The Year in Review
For the third year in a row, US stocks are strong. Almost all of the indices are hitting all-time highs. The S&P 500 led the pack up 28.8% this year. The other indices were also positive with the NASDAQ Composite up 21.4%, the Dow Industrials up 18.7%, and the Russell 2000 up 13.7%.
That said, many of the underlying stocks that make up those indexes underperformed.
When looking at benchmarks, a little known fact is that most of the indexes are either size or cap weighted. That means larger stocks make up significantly more of the index, so the performance of the larger stocks have an outsized effect on the index’s performance.
For example, Apple, Microsoft, Amazon, Tesla and Google make up 20.5% of the S&P 500. On the other hand, Newscorp, Under Armour, Gap, Ralph Lauren, and Alaska Airlines make up five one hundredths of one percent of the index. The point is that a minority of the stocks in the index drive the returns. This year’s returns were narrowly focused, which makes it difficult to compare other returns against them. It’s an “apples and oranges” comparison.
Fortunately, our portfolios did well regardless of the narrowness of the market.
We were pleased with our 2021 returns, especially considering they were so exceptional in 2020. Usually when you have extremely high returns, it is difficult to follow up with another good year because of mean reversion.
Long-Term Update
You can look for details on our various portfolio returns in Nate’s article. So let’s talk long-term returns of our flagship Top Flight portfolio.
Over the past 24 years, from January 1998 through December 2021, our Top Flight portfolio has returned 12.0% net of fees, compounded versus 8.7% for the S&P 500. To show the power of compounding, that translates into a total return of 1455% for Top Flight versus 669% for the S&P 500 Index.
Other interesting trivia is that the Ulcer Index, which measures downside risk, shows a ratio of 10.54 for Top Flight versus 16.12 for the S&P 500. Lower is better.
Finally, we use the S&P 500 because it is one of the top performing indexes and difficult to beat. However, because Top Flight is made up of four different strategies, we could technically use lower-performing benchmarks that would better match up with the stocks inside of Top Flight.
What’s Next?
Regardless of how the year plays out, the most common question is: “What have you done for me lately?” And that question is followed by: “What’s Next?”
Let’s look at how we got here and where we’re going.
Last year, better-than-expected corporate profits — which were powered by an expanding economy and incredibly easy monetary policy — deserve much of the credit.
Low interest rates, low bond yields, and rising profits easily offset worries about the lingering pandemic and higher-than-expected inflation.
But we are now looking ahead into 2022. What’s your guess on the new year?
That takes us back to the “mean reversion” issue. After last year’s strong advance, what might be in store for this year?
Since 1950, there have been 26 years in which the total annual return of the S&P 500 Index exceeded 20%, according to data provided by the NYU Stern School of Business. In the following year, the S&P 500 Index advanced 20 times, or 77% of the time, in line with the long-term average.
The average “up” year was 18.1%, while the average “down” year was 6.4%.
It’s an interesting exercise, but let’s always remember that past performance is no guarantee of future performance. Each year will have its own distinctions.
One complicating factor is that the total return of the index has doubled over the last three years, according to Dow Jones.
What dictates the market’s direction will likely be the economic fundamentals — and whatever impacts those fundamentals.
For example, what might the Federal Reserve do with interest rates? At the beginning of 2021, the Fed expected no rate hikes in 2022. However, it failed to anticipate last year’s surge in inflation.
As the year ended, the Fed’s new projections, which it released after its December meeting, reflected a forecast of 3 quarter-percentage-point rate hikes this year.
Are those potential rate hikes already being discounted by investors? If inflation fails to ease — or worse, accelerates — the Fed may take a more aggressive posture.
Let’s take this point one step further.
Longer-term bond yields have remained low in the face of a less dovish Fed, high inflation, and robust economic growth.
Will we get a reset in 2022? Or have there been fundamental changes in the bond market that are holding yields low? Or do bond investors simply believe inflation and economic growth will slow?
Corporate profits are also a key driver of stock prices. Consider this: If you were to purchase or sell a small business, wouldn’t recent and projected profitability play a big role in the sales price? It absolutely would. The same principle holds for publicly traded companies.
How will the pandemic play out?
If you follow the science, it seems like there isn’t any end. Nothing is consistent, and much of what is out there makes no sense. First Covid-19, then Delta, and we’re now seeing a surge in cases tied to Omicron. The economic impact of Delta was limited, and thus far, investors have side-stepped economic worries about Omicron. What’s next?
At what point does normal life return?
When do we stop paying people not to work and allow the free market to once again drive our economy? When do our supply chains start working again? Where is our government taking us with inflation?
We’ve posed several important questions that don’t offer easy answers. We may see a pullback in 2022, and we recognize that downturns are a part of investing.
Based on your goals, circumstances, and risk tolerance, we build portfolios that help manage risk — but we can’t eliminate risk.
If we trade the fear of a sell-off for a savings account, then we won’t participate in the long-term upside that stocks have historically offered. Conversely, take on too much risk when the market has been strong, and you may experience sleepless nights in a swift downturn.
If life events have forced you to rethink your goals, let’s talk. Quality retirement and financial plans are built to be adjusted and changed based on your stage of life and what your current priorities are. Plus, we have new technology that helps us dial in risk levels better than ever before.
Adherence to your retirement plan and a long-term focus have historically been the straightest path to reaching your financial goals. We may see volatility next year.
Predictions are generally useless — it doesn’t matter how high profile the guru making them is. They are a complete crapshoot. Even calling them educated guesses is an overstatement.
The good news is that in the past, sell-offs — when they occur — are eventually followed by rebounds. Keep this in mind as we help you set your risk tolerance.
If you have questions or would like to discuss any matters, please give me or any of my team members a call. We appreciate the opportunity to serve as your financial advisors.