In the stock market, the new year may start with a bang – MarketWatch

Investors have had to contend with large swings in sentiment this month, capping a year of seesawing risk sentiment.

After big share-price drops in high-growth companies in the late winter and early spring, broad-based buying returned in May and the rest of the summer, followed by more selling starting in late November.

With tumultuous declines in the past month, is this a contrarian “all-clear” signal for further gains? Or, with the Federal Reserve accelerating its tapering of quantitative easing and potentially raising official interest rates in 2022, is this the end of the bull run that started in early 2020?

For answers, we look to the major players: “passive” investors and the Fed.

Passive investors never sell

Passive funds, such as exchange traded funds that invest in the S&P 500 Index
have been gaining market share for decades and are now at a critical mass of all professionally managed assets.

In recent years, traditional valuation metrics like price-to-sales and market- capitalization-to-GDP have rocketed beyond historical highs, and this is no coincidence. Passive strategies are valuation-agnostic and buy whenever new money arrives. Consistent inflows from vehicles including 401(k) retirement accounts enable constant passive buying, and this dynamic could continue and perhaps even accelerate in 2022.

Market structure suffers under the passive regime, with the same “Big 3” firms now the largest holders of nearly every U.S. company, but while this continues, it is three 800-pound gorillas competing against each other to buy U.S. stocks.

The possible cause of December volatility

RMDs could be the cause of December volatility. RMDs, or required minimum distributions, apply to anyone over age 70 1/2 who has a retirement account. As the U.S. ages, with baby boomers entering their 70s, this large demographic not only holds the bulk of the wealth in the U.S., but they are also required to sell a portion of their holdings each year.

The government waived RMDs in 2020, but they are back in 2021. RMDs negatively affect the stock market because sound financial planning calls for selling equities as you age and buying more fixed income.

Just like in 2018, when required year-end selling caused an illiquid stock market to plummet over 9% in December, RMDs may not be done wreaking havoc in 2021. The good news is, once the required selling stops, illiquid markets receiving flows can rocket upwards in the new year. In January 2019, the market recovered nearly all of December 2018’s losses. We would expect a similar dynamic to play out in January 2022 should December 2021 end with more downward volatility.

Fed lights the fire, provides the extinguisher

Repeatedly telegraphed in 2021 is the Federal Reserve’s plan to slow its quantitative-easing stimulus program and raise rates in 2022.

Americans are upset with the rising prices of goods in 2021, and the Fed’s “money printing” has been part of the blame game. However, the government-bond market seems to doubt the intelligence of raising rates. As participants priced-in rising rates in 2022, the yield curve for U.S. government bonds flattened dramatically.

Curve flattening is an indication of a Fed policy mistake, namely, boosting rates into an environment where economic growth is slowing. Though real-time GDP trackers are indicating high single-digit growth for the U.S. economy in this quarter, the economy will have to stand on its own next year without the stimulus checks consumers enjoyed in 2021. Without government stimulus, growth will face major headwinds. Higher rates will stifle already tepid growth expectations, and the bond market is worried about this.

Does this mean U.S. stocks will end 2022 in the red? Probably not.

The Fed has a backbone made of wet spaghetti. If equity markets plummet along with growth expectations in 2022, the Fed could eliminate its taper plans, abandon higher rates and even add stimulus.

As we have seen, Federal Reserve governors own and trade equities, and they use their powers to preserve their own wealth. Therefore, even in the face of RMDs, slowing growth and rising interest rates, equity markets may still increase in 2022. A hedged approach to indexation could benefit most investors in this bizarre world.

Hedged strategy

While what I’ve written above is a cynical argument for higher asset prices in 2022, it is certainly not a fundamentals-based argument for remaining invested. The heavy-handed forces of passive investing and government intervention are a reality in the 2020s, and as we have seen, markets can stay divorced from fundamentals for extended periods.

Therefore, we believe a hedged equity approach will serve investors well. By having a safety net, investors can ride trends higher without risking exposure to a return to fundamentally sound valuations.

Pockets of opportunity

Increased volatility can be a patient investor’s best friend. Slight periods of outflows from investors can overwhelm the dominant investment vehicles and create great opportunities.

The last time this dynamic played out was the lockdown period in early 2020, where some spectacular, quality companies were trading at discounts as panicked selling overwhelmed passive buying.

Investors with discipline and a plan should be ready to make long-term investments should opportunity strike in the next few weeks. That said, best of luck investing in 2022.

Brian Frank is investment chief of Florida-based Frank Capital Partners LLC and portfolio manager of the Frank Value Fund.

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