2021 turned out to be another profitable year for stock investors. Except for a few brief selloff’s, the S&P 500 gained 26.9 % for the year. The Dow Jones Industrial Average gained 18.7% in 2021, while the Nasdaq Composite gained 21.4%. If one were to view the economy exclusively through the lens of the stock market, you’d think the past two years were booming.
The reality on the ground couldn’t be farther from the truth and everyone knows it. We’ve had over a year and a half of lockdowns, supply chain problems, labor shortages, parents having to stay home because their kids can’t go to school and a whole host of other issues. Despite this, the market has marched higher and higher.
The question we’ve been constantly asked this year is why have stocks done so well during this time? The simple answer is that COVID has been remarkably profitable for many of the largest companies in the country and those companies dominate the stock market indices. Retailers who had the logistic infrastructure to conduct their business exclusively online were in the perfect position to benefit when COVID struck. The same is true for almost any company that ran online, sold the work from home tools, or was deemed “essential” by the government. Of course, small businesses were the real losers in all this. Since small businesses employ most of the people in the country, what most of us see in our day to day lives has been starkly different than the profit growth in the stock market.
The other notable sign to most of us that things are way off has been the empty shelves and higher prices for just about everything. U.S. inflation closed out 2021 at its highest level since 1982. The consumer price index, which measures what consumers pay for goods and services, rose 7% in December from the same month a year ago and was up 6.8% in November. That was the fastest pace in the past forty years and the third straight month in which inflation exceeded 6%.
Inflation arises when there is too much money chasing too few goods. In this situation we have had both; huge disruptions in the availability of many things needed in manufacturing and finished goods sitting on ships outside of ports unable to be unloaded. Couple this with the massive amount of money being pumped into the economy by the government and you have the perfect recipe for inflation. This has been especially hard for retirees and those on fixed incomes. And the much-touted wage gains are in no way keeping up with prices. Inflation has clearly caught the attention of policy makers in Washington. Voters are rightfully upset in an election year and the Federal Reserve is openly concerned about the inflation data.
So what will 2022 look like? One thing is for sure – the Fed will raise rates several times this year. The Fed has also stated they’re planning to reduce the bond portfolio amassed during the pandemic via another round of quantitative easing. The Fed’s bond purchases have been the primary reason longer-term interest rates have remained so low and the main source of the increased money supply. Both of these are big contributors to inflation. Once again if inflation is the result of too much money chasing too few goods, the increased money supply is part of the problem and, due to the size, definitely the most difficult to address. The too few goods issue will eventually work itself out as COVID moves into an endemic phase and all the restrictions are lifted worldwide. Shrinking the money supply will be a much longer and trickier process.
Typically, the Fed putting the breaks on the economy is bad for stocks and bonds. But these aren’t typical times. The wealth effect the stock market brings people has become something Washington is sensitive to – the Fed included. We think they’ll tread lightly here. We believe the bigger move in stocks will be a rotation out of the fully valued large cap sector and into small and mid-cap stocks. Another piece of common wisdom that you’re sure to hear plenty of is that rising rates will be bad for the bond market. Generally speaking, that is true but not all bonds are created equal. Short-term bonds, which we typically hold, are mostly unaffected by higher rates. We are actually looking forward to higher rates because they give us the chance to reinvest at higher income levels.