(3DL) It was a mostly merry Christmas in the stock market, with the S&P 500 up 4.48% on a total return basis for the month of December. That brought the 2021 return to up 28.71%, a figure that ought to have warmed the heart of even the grinchiest investor. Provided, of course, that the grinch was fully invested.
2021 provided many reasons to not be fully invested. Indeed, with the notable exception of equity market performance, it was in many ways a disappointing year. The pandemic is still with us. Who would have predicted a year ago that at the start of 2022 we would be worrying about hospital capacity and flight cancellations? The political situation is at least as divisive and dysfunctional as it was at the end of 2020. Inflation, merely clouds on the horizon a year ago, now looms as an approaching storm.
It is tempting to imagine that part of 2021’s healthy return was due to a bounce back from recession-driven poor performance in 2020. But performance in 2020 was strong. Indeed, the 18.40% that the S&P gained a year ago seemed at the time to be barely sustainable given macroeconomic conditions. Pessimists speculated that the market had gotten ahead of itself and that 2021 would be challenged because of it.
For the three years just ended (12/31/18 to 12/31/21) the S&P has almost exactly doubled, up 100.37%. Setting aside the question of whether or not that level of performance makes any sense, it must be admitted that these past three years constituted a golden period, what is likely to be a once in a generation opportunity. Those were the good old days and, as far as we know, these are the good old days still.
The last time the S&P doubled over three calendar years was back in 1997 – 1999, when it was up 103.45%. That was the tail end of an historic late 1990s run. The three years ended 1997 and 1998 were even better, up 128.95% and 114.91% respectively. Indeed, those who see the 2019 – 2021 doubling as an obvious bear signal should be reminded that after gaining 128.95% over three years ending 12/31/1997, the S&P then added 25.58% in 1998 and 21.04% in 1999.
Then again, 1999 was something of a last hurrah. The new millennium began with what would later be called a lost decade (12/31/1999 to 12/31/2009) over which the S&P retreated, giving up -9.10% in total.
Is January 2022 more like January 2000 or January 1998? Subjectively, the psychology of the market seems to be pointing in the direction of 2000. There is a sense of foreboding, especially when the topic of inflation arises. But we would be the first to admit that we remember the start of 1998 rather dimly. It is quite possible that there was a sense of foreboding then too. Perhaps the then recent strong market performance was broadly taken as a sign that the market had become overvalued. In the absence of specific recollections, we will assume so.
Equity investors must live with a cognitive tension. We assure ourselves that stocks are assets of fundamental value that justifies, more or less, the prices assigned by the marketplace. These are not crypto currencies or collectables. A share of stock is a partial ownership of a going concern, a claim on its future profits and the right to vote for the board of directors.
As reassuring as that argument may feel at any point in time, it becomes much less so when looking back, particularly after large market gains. If today’s valuations are reasonable, then were they off by 100% three years ago? Or were they about right back then and hopelessly too high now? Or neither?
We agree that stocks have a fundamental value in a way that Bitcoins or Pokémon cards never will. But objectively possessing real value is not the same thing as justifying a particular valuation. At best, it is a safety net, a soft floor that sets a valuation minimum. There is no maximum. Ultimately, the level of the equity markets is determined by the subjective opinions of millions of market participants, and those opinions can change, sometimes suddenly.
In the deepest recesses of our grinchy hearts we believe in the long-term appreciation of capital markets in general and the equity markets in particular. More than two centuries of history are enough to convince us. But we also appreciate the profound implications of the modifier “long-term.” We remember the lost decade and its two bear markets much more clearly than we do the halcyon days of the late 1990s.
We are hoping 2022 is less disappointing than 2021 was, but we know better than to assume that it will be. We remain fully invested in most of our strategies, for now, for no reason other than we think it is more likely that the market will go up than down in the near future. Put another way, although we know the good times must end, because they always have in the past, we do not think they have ended quite yet.
The Market Sentiment Framework
We use our Market Sentiment Framework to adapt the mechanics and weightings of our full quantitative models to changing market conditions.
The Sentiment Framework gauges the current state of market psychology on two dimensions. Efficiency measures the crowdedness of the market, the volume of participants seeking investment opportunities. Lower levels of efficiency imply more market mispricing. Optimism measures the willingness of investors to take on risk in exchange for distant anduncertain rewards. Higher levels of optimism imply a better outlook for risky asset classes.
Both the Optimism and Efficiency levels were nearly unchanged in December, and remained in a narrow range throughout the fourth quarter.
Optimism began the month at 0.02 and ended at -0.02. Although it decreased modestly during the second half of 2021, Optimism is well above its pandemic lows and not that far from its post-COVID high of 0.70 seen in mid-April.
Efficiency fell slightly, starting the month at -0.21 and ending at -0.41, essentially retracing its gain for November. Efficiency continues to be comparatively low as compared to historical averages, which suggests a market that is still under stress.
Both measures are higher than where they were in early 2020, but trended lower since spring 2021. The current positioning of the Sentiment Framework implies a market that is functioning less than ideally, with modestly optimistic but still fearful investors. This would imply a positive but challenged outlook for the market as a whole, but possibly an opening for value strategies to find opportunities.
