up 2.7% on average and higher 19 out of 22 times (86.3%). What about if stocks are having a great year heading into December? You guessed it, the jolliest month of them all does better. We found there were 15 times the S&P 500 was up more than 20% for the year at the end of November and the month of December was up 11 of them with an average return of 1.7%; again, better than the average December return of 1.5%.

THREE REASONS TO BE THANKFUL

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Scott Brown, CMT, Senior Analyst, LPL Financial

There are only six weeks to go in 2021 and it has been an incredible year for the stock market bulls. In fact, in many ways it could go down as one of the best years ever. This week, in honor of Thanksgiving, we wanted to take a closer look at three reasons to be thankful. From the stock market to the economy, there are indeed many reasons to be thankful this year.

A YEAR TO REMEMBER

The S&P 500 Index is up approximately 25% for the year, which currently ranks it as one of the best years ever, certainly something to be thankful for in 2021. Although this year hasn’t been perfect, earnings have come in substantially better than expected, with 2021 S&P 500 earnings expectations up nearly 25% from where they were at the start of the year, helping to justify stocks at current levels.

If the S&P 500 were to end at current levels, it would rank as the 15th best year since 1950. In fact, the S&P 500 is on pace to be up at least 15% for three consecutive years for only the second time in history, exceeded only by an incredible streak of five in a row in the late 1990s.