Large U.S. companies produced stellar returns in the fourth quarter of 2021, while most other major equity indices had modest performance at best. As shown in the table below, the S&P 500 Index generated returns of 11.0% for the quarter. Large U.S. companies have outperformed all other market sectors for each period displayed in the table. In particular, we find the 3-year annualized performance especially notable because it was the best performing three-year period for the S&P 500 since the three-year period ending in 1999. That fact alone might raise some concern for those who believe history tends to repeat itself, considering the 1997-1999 period was followed by the bursting of the Dot-Com Bubble and a three-year bear market. As in 1997-1999, the performance of the past three years has been driven primarily by large technology and communication service companies. However, while stock valuations are relatively expensive compared to historical averages, we feel they are more reasonable than they were during the Dot-Com Era of the late 1990s and may be more justified given the work-from-home trends necessitated by the pandemic.
The table below shows the performance of major equity indices for selected time periods.
Equity Performance for Periods Ending on December 31, 2021
|Total Return Index||Market Sector||Quarter||1-year||3-year||5-year||10-year|
|S&P 500||Large U.S. Companies||11.0%||28.7%||26.1%||18.5%||16.6%|
|Russell 2000||Small U.S. Companies||2.1%||14.8%||20.0%||12.0%||13.2%|
|MSCI EAFE||Developed Int’l Markets||2.7%||11.3%||13.5%||9.6%||8.0%|
|MSCI EM||Emerging Int’l Markets||-1.3%||-2.5%||10.9%||9.9%||5.5%|
Throughout the year, equity markets frequently reacted to COVID-19 developments. The emergence of the Delta and Omicron variants both caused short-term market declines, which were quickly erased. According to the CDC, there were more than 430,000 COVID-19 deaths in 2021, which exceeded the 2020 total of 385,000. In late December, U.S. daily COVID-19 cases reached record levels at the same time the S&P 500 made new highs. It might be baffling to many as to why the stock market has done so well while the pandemic rages on. The most obvious answer is that, despite the human hardship caused by the pandemic, most of the U.S. economy has found a way to adapt. The most serious lingering impacts are only affecting specific industries. In addition, there is some thought that once the Omicron variant runs its course, the U.S. will have achieved herd immunity, between the individuals who have been vaccinated and those who obtain natural immunity after being infected. However, many public health experts expect COVID-19 to become endemic, meaning it will continue to circulate for the foreseeable future. There will likely be future instances when COVID-19 news will spook the market, but we are optimistic that its impact on the global economy will continually lessen.
Favorable monetary and fiscal policy over the last two years have been instrumental in stimulating the economy and producing gains in many asset classes, including stocks, real estate, and cryptocurrency. Low interest rates encourage borrowing, spending, and higher overall economic activity. Fiscal programs, which sent money directly to individuals and businesses, helped to support the economy, especially during the shutdown. But supply shortages and “cheap money” have led to price inflation in many goods, such as automobiles, energy, groceries, and electronics. With the economy back on firm footing, the reduction of monetary and fiscal stimulus seems to be prudent. The Federal Reserve has signaled that it will allow interest rates to gradually rise. Although a $1 trillion infrastructure bill was passed in November, most direct payments to individuals and businesses have ended. The passage of a larger social spending bill, which would include an increase in taxes, has met considerable opposition and is unlikely to pass in its current form.
U.S. economic growth remains very strong, especially when compared to a weak 2020, when COVID-19 became a pandemic, but also compared to 2019, before it started. The Conference Board estimates that the GDP will grow at an annualized rate of 6.5% for the fourth quarter of 2021, 5.6% for all of 2021, and 3.5% for 2022. The current unemployment rate has fallen to 4.2%. The labor market is expected to remain tight, as the number of job openings is currently 11.0 million for only 6.9 million unemployed individuals. Corporate earnings are at record levels. S&P 500 earnings are forecasted to have increased by 50.0% in 2021. Analysts are predicting a more normalized level of 8.6% growth in 2022.
The downside of too much monetary and fiscal stimulus and the resulting economic growth is that it has led to inflation. The Consumer Price Index rose 6.8% during the 12-month period ending in November, with energy, new vehicles, and used vehicle prices rising 33.3%, 11.1%, and 31.4%, respectively. Home prices rose 19.1% for the 12 months ending in October according to the S&P CoreLogic Case-Shiller National home price index. While individuals who own assets, such as equities and real estate, often benefit from inflation, others, such as those who are on fixed incomes are typically hurt during inflationary periods. The Federal Reserve had initially dismissed higher inflation data as transitory, believing that it would abate when supply chain problems were resolved. However, in its most recent meeting, the Fed admitted that the economic data was broadly too strong to support the transitory narrative and therefore decided to take more aggressive policy actions to moderate economic activity and ease price pressures going forward.
The strong advance in equity prices has raised concerns about overvaluation. The S&P 500 currently trades at 21.5 times next 12-month estimated earnings, compared to its 10-year average of 16.4. (The S&P 500 traded as high as 26.0 times forward earnings during the Dot-Com Bubble.) Based on its price-to-earnings (P/E) valuation, large company stocks, especially those with strong secular growth characteristics, appear to be relatively expensive. But when compared to fixed income securities, such as the 10-year Treasury bond, which currently yields just 1.5%, stocks seem to be more reasonably valued. Other equity segments have more attractive valuations. In the U.S., mid-size companies and small companies trade at P/E multiples of 16.0 and 15.1, respectively, and international companies in the emerging markets trade at 11.6.
Long-term interest rates were relatively unchanged during the fourth quarter, with the yield on the 10-year Treasury bond increasing from 1.44% to 1.51%. In its most recent meeting, the Federal Reserve indicated that it expects to raise its key interest rate three times in 2022 and continue to taper its purchases of bonds. This forecast does not bode well for longer-term fixed income investments, which lose value when interest rates rise. During 2021, the yield on the 10-year Treasury bond rose from 0.92% to 1.51%. Higher rates across the fixed income market resulted in negative total return of 1.54% for the Bloomberg Barclays Aggregate Bond Index. The fixed income portion of our managed portfolios is positioned in short-term investments to minimize the risk related to further rate increases.
We maintain an optimistic stance as we enter 2022, but also realize that returns for equities may be more modest than they have been for the past several years. A positive performance for stocks will most likely be dependent on continued expected earnings growth, moderate interest rate increases accompanied by lower inflation, and further progress in learning to coexist with COVID-19 and work around the hardships it will present.
We would like to express our sincerest appreciation for the trust you have placed in us and wish you and your family good health and happiness in 2022.
John D. Frankola, CFA Lawrence E. Eakin, Jr. Matthew J. Viverette
Vista Investment Management, LLC is a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.