How do you follow up such huge returns as we saw in US equity markets in 2020? The consensus on much of Wall Street says that we shouldn’t expect the returns we saw last year and I tend to agree with the experts on this point. In my review of 2020, we saw that the energy, real estate, IT and financials sectors all outperformed the S&P 500 in 2020. Some of these sectors are expected to continue to do well in 2022. An important part of investing is reading market sentiment. I tend to have a bias based on my personality to buck the trend and go against the crowd. This can be helpful at times but can hold back my investments. Over many years of investing, I have become aware of this bias and done my best to try and temper it. One of the consequences of this bias is that I may take contrarian positions too early in the cycle or when the market has a lot of gas left in a particular trade. I know I am not the only one with this bias. For this reason, it’s important to get a sense of market sentiment, meaning what experts and the “crowd” expect. Like an old saying on Wall Street goes: “The market can remain wrong longer than you can stay solvent.”
To start off the new year, I have taken the time to review market expectations of a number of market strategist which you can see in more breadth here and add my own view on how I am positioning myself and where I think things will head this year.
Overall Themes
After reviewing the views of a an array of different equity strategists at different institutions, a few constant themes seem to emerge for 2022. These are:
Cyclicals – Cyclicals do well when the economy does well and most economists are expecting a year of relatively healthy growth in the US and other developed countries, with the US expected to grow anywhere between 3.5% and 4%. The omicron variant put a damper on stocks related to travel and leisure at the end of 2021 but this then makes for an easy call for these stocks in 2022 as they climb back from being beaten down. Other areas included in the cyclical sector are energy, financials and manufacturing. You’ll usually know a sector is a cyclical by looking at its P/E. These stocks tend to trade at lower P/E’s due to the wider volatility in earnings over time.
Value – Value was another style of investing that seemed to have a common bullish theme among analysts in their calls for this year. When I see analysts call for value to outperform, I feel there is an implicit message in this: growth stocks are overvalued. They wouldn’t be calling for a tilt towards value to see it underperform and the fact of the matter is growth stocks have just put value shares to shame since the financial crisis, as seen below.
Many may be making this call because they see a chance for some mean reversion on a historical basis or they just see appetite for investors to pick up some stocks that are cheaper. The sentiment may be that these stocks have some rally left in them. Some more specific factors also may play a role as well.
There is a fair amount of overlap right now between value and cyclical stocks. Remember I mentioned that cyclicals tend to trade on lower P/E ratios. This is also a value factor and when combined with other characteristics like low book value and high dividend yield, many will also qualify as value stocks. Financials and travel stocks may qualify in this area at the moment. Each has its own reasons for being cheap, whether it’s the yield curve or government restrictions on travel but it’s worth noting that cyclicals and value are somewhat related currently.
These calls lead into another theme that was common: foreign developed market stocks.
Foreign Developed Markets – Foreign markets such as Japan, the UK and the EU have lagged the US market since the financial crisis. We know the story that technology stocks and US shares in general have outperformed during that time by a large margin. Will this be the year that these markets finally edge the US?
The observation that these markets have been lagging for some time is not new but one big reason why is because many of these national and regional stock markets are dominated by those same value and cyclical stocks discussed above. Just take a look at the top 5 holdings of the UK FTSE Index and you can see that it’s dominated by pharmaceuticals, consumer staples, energy or financials. All of these are either defensive (pharma and consumer staples) or cyclical (energy and financials). The story is similar for stocks in Japan and Europe. What these markets lack are the big tech companies pumping out profits which has been the case in the US and China the past 5-10 years. Much like the analyst calls to side step tech, foreign shares echo this.
The other reason foreign shares are in focus could be the perceived performance of the US economy over the course of the year. With the Fed expected to raise rates faster and sooner than their counterparts in Europe or Japan, there may be a sense that the US will slow down sooner too and there is a chance now to get in on a later rally in these other markets while they are still earlier in the economic cycle.
Overall, dollar strength was projected at least for the first half of the year. Despite inflation figures, the dollar continues to remain strong but this may not last for all of 2022, especially if investors start to see potential outside the US.
What to Avoid
Avoiding lagging sectors can be just as important as identifying the outperforming ones sometimes. I did not find a strategist bold enough to say tech will lag this year but there were a few calls on areas to avoid outside of tech.
China – The crackdown by the government has added a degree of uncertainty which wasn’t present in the past years. China had managed to produce its own tech titans in firms like Alibaba and Tencent which went above and beyond the reach of American tech firms in how their customers interact with them. The crackdown has beat down the share price of these firms and dragged the Chinese market down with it.
Some contrarians are emerging given how badly some names have been pummeled. Alibaba, still a young big tech company, is selling at a P/E of about half that of Microsoft or Facebook at 19. Others have called for smaller caps and mid caps to do well in China given the more level playing field the government has created. Either way, this market is only for those long term value pickers not looking to beat the market over a 1 year period so buyer beware.
Emerging Markets – So much hope last year and such a good start but so much disappointment. Emerging markets, which 40% of the index is composed of mainland Chinese stocks, lagged the U.S. market by almost 30% this past year.
Last year, many equity strategists as well as myself, called for emerging markets to outperform, this was clearly a bad call. The different waves of COVID battered less vaccinated and the weaker health infrastructure of emerging markets, not to mention many countries had much more severe lockdowns than even the West. The surprising strength of the dollar, despite higher than expected inflation which should weaken a currency, also played a part.
The Chinese crackdown on companies like Alibaba and ride hailing company Didi came as a shock to the market and Chinese markets dragged down the index in the latter half of 2021. Given these developments, many have shied away from these markets in 2021. Yet there is a reason to keep your eye on them still. Some value investors have swooped in to purchase beaten down names as I mentioned previously. Outperformance this year is less likely but over a number of years, outperformance may come to fruition.
My Calls
Financials – I am biased here as I am in the industry but financials caught a hot streak last year. While the media was fixated on tech, firms like PNC and Bank of America returned 40% and 50% respectively. Although we won’t see returns that high this year, there is still some rally likely left here and valuations are fair.
Energy – Not a controversial call here. Some analysts are calling for $120 a barrel oil by June of 2022. A cold winter in Europe and increased travel, as well as supply disruptions support this. Yet I expect energy to remain volatile. Even when returns are higher for energy, there are huge fluctuations in share prices, maybe even more so now that energy is more controversial as many investors continue to move to ESG stocks.
Tech Will be Volatile – Even if it outperforms, it will be a bumpy ride. The same goes for crypto. We’ve seen this already as tech has taken a dive to start the year with the Nasdaq losing as much as 7% to start the year. A large number of tech firms are seeing falls of as much as 50% which just leaves the shares of big tech to make up for losses. The likes of Apple and Microsoft will struggle to outperform given their rich valuations.
Value – The beginning of the year has shown that value has some momentum. Cheaper quality stocks surged while tech stocks stumbled. It’s early to say value will triumph this year but like emerging markets did last year, the start is promising. There is the perception that higher rates will temper the growth of tech stocks but I tend to be of the opinion that many market participants may be starting the rotation into more value based on tech valuations as well as because of where we are in the economic cycle. Momentum isn’t a word often used for value in the past 10 years but the momentum factor could give value wings this year.
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