- Using the Overton Window and Occam's Razor to help investors look at how Covid and inflation will impact the market in 2022.
- Why IWM could outperform SPY after lagging by 13.5% in 2021.
- Looking at energy prices as the main driver of inflation and why they look set to stay elevated.
- How global quantitative easing is keeping inflation from showing up in the bond market.
The market likes to climb a wall of worry is one of the oldest sayings on Wall Street, and in the context of what occurred in 2021, it is certainly a perfect fit. With all the headwinds that stocks faced ranging from Covid to inflation to Fed policy and significant proposed tax hikes, markets held up and rewarded the buy-the-dip crowd time and time again. With the S&P 500 returning 27% for the year, 2021 has truly been an outstanding year for the bulls. So, what's in store for 2022, and what will the wall of worry look like in the upcoming year? Will it be another buy-the-dip year, or will the bears finally be rewarded for having consistently dire outlooks on earnings and valuations? While all that remains to be seen, what we can do for now is take a look at two major items, Covid and inflation, and see how they might impact 2022.
Typically, a market outlook consists of combining consensus earnings, rates estimates, and a multiple in line with previous similar market environments, and one can produce a rational and possibly accurate prediction. However, 2022 is a rather peculiar year in that we are dealing with an unprecedented combination of a global health scare and a stagflationary (low growth/high inflation) economic environment. So, to take a better look at these complex situations, we can go outside of the traditional financial analysis tool kit and borrow some concepts from political science and, brace yourself, philosophy.
As we finish the second year of dealing with Covid, there has been considerable progress made in managing the virus through vaccines and various therapies. So much progress has been made that there has been a shift in how medical professionals describe Covid in terms of it becoming endemic, meaning similar to the cold and flu viruses we have had for generations. We are even now seeing this transition filter through mainstream media outlets as people accept how widespread Covid has become while severe symptoms and death rates have declined. With so much of the country returning to normal life, the ideas of shutdowns, remote schooling, and other restrictions have become far less palatable to large groups of people and that can have a significant impact on how public policy is determined. In political science, such shifts in public opinion and how policymakers react to it are measured by the Overton Window. The Overton Window is a theoretical framework which places publicly preferred policies within the "window" and the disliked ones outside of it and is all done with the assumption that politicians will be more inclined to enact the "window" policies which help get them reelected. So, in terms of Covid, the window for a return to normal life has gotten larger, which will draw greater political will towards a full return to normal life. This is important for investors to be aware of because as public opinion and official policies change on Covid, there could be significant changes in markets. A sustained pivot towards pre-Covid living and working is the catalyst companies need to get back to long-term project planning, increased capital expenditures, and the restaffing of urban centers. As we saw big tech and other large cap names dominate the "shutdown" economy, we could now see a reversal of that dominance and a resurgence in the Russell 2000 (IWM) which underperformed the S&P 500 (SPY) by 13.5% in 2021. Fed policy which is also keenly focused on Covid could shift towards a slightly more accelerated (but not excessive as is discussed in the next section under inflation) rate normalization policy which would additionally favor the Russell versus large cap high duration (rate sensitive) names.
Now we can move on to everyone in financial media's favorite word, inflation! Inflation poses its own difficulty in analysis because we can all agree that it is there but not what is actually causing it or what effects it may have on the bond market. Economists and analysts mostly like to rely on the classic explanation that inflation is simply a result of too much money chasing too few goods. While that can be true in some situations and it certainly meshes well with the argument of Covid-related unemployment benefits driving inflation, it is still a rather limited explanation. Then, we have the White House explaining inflation as being a result of such a great economy which is clearly self-serving but does have some merit in that rising prices are a result of companies maximizing profits. All that being said, the most likely cause of inflation and something that falls right in line with Occam's Razor would be energy prices. Occam's Razor is a philosophical principle for narrowing down competing explanations to the simplest one being the most preferred and probable. In this case, given how pervasive energy is throughout the economy and how it is such a critical input to produce goods and services and especially as an input throughout the supply chain, it's clear that the year-long rise in energy costs has been a key driver of inflation. Unfortunately, this is also a very destructive form of inflation in that it erodes consumer discretionary spending through higher gasoline prices. For example, using 2020 EIA gasoline consumption data, the year-over-year increase of $1.03 per gallon of AAA regular gas results in a loss of $127 billion (annualized) to higher gas prices. Given that total November online retail sales were $105 billion, we can see how destructive sustained elevated gas prices could be. Seeing how resilient oil prices have been in the face of modest production increases from OPEC+ and the effectively futile (see below chart of daily oil prices) release of oil from US reserves, inflation is set to remain elevated. Really, the only way out of higher energy prices is for there to be a change in our domestic energy production policies which is something that seems unlikely for now. Even the Fed will be faced with a problem here because rate hikes will not ease energy prices unless they hike to the point of killing economic activity but that would clearly go against their mandate. The critical point to keep in mind regarding inflation and investments is that even as inflation runs hot, we still may not see that show up in the treasury market since global quantitative easing by central banks has effectively neutralized bond markets. This is another negative for consumers since people are still paying higher prices but then can't even recoup some money back through better rates in various money market instruments. And, thanks to the relative value focus of global bond investors, until we see the German yield curve get well out of negative rates, the US yield curve will not move significantly higher, which ultimately provides support for US equities.
So, with some practical views on Covid and inflation in mind, we can look at market valuation and what else could be in store for 2022. Using current operating earnings estimates provided by S&P of $220, we see that the market is trading at 21.6x 2022 earnings and 25.2x trailing. Both levels are already expensive versus historical averages, and based on valuations alone, they present a yeoman's task for the market in 2022. With Congress in gridlock, a dovish leaning Fed, business activity metrics all in expansionary territory and unemployment claims having normalized, the economy is on stable ground. Sadly, inflation will continue to eat away at discretionary spending and be a headwind to earnings growth until we can get a change in energy policies which could happen in late 2022 if Republicans were to regain control of the house, as many political pundits are predicting. Unfortunately, this leaves the market little room for error to keep today's 25.2X multiple going forward while the possibility of stumbling along the way and having a low return year increases. To put a number on all of this and using a slightly conservative 24x multiple with existing earnings estimates gets us to S&P 5,280, a 10.7% return for the year. However, given what the market was able to do in 2021 and with the good fortune of some positive news, the bulls could end up just smashing through that wall of worry in 2022.
This article was written by
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