* The setup for 2022 is far different than 2021.
* After a lengthy period of unbounded fiscal and monetary largesse we are exiting peak economic activity and peak liquidity
* Sell strength and buy weakness?
* The growth and narrow market performance bias into "The Nifty Seven" has grown ever more extreme, conspicuous and worrisome
* Since April 2021, over half of the S&P gain is from only five stocks
* The January effect this year might result in weakness in the anointed "Nifty Seven" as investors defer a tax event and strength in beaten-down value stocks as investors see relative value
* I remain fearful of Omicron not because of its virulence but due to its likely continued impact on supply chains and, in turn, inflation
"Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names."
- Bob Farrell's Ten Rules on Investing
Equities are ending the year with a burst of near-unprecedented enthusiasm.
By the end of the week it is likely that the S&P 500 Index will have experienced an outsize annual compounded rate of return over three years of more than 23% per year.
Momentum, temporarily halted with fears regarding the onset of Omicron earlier in the month, has reappeared in an orgy of seasonal and holiday optimism.
Many are buying the strength as the altar of price momentum has been inviting to those passive strategies/products and others that worship there. After all, that strategy has been working.
But those who own stocks away from the favored few know the real pain that has been levied in the markets over the last few months. Sure, the gewgaws have been decimated, but so have a wide swath of popular and profitable stocks. Some random examples are stocks such as SoFi (SOFI) , DraftKings (DKNG) , Citigroup (C) , Twitter (TWTR) , PayPal (PYPL) , General Electric (GE) , any of a number of media and telecom stocks and numerous "stay at home" stocks such as Zoom (ZM) , DocuSign (DOCU) , Peloton (PTON) and so many others.
VIX and other measures of volatility have collapsed abruptly -- in the case of VIX from about 32 to 17 in a matter of a week. Interest rates, by contrast, have done little, though the curve has flattened as short-term interest rates have moved up considerably (the two-year from 20 basis points to 80 basis points) and the 10-year US note yield looks like it will close the year about 50 basis points higher than a year ago.
After rallying by more than 250 handles since a week ago Monday (Dec. 20), market participants have appeared to shred any concerns regarding prospective economic growth, the accumulating U.S. debt load, a degree of political partisanship (in a backdrop of cultural extremism) rarely encountered, a monetary pivot (historically, a one percentage point rise in the fed funds rate reduces valuations by about 15%), still-stubborn signs of continuing inflation, continued supply chain disruptions and logistical nightmares, health uncertainties, a widening income and wealth gap and extended valuations.
Omicron May Extend Supply Chain Disruptions and Raise Inflation
In part, a less virulent Omicron seems to have been a contributing influence to the market rally. Some are even thinking that it will serve to reduce the impact of COVID, transforming the pandemic into an endemic. I would note that a less malignant Omicron has been my baseline expectation since the variant was exposed, but I remain fearful of the knock-on economic consequences from U.S. and non-U.S. imposed restrictions on supply chains.
However, the knock-on impact of Omicron is likely to extend the length of supply chain disruptions and, in turn, could produce unexpectedly stubborn and higher levels of inflation.
On Tuesday, my pal Jim Cramer tweeted this out on a trip to Dollar General (the scarcity of items has become commonplace):
Are Valuations Justified?
The question is whether the optimism in the face of a very real wall of worries justifies today's valuations and whether the market's extreme bifurcation will have negative market consequences.
While valuations and sentiment are not very good timing tools, I have spent a lot of time chronicling how we are in the 95th to 100th percentile in stock market valuations (Shiller's CAPE, total market cap/GDP, etc.). To me, the following chart (S&P price to sales, which cannot be manipulated by adjustments) best highlights the degree of overvaluation present today:
The Era of Irresponsible Bullishness May Soon Be Over
"The year began with a marriage of fiscal and monetary policies the likes of which the world had never seen; the year ends with a potentially failed BBB bill and a central bank that's quickly getting out of the bond buying business."
- Tony Pasquariello, Goldman Sachs
My market view is clear, and for now, wrong-footed.
While there is a possibility that the headwinds listed in this missive may have positive market and economic outcomes, I remain doubtful and I would attach a growing probability that economic growth will slow relative to expectations and that inflationary pressures will continue in the face of supply dislocations influenced in large measure by country and business restrictions, serving to result in disappointing corporate profits.
Putting aside rate hikes, the Fed is ending a $1.44 trillion quantitative easing program in the next three months. That is more than QE1 and QE2 combined and is 40% above the size of QE3. This liquidity faucet is being turned off at the same time the European Central Bank is ending its pandemic emergency purchase program (PEPP). BoE is over, BoC is over and QE from the Reserve Bank of Australia might end in a few months.
With rates hugging the zero bound, the Federal Reserve's monetary pivot will prove problematic to the markets as it now has novel constraints with persistent inflation.
That excess in time and amount of policy has put us in a bind by:
* Stoking a dangerous asset bubble fueled by the liquidity of policy
* Deepening income and wealth inequality
* Embarking on a policy of money printing that has generated inflation from which it will be hard to escape
Reflecting my fundamental concerns, but out of respect for the current price momentum, I am basically in a market neutral position, where I plan to end the year.
What Else Do I Expect for 2022?
As I have written, the only certainty is the lack of certainty, so developing a set of baseline assumptions and conclusions for next year is as hard as it has ever been. But I will take a shot at it and offer my views of what may be in store next year:
- A general valuation reset lower. On average, over history, a 100-basis-point rise in fed funds rates is associated with about a 15% valuation adjustment lower. Considering today's elevated valuations, that reset has the potential of being more than the historic average.
- A hard rotational shift from growth to value. To some degree, this reflectsthe Fed's pivot, which will likely produce higher interest rates, serving to adversely impact discounted cash flow models of long-dated growth stocks.
- Disappointing EPS growth (probably under 5%) compared to higher expectations. One of the biggest surprises this year has been the resilience of corporate profits. However, contributing potential negative influences include likely margin pressure from higher costs, a Fed tightening, some evidence of pulling forward demand, etc.
- Modest EPS growth (if any growth at all) when combined with lower valuations could translate into negative overall returns for the S&P in 2022.
- With continued high inflation (a regressive tax), a continued widening in the income/wealth gap houses a wide range of social, economic and political problems and investment ramifications.
- A more aggressive Fed than is reflected in general expectations. Less liquidity could result in a marked reduction in flows into equity funds, which has provided unprecedented fuel to the markets in 2021. (See my Surprise List for 2022.)
- Continued supply chain problems that, in part, fuel inflation and inflationary pressures to levels well above consensus. It is important to remember that many of the most important supply chains lie overseas, where more restrictive business and social closures have been put in place. In other words, the U.S. doesn't totally control its economic destiny in a flat and interconnected world. (See Jim Cramer's Dollar General tweet above)
Sell Strength, Buy Weakness?
While I recognize that the dominant emotion or view by the many is simply to buy the best-performing stocks (read: The Nifty Seven - Facebook (FB) , Amazon (AMZN) , Apple (AAPL) , Netflx (NFLX) , Alphabet (GOOGL) , Nvidia (NVDA) , Microsoft (MSFT) ), as a consequence of the above and based on other factors, it is hard for me to find much value in today's market.
Again, consider the concentrated performance of the anointed stocks. Since April 2021, more than half of the S&P gains were contributed by only five stocks (Tesla (TSLA) , Microsoft, Nvidia, Apple and Google). That would be fine if the stocks weren't richly priced. Unfortunately, the valuations of the 10 largest S&P stocks are very extended; they sell at more than 68% above their average price-to-earnings ratio of the last 25 years.
Another issue to keep in mind is whether the selling in The Nifty Seven has been deferred to early January in order to avoid a 2021 tax event. Tactically, I am short SPDR S&P 500 ETF (SPY) and Invesco QQQ Trust (QQQ) in anticipation of the possibility of some sort of dump in the league-leading stocks of 2021 in early January.
Finally, some stocks meet my criteria (e.g., ViacomCBS (VIAC) , AdvisorShares Pure US Cannabis ETF (MSOS) , AT&T (T) and C, among others) now, but those are in the deep value space where the momentum crowd lacks interest and where tax selling (in a low-volume backdrop) has been conspicuously ugly during the month of December. As today is the last trading day of the year where losses can be taken, I would consider holding one's nose by initiating or adding to some of those value laggards that likely have been beaten down by the aforementioned and what I believe to be rather indiscriminate tax selling.
"We think about and are taught about money in ways that are too much like physics (with rules and laws) and not enough like psychology (with emotions and nuance). physics isn't controversial. it's guided by laws. finance is different. it's guided by people's behaviors."
- Morgan Housel
The setup for 2022 is far different than 2021.
Actually, it is far different than at any time in the last 13 years -- a period in which returns for basically all but one of the years has been positive. (Note: 17 out of the last 19 years have shown positive S&P returns!)
Most importantly, fiscal and monetary policy is no longer unbounded and we are likely well past the points of peak economic activity and peak liquidity.
Irresponsible bullishness may be over, and the narrowness of the market's advance (see Bob Farrell's quote at the beginning of this column) is likely approaching an extreme... just as financial conditions tighten.
The 12-year Bull Market may be on fumes.
(This commentary originally appeared on Real Money Pro on Dec. 29. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)