A TALE OF TWO MARKETS
U.S. stocks returned 25.7% in 2021. An exceptional year by any standard. U.S. stocks climbed the proverbial wall of worry. A new president. A resurgence in the virus and new mutations. A siege on the U.S. Capitol. Higher than expected inflation. Soaring energy prices. A global supply chain disruption. Labor shortages. Rising tensions in Russia and China. Rising interest rates.
Despite these concerns, stocks moved higher on the back of stronger than expected earnings. 2021 earnings grew a staggering 46% fueled by a vaccine-led economic reopening. Earnings growth was not only exceptionally strong, achieving one of the top five fastest growth rates in the past 40 years, it far outpaced market expectations. Heading into 2021, earnings growth was targeted to grow 21%. The actual earnings growth rate of 46% more than doubled the initial expectations. Yet another example of the difficulty and risk of relying on estimates and one year predictions for investment decisions.
U.S. stocks generated these strong returns with minimal volatility. During the year, the maximum intra year stock market decline was only 5.2%. This is the second smallest drawdown since 1995. In the past twenty years, stocks typically experience a double-digit drawdown during the year. Higher returns with historically low volatility attracted more investors and more dollars into the market further boosting the market. Strong returns were not limited to the favored growth sectors, like technology. All eleven sectors (technology, healthcare, energy, financials, etc.) posed double digit returns. This has not happened since 1995.
As of December 31, 2021, one, three, five and ten year annualized total U.S. stock market returns were 25.7%, 25.8%, 18.0% and 16.3%. How strong are these returns versus history? These are the highest returns over the respective time horizons in over 20 years and top five all-time. U.S. stocks are up nearly 115% since the pandemic bottom marking one of the fastest bull markets in the past 60 years.
Where do stocks go from here? Assuming earnings growth and low interest rates were the primary catalyst for stock returns, these tailwinds are expected to diminish. 2022 earnings growth estimates are pegged at an 8.3% growth rate. Not bad on the back of a nearly 50% growth rate in 2021, but certainly a slowdown. Stocks also benefitted from lower interest rates. The benefits were two-fold. Lowering borrowing costs was accretive to earnings, and investors seeing limited returns in fixed income were pushed to seek potentially higher returning alternatives, such as stocks. With the earnings and interest rate tailwinds blowing less strong, stock return expectations are reduced relative to the outsized returns U.S. stock investors enjoyed in 2021.
The bond story in 2021 was nearly the exact opposite of U.S. stocks. Bond returns, based on the Bloomberg U.S. Aggregate Bond Index, were -1.54% in 2021. This was the first negative year since 2013 and second worst annual return since 1994. The culprit was largely bad timing. Bonds returned 7.49% in 2020 benefitting from the Federal Reserve lowering rates to all-time lows and using their own funds to buy bonds. These positive catalysts started to reverse in 2021. With interest rates reaching all-time lows in 2020, the path of least resistance was to move higher, absent another pandemic induced flight to safety. As inflation exceeded expectations and economic growth exploded, investors started pricing in expected interest rate increases, driving up bond yields. Bond prices and bond yields move in opposite directions. Higher yields mean lower prices. Thus, bond prices were pressured resulting in negative bond returns in 2021.
INTEREST RATES ARE MOVING UP
In late 2021, the Federal Reserve acknowledged that inflation pressures were more than transitory and laid the groundwork for multiple interest rate increases in 2022. Higher interest rates are a welcome event. U.S. bonds have struggled to cover inflation, returning 2.90% annually over the past 10 years. Interest payments are the largest return source for bonds, higher rates mean larger interest payments. Good news for bond investors. Higher rates also signal that the Federal Reserve is ready for the economy to stand on its own feet. In 2020 and 2021, the Federal Reserve provide the largest economic stimulus in history through its interest rates policies, loan facilities and bond buying programs. An economy less dependent on central bank and government intervention should be healthier in the long term.
It remains to be seen how high the Federal Reserve will raise rates. There may be some pressure to slowly raise rates. With the U.S. Federal borrowing exceeding $28 trillion and deficits now the norm, a rapid interest rate increase could cause unintended consequences. Low interest rates pushed many investors into stocks searching for higher yielding opportunities. A dramatic rise in rates could push these marginal holders to return to bonds for income and more stability. Growth stocks, notably long duration stocks with limited current cash flow, could face headwinds as future cash flows are discounted at higher rates. Rising rates could also increase the risk of curtailing economic growth and swing the economy toward recession. Lowering rates is easy. Bond and stock investors both win. Raising rates is much harder.
IT MIGHT BE TIME TO EXPAND THE PLAYBOOK
Large cap U.S. growth stocks have enjoyed nearly 20% annualized returns over the past 10 years. These returns have more than doubled foreign developed stock returns and returned more than four times emerging market stock returns. Large cap growth stocks have returned 60% more than U.S. mid cap and U.S. small cap stocks and doubled U.S. value stocks over the past three years. Apple, Microsoft, Alphabet, Tesla, Facebook, Netflix, Amazon and Nvidia have certainly awarded investors, both those holding shares directly and those owning large cap index funds.
While the growth prospects for these companies are likely to remain strong, it is doubtful that all growth stocks will meet the high expectations implied in their stock prices. Fortunately, less loved sectors of the US stock market are attractively valued, and non-U.S. stocks, which are less weighted to technology, could
benefit from a sustained global economic expansion. These relative underperformers could surprise over the next few years. There was a time when U.S. growth
stocks were scorned and unloved too. Diversification can be frustrating at times, but it remains a tried and proven way to lower risk, preserve capital and capture
The information contained in this material is based on sources believed to be true and reliable; however, its accuracy is not guaranteed. This material should not be construed as a recommendation to buy or sell specific securities. Views are based on market conditions, economic data, and other information at the time of publication and are subject to change.