Paulsen's Perspective

The S&P 500 has yet to fall 10% from its recent record high, but it sure feels like such a drop is nearing. If it does suffer an “official correction” (a 10% to 20% decline), it would be a relatively rare event considering the contemporary pessimistic and cautious mindset of consumers.
 

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Most everyone expects bond yields to spike higher this year. So do we! Our best guess, aligning with the consensus, is the 10-year U.S. Treasury bond yield will reach 2.25% to 2.50% by the end of 2022. Nevertheless, it’s not likely to be a straight line up. Instead, bond yields seem poised to experience a year of “spurts & stalls.”

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In recent decades, U.S. companies have dramatically improved the profitability of labor. The implications for the valuation of equities have gone virtually unnoticed! An unprecedented surge in business-investment spending in relation to the overall economy—primarily driven by new-era technologies introduced since the early 1990s—shows evidence of substantially and, perhaps permanently, lifting the stock market-valuation range. If this proves correct, investors will eventually have to “Get Used To Higher Valuations.”

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As bond yields climb to their highest level of the recovery, we are all getting a glimpse of our portfolio future. 

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As the new year begins, the Federal Reserve has taken center stage. Fears swirl around “when,” “how fast,” and “how much” the Fed may raise interest rates in 2022.

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As shown in the accompanying chart, since the very start of this pandemic, every significant change in the U.S. COVID-case count has “moved” bond yields in an inverse fashion. That is, until the last couple of weeks?

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During the last year, real GDP growth was among the strongest of the post-war era, job creation was spectacular, wages rose by one of the fastest clips in almost 40 years, and annual retail sales grew by an astounding 18%. On top of that, housing activity was on fire, core capital-goods orders rose to a record high for the first time in more than 20 years, and corporate profits were unprecedented.

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As the Omicron variant ravages the country, we begin the New Year with a resigned realization that COVID is likely a part of our lives forever. We are vaxxed, masked, tested, distanced, and saddened by our shocking loss of loved ones! We are resolved to finally move beyond and pursue a new post-COVID normal, practice appropriate ongoing caution, and expect additional hardships. But we are also determined to return to our routines and again embrace aspirations, interactions, and the business of fulfilling lives. Although COVID will still be with us this year, Americans are poised for the pandemic to become endemic!

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This year, the U.S. dollar played a significant role in the financial markets (Paulsen’s Perspective, December 10, 2021), and its movement in 2022 will likely prove equally important.

Forecasting the dollar is extremely difficult, and many would say it is a fool’s game. My personal experience predicting the greenback has not been particularly good, but a “fool” is rarely discouraged from trying again. Traditionally, U.S.-dollar outlooks are based on relative economic-growth rates (i.e., expected real U.S.-GDP growth compared to overseas), anticipated inflation rates, a comparison of relative monetary policies, and excess long-term yield spreads.

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Since September, the stock market has been periodically battered by renewed pandemic fears (Delta and now Omicron), increasing anxieties about pending Federal Reserve tightening, selloffs among popular new-era stocks, and ongoing concerns about high valuations and inflation. This has taken a toll on investor sentiment, as highlighted by several survey measures and market indexes.

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As the Federal Reserve turns more hawkish and expectations for higher interest rates mount, investors are lowering exposure to growth stocks. Typically, growth stocks exhibit a higher duration than value stocks because a larger proportion of their cash flows won’t be received until the distant future. Consequently, like longer-term bonds, growth stocks are generally expected to struggle when yields rise.

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The stock market has been stressful of late. First, the S&P 500 had a rough autumn, declining by more than 5% from September to early October; after a brief recovery, stocks hit another sudden air pocket in late November. Both times, the VIX™ Volatility Index spiked above 20, and broader-market stocks suffered even steeper declines (e.g., small caps, cyclical stocks, and international investments).

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To maintain sanity and protect fragile psyches, investment managers share a code. If results are good, it’s due to extraordinary foresight and skill. Whereas bad years are simply the product of unpredictable “bad luck.” In 2021, however, whether thanks or blame is deserved, “King Dollar” drove investment returns—as the following chart pictorial demonstrates.

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As shown in Chart 1, the relative one-year-forward Price/Earnings (P/E) multiple of the S&P 600 Small Cap index is near the lowest level ever recorded since it was first introduced in October 1994. It is now as low as it was at the height of the dot-com mania when everything outside of tech stocks underperformed.

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With all the crosscurrents weighing on the economy and financial markets, it is easy to get lost in the weeds attempting to figure out what the stock market may do in the coming year. Will Omicron force another economic shutdown, bringing a serious market decline? Will inflation prove the Fed is correct in retiring its “transitory” tag, forcing monetary officials to speed up tapering and perhaps raise rates sooner than expected? Will high valuations finally catch up with Tech stocks?

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Headline inflation reports, including the Consumer Price Index and wages, continue to run disturbingly hot! As a result, investors worry that ongoing inflation pressures will eventually contract equity valuations, push bond yields higher, and force the Federal Reserve to act much sooner and more aggressively than planned.

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Even though cyclical stocks’ excess return has been somewhat modest in 2021, they have done well overall since the start of this bull market. Moreover, while the economy is poised to slow next year, real-GDP growth should post another healthy gain near 4% to 4.5%—helping to keep cyclical stocks in a leadership position. Thus, owning a wide variety of cyclical stocks again during 2022 probably makes sense. Still, there are a couple of reasons investors should consider tilting those cyclical bets toward consumer cyclicals rather than industrial cyclicals.

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Why do we own bonds? I understand the nostalgia. After all, bonds have been part of portfolios ever since, well, there have been portfolios. They have always represented the consummate balancing asset; bonds make those risky stocks tolerable and allow a restful night’s sleep. But, just like Linus and his blankie, it’s tough to let go of such a comforting friend.

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The U.S. labor market holds the key to the duration of the economic expansion and its corollary bull market. In October, the U.S. unemployment rate declined to 4.6%—which is lower than 75% of the time since 1948. Although there’s still room for further improvement, historically, when the unemployment rate fell below 4%, economic conditions often became difficult.

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Just cleaning out the “thought box” today…

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