Last week we talked about our market projection for 2022 and this week we want to discuss our economic outlook for next year, a sector to watch, and the value of sticking with a plan.
From the 30,000-foot view, the COVID-19 lockdowns and reopening played out pretty much as we thought they would. Economic activity collapsed in the first half of 2020, then exploded in the third quarter. Ever since, there’s been strong but erratic quarterly growth.
As a STRONG reminder, this is not a normal business cycle and shouldn’t be treated as one.
We’ve seen how shutting down economies and free flows of information causes big supply chain issues. Unfortunately, small firms have suffered more than large companies. While the earnings and profits of big, publicly traded companies have largely soared, overall real gross domestic product (GDP) looks like it will end lower than if COVID-19 had never happened.
So, what do we see happening as the economy (hopefully) normalizes in 2022?
- Real GDP will settle in at 3.0% next year, a slowdown from this year, which was artificially boosted by big deficit spending. Why not less than 3.0%? We think small businesses will bounce back stronger as the economy normalizes, boosting economic numbers as a result.
- Inflation will run at 4.0% or more next year. It will be driven by increases in rental housing costs, which make up more than 30% of the consumer price index (a key inflation indicator).
- Solid job growth will continue as plenty of openings remain. Next year should see about 325,000-350,000 new jobs per month on average. While that’s positive, it puts us on a pace that is just 700,000 more jobs than the pre-COVID employment trend.
In summary, this is good economic growth from a historical perspective. However, it’s not enough to get us back to where we would’ve been if COVID-19 didn’t occur. But baby steps are better than no steps.
Next Hot Area?
Our readers know we’ve identified different strategies to achieve investment goals based on economic conditions (e.g., dividend growth stocks, real estate, business development corporations, green energy). Now we want to close out 2021 by covering small-cap value stocks, which should benefit from the continued economic recovery (we will be beefing up our asset allocation in small-cap value in Q1 2022).
When swirling data uncertainty is overwhelming, remember that macro-level indicators with track records help us predict investment performance going forward. They help us tune out the noise. So now we want to turn our attention to small-cap value stocks and highlight the positive macro-level indicators driving our increased weighting in this sector going forward.
One of the best indicators of small cap success is the yield curve (the spread between the 10-year and 2-year Treasury notes):
Small caps are tied to the economic stage we’re in right now. The reason small caps are so tied to the yield curve and economic cycle is due to their embedded value tilt. Value stocks are cyclical, meaning they tend to do better when the economy is growing.
For an easy comparison, more than 53% of the S&P Small Cap 600 Value Index’s market capitalization is in cyclical, value-oriented sectors like financials, industrials, real estate, energy, etc., versus only 27% of the S&P 500:
Small caps can be a great inflation hedge. Given small caps’ value tilt, they’ve historically beaten large-cap stocks when inflation has been above trend:
We’ve seen a good example of this in 2021. Even after the recent pullback, small-cap stocks are still up 27% this year through the beginning of December.
While the current U.S. administration and rest of the world is looking to tax billion-dollar companies with a 15% global tax, that would only affect one firm in the S&P Small Cap 600 Value versus hundreds in the S&P 500. Therefore, if tax hikes happen, small caps are better positioned to handle them than larger firms.
Mergers and Acquisitions (M&A)
This helps small caps because they are often attractive takeover targets. Many times, when a company is bought out, shareholders benefit. Similarly, when competitors are purchased, the remaining small cap firms benefit from lessened competition or increased valuations.
Strong U.S. Dollar
The U.S. dollar has risen a bit more than 7% in 2021 so far on the back of the U.S. economy’s performance in recovering from COVID-19. Dollar strength typically hits larger companies more than smaller companies because of their global operations (small caps typically have domestically centered revenue bases). Again, small caps are better positioned to handle a strong U.S. currency.
We know we’ll get questions about why we keep mentioning small-cap value as a potentially hot area of the market as opposed to the more broad-based small cap investment thesis centering on the Russell 2000 Index. In one word – quality.
The S&P Small Cap 600 Value requires companies to have four consecutive profitable quarters. It’s sort of a built-in quality filter. Therefore, this subset of the small-cap universe is higher quality, in our opinion, than the Russell 2000. This keeps with our quality theme, and we think it’s a better choice for small cap exposure, especially if growth slows as interest rates climb.
Quality matters. The Russell 2000’s broader composition helps it soar in early economic cycles and coming out of recessions. But in more mature economic recoveries like now, the S&P Small Cap 600 Value tends, historically, to outperform the Russell 2000 (the same is true generally over the time too). Plus, when markets get rocky, quality stocks can weather the storm better, in general.
Lastly, the cherry on top is the S&P Small Cap 600 Value trades at a forward price-to-earnings (PE) ratio of 15.3x, whereas the Russell 2000 trades at a forward PE ratio of 24.5x. Why is that? Almost a third of the Russell 2000 is made up of unprofitable companies, which inflates its overall valuation:
These tailwinds are what provide small-cap value stocks as a cheap, oversold inflation hedge going into 2022. We are going to be adding the sector to our model portfolios for the first time in years because the data profile makes sense.
Stay the Course
With this being the last post of 2021, we wanted to leave our readers with one last chart that reinforces the value of having a plan and sticking to it. Consistency is critical, even in times of volatility. It’s our belief that remaining consistent is the only way to win over time.
We all know stocks average about 8-10% annual returns over the long run. We also know there are more good years than bad.
But what most people don’t know is that in any given year, the S&P 500 averages a -14% intra-year drawdown on the way to earning that average of 8-10% annually. You can see it in this chart:
The bottom line is that volatility is normal, especially as we enter more typical market cycles in 2022. As an investor, you have to be in it to win it. So, remain strong, be consistent, and stay the course.
Happy New Year and best wishes to everyone for a great 2022!
Securities sold through CoreCap Investments, LLC. Advisory services offered by CoreCap Advisors, LLC. Cornerstone Financial and CoreCap are separate and unaffiliated entities.