Market Commentary – Taking Stock of the Bull and Bear Case

Market indices have had heady returns over the last several years. The S&P 500 index has had double-digit gains in five of the previous six calendar years, compounding at an 18.5% annual rate over the past five years and a 16.5% clip over the past ten years. Comparatively, since 1928, the index has returned 10% per year on average, buoyed by the last decade of positive market years. Looking forward, without making bold predictions, it is reasonable to expect that above-average annual returns may be harder to replicate.

While staying grounded in our core investment principles (which we revisit below), we think it’s a helpful exercise to take stock of the current economic and investing environment. And, as you make your list of New Year’s resolutions, we recommend that you include meeting with your advisor to review your overall strategy and risk tolerance.

As we consider the bull and bear case, we acknowledge that we are long-term investors and lean optimistic. We are firm believers in the power of compounding and the benefits of staying invested through market and economic cycles.

Taking Stock of the Bull Case

The market has reached new record highs by climbing the proverbial wall of worry and overcoming a myriad of economic, health, and policy issues. Solid economic and earnings growth, with an assist from monetary and fiscal stimulus, have been the underpinnings. The market has also been discerning, applying skepticism to recent, unseasoned IPOs and to stocks whose valuation was disconnected from underlying earnings. In our view, the continued health of the market and bull case for stocks rests on whether underlying fundamentals sustain and if market sentiment remains in check.

The positive outlook for stocks is supported by (1) strong consumer and corporate balance sheets, (2) full reopening of the economy, (3) a measured approach to withdrawing accommodation from the Federal Reserve (Fed), and (4) continued attractiveness relative to long-term bonds.

Consumers are a significant driver of the U.S. economy, as consumption spending comprises almost 70% of annual U.S. gross domestic product (GDP). With high demand for workers and a high personal savings rate, consumers have the wherewithal to continue spending. Corporations are similarly well positioned with high cash levels on their balance sheets and ready access to capital. Borrowing costs remain attractive with corporate credit spreads at record-low levels, encouraging capital investment and merger and acquisition activity.

Like everyone else, we hope that Omicron moves Covid from being a pandemic to an endemic disease. Progress on vaccination rates and therapeutics as well as our collective ability to adapt to the virus should enable a full reopening of the economy and continued economic growth.

The Fed’s dual mandate of reducing unemployment and keeping inflation at bay could work in investors’ favor in 2022. Inflation is clearly a concern, and the Fed has signaled its intent to be more hawkish. We expect the Fed will end its quantitative easing program and raise its benchmark rate 2-3 times in 2022. Still, the Fed may not have a heavy hand as overall employment is 5 million jobs short of the level in February 2020 at the beginning of the pandemic. Mid-term elections may also pressure the Fed to be more surgical in fighting inflation to preserve the economic recovery.

Equity valuations are elevated on an absolute basis, but remain attractive when compared with other asset classes, especially long-term bonds. The S&P 500 index trades at 21 times next year’s earnings versus a long-term average of 16 times earnings. While further multiple expansion may be difficult to achieve, earnings growth near 10% and a positive equity risk premium provide valuation support and a continued case for equities.

Taking Stock of the Bear Case

The pandemic has brought bottlenecks, supply chain issues, and the highest inflation readings in four decades. It has also brought with it unprecedented monetary and fiscal stimulus and record stock market highs. The bear case rests on the vulnerability of the market to (1) the negative impact of inflation on corporate profit margins and spending, (2) the pace of Fed tightening in response to inflation, and (3) valuation levels.

Corporate earnings have been driven by strong pent-up demand and a healthy consumer, resulting in operating profit margins near record levels. However, going forward, we expect profit margins may be tested by rising input and labor costs. Companies will do their best to pass along these costs, but consumers may be hard-pressed to maintain their spending if inflation doesn’t ease.

The Fed’s balance sheet has ballooned to over $8 trillion, more than doubling since the beginning of the pandemic. As the Fed pivots to a less accommodative stance, we believe it will move at a measured pace, but there is a risk that it may raise rates more quickly than the market is discounting.

Lastly, the stock market’s valuation is not inexpensive. While valuation alone is not reason enough for bearishness, historical data has shown that higher starting valuation levels correlate with lower subsequent 5-year annualized returns. Further, there is an inverse relationship between inflation and earnings multiples, so we are mindful of the valuation ceiling that persistent inflation could present.

On balance, we see a continued economic expansion into next year and solid operating fundamentals, which should bode well for equities. Nevertheless, we revisit our core investment principles as a reminder of maintaining a long-term perspective as bouts of volatility should be expected.

Core Investment Principles

At The Fiduciary Group, we focus on constructing portfolios that enable our clients to maintain their asset allocations throughout the market cycle, especially during the stressful periods when it matters most. In other words, we accept the fact that we cannot predict bouts of volatility. Instead, we devote our time and attention to preparing clients to weather changing market conditions.

We invest in financially sound companies with strong balance sheets that can withstand tough times. We look for sustainable competitive advantages, and the opportunity to partner with management teams who are trustworthy and capable. Changes in the stock price will ultimately be determined by the results of the underlying business. The ability to accept short-term market volatility with equanimity while remaining focused on what truly matters is critical to long-term success in investing.

We also believe in the importance of asset allocation and diversification such that clients’ investment strategies are aligned with their future cash needs. We focus on each client’s ability to bear risk and their capacity to withstand the swings that accompany changes in market values. Individual client circumstances inform our investment decisions. Ultimately, our goal is to intelligently balance the mix of stocks and bonds to adequately capture the benefits they provide for investors while also remaining cognizant of their shortcomings. It’s imperative for clients to remember that the world of investing will not always be as rosy as it is today. Our objective is to set asset allocations so clients will have the conviction to stay invested throughout the market cycle and experience the benefits of long-term compounding.

As investors, our strength lies in how we choose to react to market volatility. We affirm our belief that a balanced, diversified approach helps clients stay invested throughout market and macroeconomic cycles and puts them in the best position to achieve adequate returns over the long run.

As always, we greatly appreciate the trust our clients place in us.