by Karen Langley | UPDATED December 26, 2021 05:30 AM EST
Stock investors may be less willing to accept higher valuations as the Fed’s expected interest rate hikes in the coming year
US stocks are on track to end 2021 with another year of outsized gains. Many investors aren’t expecting a repeat in 2022.
After rising 16% in 2020, the S&P 500 is up 26% so far in 2021. Corporate profits and easy monetary policy have fueled the race. Earnings growth is expected to moderate next year, and the Federal Reserve plans to raise interest rates, taking away key supports for the stock market’s rally.
When rates are low, investors put weights on riskier assets like stocks to generate returns. When inflation intensifies and policymakers raise interest rates, the value of companies’ future earnings falls and investors have more options to make money.
Rock-bottom interest rates helped prop up equity valuations in early 2020, and they have remained high for months. Many analysts and investors now believe that a hike in rates is likely to raise valuations further, and could lead to a fall in them.
Although stock indexes often rise early in the cycle of interest rate increases, tighter monetary policy keeps portfolio managers on a shorter leash and insulates many of them about taking on more risk.
Tiffany Wade, senior portfolio manager at Columbia Threadneedle Investments, said, “We know rates are going to go up. How soon can you start positioning around valuations before that?”
Last week, the S&P 500 traded at about 21 times its expected earnings over the next 12 months, according to FactSet, which is slightly less than 19 times the five-year average.
Some strategists believe that a change in monetary policy may help limit stock gains to higher levels keeping in mind their long-term trend. The S&P 500 through the past year has generated an average annual gain of 8.4% since 1957, the year it was introduced. But it’s coming from three more strong years. The index jumped 29% in 2019, exceeding its advances in 2020 and so far in 2021.
“It’s not normal,” said Joseph Amato, president and chief investment officer of equities at asset manager Neuberger Berman. “It’s been an extraordinary period of comeback, and our expectation is that you’re not going to see that kind of market performance. 22.”
Of course, there’s reason to be modest about stock predictions: Analysts can’t predict world events, or even how the market will react to them. Many analysts had thought stocks would slide into 2020 after the Covid-19 pandemic hit the US, with analysts underestimating the strength of the market’s 2021 rally.
“A year is such a short period that it is difficult to accurately predict where a stock will be a year from now,” said Anit Chachra, portfolio manager at Janus Henderson Investors.
Still, many of the structures that support the market will fade over the next year. Profits in 2020 and 2021 have been fueled by government spending and central bank intervention, including near-zero interest rates.
The Fed this month laid the groundwork for interest rate hikes early next spring and approved plans to more quickly wind down the bond-buying stimulus program. Democrats face an uncertain future after a nearly $2 trillion education, health care and climate package by Sen. Joe Manchin (D., W.V.A.) last week said he would oppose it.
Wall Street strategists are predicting small gains for the S&P 500 in 2022. Among the 13 banks and financial services firms whose analysts have published 2022 forecasts, the average target for the S&P 500 to end next year is 4940, about 4.5% higher than where the index closed. Thursday.
On the high end of next year’s projections, strategists at BMO Capital Markets are predicting that the S&P 500 will end 2022 at 5300, up 12% from its current level. The BMO team expects the company’s earnings growth to help propel the shares higher.
Meanwhile, strategists at Morgan Stanley said their central scenario was for the S&P 500 to end the year at 4400, a 6.9% decline. He expects the price/earnings multiplier to fall next year as bond yields rise.
The slimmed-down valuation will be especially important for a stock index like the S&P 500, as it is driven by large tech stocks that often trade at high multiples. Microsoft Corp., Nvidia Corp., Apple Inc., Alphabet Inc. and Tesla Inc. As recently as this year it took nearly a third of the benchmark’s gains. Tesla last week traded at about 123 times its expected earnings over the next 12 months, while Nvidia traded at about 58 times.
Profits of large US companies are expected to increase next year, albeit at a slower pace than this year’s. Analysts forecast earnings for S&P 500 companies to grow 9.2% in 2022, down from the 45% profit growth projected in 2021, according to FactSet.
Still, many investors said the earnings were a reason to believe the market could continue to rally.
“It’s easy to find a lot of things that can go wrong,” said Steve Colano, chief investment officer at BNY Mellon Investor Solutions. “At the end of the day, earnings drive the equity markets.”
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