December 2021 – Embrace the Dystopia

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Does this mean US stocks will end 2022 in the red? Probably not. The Fed has a backbone made of wet spaghetti.

Investors had to contend with large swings in sentiment early this December. After some serious drops in high-growth companies with some prices being cut in half, broad-based buying has returned to US markets. This is like the police raiding a high-school keg party, only to turn the music back on and say “party on!” Is this the all-clear for further gains? Or, with the Fed set to taper its quantitative easing program and potentially raise rates in 2022, is this the end of the bull run from early 2020? For answers, we look to the major players: passive investors and the Fed.


Passive Never Sells…

Passive funds, like ETFs that invest in the S&P 500, have been gaining market share for decades and are now at a critical mass of all professionally managed assets. In recent years, traditional valuation metrics like Price / Sales and Market capitalization / GDP have rocketed beyond historical highs and this is no coincidence. Passive strategies are valuation agnostic and buy whenever new money arrives. Consistent inflows from vehicles like 401(k) retirement accounts enable constant passive buying, and this dynamic could continue and perhaps even accelerate in 2022. Market structure suffers under the passive regime, with the same “Big 3” firms now the largest holders of nearly every US company, but while this continues, it is three 800lb gorillas competing against each other to buy US stocks.


…Except for RMDs

RMDs could be the cause of December volatility. RMD, or Required Minimum Distributions, apply to anyone over the age of 70.5 who has a retirement account. As the US ages, with baby boomers entering their 70s, this large demographic not only holds the bulk of the wealth in the US, but they are also required to sell a portion of their holdings each year. The government waived RMDs in 2020, but they are back here in 2021. RMDs negatively affect the stock market because sound financial planning calls for selling equities as you age and buying more fixed income. Just like 2018, when required year-end selling caused an illiquid stock market to plummet over 9% in December, RMDs may not be done wreaking havoc in 2021. The good news is, once the required selling stops, illiquid markets receiving flows can rocket upwards in the new year. January 2019 recovered nearly all of December 2018’s losses, and we would expect a similar dynamic to play out in January 2022 should December 2021 end with more downward volatility.


Fed Lights Fire – Fed Provides Fire Extinguisher

Repeatedly telegraphed in 2021 has been the Federal Reserve’s plan to slow its Quantitative Easing program and raise rates in 2022. Americans are quite upset with rising prices of goods in 2021, and the Fed “printing money” has been part of the blame game. However, the government bond market seems to doubt the intelligence of raising rates. As participants priced-in rising rates in 2022, the yield curve for US government bonds flattened dramatically. Curve flattening is an indication of a Fed policy mistake, namely, raising rates into an environment where economic growth is slowing. Though real-time GDP trackers are indicating high single-digit real growth for the US in Q4 2021, in 2022 the economy will have to stand on its own without the stimulus checks consumers enjoyed in 2021. By definition, growth will slow in 2022 compared to the government stimulated growth of 2021. Raising rates will stifle the already tepid growth expectations, and the bond market is worried about this.


Does this mean US stocks will end 2022 in the red? Probably not. The Fed has a backbone made of wet spaghetti. If equity markets plummet along with growth expectations in 2022, the Fed could eliminate its taper plans, abandon higher rates, and even add stimulus. As we have seen, Federal Reserve governors own and trade equities, and they use their powers to preserve their own wealth. Therefore, even in the face of RMDs, slowing growth, and rising interest rates, equity markets may still increase in 2022.


Embrace the Dystopia

While the above is a cynical argument for higher asset prices in 2022, it is certainly not a fundamentals-based argument for remaining invested. The heavy-handed forces of passive investing and government intervention are a reality in the 2020s, and as we have seen, markets can stay divorced from fundamentals for extended periods of time. Therefore, we believe a hedged equity approach will serve investors well. By having a safety-net, investors can ride trends higher without risking exposure to a return to fundamentally-sound valuations.


The Bottom Line – Pockets of Opportunity

Increased volatility can be a patient investor’s best friend. Slight periods of outflows from investors can overwhelm the dominant investment vehicles and create great opportunities. In our next update we will detail one such example – a high quality business trading at a reasonable valuation with great long-term growth prospects. Have a happy holiday and best of luck investing in 2022![/vc_column_text][/vc_column][/vc_row]