2021
In Review
We are dealing with completely unchartered waters. No one… And I mean no one who is alive today has ever managed money through a worldwide pandemic. 2022 is set up to be a successful year, but it wouldn’t surprise me to see it be a bit more bumpy along the way.
We experienced supply chain disruptions, which weren’t helped when a massive cargo ship turned sideways and completely blocked the Suez Canal for six days.
We experienced the “great resignation,” seeing a record number of U.S. workers quitting their jobs, to either seek better employment or retire early. We’ve seen inflation rise to levels not seen since the early 1980s, fueled by higher wages demanded by those still willing to work and higher commodity prices due to our supply chain disruptions. We saw a full rollout of three different vaccinations, which were brought to market in record time. We saw a summer surge of new cases of COVID, as Americans traveled in numbers not seen since the pandemic began.
The year ended with the emergence of the omicron variant, sending the daily new cases of COVID to record levels. One would think with all these challenges the broad-based markets would have experienced a more challenging year. Instead, the S&P 500 climbed 26.89% for the year and only experienced one 5% pullback during the year (in September).
2021 also saw major leadership changes during the year. “Value” investments lead the charge for the first four and a half months of the year, outperforming their growth counterparts by more than 10% through early May. Then value-oriented investments stalled out and barely showed additional performance throughout the rest of the year (see red line in the graph provided). Growth stocks caught up to value stocks in the third quarter and surpassed them for the year as you can see from the graph provided (value stocks are in black, growth stocks are in purple). Large-cap growth companies finished the year up 31.24% versus large-cap value companies which finished the year up 23.46%
The bond market didn’t help investors seeking to lower the risk in their portfolios. Long-term treasuries lost more than 4% and the Bloomberg Barclay’s Aggregate Bond Index cost investors more than 1 %, its third-worst performance since 1976 (see charts below).
Investment-grade corporate bonds declined 1.0%, while TIPS and high-yield bonds showed solid performance, up 6.0% and 5.3% respectively. Last year was particularly kind to most international bond indexes, with the only shining light being China Aggregate Bond Index which was up 5.7%.
The U.S. stock market saw a similar reshuffling of leadership. The worst three sectors in 2020, all with negative performance, were the top three performing sectors during 2021. Energy was up 54.6% in 2021, toping all other sectors. Energy was down 33.7% in 2020. Real Estate (up 42.5% in 2021, down 2.2% in 2020) and Financials (up 35% in 2021, down 1.7% in 2020) rounded off the top three sectors. While these sectors provided strong performance, they only represent 16% of the S&P 500’s weighting (Energy 2.7% weighting, Real Estate 2.8% weighting, and Financials 10.7% weighting). Energy’s 54.6% return, for example, only contributed 1.09% to the S&P 500’s 26.89% weighted price return.
Although valuations remain at lofty levels, we saw a slight improvement in stock valuations during the year, as earnings growth outpaced price appreciation.
Growth companies continue to trade at historically high levels. Large-cap and mid-cap growth earnings didn’t
outpace their price growth, making them even more expensive today than they were a year ago.
The United States economy has rebounded strongly since the reopening of our economy. As you can see from the graph below, our economy is larger now than prior to the worldwide pandemic.
Inflation is front and center as an area of concern for the Federal Reserve, who began tapering their bond purchase program in November and is expected to cease all bond purchases in the spring of 2022. The Federal Reserve dropped the term “transitory,” as the U.S. Consumer Price Index rose from 1.4% at the beginning of the year up to a 6.8% annual rate.
Surprisingly, we haven’t seen a strong reaction to inflation in the markets. Gold, which some investors believe is a strong hedge against inflation lost value in 2021. Gold prices have crept up from their March lows. While we don’t believe that gold is a great investment or a great inflation hedge, we will be monitoring gold’s technical movements to identify opportunities.
2022 Outlook
We start 2022 with strong momentum, with the stock market having a strong 4th quarter. While Polaris Wealth is not in the habit of predicting future market performance, knowing it is a futile proposition for those in Wall Street who are trying to make a name for themselves. Instead, we will say that we are bullish about 2022. We will show you what we like going into the year and show you what we are monitoring as concern points. I will conclude with some direct advice about ways that you can improve upon your overall portfolio’s long-term performance.
What We Like:
We experienced record earnings during the first three quarters of 2021. Earnings season will begin during the third week of January, providing us fourth-quarter results. We expect strong earnings and future expectations for 2022 and 2023 earnings look even stronger.
We expect valuations figures to improve as a result of this expected earnings growth.
We don’t have to have a market correction to see improved valuations. As you can see from the illustration provided, earnings growth outpaced price return.
There are high expectations for the S&P 500 companies in 2022. If these companies produce strong earnings, the market can continue to rise and provide strong results while valuations continue to improve, which is what we expect in this upcoming year.
We have written at great length about the impact that the economy has on the stock market. Here’s a quick summary. A good economy doesn’t guarantee a good stock market. The market can correct due to being overvalued (think back to the dot-com bubble bursting) and it can correct because the sentiment of the markets shifts (think about the 2018 correction). The opposite can’t be said. If the economy is contracting due to a recession, the average company will not fare well. It is imperative to understand what is going on economically and have this information as quickly as possible.
This is why we track the Index of Leading Economic Indicators (LEI) and the Chicago Fed National Activity Index. Both are monthly data points. As you can see from the graph below, the LEI has provided warning signs of recessions to come. Typically, these signals provide us warning several months in advance, as you can see from the arrows in the graph.
The Chicago Fed National Activity Index is another economic indicator that Polaris Wealth monitors to understand how the U.S. economy is performing. They take 85 monthly economic indicators to supply us with the graphs provided. The top graph (in blue) shows the growth of the overall economy.
The bottom graph (in red) provides the monthly direction. When the red line crosses above the top dashed green line it indicates inflation. When the red line crosses below the lower dashed green line it indicates economic contraction. As you can see, this indicator has provided excellent transparency to where we stand economically. This indicator helped provide Polaris Wealth with the insight to get very defensive during the Great Recession of 2008.
Both of our tried and true economic indicators are pointing towards continued economic expansion and show no signs of a pending recession.
We’ve seen unemployment rates continue to fall, coming down to levels close to where they were before the pandemic caused our economic shutdown.
We’ve also seen wages increase at levels not seen since the early 1980s. While a 5.9% wage increase is well above the 50-year average of 4.0%, it is almost a full percentage point below inflation.
Investors with Polaris Wealth know that the great majority of the way we invest our strategies is in dividend-paying stocks. Historically, dividend-paying companies provide a muchhigher overall return to their
investors than their growth peers, while taking less risk.
As you can see from the graph provided, companies that pay a dividend, or better yet, are increasing their dividend, do better than the S&P 500 and non-dividend paying companies (also known as growth companies).
We think dividend-paying companies are well-positioned to prosper in 2022.
While the broad-based markets appear to be overvalued, dividend-paying stocks are very cheap as compared to growth companies on a relative basis.
As you can see from the graph, value oriented companies haven’t traded this cheaply in comparison to growth since the late 1990s.
Historically, value has outperformed growth approximately 60% of the time. Growth has been in favor for the past five years. It is only a matter of time before we see value companies take the reins and lead the markets higher.
Concern Points:
The markets have been very resilient in the face of significant adversity. The concern points that I will bring up are just that… concern points. They don’t mean that they will create a bear market. They are things that we will be monitoring to remain vigilant in how we position our portfolios.
COVID
The markets never like uncertainty. The latest COVID variant, omicron, has lifted daily new cases to levels we have not seen since the pandemic began. As you can see from the graph provided, the daily new cases in the United States are more than double the worst levels we saw in December of 2020 and January of 2021.
Almost twenty percent of our population has tested positive for COVID, with over 18 million active cases as I write this article. This is obviously very concerning because it could lead to further economic disruptions if it is not brought under control.
While medical professionals are saying that the omicron variant is more contagious but less deadly, it is very concerning to see our hospitalization rates nearing the all-time highs we experienced a year ago.
Each time we’ve seen a spike in hospitalization rates, we’ve seen a rise in death rates. This is due, in part, to our hospital system being overwhelmed by the number of patients in their care. Let’s keep our fingers crossed that the medical experts are correct and that we don’t see a rise in our death rate.
Supply Chain Disruption
The ongoing supply chain issues that we are having in this country and what we are seeing abroad continue to cause concern for investors, as the world tries to resume “life as we knew it” in the face of our continuing worldwide pandemic. This has led to the delay in getting some goods, a shortage of some products, and an increased cost of goods. This has led to inflation at levels that we haven’t seen in over forty years.
One of the causes of our supply chain disruption is the significant drop in the number of Americans working today. Called the “Great Resignation,” we have seen approximately 4.5 million workers resign from their job. It is estimated that seventy percent of those that quit won’t be returning to a job, they will be retiring early. As you can see from the graph provided, the percentage of workers is approximately two percentage points below where we were prior to the pandemic. This is millions of works who will not be filling essential jobs.
Top 10 Stock Concentration & Valuation
The S&P 500’s price movement continues to be disproportionately dominated by the 10 largest companies in the index, hovering at levels not seen in 40 years. Indexes are supposed to be “barometers,” providing us an understanding of the over health of all stocks. If the top 10 stocks in an index represent almost one-third of how the index moves in price, how is it a good representation of the other 490 companies being tracked? It isn’t. As these 10 stocks perform, so will the rest of the index.
This becomes especially troubling when the top 10 companies in the S&P 500 are trading 168% higher than their historical valuations. Does this mean that the S&P 500 is due for a correction? No.
Fed Action
The Federal Reserve Bank (FED) has been very transparent about their plans to cut stimulus and start addressing inflation. The Fed was a major backstop to the financial markets when COVID hit, and our economy shut down. The Fed had been committed to buying $120 billion in treasuries and mortgages. Why would the Fed do this? As a way of trying to control interest rates.
As you can see from the illustration provided, there is an inverted relationship between interest rates and price. The increased demand caused by the Fed buying bonds forced prices up and interest rates down. The Fed announced in November that they were going to cut back the amount of bonds they were buying each month by $15 billion. They doubled the cut back in December and announced that they would cease all bond purchases by the spring. This action will cause interest rates to rise
The Fed is also projected to make three to four hikes in Fed Fund rates during 2022.
This will also have a direct impact on interest rates. There is virtually no probability that the Fed will leave rates
alone, as seen in the illustration provided.
We’ve discussed the impact of rising interest on the bond market in several past articles but given that we have seen the 10-year treasury yield go from 1.51% on December 31, 2021 to 1.76% on January 7, 2022, we think it is worth reiterating the risk we see in the bond market. This quick move in intermediate interest rates was a direct result of the Fed’s tapering process.
Further cutting and the elimination of this bond purchasing program will put more stress on bond prices. Adding three or four rate hikes on top of the tapering will havea material impact on the bond market. We’ve provided a chart so you can see the impact that a 1% rise in interest rates has on different types of bonds. There aren’t many bright spots.
In addition, the current
yields provided by the bond
market aren’t higher than core
inflation rates. As you can see
from the graph provided, the
10-year treasury was providing
investors a 1.51% yield at the
end of 2021.
The issue is core inflation was 4.96%, meaning an investor was losing 3.45% per year by having this investment in their portfolio.
Conclusion
I have worked in the financial industry for 30 years, with 27 of those years directly working with individual investors. This has been a blessing and a curse. I love the impact that we’ve had on so many people’s financial lives. I have helped so many people get into retirement successfully and enjoy a prosperous and fulfilling retirement. In many cases, we’ve grown old together. But I’ve also seen, time and time again, individual investors financially harm themselves by allowing their fear to get the best of themselves. I’ve seen it happen far too often in the past few years. An investor reads an article or sees a TV program (or worse yet, it’s a gut feeling) and allows that information to influence them to make the irrational decision to “go to cash.”
The average investor, trying to manage their own portfolio, does a horrible job managing their own money. As you can see from the Dalbar study provided, the average investor has a meager 2.9% average annualized return over the past 20 years. This is slightly better than inflation and a fraction of the stock market or a balanced portfolio. There are many reasons why investors perform so poorly. They might not have the time to manage their money on their own, they may not have the formal training or knowledge, or perhaps it’s just not an area of interest of theirs and they don’t want to spend the time to learn. The biggest reason that I have seen some investors succeed where others fail is due to their emotions. Most investors who invest on their own buy when they feel comfortable and sell when they don’t feel comfortable. This leads to buying high and selling low, a receipt for disaster.
Many investors turn to professionals to help them improve their portfolio performance. What I always find amazing is when these investors then call us and ask us to “take them to cash” because they are fearful about what is going to happen in the market. Why have you hired a professional investment firm, who spends countless hours researching the markets, who spends significant money on unbiased research, and who has a track record of navigating difficult markets, if you are going to make extreme decisions and remove their discretion on how to best manage your investments? It makes no sense to me. We are dealing with completely
unchartered waters.
No one… And I mean no one who is alive today has ever managed money through a worldwide pandemic. 2021 was a reasonably calm year, with only one 5% correction during the year. 2022 is set up to be a successful year, but it wouldn’t surprise me to see it be a bit more bumpy along the way. Please don’t self-sabotage yourself by making rash decisions. We are better equipped to make these tough decisions for you and have a track record of making very wise decisions for our clients. Polaris Wealth is a tactical manager. We will get defensive with your portfolio if or when our clinical research deems it appropriate.
We would encourage you to meet with your financial adviser at Polaris Wealth to discuss your current asset allocation. Depending on your risk tolerance (and stomach) we would encourage you to lower your bond exposure or even temporarily eliminate it given the current inflationary environment we are currently in starting the year. Bonds will most likely show a negative return in 2022. It’s hard to imagine them being able to fight off tapering and the upcoming Fed action. And the best way to combat inflation is to grow your portfolio. Work with your financial advisor and reconsider your overall exposure to stocks versus bonds. Look at how much of your portfolio is positioned in growth stocks versus value stocks.
We would also encourage you to limit your cash exposure. I hear from clients all the time that they are keeping cash on hand to invest when the markets pull back. Please ask yourself this question, what did you do the last time the market pulled back? Did you invest that cash or were you too nervous to invest it? Most investors freeze when put to the test. Sitting on significant cash can materially impact your financial future. You are guaranteeing yourself the loss of future buying power. Cash is earning you nothing and CPI inflation is at 6.8%. Are you willing to lose almost 7% of your buying power over the next year, or should you invest that money and try to offset inflation?
