LPL RESEARCH PRESENTS outlook 2022- Staying In the Zone

By Celeste Orozco | January 25, 2022 |

We expect solid economic and earnings growth to help stocks deliver gains in 2022.

When forecasting stock market performance, we start with the economic cycle. We believe we are currently approaching—or are already in—the middle of an economic cycle with at least a few more years left. Historically, if this holds true, then we believe the chances of another good year for stocks are quite high, which is an important added factor for our positive outlook for stocks in 2022 [Fig.3].

The mid-cycle push

Looking more closely, in a mid-cycle economy, recession fears do not typically cause stocks to fall in a given year, nor do stocks typically surge as investors celebrate emerging from the prior recession. Over the past 60 years, the S&P 500 Index was up an average of 11.5% during the 30 mid-cycle years we identified, with gains in 80% of those years [Fig.4]. As you can see, stocks rose during most of these mid-cycle years, with 1966 and 1977 the only two years with double-digit losses.

The Fed, which we expect to start raising interest rates in early 2023, can also help us gauge the cycle because the central bank typically begins to raise rates when the economy is exhibiting mid-cycle characteristics. That also characterizes 2022 as a likely mid-cycle year. Historically, stocks have done very well during the 12 months leading up to the Fed’s initial rate hike, with gains in each of the past nine instances and an average gain of 15% [Fig.5]. We expect stocks to follow this mid-cycle pattern and potentially deliver double-digit gains next year as the economy continues to expand at a solid pace.

Earnings are the anchor

An expanding economy is a great start, but stocks fundamentally derive their value from earnings. On the top line, the environment for companies to grow revenue next year should be excellent, with potential for above-average economic growth and some pricing power from elevated inflation. Revenue growth has historically been well correlated to nominal GDP growth, which is simply real GDP growth (the inflation-adjusted number that’s normally reported) plus inflation. Our 4–4.5% real GDP growth forecast for next year plus perhaps 3% inflation (about the consensus forecast for the increase in the Consumer Price Index) puts a 7% revenue increase in play. With stable profit margins and increasing share buybacks likely next year, a double-digit percentage increase in S&P 500 earnings per share (EPS) is a possibility. But COVID-19-related supply chain issues and materials and labor shortages are risks that could lead to higher costs in 2022, weighing on profit margins. Many companies warned of such pressures during third-quarter earnings season. As a result, we are forecasting slightly below-average S&P 500 earnings growth of 6% in 2022, which should result in earnings of $220 per share [Fig.6]. Higher corporate taxes could eat into some of those earnings gains next year, though that may be widely anticipated and likely at least partly reflected in valuations.

Valuations may not provide the assist

Forecasting a year ahead is tough enough, but predicting where stocks might be at the end of 2022 actually requires us to look ahead to 2023. The 2023 earnings outlook will determine where valuations are likely to be at the end of 2022. Strong earnings gains in 2021 have prevented the price-to-earnings ratio (P/E) for the S&P 500 from going much above 20. In fact, stocks are actually more reasonably priced as 2022 approaches than they were at the start of 2021, because 2021 earnings are tracking more than 20% above the estimate when the year began. While a 21 P/E is above the long-term average of around 16, we believe still low interest rates justify current valuation levels. But P/E multiple expansion will likely be difficult if interest rates rise in 2022, potentially leaving earnings growth as the primary driver of any stock market gains.

S&P 500 knocking on the door of 5,000

5,000 on the S&P 500 will be a nice round number for investors to celebrate. But will that celebration take place in 2022 or later? If we assume S&P 500 EPS growth improves in 2023 to around its long-term average at 8% ($235 in EPS), while the P/E stays about where it is between 21 and 21.5, the S&P 500 could be fairly valued at

5,000–5,100 at the end of 2022. Note, however, that stocks can stay above (or below) fair value for an extended period of time due to market sentiment, so we would not necessarily view reaching that target as a sell trigger. If interest rates stay lower for longer and support P/E multiple expansion, stocks could potentially exceed this target by year-end 2022. But if profit margins face more intense pressure than anticipated, possibly from wages, earnings may have a hard time growing at all in 2022.

The race continues in 2022

Prospects for above-average economic growth and accompanying earnings gains in 2022 point to another potentially good year for stock investors. While the pandemic is not completely behind us and there are several other risks to watch, particularly inflation, stocks have historically done well in mid-cycle economies. We do not expect 2022 to be an exception.

Equity asset allocation recommendation

Market Cap

We favor small and mid cap stocks over large caps as 2022 begins, but as the economic cycle matures, large caps may be better positioned and balanced exposure across the market cap spectrum relative to benchmarks may be more appropriate.

Style

We maintain a slight preference for value over growth to benefit from potentially above-trend economic growth in 2022. Rising interest rates and higher inflation are conditions that have historically been favorable to value-style stock performance.

Sector

We favor the cyclical value sectors, particularly financials and industrials, over the defensive value sectors such as consumer staples and utilities. We’re neutral on the big technology-focused growth sectors for steady earnings and innovation. We find the real estate sector attractive for its rich yields, benefits of the economy reopening, and tendency to effectively manage inflation. Healthcare is attractively valued and a sector to watch

Region

We favor the U.S. over developed international markets (primarily Europe and Japan) as we enter 2022 because of the relatively healthier U.S. economic growth outlook and the strong U.S. dollar, but international equities may become increasingly attractive as COVID-19 restrictions are removed globally. Our emerging markets equities recommendation remains negative due to ongoing regulatory risks in China, which could slow earnings growth expectations while increasing uncertainty.

This research material was prepared by LPL Financial LLC. Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC). Insurance products are offered through LPL or its licensed affiliates. To the extent you are receiving investment advice from a separately registered independent investment advisor that is not an LPL affiliate, please note LPL makes no representation with respect to such entity.

Not Insured by FDIC/NCUA or Any Other Government Agency

Not Bank/Credit Union Guaranteed

Not Bank/Credit Union Deposits or Obligations

May Lose Value

Posted in Insurance Management