MARKET SUMMARY: Even the alarming arrival of the Omicron variant failed to curb the stock market’s advance during the fourth quarter. S&P 500 stocks advanced 11.0% in the quarter, padding their gain for 2021 to a stout 28.7%. As has become the norm, though, the index return masks the true dynamic of the market. Goldman Sachs points out that Apple, Microsoft, Nvidia, Tesla, and Google were responsible for 32.6% of the market’s return. The quintet comprises 21% of the entire 500-stock index and delivered a staggering 66% return for the year. Beyond those names, outperformance was clustered in similar “high beta” (i.e., riskier) names. Safer securities in the high dividend and low volatility space were rewarded with generous returns of 26.0% and 24.4% respectively. Lagging the bunch were diversified stock funds, which according to the Wall Street Journal posted a return of 22.5%. Our conservative strategy had a tremendous year, with a total return just behind the S&P 500 index.
The 10-Year Treasury bond began the quarter yielding 1.44% and ended barely changed at 1.51% – exceedingly curious given the November inflation print of 6.8%. It was still an active quarter for bonds, though, as yields at the shorter end of the curve edged higher due to the signal of future Federal Reserve rate hikes. The Barclays Government/Credit index managed a slight gain of 0.2% for the quarter, barely tempering a difficult year for bonds. The final tally for the index was a loss of 1.8% in 2021.
ECONOMIC FORECAST: 2021 was a remarkable year for U.S. economic growth. GDP surged an estimated 5.2%, buoyed by resilient consumers and business investment. It was the highest growth since the post-war boom of the late 1940s and was achieved in the face of a severely constrained supply chain. Workers returned to the labor force in record numbers, with the unemployment rate settling at 3.9%, close to the 3.5% pre-pandemic rate. Wages surged over 4% and consumer balance sheets remain healthy with low debt loads and an estimated $2.2 trillion in excess savings.
Estimates are for 4% economic growth in 2022, close to double the rate of the post-Financial Crisis recovery. We believe this could be conservative given the strength coming out of last year. The latest ISM Manufacturing report showed easing transportation conditions, a major growth constraint of last year. International trade, particularly exports from the U.S., should be a renewed source of growth as the COVID crisis continues to fade. Inflation pressures, which surged to 30-year highs in 2021, will likely moderate in the coming year. Yet higher oil and home prices could keep inflation elevated above the Fed’s comfort level, setting the stage for a policy mistake. We see this as a low probability event and expect 2022 to be a solid year for economic growth and a constructive environment for risk assets.
FIXED INCOME STRATEGY: We anticipate that interest rates will drift up over the course of the year, although not in a dramatic fashion. Inflation is of course the bane of bond investors and will remain a concern, but it is worth noting that the major inflationary forces are focused in the durable goods areas rather than non-durable areas such as services. Durable goods prices are heavily impacted by supply chain issues which we believe are beginning to unwind. In addition, there remains an ocean of liquidity from both domestic and international sources to support bond prices, even with the tentative tightening steps that the Fed will take in 2022. We plan to continue our defensive posture by maintaining a relatively short duration position augmented by an overweight of high-quality corporate bonds.
EQUITY STRATEGY: While it is unlikely that equity market returns match those of last year, we anticipate solid performance in the coming year. As you know from past writings, FANG and other high-growth stocks (FANG+) have been the dominant driver of index performance in recent years. Valuations are now quite stretched, and we believe we are close to the limits of investor irrationality for these shares. Gains this year are likely to be concentrated in more value-oriented shares, an investing approach squarely within our relative value investing style.
Our equity selections consist mainly of higher quality shares with reasonable valuations relative to their growth potential (measured by the PEG ratio). History shows this investing approach wins out over the long run. The portfolio statistics in the chart below illustrate our positioning relative to the S&P 500. A higher yield provides additional income, a commodity in short supply with the current low bond yields. Our P/E ratios are much lower than the index, a result of limiting exposure to high-flying FANG+ valuations. While we concede a small amount of earnings growth (18.9% vs. 19.6%) by underweighting these names, we gain a greater margin of safety in valuation. A lower price/book ratio, the most common valuation measure in value investing, further bolsters our positioning. Lastly, the earnings strength numbers verify we have not fallen to the common prey of the “value trap”; our selections are time-proven, consistent earners.
We remain broadly diversified across industry sectors while increasing the weighting of those sectors likely to outperform over the coming year. We recently increased exposure to the financial sector. Strong bank balance sheets, increased consumer loan demand and increasing interest rates are all tailwinds for these shares. We continue to overweight healthcare shares which have long-term growth potential given US demographics. Lastly, we are underweight in technology as valuations have gotten stretched over the past year. Collectively our position is more defensive than the overall market. We believe this to be the appropriate posture given current valuations and the gradual slowing of the business cycle.
ASSET ALLOCATION: The vast majority of a balanced portfolio’s return and risk come not from security selection, but from the asset allocation decision. This was particularly evident in 2021, as our equity and fixed income component returns hovered near their benchmarks yet overall portfolio total returns handily outperformed. Conditions are bullish for stocks and bearish for bonds in 2022, so proper asset allocation will again be critical. Thankfully, we enter the year with the same backdrop that we have faced since the end of the Financial Crisis – an equity risk premium (the excess return expected from stocks over bonds) that continues to hover near two standard deviations above the historical norm, once again favoring stocks. The model has proven itself over the 2010-2021 period, indicating the proper asset allocation in nine of the twelve years. It has paid handsomely, as stocks delivered a 15.0% annualized total return versus 4.4% for bonds.
As always, we test the long-term thesis from our quantitative asset allocation model versus our economic forecast, as the stock market’s short-term path is highly dependent on the economy. While we do not expect 2022 economic growth to top the 2021 boom, conditions are still extremely supportive for the coming year. Indications are that Omicron is less severe than its predecessors and offers protection from legacy strains, perhaps moving us closer to herd immunity. Even if this proves too rosy, governments and the populace have grown accustomed to living with COVID, and the prospects for a return to draconian lockdowns is slight. With so much liquidity in the system and consumer balance sheets flush with trillions in cash, the setting is therefore ripe for continued consumption – and at a voracious pace.
Although the economic setting is quite favorable, stocks do appear a bit expensive on their own – particularly for fan favorites such as Tesla and Nvidia. However, as our equity risk premium model shows, without question, they are significantly undervalued versus the puny yields offered by bonds. In fact, interest rates would have to increase almost 1% for the return spread to return to within two standard deviations higher than the historical average. Bottom line, conditions are still comfortably within high confidence bounds for maintaining an overweight equity position in balanced portfolios.