2022 Market Outlook: The Last Dance

Summary

• This time is different.
• The greatest threat facing investors in a generation.
• Reasons for reassurance and the key risk facing investors in 2022.
• Expect increased volatility across asset classes.
• A market full of opportunities in the year ahead.
• This idea was discussed in more depth with members of my private investing community, Global Macro Research. Learn More »

DaLiu/iStock via Getty Images

“It’s a great run. We’d had a wonderful time. Good team. Time to go.”

--Phil Jackson, The Last Dance, 2020

It’s been a great run over the past 13 years for financial markets. After shaking off the near collapse of the global financial system in early 2009, the U.S. stock market is seven times higher, the 10-year U.S. Treasury yield has fallen by roughly three percentage points, and gold prices have nearly tripled. No matter how you were allocated, investors have been set up to win in dynastic proportions. We’ve had a wonderful time. Good markets. Time to go.

This time is different

Cue gasp and pearl clutch. How could any reasonable investor even consider not staying fully invested in today’s markets that have done so well for so long? After all, we all know that stocks always overcome any short-term downside volatility and go higher over time, right? And we all know proclaiming that “this time is different” is the death knell for any investor? All great questions. Let’s explore each and more as we look ahead to 2022 for financial markets.

“Most people struggle to be present. . . Most people live in fear because we project the past into the future.”

--Mark Vancil, The Last Dance 2020

Always be present

While most people might live in fear because we project the past into the future, the exact opposite is most often true when it comes to investors in financial markets. Many investors bask in overconfidence because they project the past into the future. Stocks have been effectively going up for the past 13 years, so why shouldn’t we reasonably expect stocks to continue going higher for another year? And it’s well known that the investment highway is littered with more than a decade worth of bears that have raised flags of caution along the way only to be proven dead wrong. Even the COVID crisis was quickly brushed off with the S&P 500 now one-third higher today versus where it was prior to its global onset in February 2020. The past has repeatedly taught us to stay fully invested and carry on.

But here's the problem. We don’t get rewarded in the present and future for the victories of the past. Instead, it's important as investors to consider the markets we have in front of us at any given moment in time and the best opportunities regardless of what has taken place in the past up to this moment. Being present is what helps protect against the investor propensity to buy high and sell low, which of course is in direct violation of rational consumer behavior in all other areas of our lives where we like to go shopping for things on sale (buy low) and selling items we may own at a premium (sell high). Being present also helps guard against potentially unjustified overconfidence and getting blindsided by the next market downturn (the ol’ “how could we have seen it coming?” phrase that gets rolled out by many “experts” seen regularly in the financial media).

So what's true in the present today?

For stocks, the S&P 500 Index is trading near its highest valuations in history on both a current price-to-earnings as well as a cyclically adjusted price-to-earnings basis. Only during the peak of the technology bubble were stocks more expensive than they are today. On the surface, this is potentially a real problem for stock investors.

But wait a second! C’mon Parnell, how can you mention the CAPE and being in the present. We all know the CAPE is not a useful predictive market tool at any moment in time. Also, back during the tech bubble, the 10-year U.S. Treasury yield was near 7%. Today, it’s around 1.5%. So while stock investors effectively had a negative equity risk premium and were heavily reliant on continued strong earnings growth ultimately evaporated two decades ago at the turn of the millennium, today stock investors are still being paid a decent premium above Treasuries for the added risk of owning stocks at a time when strong earnings growth is reasonably projected to continue into 2022.

So while stocks are indeed expensive, they still have room to run higher on this basis.

So far, so good for the present.

But what about the implications of this inflation story that everyone keeps talking about? This is where things start to get dicey.

The last reading on inflation for November 2021 was an increase in prices of 6.9% vs. the same time a year ago. This is the highest such inflation reading since June 1982 nearly forty years ago. Why does this matter? Because with the 10-year U.S. Treasury yield around 1.5%, this means that investors are receiving a yield on their Treasury holdings of -5.4% after inflation based on the latest reading for November. Now, this is not necessarily a problem if recent high inflation readings end up coming back down (“transient” inflation – prices follow the green arrow down in the chart below).

But what if these recent price spikes end up continuing well into 2022 (“sustained” inflation? Presumably under this outcome, Treasury investors will start demanding a much higher yield to continue lending money to the U.S. government (yields follow the red arrow up in the chart above). And if Treasury yields start spiking higher, then the thesis for continuing to own stocks quickly evaporates as the still positive equity risk premium for stocks despite historically high price-to-earnings ratios quickly turns sharply negative. In other words, the peak stock valuations that have not mattered for so long would suddenly matter a whole lot.

In short, if sharply higher Treasury yields due to “sustained” inflation, then sharply lower stock prices.

Yeah, yeah. But we all know that if stock prices start falling sharply that the U.S. Federal Reserve will quickly come to the rescue with more monetary stimulus to save the day. After all, this has been the script for as long as we can remember in the past.

Alas, we're not investing in the past. We're investing in the present. And this brings us to arguably the biggest downside risk that investors have confronted in a generation as we enter 2022.

The Greatest Threat Facing Investors In A Generation

“It’s a simple game. But when you leave this confined zone, it’s hard. It’s hard.”

--Dennis Rodman, The Last Dance 2020

A generation of stock investors have been conditioned to expect it time and time again. Any professional investor under the age of 35 along with anyone new to investing in stocks over at least the past 13 years if not the last 34 years knows the drill all too well. U.S. stocks as measured by the S&P 500 Index start to fall anywhere between -7% to -12%, the U.S. Federal Reserve comes rushing in with jawboning reassurances of “whatever it takes” style monetary support if needed if not turning on a dime with outright interest rate cuts and large-scale asset purchases via quantitative easing, and U.S. stock prices quickly rebound higher to new all-time highs. This was a story that played out during 2009, 2010, 2011, 2014, 2015/16, 2018/19, and 2020. Why wouldn’t we expect anything different in 2022? After all, the “Fed put” of ensuring stability in financial markets that was first introduced to us all the way back in the immediate wake of the 1987 stock market crash is the Fed’s implied third mandate, right?

Here’s the problem. Over the past 13 years since the onset of the Great Financial Crisis, the Fed has had a simple and straightforward monetary policy hand to play in this regard. Given that we were mired in a sluggish growth and disinflationary/deflationary economic environment, the Fed had the freedom to pour on as much expansionary monetary stimulus as it wanted since inflationary pressures were all but dead. In other words, the monetary policy environment and financial markets were flowing in the same direction. Goldilocks as far as the eye can see.

But as we enter 2022, the story is now the exact opposite (hence the “this time is different” quip above). The fires of inflation are now burning not only in the U.S. but all around the world. Of course, central bankers have no one else to blame other than themselves along with their fiscal policy maker counterparts for painting themselves into a very tight corner by grossly, wildly, excessively, recklessly overstimulating the economy and financial markets in response to, not a financial crisis, but a health crisis early last year. And after first proclaiming back in 2020 that they would remain accommodative for as long as it takes and since repeatedly promising that inflation pressures would be “transient,” the Fed is now more recently shifting with swiftness toward pressing increasingly hard on the brakes in tightening monetary policy. In other words, the increasing rise of inflationary pressures has monetary policy and financial markets now in direct cross currents against one another.

So while investors have been conditioned for the last 13 years for the Fed to scramble to the rescue of financial markets at the first signs of trouble, the Fed no longer has this flexibility at least for the time being. And the next time that the S&P 500 Index is careening to the downside for some seemingly inexplicable reason over the coming year (see December 2018, for example), the Federal Reserve and its global central bank brethren very likely will no longer have the flexibility to abruptly change course toward monetary easing as it has so many times in the past.

Instead, depending on how persistent inflationary pressures prove to be over the course of the coming year, they may be forced to stay the course with increasingly restrictive monetary policy. After all, given the choice between increasingly eroding the purchasing power of the broad general public or further propping up the grossly overinflated asset prices owned by a narrow group of already wealthy investors to yet another fundamentally unjustified all-time high on the S&P 500 Index, monetary policy makers are likely to choose the former over the latter in the year ahead (or at least I hope they would – otherwise have we learned nothing from Arthur Burns and William Miller?).

This means a -7% to -12% drop in the S&P 500 could ultimately continue to roll down hill in fits and starts into a full-fledged bear market (gasp, double gasp!). Not the fleeting, went away on a two week vacation and you missed it kind like we saw in March 2020 mind you, but an actual bear market with teeth and time that torture investors with head fake countertrend rallies, lower highs and lower lows for 12 to 36 months like we typically saw in the past every four years or so on average as part of the traditional business cycle prior to the Great Financial Crisis.

How would we as investors possibly survive such an outcome!?! The same way we have every time over the past couple of centuries here in the U.S. We allow market excesses to cleanse themselves (a la tech bubble) while picking up attractive long-term investment opportunities in assets that are either already reasonably valued or are oversold along with the broader market. As long as the financial system is not collapsing, and the good news is that the banking system is currently healthy and well capitalized (unlike the years heading into the financial crisis), we’ll do just fine and financial markets would be better and healthier for it in the long run.

Sustained Inflation Is Not My Base Case

“That’s the sign of a good man, if you can talk s--- when it’s even score or talk s--- when you’re behind score. When you’re ahead, it’s easy to talk”

--Michael Jordan, The Last Dance 2020

Although the sustained inflation scenario is the biggest downside risk facing investors heading into 2022 – stocks down possibly into a full-blown bear market, bonds prices down and yields up, gold down too at least in the intermediate-term believe it or not – it is not my base case scenario.

Instead, I remain in the transitory inflation camp as my base case. Although I had been in the potential sustained inflation camp as recently as the first quarter of 2021, I have increasingly shifted toward the view since that while the spikes in consumer prices that we’ve seen in the second half of 2021 were inevitable and are likely to continue into the first half of 2022, that these inflationary pressures will ultimately prove transient (six to nine months of high inflation is not “sustained” – see the period from November 2007 to September 2008 as the most recent example to this point) and that consumer and producer prices will eventually cool down as supply chain disruptions gradually resolve themselves (even with the Omicron variant currently raging) in an economy that is fading as the sugar high effects of fiscal and monetary stimulus increasingly wear off in 2022. From a structural perspective, I also cannot ignore the breathtakingly high levels of sovereign and corporate debt that is inherently disinflationary/deflationary, particularly if bond yields start to drift higher in the coming year.

Of course, it’s not enough to simply hold this view. It's worthwhile to present evidence to support it. And the financial markets themselves provide useful information in support of the transient inflation view. Not the stock market (a.k.a. the “dumb money” according to market pundits), mind you, as this ceased being a useful barometer to indicate anything much useful at least a decade ago if not longer (hopefully it will become useful once again, but monetary policy makers will have had to completely left the building at least for a little while first). Instead, the bond market (a.k.a. the “smart money”) continues to be a useful place to look for clues as it has been for many decades now.

Let’s begin with Exhibit A, which is effective Treasury yields themselves. If we were truly now entering a sustained inflation environment, the 10-year U.S. Treasury yield would not have been trending marginally lower for the last nine months in holding below 1.75%.

And the 30-year U.S. Treasury yield certainly would not also be trending even more decidedly lower at more than 60 basis points below its highs from earlier this year.

The knee jerk retort to these observations is that these long-term yields are lower due to Fed Treasury purchases as part of their Quantitative Easing program. But here’s the problem with this response – the volume of Fed purchases in the Treasury market is mere fraction of the overall volume in the market place. This is why we saw Treasury yields actually rise, not fall, during past rounds of quantitative easing early last decade during QE1, QE2, and QE3, as private market investors were selling more Treasuries than the Fed was buying on net during these past programs. And the fact that we have seen a net inflow of nearly $600 billion from retail and institutional investors into mutual funds and ETFs over the course of 2021 despite the building outbreak of higher inflationary pressures indicate that the financial markets are simply not buying the sustained inflation story.

But let’s dig further.

Both of these charts measure the additional yield that investors require for investing in long-term Treasuries (10-year, 30-year) versus short-term Treasuries (2-year, 5-year). If these values are increasing, this implies a steepening yield curve and an economic outlook that includes stronger economic growth and higher inflation. But since the end of 2021 Q1, these values have been sharply decreasing, which implies a flattening yield curve and a more uncertain economic outlook that includes slowing economic growth and the eventual return of disinflationary/deflationary pricing pressures.

I have a bunch more, but let’s go one more before calling it quits for now (I suspect I’ll be writing frequently on this topic as we begin to work our way through 2022).

Both of the charts above show expected inflation over the next five years and ten years, respectively. While both of these readings were charging sharply higher as recently as May 2021, they have since largely flattened outside of a brief spike in October and early November that has since reversed itself. What this signals is that the mounting high inflation concerns among bond investors through the first year after the COVID crisis recovery have since largely abated as these readings have leveled out.

For these reasons among others, I maintain the view that inflation pressures will prove as transient today as they were back in 2008 when I posted my second ever article on Seeking Alpha entitled “Inflation Fears Are Overblown.” I got roasted in the comment section back then for my view – “In fact, almost everything the author says is incorrect” – and I look forward to more of the same with this latest outlook article today.

And if this transient inflation view plays out over the sustained inflation or stagflation scenarios (I should note that I do assign meaningful probabilities to both of these outcomes today as well, so I certainly would not completely rule out the possibility of either, but transient inflation remains my highest probability base case scenario), it would suggest that the potential downside pressure on stocks, bonds, and gold will not be nearly as pronounced as outlined in the sustained inflation scenario above.

But before we wipe away the sweat from our brow and steam confidently into 2022 on the back of the Santa Claus stock rally that finally appears to be starting to take form, it also does not mean that stocks, bonds, and gold are all still not without meaningful risks as we enter 2022. In fact, the coming year may bring with it some of the most unsettling volatility, both to the upside and the downside, that we have seen in the stock, bond, and gold market that we have seen in a long time.

The Key Risk Facing Markets In 2022

“The big downfall of a lot of players who are otherwise gifted is thinking about failure”

--David Aldridge, The Last Dance 2020

We knew we would arrive at this point. One could see it coming over a year ago.

The Fed was all in and a whole lot more with extraordinary monetary stimulus unbelievably aggressive it would leave Ben Bernanke and Mario Draghi blushing in response to once again – wait for it – a health crisis. Not a financial crisis, but a health crisis. It’s not to say the Fed should not have intervened in response to COVID – this was obviously the right call - but they didn’t need to go so incredibly far over the top for so long with their intervention.

At first, the Fed promised they would remain easy for as long as imaginable. But then the economy started to regain its footing as markets were sent soaring. Thus, the Fed changed its tune to transient inflation to justify their keeping their foot pressed to the floor of the monetary policy accelerator despite the fact that things were getting a whole lot better. After all, the Fed wanted to avoid its repeated post GFC “mistake” of withdrawing monetary stimulus too early only to see financial markets roll back over (not the economy, mind you, but financial markets – a key weakness of the Fed over the last couple of decades is dogmatically focusing on the wrong shiny object).

Of course, staying far too easy for far too long in an environment of arguably excessive fiscal policy and persistent supply chain disruptions was ultimately going to lead to a spike in inflation that would persist until the fiscal and monetary policy sugar high final wore off and supply chains came fully back online. Thus, the known challenge for the Fed was whether they would have the resolve to stick to their transient inflation guns when the inevitable pricing spike came. Of course, as we have come to know all too well about the Fed, they are a capricious bunch. The most recent example was Christmas Eve 2018 – we saw little to no change in the economic data, but plunging financial markets over a series of weeks (from heavily overvalued levels) had the Fed completely shifting on a dime from further interest rate increases and balance sheet reduction on autopilot in 2019 to projecting interest rate cuts virtually overnight. Predictably, once the inevitable inflation spike finally arrived, the Fed lasted about two months before folding and jumping the sustained inflation bandwagon.

I like my major central banks to have discipline and to be deliberate and calculated in their policy announcements and decision making. Unfortunately, the central bank we have (and the Fed is certainly not alone among global central banks in this regard) acts very much the opposite.

This fickle behavior has worked to investor advantage since the financial crisis, as it has meant the Fed pouring a lot more sauce into the monetary policy punchbowl for more than a decade now.

But as we move into 2022, this Fed capriciousness is likely to bite investors in the proverbial keester. For as the Fed increasingly slams on the policy breaks to fight an inflation problem that by some readings may have already been projected to eventually fade as much as nine months ago now, they risk whipsawing the economy back down into recession with an associated reduction in inflation pressures that may lag to the downside due to ongoing supply chain issues.

Not only is the market likely to struggle with the fact that the greatest fool with an unlimited checkbook in the Fed is no longer buying assets hand over fist by March of next year and that stocks with nosebleed valuations will be forced to finally stand naked (don’t even get me started on the likes of Tesla and Bitcoin), but the fact that the financial media narrative du jour and subsequently the Fed policy directive has the potential to evolve from transient inflation to sustained inflation to stagflation to outright recession over the course of the next 12 to 18 months is not something financial markets including stocks are likely to be comfortable with at all.

Even if we don’t see the onset of a new bear market in stocks, a sustained spike higher in Treasury yields, or another big drop off in the gold price in 2022 (none are my base case), investors should be ready for much greater volatility across all of these categories in 2022 because of the Fed and the associated effects of their actions.

Before we go any further, none of this represents failure for investors. Instead, it represents markets being forced (because the Fed would never, ever do it voluntarily) to make a long, long, long overdue shift in finally get back to normal. And it also represents opportunity for those that are prepared and at the ready.

A Market Full of Opportunities In 2022

“Look I don’t have to do this. I’m only doing this because it is who I am. That’s how I played the game. That was my mentality. If you don’t want to play that way, don’t play that way.”

--Michael Jordan, The Last Dance 2020

The market set up for 2022 is a lousy one for growth stocks. This is particularly true for the large-cap tech stocks whose valuations have soared into the stratosphere driven by the previously endless tailwinds of sluggish growth, disinflation, defensive growth (if this is actually a real thing with tech – smells “transient” to me at the end of the day), and robust cash flow generation. As a result, I remain meaningfully underweight technology, media, telecom, online retail (cough, Amazon.com, cough), and anything else that has an egregiously high price tag as we enter 2022.

Instead, the market set up is attractive for a number of other stock sectors.

Leading among these is the health care sector, particularly big pharma and large biotech stocks. Valuations across these segments are currently dirt cheap – low P/E ratios mean high earnings yields, which is an attractive characteristic from a company with true defensive growth characteristics and strong pricing power (Washington can talk all they want about regulating drug prices, but this is a very steep climb given the power of the pharma lobby). And future demand is likely to be increasingly strong, particularly as we continue to emerge from COVID and all the long-term direct and indirect health care related complications it is likely to bring in the years ahead.

Another stock market sector that looks attractive heading into 2022 is consumer staples. The sector has been a relative laggard in recent years. As a result, valuations have become attractive in this traditionally more sustained growth area of the market. This is particularly true among food processing companies. And given that these defensive firms generally have wider economic moats and reasonable pricing power, these are beneficial characteristics in an environment marked by higher inflation in the coming months.

Other stock market sectors that look attractive heading into 2022 for more obvious reasons are industrials, energy, and materials stocks. While industrials in general stand to benefit from the recently passed infrastructure bill, my most favored segment within this space is the defense industry, as I anticipate the geopolitical landscape could look notably different and quite a bit more contentious come this time next year. As for energy and materials, I favor the integrated oil majors and industrial metals producers not only as an inflation hedge but also given their discounted valuation characteristics in many cases.

Another attractive theme heading into 2022 is developed international stocks. The more tech driven and growthy U.S. stock market is the most expensively valued in the world by most measures, in some cases by a decent margin. As a result, developed international markets, many of which are more cyclical in nature, are trading at some of their most discounted valuations relative to the U.S. in decades. Much like the sector themes within the U.S., these same forces should set up to be more supportive of developed international stocks relative to the U.S. in 2022. Favored markets include South Korea, Germany, Canada, and Japan among others.

What about bonds and gold?

While the 40-year trend in Treasury yields remains solidly down (which has been great for Treasury prices all along the way), anticipate a choppy year for Treasuries that could see yields marginally higher or lower before 2022 is said and done. Not a segment I would be eager to pour into at this point, but not one that I would abandon either heading into next year.

As for gold, weakening in the early part of 2022 would not be a surprise given expectations for more restrictive monetary policy. But the environment may become increasingly favorable for gold as the year progresses, particularly if the Fed ends up strangling economic growth in expense for attacking an inflationary threat that proves fleeting.

Both bonds and gold are markets that warrant much closer attention than usual as we move through the early months of 2022.

The Bottom Line

The coming year is set up to be unlike any other in recent post GFC memory. The Fed has shifted course dramatically and is now fully engaged in fighting an inflation beast that may indeed be transient at the end of the day. But this sharp turn toward increasingly more restrictive monetary policy in the months ahead promises to bring much more volatility across asset classes including stocks, bonds, and gold. But despite a likely increasingly volatile broader market climate, attractive investment opportunities remain abundant. This includes a number of stock sectors within the U.S. stock market, many of which have been out of favor in recent years, along with many developed international stock markets outside of the U.S.

Disclosure: I/we have a beneficial long position in the shares of TLT, PHYS, EWY, EWG, EWC, EWJ either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.