This is exactly what we should expect. The Federal Reserve’s zero interest rate policy and quantitative easing program kept bond yields around a full percentage point lower than they otherwise would have been.
And that in turn allowed the stock to trade at a higher earnings multiple than it normally would have. Closing the Fed’s liquidity taps reversed that, exactly what might have been predicted. The market response last month was quite rational.
And that’s why I wouldn’t expect a quick rebound from today’s more subdued market level. Valuations have retreated to a more reasonable level, so the onus is now on earnings to drive markets forward.
The current expectation is for earnings to grow by around 8% this year. That’s less than we expected a month ago, but not by a huge margin.
With about a third of the S&P 500 having reported so far in the fourth-quarter earnings season, most have slightly exceeded expectations. We are on the right path. The gains hold.
For stocks to keep their heads above water this year, those profits must continue to be generated.
Two other things will also be needed. The first is that the Fed manages to walk a political tightrope, raising rates just enough to contain inflation, but no more than absolutely necessary. An overly aggressive policy mistake is rightly at the top of investors’ list of concerns.
The second is more difficult to predict by its very nature. We must avoid unpleasant geopolitical surprises. It is unclear what the West’s reaction would be to a Russian invasion of Ukraine, nor what the subsequent market reaction would be. But it’s hard to imagine an already jittery market reacting positively.
So it will be more difficult this year. How can investors navigate the choppy waters ahead?
Looking back 20 years to the last major tech bubble unwind, there was actually no shortage of investment opportunities.
At the time, they came in the form of high-yielding “old economy” stocks, companies that investors mistakenly thought had no future in an internet-enabled world. The reality was different.
As the bubble burst, the 6-7% dividend yields of companies such as Boots and Whitbread suddenly looked rather attractive.
One sector that has significantly underperformed in recent years is utilities. It’s not surprising. Defensive stocks that rise and fall less than the market as a whole tend to lag when stocks rise sharply.
However, these dated stocks are as far below trend as they were in 1999, after which they outperformed massively for a two-year period when the dotcom bubble burst.
It does not look like we are facing a repeat of this painful market decline. But in relative terms, I wouldn’t be surprised if 2022 turns out to be another year in which ugly ducklings start to look like swans.
Tom Stevenson is Chief Investment Officer at Fidelity International. The views are his. He tweets at @tomstevenson63