Broker Check

A 2022 Projection and How We Got There

| December 20, 2021
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We mentioned in last week’s post how we’d soon be examining the year ahead. Today we’ll look at 2022 on a macroeconomic level and how we think things could play out next year. Last week we mentioned how the big selling could be subsiding and an earnings-led ramp up to next year’s business cycle could be in the cards.

But the market had other plans.

In an instant, the fourth quarter choppiness continued last week with a quick reversal to more selling, despite great earnings performance. The green circles in the following two charts show the sudden “big money” institutional selling in both stocks and exchange traded funds (ETFs):

We know that’s tough for investors, but that's often how it goes. The fundamentals look great, as do the future prospects, yet the price remains stagnant or maybe even drops. As you can see in the chart below of MAPsignals’ trusty Big Money Index (BMI), which measures institutional investor activity, both the BMI and the Russell 2000 have just chopped along sideways for much of the year:

So, the question for today, and then looking forward, is what is an investor to do? Seemingly everything but the stock price looks good. Will that change, or is the “winner” really a loser? In times like these, we remind everybody to be consistent – fight frustration or emotion and stick to the plan.

Even looking back to some historical data from 2018, we had a sideways market and BMI. We also had a rough end of the year with the major indexes each losing 2-3% on Christmas Eve alone. However, on the back of strong earnings heading into 2019, the Russell 2000 rallied 34%, and the BMI experienced a similar rally.

There are other comparable actions over the last 30 years too. We use these examples as a foundation to reinforce how in extreme situations, sticking to the plan, trusting the fundamentals, and having faith in earnings are as important as ever.

How do we at Cornerstone address these issues? It’s a three-part answer:

  1. We have a process and stick with it, being sure not to jump ship when things get unsteady, as they inevitably will.
  2. We use market indicators like the BMI to pinpoint extremes.
  3. Our focus is on outlier stocks and/or market sectors that have strong fundamentals, earnings, and revenue. This combination reflects quality, and owning high-quality assets gives us the best long-term odds to beat the indexes.

Still, the market will always bob and weave. Even the best stocks fluctuate in value. But being able to hold them and be consistent is one of the biggest differentiators when the dust settles (on a side note: here is an interesting story about an investor who has beat the market consistently while holding some stocks for more than 40 years).

Understanding all that, what is the path forward? Here are our expectations for 2022 and our plan to invest successfully.

Data, Fundamentals Win Out

Readers and clients know we were bullish in 2021 and that has obviously paid off. As of Friday, Dec. 10, 2021, the S&P 500 was up more than 25% on the year.

Remember, the reason we were bullish, even amid widespread fears of COVID-19, is because we stick to fundamentals and assess fair value by using economy-wide profits and interest rates. That's what we call our capitalized profits model. It takes the government measure of profits from the gross domestic product report and discounts it by the 10-year Treasury note yield to calculate fair value.

When we look at third quarter 2021 profits, they were up 20.7% versus a year ago and up 22.3% versus the pre-COVID peak at the end of 2019. So, gazing ahead to 2022, based on our capitalized profits model our estimation is that the S&P 500 will reach 5,250, which would be up 11.4% from last Friday, Dec. 10. We also expect the Dow Jones Industrial Average to rise to about 40,000.

With our capitalized profits model, the key question is always what discount rate should be used. If we use the current 1.5% yield of the 10-year Treasury, our model suggests the S&P 500 is grossly undervalued. But to be cautious, we plug in alternative, higher long-term rates, understanding that interest rates are expected to rise in 2022.

So, using merely third quarter 2021 profits, it would take a 10-year Treasury yield of about 2.75% for our model to show that the stock market is currently trading at fair value. Importantly, that assumes no further profit growth, which as we discussed a couple weeks ago, is unlikely:

We expect the 10-year Treasury yield to finish 2022 somewhere around 2%. But again, for conservatism, we chose to use a discount rate of about 2.5%. Using just third quarter 2021 profits creates that fair value estimate for the S&P 500 of 5,250. Remember, this doesn't even consider any higher profits in the year ahead.

The bottom line is that we are bullish still, just perhaps slightly less bullish than in years past. It’s important to remember that we haven't had a 10% market correction in 2021 yet. And while we never try to time the market, we wouldn't be at all surprised if such a correction happened in 2022.

To sum up our quick projection for 2022 overall, the scenario we described is likely to be constructive for equities. The fundamentals line up nicely. And while there are some clouds far away on the horizon – like interest rates, inflation, and fading fiscal stimulus – they are not overhead just yet.

Next week we’ll examine 2022 through a microeconomic lens. We’ll also go into more detail on specific market sectors that could benefit in the year(s) ahead. Until then, we hope everyone enjoys the holiday season and we wish you a very Merry Christmas!

Securities sold through CoreCap Investments, Inc., a registered broker-dealer and member FINRA/SIPC; advisory services offered by CoreCap Advisors, Inc., a registered investment advisor. Cornerstone Financial and CoreCap are separate and unaffiliated entities.

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