Q4, 2021 Stock Market Recap

In this Q4 recap: U.S. economy confronts a new COVID-19 variant amid continuing inflation and supply chain bottlenecks. Europe institutes new social restrictions in response to a surge in Delta and Omicron variant infections. Investors turn cautious as uncertainties increase.

The stock market kicked off the fourth quarter with a powerful rally in October and added to those gains into November until investors were blindsided by news of the emergence of a new COVID-19 variant, Omicron, and testimony by Fed Chair Jerome Powell that escalating inflation and an improving labor market warranted consideration of an acceleration of its bond purchase tapering plans.

Markets, as a rule, do not like surprises and uncertainty and the combination of a new variant and a suddenly more combative Fed sent stocks into a skid that largely erased the November’s accumulated gains. Market reaction to the Omicron news was exacerbated when the news hit–on Black Friday, a day that typically provides less liquidity since many investors and traders are on holiday.

Investors soon learned the contours of what a more aggressive monetary policy would look like. In its mid-December meeting, the Federal Open Market Committee (FOMC) announced plans to speed up its bond purchase tapering schedule and signaled that, once tapering is concluded in March 2022, up to three rate hikes may follow.

Markets settled down into the final weeks of the quarter as early indications suggested that Omicron’s health impact was less severe than the Delta variant. Relieved that its economic consequences may be less than initially feared, reinvigorated investors jumped back into the market, pushing stocks higher into the end of December and capping a strong year of performance.

Corporate profits for the third quarter were solid. Eighty-two percent of the companies comprising the Standard & Poor’s 500 Index reported earnings above Wall Street analysts’ expectations, posting an average earnings growth rate of 39.8% in the third quarter. This earnings momentum is anticipated for the fourth quarter, with an earnings growth forecast of 20.9%, which, if realized, will mark a historical high watermark in corporate profits.¹

The US Economy

After a Delta variant-induced slowdown in the third quarter, signs are pointing to a strong economic rebound in the fourth quarter and solid growth into 2022. Though the official economic growth rate for the fourth quarter won’t be reported until January’s Gross Domestic Product (GDP) report, according to the Federal Reserve Bank of Atlanta, which tracks economic data in real time, their model is indicating a 7.2% annualized real rate of Q4 GDP growth.²

This economic rebound overcame several headwinds, including accelerating inflation, supply chain bottlenecks, a labor shortage, and a pending pivot toward monetary normalization.

The labor market evidenced considerable recovery as initial jobless claims fell steadily, while the unemployment rate shrank to 4.2% in November, even as some 600,000 Americans entered the labor market and the labor participation rate rose to pre-pandemic levels.³

The nation’s manufacturing sector gathered momentum in the fourth quarter. The Institute for Supply Management (ISM) Manufacturing Index rose in November for the eighteenth straight month, with the trend pointing toward a faster acceleration in that growth.⁴

Looking ahead, one survey of economists conducted by the Federal Reserve Bank of Philadelphia shows a median forecast of 3.9% in GDP growth in 2022, with stronger growth in the first half of the year and a moderating expansion in the final two quarters.⁵

Especially noteworthy is the American consumer, the primary driver of economic growth. Americans have stockpiled $2.3 trillion of excess savings (i.e., savings above pre-pandemic levels), providing a strong underpinning to fuel future economic activity.⁶

While the economic outlook appears positive, headwinds exist.

The economic impact of Omicron is difficult to estimate. For now, it appears unlikely to lead to widespread lockdowns, but it may pose the potential to prune economic growth at the margins.

Perhaps the most concerning potential financial risk is inflation, which has persisted at an elevated rate for longer than the Fed expected. November’s Consumer Price Index (CPI) provided little comfort, as prices jumped at a rate not seen in nearly forty years, rising 6.8% year-over-year. It was the sixth consecutive month that inflation exceeded 5%.⁷

Shaky consumer confidence is another possible risk. Though consumers may be flush with excess savings, spending requires consumers to be confident about their personal situations and the economy. In the University of Michigan’s November consumer sentiment survey, Americans expressed less optimism than at any time since the credit crisis years, largely due to rising inflation and perceived government inaction to address it.⁸

While additional risks may present further challenges, the overall expectation, nevertheless, is for continued economic expansion in the near- to intermediate-term.

Looking Back, Looking Forward

Investors enjoyed robust stock market returns in 2021. It was a performance that had less to do with P/E ratio (Price-to-Earnings) expansion – the market P/E actually came off its high – and more a result of strong earnings growth.

One overlooked feature of the stock market’s 2021 performance was the successive waves of rotational corrections. From the view of major indices, stocks enjoyed a steady rise throughout the year without a correction (i.e., a decline of 10%-20%), suggesting a generally stable, even placid, stock market.

However, beneath this smooth ascent were periods of volatility for specific industry groups. For example, as of November 26, while the year-to-date return on the S&P 500 was 22%, 92% of its constituent stocks experienced at least a 10% decline from their YTD highs, with an average drawdown of 18%. Similarly, the technology-heavy NASDAQ Composite, which was up by 20%, saw 89% of stocks with a drawdown of at least 10% and an average retreat from YTD highs of 40%.¹⁴

In other words, while the major market indices did not experience a correction, most stocks comprising these indices suffered corrections at some time during the year.

It is unrealistic to expect a repeat of the 2021’s outsized gains, but the consensus of Wall Street analysts is one of modest price gains in 2022 amid continued economic growth and low, though rising, interest rates.

While the market may be affected by multiple “known unknowns,” e.g., geopolitical flare-ups, trade frictions, or inflation, there are several key ones worth highlighting.

The Federal Reserve began to pivot toward monetary normalization, announcing in December an acceleration of bond tapering and the possibility of up to three interest rate hikes. Markets expected this, so this may already be priced in. However, if the Fed finds itself behind the inflation curve and needs to increase the number of rate hikes or accelerate their pace, it may unsettle investors.

Corporate earnings growth is anticipated to moderate in 2022. This is to be expected considering the rate of economic expansion will likely slow and its comparative period, 2021, established such a high bar.

That said, 4Q 2021 earnings (reported in 1Q 2022) is forecast to grow by 20.9%, which, if that materializes, means 2021 full-year earnings growth will be 45.0%. For 2022 Wall Street analysts are projecting an 8.8% jump in corporate profits. This is a substantial come-down, but it represents healthy growth from a high watermark. Should companies exceed these expectations, it may help support higher valuations.¹⁵ 

Another important market influence may be a slowdown in China’s economy. A deceleration in the growth of the world’s second largest economy may translate into lower consumption of imported consumer goods or production of manufactured goods, representing a potential risk to the global economy.

Possible rate hikes, higher inflation, and moderating economic growth may sound like a recipe for a tepid stock market, but history tells us that stocks are more likely to rise in a rising interest rate environment and during periods of moderate economic deceleration. While past performance is not a guarantee of future returns, it suggests that markets may advance under less-than-optimal circumstances.¹⁶