(Michael Corty, Morningstar Investment Management) The S&P 500 generated an impressive total return for the year, continuing the strong rally that occurred over the last nine months of 2020. Paraphrasing an old Wall St. saying that applied during 2021: the stock market tends to climb a wall of worry. Financial headlines over the course of the year focused on concerns such as inflation, disruption to supply chains, and government debt-ceiling limits. As the year ended, the latest “worry” was the omicron variant of COVID-19, which seemed likely to become a headwind for near-term global economic growth.
The future level of inflation remains an unknown, as it’s a widely debated topic among economists and one of the more challenging economic variables to forecast. The consumer-price index (CPI), which measures what consumers pay for goods and services, increased 6.8% year over year in November. This year-over-year CPI increase was the highest since 1982. In response to higher levels of reported inflation, the Federal Reserve started to telegraph plans to wind down its bond-buying stimulus program earlier in 2022 than previously anticipated. The Federal Reserve is also projected to make at least three 25–basis-point increases to the Fed Funds rate in 2022. Fed Chairman Jerome Powell appears to recognize it’s more than just the pandemic-driven supply-chain bottlenecks driving the current upswing in inflation. A modest level of inflation is generally viewed as beneficial for a growing economy. However, inflation that remains too high for an extended period can be unhealthy, as it reduces demand.
Some pockets of speculative fervor we’d highlighted in recent Focus on Equities letters—such as special purpose acquisition companies, meme stocks, and high-growth stocks with large operating losses—started to experience price declines during the second half of 2021. Perhaps the prices are starting to reflect a more sober and realistic assessment of future cash flows—time will tell. The reason we referenced these speculative examples in prior letters is that they tend to grab investor attention and serve as the antithesis of our valuation-driven approach to managing the Select Equity Portfolios.
Market Forecast for 2022
So now we’ll reveal our 2022 total return forecast for the S&P 500: we do not know! This answer is consistent with our past annual “predictions” and our view that we don’t forecast other macroeconomic variables. In our view, the near-term economic outlook is always uncertain, with a mix of various headlines that can be cherry-picked to make a positive or negative case for the near-term direction of the overall stock market. Economic surprises, unexpected changes in corporate earnings, and unforeseen geopolitical shifts can wreak havoc on short-term predictions. This is one of the reasons we like to think in terms of a range of outcomes rather than point estimates.
The price/earnings ratio for the S&P 500 is elevated versus history, which is due in part to the current low level of interest rates. At year-end, the benchmark 10-year U.S. Treasury yielded roughly 1.5%, which remains very low versus historical levels. Our portfolio management team has enough experience to realize that it’s hard to predict the direction of interest rates. With that said, in terms of a range of outcomes, we see more upside risk to interest rates, so investors should consider that possibility. While aggregate U.S. market valuations appear elevated versus history, we maintain a favorable view of our Select Equity Portfolios. We build focused portfolios with our highest conviction ideas and don’t have to buy the entire market, especially the frothier stocks.
The Select Equity team is aware of the current inflationary environment from our general reading, personal experience, and tracking management commentary on earnings calls from companies we monitor or own in the portfolios. Overall, we don’t consider our portfolios too heavily weighted for any one specific outcome regarding inflation or any other macroeconomic scenario. As long-term investors, we aim to build portfolios that perform well in multiple scenarios. Over the long term, we believe owning a portfolio of undervalued, high-quality stocks is a good option for maintaining future spending power ahead of inflation.
We believe it’s important for our clients to maintain reasonable expectations from the U.S. equity market. We assume that individual investor expectations for future returns have moved higher over the past several years—likely in reaction to the strong returns posted over the trailing five- and 10-year periods. We think it’s overly optimistic to extrapolate these returns into the future. Also, investors should be prepared for a more volatile set of returns, as the path forward could be bumpier than what occurred in 2021. Your financial advisor can help you make sure your current asset-allocation plan is appropriate for your risk tolerance and is on track to help you reach your long-term financial goals.
As always, we thank you for your business.
Index Information Individual index performance is provided as a reference only. Each index is unmanaged and is not available for direct investment. Since indexes and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although index performance data is gathered from reliable sources, Morningstar Investment Management cannot guarantee its accuracy, completeness or reliability. Index data sources are as follows. S&P 500 Index—An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. The S&P 500 is a market value weighted index. Moringstar US Small-Mid Cap Index—The index tracks the performance of US mid-cap stocks that fall between 70th and 90th percentile in market capitalization of the investable universe. In aggregate the Mid Cap Index represents 20% of the investable universe. MSCI ACWI Ex USA Index —Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 24 Emerging Markets (EM) countries*. With 2,150 constituents, the index covers approximately 85% of the global equity opportunity set outside the US Important Disclosures The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security. Except as otherwise required by law, Morningstar Investment Management LLC and its subsidiaries shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. Please consult with your financial advisor before making any investment decisions. Neither diversification nor asset allocation ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results. Investments in common stocks involve risk (e.g., market and general economic conditions) and will not always be profitable. Common stocks are typically subject to greater fluctuations in market value than other asset classes as a result of such factors as a company’s business performance, investor perceptions, stock market trends and general economic conditions.
