Published December 10, 2021
Continuing from last week’s outlook for 2022, we provide the second part below, this part focused on the economy and stock valuations.
“The 2020 COVID recession was sharp, but short at only two months; while the rebound in activity has also been sharp, but uneven across economic metrics. Overall gross domestic product (GDP) moved from the recovery phase to the expansion phase as of the second quarter of 2021. As highlighted in the visual below, the question heading into 2022 is where we go from here—especially due to the stark reminder on this year’s “Bleak Friday” that the pandemic is nowhere near behind us.
Oh c’mon omicron!
How many times over the past 18 months have we started to breathe signs of relief that the pandemic was rounding the corner to becoming endemic, only to be hit by second or third waves, the delta variant and now the omicron variant?
Based on initial World Health Organization (WHO) findings, the omicron variant spreads more quickly, can cause more serious cases, and/or may decrease the effectiveness of vaccines and treatments. What we’ve learned from the delta variant is that it’s difficult to arrest the spread. What the entire world has learned throughout the pandemic, however, is that it’s the restrictions and/or lockdowns imposed that cause the most economic damage; while countries have vastly different reaction functions.
The rub at this stage in the global recovery is that the economic, supply chain, and inflation backdrop is significantly changed relative to prior waves/variants. The pandemic has exposed instability in complex global supply chains; possibly ushering in a coming secular environment of pervasive supply shocks, vs. the demand shocks that were more commonplace for much of the past two decades. Expect more talk about companies switching from just-in-time inventory management to just-in-case. We all have to wait to see if the effects of omicron are significant; and whether they do more damage to demand, or exacerbate supply chain problems.
What say you LEI?
Without yet possessing more detailed analysis of the threat of omicron, we’re left with more traditional ways to judge the economic landscape for the coming year. As shown below, the Leading Economic Index (LEI), shows that the U.S. economy remains strong and well above the pre-pandemic high. The average span between LEI highs historically, and recession (gray bars) starts has been 12 months. While there is no sign of an imminent peak, a more serious economic threat wrought by omicron, or any number of other threats, could put a dent in leading indicators.
LEI Not Yet Looking Back
Source: Charles Schwab, Bloomberg, The Conference Board, as of 10/31/2021.
Consumers’ strength being tested
Consumer spending drives 70% of overall U.S. real GDP; with the metric of retail sales a proxy for consumption. As shown below, thanks to copious fiscal and monetary stimulus, consumer spending has been on fire; but with significantly different trajectories for goods and services consumption. The wholesale economic lockdown imposed in the spring/summer of 2020 led to an unprecedented divergence; while 2021’s reopening phase led to the start of a convergence. Virus trends hold a key to whether the convergence gets arrested.
Goods/Services Divergence/Convergence
Source: Charles Schwab, Bloomberg, as of 10/31/2021.
One thing is for sure is that the future for certain pockets of goods consumption looks a bit bleak given elevated inflation. As shown below, buying intentions for large-ticket items, including vehicles, houses and household durables have imploded.
Implosion in Buying Intentions
Source: Charles Schwab, Bloomberg, as of 11/30/2021.
The virus, and this year’s inflation surge, have also put a big dent in broader measures of consumer confidence. There is one consumer-based spread that bears watching heading into 2022, as it could represent the first heads-up for a possible recession. Consumers’ confidence about their present situation has weakened, but there’s been an even greater deterioration in their expectations for the future; resulting in a historically wide spread between the two, as shown below (a consistent recession warning in the past). This could be part of the impetus behind recent weakness in bond yields, an implication for slower economic growth and something at odds with the narrative of rising inflation (which we cover next week).
Consumers Less Optimistic About Future
Source: Charles Schwab, Bloomberg, as of 11/30/2021.
Alerting to risks means we don’t get it?
A big impact on stocks in 2021 has been the emergence of retail investors. Looking at this cohort we note that “for their entire life, the market has gone up [and] if you say otherwise, you just don’t get it.” As one observer noted for this group, “There is a surrender-to-the-narrative-or-else attitude online, and it’s really frightening. Because if you say Bitcoin is overvalued, or Tesla is overvalued, or whatever popular SPAC is overvalued, these trolls in anonymous accounts come out of the woodwork and start attacking you.”
Narratives—even those bordering on the absurd—can push markets higher than fundamentals justify. Still, heading into 2022, what history says about valuations, earnings and sentiment is mixed-to-concerning.
Earnings’ fire becoming less hot in 2022
S&P 500 earnings have been on fire since mid-2020; with a sharp v-recovery into the second quarter peak. Earnings growth, although still strong in an absolute sense, is expected to descend through at least the first half of next year. As shown below, there is a close historical relationship between the growth rate in S&P 500 earnings and the year-over-year change in the index itself. This in and of itself isn’t a warning of impending doom; but is perhaps a message to curb your enthusiasm about future equity market returns remaining as robust as the pace of the past 20 months.
Earnings Growth Rate Tied to S&P 500 Returns
Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 11/26/2021. 4Q08’s reading of -67% is truncated at -40%, 4Q09’s reading of 206% is truncated at 80%, and 2Q21’s reading of 96% is truncated at 80%.
In addition, upward earnings revisions (by Wall Street’s analysts) have taken a turn for the worst, as shown below. This supports our view that companies bucking the broader trend and enjoying higher earnings revisions will continue to perform well relative to the overall market in 2022.
Earnings Revisions Under Pressure
Source: Charles Schwab, Bloomberg, as of 11/12/2021. Revisions index measures the number of equity analyst revisions upgrades (positive) and downgrades (negative).
Stocks expensive, unless using “yields lens”
Earnings are a component of many popular valuation metrics. The “heatmap” below shows that most valuation metrics are well into the red (expensive) zone as we head into 2022; with the notable exception of those which measure valuation in the context of low bond yields. (Another take on this, however, is that bonds are expensive, which makes stocks look “artificially” cheap.)
Source: Charles Schwab, Bloomberg, The Leuthold Group, as of 10/31/2021. Due to data limitations, start dates for each metric vary and are as follows: CAPE: 1900; Dividend yield: 1928; Normalized P/E: 1946; Market cap/GDP, Tobin’s Q: 1952; Trailing P/E: 1960; Fed Model: 1965; Equity risk premium, forward P/E, price/book, price/cash flow, rule of 20: 1990. Percentile ranking is shown from lowest in green to highest in red. A higher percentage indicates a higher rank/valuation relative to history.
Honing in on the last row of the heatmap above, market cap/GDP is often referred to as the “Buffett Indicator” given it’s Warren Buffett’s oft-expressed favorite valuation metric. As shown below, never before in the post-WWII era have stocks been as richly valued relative to the size of the economy. This relates back to our concern that the next serious correction or bear market in stocks could have an outsized impact on both confidence and the economy.
Buffett Indicator in Stratosphere
Source: Charles Schwab, Bloomberg, as of 6/30/2021.
Adding salt to that potential wound is the fact that U.S. households currently have more than 60% exposure to equities—about even with the prior peak in 2000, as shown below. It shouldn’t come as a surprise that the higher the equity allocation historically, the lower the subsequent long-term return. This doesn’t necessarily suggest impending doom for equities next year; but it’s a cautionary tale longer-term.
Households’ Exposure to Equities in Rarified Air
Source: Charles Schwab, Bloomberg, ©Copyright 2021 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at http://www.ndr.com/copyright.html. For data vendor disclaimers refer to http://www.ndr.com/vendorinfo/, 12/31/1951-6/30/2021. Equity allocation (includes mutual funds and pension funds) is % of total equites, bonds and cash. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Euphoria is not an investing strategy
Just as panic is not an investing strategy, nor is euphoria or FOMO (fear of missing out). SentimenTrader’s Panic/Euphoria Model below shows a recent parabolic increase in euphoria relative to panic. When excessive optimism, heightened complacency, and/or speculative froth is accompanied by healthy market breadth, it’s less of a concern. Given weaker recent breadth trends, the combination bears close watching in 2022.
Euphoria’s Unprecedented Surge
Source: Charles Schwab, SentimenTrader, as of 11/29/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance does not guarantee future results.
Buying and speculation has increasingly been leveraged by increasing levels of margin debt. Heading into 2022, the ratio of cash at brokers is at a record low relative to record high margin debt, as shown below. Given that margin is being used by a broader cohort of investors, it means that margin calls may come more frequently and after smaller downside moves in stocks; a risk to consider as we head into 2022.
Record High Margin, Record Low Cash Balances
Source: Charles Schwab, Bloomberg, ©Copyright 2021 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at http://www.ndr.com/copyright.html. For data vendor disclaimers refer to http://www.ndr.com/vendorinfo/, as of 10/31/2021.
What to do
I don’t manage portfolios, but I have much sympathy with what two investing legends have recently said. Leon Cooperman has been very vocal about being “a fully invested bear;” and Julian Robertson believes that “trying to sell short in this market is like being run over by a train that’s going to derail a mile down the road.”
The environment that persisted in 2021 could persist in 2022. As shown below, for all the talk of a “resilient market,” under the surface, the churn in terms of drawdowns was significant. Rotational corrections are preferred over the bottom falling out all at once; but there is a risk that indexes, at some point, reflect more of the weakness that has persisted under the surface.
Source: Charles Schwab, Bloomberg, as of 11/26/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Macro backdrops that include slower growth, and a move from a loose to tighter monetary policy, tend to usher in higher intra-market correlations and greater tail risks.”
Market Update
Stocks bounced back +1.2% Monday as investor concerns over the potential economic effects of Covid variant Omicron eased. The rebound accelerated Tuesday with a +3% rally in the Nasdaq. China moved to inject liquidity into market relaxing fears spurred by recent failures in the Chinese property market and investor-unfriendly policy moves by the country’s leadership. Oil prices spiked +4% on the news. A strong performance from Apple’s shares pushed stock indexes to a third straight daily gain in Wednesday’s trade. The +0.3% move higher was much more than offset by Thursday’s losses. The tech-heavy Nasdaq slid -1.7% with England imposing restrictions in the face of the Omicron variant. Interest rates ticked downward after three days of gains. Interest rates slumped further Friday as investors viewed the monthly inflation report as perhaps representing the measure’s peak reading. Inflation has been a concern for investors, though interest rates have been mostly trending downward the past couple of months as investors seem more worried about the economy slowing next year.
Stocks bounced back from the post-Thanksgiving Friday selloff. The S&P 500 (SPY) gained +3.82% to more than recover the prior week’s drop. The Nasdaq (QQQ) added +3.88%. Smallcaps (IWM) have returned to being market laggards after their early-November breakout effort failed. The group rose +2.42% this week after falling the four straight prior weeks.
Warm wishes and until next week.