Commentary | 4Q 2021
2021 Q4 Market Recap
In the fourth quarter of 2021, the stock market, as represented by the S&P 500 Index, generated a return of 11.0%. For all of 2021, the market produced a return of 28.7%. 2021 was the third consecutive year in which the market produced returns well above the average of 11.5% achieved over the last 50 years. In 2020 and 2019 the market produced returns of 18.4% and 31.5% respectively. The broad market has generated a positive return in every year since 2009, except one, and the average annual return over that period was 16.0%, again well above the historical average.
The favorable returns of the last quarter and for the full year 2021 were experienced by the larger components of the overall markets as well. The S&P SmallCap Index returned 5.6% for the quarter and 26.8% for the year 2021. The S&P Growth Stock Index produced a return of 13.4% for the quarter and 32.0% for the year. During those same periods, S&P Value Stocks generated returns of 8.3% and 24.9%. All eleven economic sectors in the S&P 500 experienced double digit returns during the year. The sectors with the largest gains were Energy, Real Estate, Technology and Financials.
At the end of 2021, economic conditions were beginning to deteriorate. Inflation, as measured by the CPI (Consumer Price Index) was just below 7% at an annual rate. This was the highest rate experienced in almost 40 years, and it was well above expectations. Gasoline prices, which are a politically sensitive metric, rose 58% on average in 2021. Overall food prices rose faster than the CPI with beef, veal, poultry, dairy, and egg products rising the fastest of the food components of the Index.
Employment conditions remained mixed in the fourth quarter. Jobs were created but at a pace below expectations. In December payrolls grew by 199,000 versus expectations of a 422,000 increase. Unemployment fell to 3.9% by the end of the year, while the labor force participation rate remained well below the level experienced just prior to the beginning of the pandemic. If the participation rate rose to the earlier level, the unemployment rate would be higher. Real wages have been declining as inflation has increased. Despite the decline in real wages, consumer confidence began to rise in the fourth quarter of the last year, but it remained below the levels it achieved just prior to the onset of the COVID-19 pandemic.
The Price Earnings Ratio for the S&P 500 Index was close to 30 times trailing twelve months earnings at the end of the fourth quarter. This level is about twice the historical average. The market’s ability to support this high valuation reflects a generally optimistic outlook on the part of market participants. Corporate profits rose an estimated 12% to 13% in 2021, and they are expected to rise another 5% to 10% in 2022. Real economic growth in 2021 is estimated to have been 5% to 6%, and the consensus expectation is for 3% to 4% real growth in 2022.
Market Commentary & Outlook
For these expectations to be realized the economy must negotiate some significant challenges. Specifically, the Fed has stated it will begin to try to reduce the rate of inflation which has risen substantially throughout 2021. At the same time, policy responses to the Covid-19 pandemic continue to interrupt economic growth. In addition to these challenges, there are others of lesser significance. At the end of 2021 there was some indication market participants were beginning to focus on these issues. While the ratio of the number of stocks advancing versus those declining was falling by the end of the fourth quarter, indicating a slowing of the overall advance in stock prices, the VIX, a measure of the expectation for near-term market volatility, remained at the lower end of its range for the year.
The Fed announced plans to raise short-term interest rates as it begins its effort to reduce inflation in 2022. In the past 75 years when the Fed has tried to reduce inflation it has almost always brought about a recession. This unfortunate result reflects the Fed’s focus on interest rates as a policy tool rather than the quantity of money, and its outdated understanding of the relationship between job creation and inflation. The source of the current increase in inflation is an increase in the rate of growth of the money supply. The money supply has risen rapidly since the market dislocation of 2008 and 2009. The Fed has added more than $5 trillion to the Monetary Base (high powered money) as it provided support to financial markets during the earlier period and more recently as part of its effort to prop up the overall economy as policy responses to the pandemic threatened economic stability.
Currently, as it has in the past, the Fed is acting on the belief that increasing economic growth is the primary cause of inflation. This belief is made explicit in the Phillips Curve model which posits an inverse relation between unemployment and inflation. The Fed has embraced this model while it is inconsistent with the data. During the 1970’s, real growth declined, unemployment increased, and inflation increased. During the 1980’s real growth increased, unemployment declined, while inflation decreased. In the years since the 1980’s, there is no credible evidence real growth drives inflation.
Those who embrace the Phillips Curve model believe it is necessary to slow economic growth to reduce the rate of inflation; nothing could be further from the truth. An increase in the amount of goods and services during a regime of stable monetary policy will lower inflation and not raise it, all other things being equal.
Raising interest rates is not a reliable method for reducing the rate of growth of the money supply. During the great Depression of the 1930’s, interest rates were near zero, but the money supply declined; the rate of growth of the money supply was negative. In the recent past, interest rates were near zero and the money supply increased rapidly. The impact of manipulating interest rates on the money supply is indeterminate. If the Fed wants to control inflation, it should focus on controlling the rate of growth of the money supply.
The increase in the Monetary Base was driven by the Fed’s purchase of assets in the open market. The Fed has been buying assets at the rate of about $120 billion per month recently. This activity first helped to stabilize markets in the 2008/2009 period and then aided the Treasury’s effort to run large budget deficits in the past two years. The Congressional Budget Office (CBO) now projects the Federal budget deficit will be approximately $3 trillion in 2021 and average $1.2 trillion per year for the next ten years. If the Fed steps down as a primary purchaser of Treasury debt, credit markets will become congested. Both long-term and short-term interest rates are likely to rise. While the Fed has no obliga
tion to buy Treasury securities, pressure to finance the deficits will originate in the ranks of elected officials. In 2022, the Fed will be forced to navigate between the demands of the Treasury and the effort to reduce inflation. The outlook for real growth, inflation, and corporate profits is troubling.