After Exuberant 2021, Investors Must Take Heart in 2022

Remember when we were kids, spending the day at Six Flags or some other amusement park, binging on roller coaster rides and any number of other thrilling adventures?

At the end of the day, we were disappointed that the fun was over and a little bummed that we were walking back into a calmer, more mundane reality. We were kids, so our post-park depression may not have been mollified by what was ahead, like summer camp, our family vacation, the scout trip, or some other big adventure.

That may be how a lot of investors are feeling today, as we watch the stock market move into what is shaping up to be a tumultuous 2022. Last year’s market was one of those wild rides that left everyone laughing and high fiving all the way to the turnstiles. The S&P 500 gained 29% on the year and posted 70 record closes while 88% of stocks in the index posted positive gains. Indeed, there was plenty to smile about.

In comparison, 2022 may seem more like that long walk back to the parking lot with our parents. We can feel the exuberance wearing off as we consider an economy beset by inflation and interest rates poised to go up. The S&P started January in a pretty good mood, hitting another all-time high before slumping into correction territory later in the month.

But let’s remember that parking lots are not the end of the world and going home is much better than spending the rest of your life in an amusement park. How long can the market keep powering higher at double digit rates, anyway? After all, the S&P was up more than 18% in 2020, despite the pandemic.

As we’ve seen in January, the market is not going to respond well when the Fed starts raising interest rates in March, but even with the expected increases, rates will still be low relative to historical norms.

Speaking of history, S&P 500 returns have been quite good in years following market gains of 25% or more. On average, second-year gains have been 14% with only three instances of negative returns. Corporate earnings are also expected to grow in 2022, with analysts predicting a 9% jump in profits.

While trying to predict returns over a one-year period is little better than a dart-throwing exercise, it would be safe to expect 2022 returns to be lower than they were in 2020 and 2021, so wise investors will control the things they can control. They will maintain portfolio diversification to reduce risk, rebalance portfolios in a disciplined way, contain costs to increase net returns, and harvest tax losses when appropriate.

This year may seem like the ride home from an amusement park, but remember, the next big adventure could be right around the corner.   

Reynolds: Inflation fears prompt new investment strategies

Inflation is not something we have had to talk about much over the past few decades. In fact, many of us weren’t even born the last time the Consumer Price Index, or CPI, peaked to levels that shook the economy.

Those who were around in the 1970s may remember watching staples like a loaf of bread double in price along with the average price of a new car. Gasoline led the inflationary charge, tripling in price from 36 cents to $1.19 per gallon.

Fortunately, the Federal Reserve Bank has used monetary measures to help keep inflationary pressure under control since the CPI hit 13.5% in 1980. But those days left a lasting impression.

Inflationary alarm bells began ringing louder this summer when the CPI rose to 5.4% in June, the highest it has been since the global financial crisis battered the economy in 2008. So, there is no wonder all eyes are on Fed Chairman Jerome Powell.

“Transitory” is the word Powell is using to describe the current run-up in consumer prices, but market watchers worry inflation could be more stubborn, prompting interest rate hikes, slowing the economy, and dragging down stock prices.

Inflationary pressures abound. A worker shortage and an abundance of cash in consumer bank accounts means there are a lot of dollars chasing a constrained inventory of products and service, leading to higher prices. The price of lumber is one well-known example, but prices are going up on everything from fast food to cars and trucks.

For an explanation, look no further than the size and scope of government stimulus. Between the Trump and Biden administrations, more than $5.3 trillion was allocated to shore up the economy during the pandemic. The fiscal response, combined with the Fed’s multitrillion-dollar monetary response in 2020, has led to the largest ever annual increase in money supply.

There is simply no historical guide to show us what inflation may do in response to such unprecedented government action. Chairman Powell could be right, and inflation may well fade as the economy reaches post-pandemic equilibrium. But investors are looking for ways to protect their money from a potential return to the 1970s.

Obviously, cash is out, and investors should also be cautious about fixed-rate bonds, which are particularly at risk in inflationary periods. For example, the 30-year U.S. Treasury bond currently yields about 2%. If inflation runs at 3% over the next 30 years, investors will lose about 1% a year in purchasing power.

For bond investors, there are alternatives. Inflation can lead to higher interest rates, so bonds with shorter maturities are better suited to take advantage of higher rates when maturities are reinvested. Perhaps the most straightforward way to protect a bond portfolio against inflation is to use Treasury Inflation-Protected Securities, which are bonds that receive an increase in principal value that is equal to the rate of inflation.

Stocks have a mixed record when it comes to inflation. On the downside, inflation usually forces interest rates higher, which can push earnings lower, leading to lower stock prices. On the other hand, companies can adjust prices in response to higher costs or higher demand, which is a built-in protection against inflation.

Remember that mild inflation is not necessarily a bad thing. The Fed would like to see inflation settle at 2%. The economy and markets seem to be comfortable with that, and historically, the market has delivered its highest real returns when the rate is between 2% and 3%.

Savvy investors ignore politics, keep focus on long term

If you like hyperbole, this is the election year for you. Strong feelings abound on both sides of the political spectrum, and heated passions have spilled into many facets of society that are usually benign to politics.

In our office, we talk about politics almost every day with clients concerned about who might be our next president. It does not really matter whether they are liberal or conservative. The fears are the same.

“If Donald Trump wins, I’m pulling out the market,” some say. Others say they’ll make for the sidelines if Joe Biden becomes president. But jumping off an emotional ledge just because of an election is a serious mistake.

Political tides ebb and flow, and presidential administrations come and go, but markets continue to gain value over the long term and reacting to an election cycle is not a winning investment strategy. Successful investors stay focused on long-term goals and resist making short-term decisions based on politics.

We can look back at history and assess how markets have performed under various leadership configurations, such as a Democrat in the White House and a Congress split between the two parties. Historians have documented trends, but those trends are not necessarily predictors of future performance.

For example, look at the current configuration. The Dow Jones Industrial Average has an abysmal record when there has been a Republican in the White House and a Congress split between the two parties, averaging 1.1% in the first two years after the election, according to Fidelity Market Research. That is the worst performance of all possible configurations.

Historians might have advised investors to jump ship when the Republicans lost the U.S. House of Representatives in 2018, leaving President Trump to work with a split Congress. But those who ignored history are glad they did. The Dow gained nearly 6,000 points before the bottom fell out in February. Even with the coronavirus selloff, the index is still ahead of where it was in January 2018.

History can be intriguing to study, but election outcomes and future market performance do not necessarily align, so it’s easy to see why experienced investors don’t react to political outcomes. Instead, investors focus on interest rates, corporate tax rates and earnings.

For example, today’s markets are largely driven by a low 21% corporate tax rate and historically low interest rates.

The outcome of a presidential election would not necessarily change either of those variables. A Democratic president might attempt to raise the corporate tax rate, but it is safe to assume a Republican majority in the Senate would thwart that attempt. Even if Democrats take the Senate majority, a corporate tax hike could face strong opposition from Republicans and even some Democrats.

As for interest rates, the Federal Reserve has demonstrated a strong commitment to keeping rates low for the foreseeable future, and it’s important to remember that the Fed functions independently from the president.

There are many arguments and counterarguments about public policy from Washington, but the fact is our government is well-balanced, and it has functioned effectively for 244 years. As divided as society seems to be right now, the historic fundamentals of our government remain the same.

So, it is important for investors to set politics aside and remember that elections have short-term effects. Meanwhile, they will be investing through many different presidencies and Congresses, and despite all of the hyperbole out there right now, the best investors follow a long-term path to their financial goals and avoid drastic moves based on an emotional response to the political season.

Zac Reynolds is chief investment officer at Oklahoma City-based Full Sail Capital, and he is one of the firm’s founding principals.