The S&P 500 rallied 26.9% in 2021, thanks in large part to record earnings revisions, the strongest economic growth in decades, and unprecedented stimulus from the Federal Reserve. Those conditions will almost assuredly not be as market friendly in 2022. Earnings growth should slow to single digits, real GDP could be below 4%, and the Fed is preparing the markets for a quicker taper and a tightening cycle.

Not surprisingly, 2021 was a year of unprecedented economic growth. Stoked by massive global fiscal and monetary stimulus and a vaccine rollout which unleashed pent-up demand, the U.S. economy expanded 5.7% in 2021, the fastest pace since the early 1980s. This helped fuel a rise in the S&P 500 of more than 10% for a third consecutive year― for the first time since 2012-2014. The popular averages were able to rally strongly for several reasons. Top of the list is the expected 65% growth in S&P 500 earnings. Consensus started the year anticipating 22.8% earnings growth, making the upward revision the biggest since data began in 1984. Record equity mutual fund inflows and a resurgence in stock repurchases more than offset stock offerings.

But the biggest factor of all was the strength of the mega caps, or the FAANG (Facebook, Apple, Amazon, Nvidia, Google) +Microsoft and Tesla, which account for nearly 30% of the S&P 500 index and were up 28% on a market cap weighted basis. This means the remaining 493 stocks were net -2% on an absolute basis, thus overstating general strength in equities. In fact, when looking beyond the popular average cap-weighted U.S. indices, the performance looks very different. For example, the equal weighted Small-Cap Growth Equity Series fell 4.8%! Additionally, value outperformed growth among small-caps with the Russell 2000 Value beating the Russell 2000 Growth by 25.4%, the second-biggest spread on record, with data beginning in 1979. So, 2021 was indeed a year of mega cap and not a statement of broad-based equity strength.

As far as 2022, the equity market outlook is riddled with many risks, most notably the actions of the Fed. Moreover, supply chain problems and higher inflation will remain entrenched in the near term. Despite the strong growth, the maturing economic cycle, tighter global monetary policy, Covid, and rising uncertainty may present headwinds to equities throughout 2022. The Fed is poised to start hiking short-term rates as soon as March. History suggests in the six months before and six months after the first Fed rate hike, the S&P 500 has risen an average of 9.3%. But speed matters. The impact of rate hikes has been felt sooner during fast cycles (Fed raises rates at every meeting, on average) than during slow cycles (Fed waits at least one meeting in between, on average). A more restrictive Fed is a leading candidate for the cause of corrections or a shallow bear market. In addition to rate hikes, fiscal stimulus will be far smaller in 2022 than in 2021. The removal of stimulus during the first half of mid-term years is common. That is why the S&P 500’s average post-war gain of 6% in mid-term years is the weakest of the four.

Uncertainty brings volatility, now likely to remain elevated with corrections more stiff and more frequent than we have seen in the recent past. Absent a recession (which we currently do not anticipate) the down-side corrections are likely to be technical and structural in nature but short in duration, as scary as they may feel in the moment. As always, we will continue to monitor the economic and investment landscape and make changes accordingly.