Analysis: US stock investors wonder how much gas is left in the 2022 rally

People are seen on Wall Street outside the New York Stock Exchange (NYSE) in New York City, US, March 19, 2021. REUTERS/Brendan McDermid/File Photo

NEW YORK, Dec. 23 (Reuters) – The US stock market is expected to deliver a three-peat of stellar annual returns, but the chances of a comparable performance in 2022 could be threatened by a more aggressive Federal Reserve, slowing earnings growth and a brutal pandemic .

With just over a week to go into the year, the S&P 500 (.SPX) is on track for an 87% gain since the end of 2018, its best three-year performance in more than two decades. The benchmark is up 25% so far in 2021 after double-digit returns in the previous two years.

If history is any guide, next year’s gains may be less impressive, but not necessarily bad.

According to Jessica Rabe, co-founder of DataTrek Research, the S&P 500 has had three straight years of double-digit returns, nine times since 1928.

Earnings in the year following such periods were weaker on average, with an index averaging 8.4%, compared to the overall average aggregate return of 11.6%, DataTrek found. Shares rose in five of those nine years and fell in the other four.

“The odds of this kind of positive dynamic continuing into the next year is a coin toss,” Rabe said in email responses to Reuters. “But the S&P’s performance has historically proven to be asymmetrical, as positive returns far outweighed negative returns in the fourth year.”

A Reuters poll of strategists earlier this month predicted the S&P 500 would end at 4,910 in 2022, up 4.5% from Wednesday’s close. read more

The Fed’s three projected rate hikes in 2022 — a more aggressive path than markets expected weeks ago — will keep investors’ attention, threatening to drive bond yields higher and undercut relatively risky assets like stocks.

But the economic growth that is driving the central bank to raise interest rates could also help boost equities.

The S&P 500 has risen an average of 7.7% in the Fed’s first year of raising rates, according to Deutsche Bank’s study of 13 hiking cycles since 1955.

“We still see a decent environment for equity investors in 2022, although we don’t expect the kind of gains we’ve seen,” said James Ragan, director of asset management research at DA Davidson, who forecasts half-digit growth for the S&P 500 in 2022.

Ragan favors sectors that will mainly benefit from a solid economy, such as financials, manufacturing and materials, but also companies that can pass on price increases during an inflationary environment.

“We think it’s still good overall GDP growth should allow companies to still make a profit, but we’re concerned about valuations,” Ragan said.

EARNINGS STRONG ENOUGH?

Rising bond yields, which typically come with higher interest rates, could put pressure on already stretched equity valuations, as projected corporate cash flows will be discounted at higher rates in standard stock valuation models.

The S&P 500 is trading at about 21 times 12-month earnings estimates, compared to the historical average of 15.5 times, according to Refinitiv Datastream.

While strong gains may still bolster the case for equities, S&P 500 corporate earnings are expected to grow 8.3% next year, after recovering nearly 50% in 2021, according to Refinitiv IBES.

“Income growth and revenue growth should be enough to push stock markets up, but the risk is that they will disappoint,” said Michael Arone, chief investment strategist at State Street Global Advisors.

The earnings picture is also clouded by uncertainties about COVID-19 as the Omicron variant takes hold around the world. While investors doubt widespread US government lockdowns related to the virus will return, consumers “may spend more cautiously amid a renewed wave of Covid infections,” according to a recent Oxford Economics note, which forecast consumer spending increase by 4.3% in 2022 after record growth of 8.1% this year.

Another joker for investors is the US midterm elections in November, in which Democratic Party control of President Joe Biden’s Democratic Party is seen as weak.

Whether technology and growth stocks, which have led the U.S. market for the past decade, can maintain their strength, too, remains to be seen. For example, those stocks are particularly sensitive to higher yields because their valuation is more dependent on future earnings.

Wider markets could be in trouble if giant growth stocks falter. Profits in six companies: Microsoft Corp (MSFT.O), Apple Inc (AAPL.O), Google parent company Alphabet Inc (GOOGL.O), Nvidia Corp (NVDA.O), Tesla Inc (TSLA.O), and Meta Platforms Inc (FB.O), formerly Facebook — accounted for about a third of the total return of the S&P 500 in 2021 as of Tuesday’s close, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

“We may begin to see underperformance in technology and outperformance in sectors that are undervalued,” said Andre Bakhos, managing director at New Vines Capital LLC in Bernardsville, New Jersey. “Due to the nature and design of the S&P, it would likely have a lower market.”

Reporting by Lewis Krauskopf in New York Editing by Ira Iosebashvili, Megan Davies and Matthew Lewis

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