Notwithstanding the challenges the COVID-19 pandemic presented, global growth accelerated throughout the year and equity markets posted strong gains, noting the S&P 500 was up 28.7% on a total return basis. The rapid rise in equity prices, as well as housing prices, lifted US household net worth to $142 trillion in the second quarter of 2021, up an astonishing $31 trillion from Q1 2020. To put this into perspective, US households grew their net worth more in the past five quarters since the onset of the pandemic than they did in the preceding, pre-pandemic five years. All told, calendar 2021 was a remarkable year for investing.
Despite the recent discovery of the COVID-19 Omicron variant and the potential impact it (or other variants) presents to the global economy, we believe we are entering 2022 with a strong economic backdrop. We expect consumer and business spending to be robust given strengthened balance sheets and excess liquidity, combined with improving visibility as we gain comfort with and adapt to the challenges that COVID-19 presents. Additionally, financial conditions remain accommodative, noting real bond yields remain in negative territory and credit spreads are tight. While inflation remains at elevated levels (the likes of which have not been seen for decades) and monetary policy tightening is expected to commence in 2022, the current landscape is constructive for equities. It is worth noting that, historically, the year following an initial Fed rate hike tends to be positive for equities.
Overall, we expect equities to appreciate in the coming year owing primarily to earnings growth rather than valuation expansion, as the latter has increased over the years due to a lower interest rate environment and the accompanying lower cost of capital. With interest rates expected to rise in 2022, multiple expansion will become increasingly challenging. Additionally, a rising interest rate and concomitant higher cost of capital environment may also limit the ability of companies to raise capital and undertake M&A relative to recent past. With that said, business fundamentals remain healthy, and we expect this to result in higher corporate profitability in the near term. Based on analysts’ bottom-up earnings estimates, S&P 500 earnings are expected to grow at a faster clip than historical averages (+6.7% CAGR over the past 50 years).
While valuations have increased because of the favourable interest rate environment, we believe that many of the constituents that make up the S&P 500 have not seen their valuations expand to the same degree as certain “high-growth” companies that dominate the Communications Services, Consumer Discretionary, and Information Technology sectors. Notably, Alphabet (Google), Meta (Facebook), Netflix, Amazon, Tesla, Apple, and Microsoft, in aggregate, account for 26.1% of the S&P 500, while the Information Technology sector comprises close to 30% of the index. The next largest constituent is the Health Care sector, which stood at approximately 13% in late December 2021. While the current forward price-to-earnings (P/E) ratio on the S&P 500 was 21.0x in late December 2021—an historically high level—if the aforementioned seven companies were excluded from the composite P/E calculation, the S&P500 P/E multiple would be 18.6x, closer to the longer-term average of 16.3x over the past thirty-plus years.
S&P 500 – 12-month Forward P/E, 1990 – 2021 YTD
S&P 500 Heavyweights – Company-specific 12-month Forward P/E – December 17, 2021
To address the valuation disparity between the high-flying growth stocks, combined with their significant index weights, and their S&P500 peers, we have chosen a more balanced cross-section of holdings and, consequently, have moved into an equal-weighted S&P 500 ETF, the Invesco S&P500 Equal Weight ETF (RSP).
Turning to the Fixed Income component, the forty-year bull market run for the bond market looks to have turned as the bond market posted an annual price loss in 2021 (S&P U.S. Dollar Global Investment Grade Corporate Bond 10+ Year Index: –7.0%). Given posturing by central banks—particularly the Fed that indicated they would start tightening in 2022 with as many as three rate hikes—we believe that price risk remains elevated as a higher interest rate environment would put downward price pressure on bond funds.
Overall, from an asset mix perspective, we prefer equities and alternative investments over bonds and have reduced our exposure to fixed income accordingly.
Jayson Moss, CFA
Chief Investment Officer
Sources:
- Scotiabank GBM Industry Report, Focus 2022, Running Ahead of Inflation with Equities, December 9, 2021
- Scotiabank GBM Portfolio Strategy, Shortages: In the Eye of the Storm, October 20, 2021
- CIBC Capital Markets, Institutional Usage Of ETFs Growing, Ample Room For Continued Growth In Balanced Mandates, December 6, 2021
- S&P Capital IQ (index returns)
To learn more about Evolve Wealth Advisors, please visit our website at www.evolvewealthadvisors.com. Should you have any questions regarding your account or how Evolve Wealth Advisors can help with your future Estate or Retirement planning needs, please contact Peter Henry, CEO at 818-970-6940 or Patrick Kinney, COO at 503-490-0273.
Disclosures:
The market commentary appearing above has been prepared by personnel of and for Evolve Wealth Advisors, LP. The information contained within the commentary is provided as general market commentary only and does not constitute any form of regulated financial advice, legal, tax, or other regulated financial service. It is not considered to be investment research or a research recommendation, as it does not constitute substantive research or analysis. Any charts or graphs does not reflect past or current recommendations by Evolve Wealth Advisors and should be considered an academic treatment of empirical data. Investors should consult their financial advisor when applying the assumptions of any chart or graph.
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