The continuing volatility in the stock market is troubling. It is likely signaling difficult times ahead as early as January or February 2022. As such, it is time to consider risk management.
After more than a decade of steadily rising equity prices with few interruptions, investors have been lulled into believing that investing in stocks is a riskless game of never-ending profitability. Newcomers to the stock market arena, like your typical Robinhood investor, have been using stocks to supplement, or even replace earned income. Unfortunately, I believe we are entering an environment where the investment themes are changing to our detriment.
The most important change I see has been the pivot in the Federal Reserve Bank’s monetary policy from dovish to hawkish. The Fed’s focus switch from full employment to combating inflation is expected to reduce liquidity in the markets. That decline in liquidity, which has been supporting the financial markets for years, is going to impact the equity markets negatively. I believe that has already begun.
Inflation, one of the worst economic aftershocks of the pandemic, is the second variable that I see impacting stocks and bonds. Do I expect a hyperinflationary environment in 2022? No. But I do believe inflation will remain persistent throughout most of the year. A little inflation, experts say, is good for stocks. That’s probably true, but we are beyond “a little” at this point. Inflation is impacting corporate earnings, reducing profit margins, and forcing many companies and small businesses to raise prices.
That leads me to believe that in the first half of 2022, lower corporate earnings will not be able to justify the present price levels of the stock market. As earnings and guidance weaken somewhat, so will the stock market. That is not a good environment for further market gains.
The economy will also suffer. Consumers, thanks to continued price increases, may reach a point where they curtail some of their purchases. They may focus on buying things they need, like consumer staples, as opposed to things they want. That will slow the economy. As a result, we could live through a few months that could best be described as “stagflation.” That means a slowing economy and rising inflation.
I think that this stagflation, if it were to occur, would be a transitory event. By the second half of the year, we could see inflation begin to moderate (as supply shortages are resolved) and the economy grow, even if it is at a slower rate. If all of the above were to occur, it would put the Fed between a rock and a hard place. They may be forced to choose between protecting Main Street from the crippling effect of further rises in inflation. But if they do raise interest rates, as they intend to, they risk precipitating a serious decline in the stock market.
What, therefore, should an investor do as we enter the New Year? We may still enjoy a somewhat abbreviated Santa Rally this week. Much will depend on how the markets react to the inflation data on Thursday, December 23, 2021. If the markets take the data in stride, there is a bigger chance that the markets climb between Christmas and New Year’s.
But looking forward into 2022, I am expecting a double-digit decline in the stock market (20%-plus) sometime in the first quarter (Q122). It could happen as early as the third week in January and last through February or beyond.
At the very least, investors should reduce risk. There is no guarantee that “buying the dip” is going to work going forward. And even if it does, the equity rewards may lie elsewhere. International markets may hold better promise than stocks in the U.S.
For those who have been managing money on their own, I advise you to seek out a professional investment manager and do it quickly. The coming environment will demand experience, knowledge and a cool hand.