Quarterly Update

2021 was another year where market returns didn’t seem to line up with reality. Multiple waves of the coronavirus pandemic added uncertainty while domestic and global politics dampened the mood at times. Inflation took off midyear and negative news seemed to mount as the year closed. The stock market reacted to all this, sometimes in volatile fashion, but prices for most asset classes just kept rising. The S&P 500 hit a new high nearly 70 times last year, just missing the record of 77 in 1995. Simply amazing when you consider the current social and economic backdrop to our lives.

Here’s a roundup of how major markets performed during the fourth quarter and year-to-date, respectively:

• US Large Cap Stocks: up 11%, up 29%
• US Small Cap Stocks: up 2%, up 14.5%
• US Core Bonds: basically flat, down 1.8%
• Developed Foreign Markets: up 2.7%, up 11.7%
• Emerging Markets: basically flat, up 1.3%

We can easily see from this list which asset classes were investor favorites during the year and a similar dynamic played out during Q4. The largest stocks fared best while smaller stocks struggled. Domestic stocks performed substantially better than foreign stocks. Top performing sectors were Energy and Real Estate, up 53% and 46% respectively, for all of 2021. Investors had shunned both sectors during the worst of the pandemic but seemed eager to make up for lost time this year. Financials and Technology were each up almost 35% for the year while more defensive sectors like Utilities and Consumer Staples grew a little over 17%. Communication Services, home to massive companies like Google, Facebook, Apple, and Disney, outperformed in 2020 but underperformed this year, rising nearly 16%. Not bad for the worst performing sector!

Underperformance was easy to spot during 2021 because the spread was so large. Small company stocks in the US underperformed for most of the year. These companies are generally more susceptible to pandemic woes (supply chain disruptions, interest rates and inflation, changes in consumer behavior, etc.) and have historically been more volatile anyway. Investors couldn’t decide how to feel about these stocks as uncertainty rose around the Delta and Omicron variants. Still, all things considered, a 14.5% annual return for small caps is nothing to sniff at.

Underperformance was more pronounced in the bond market. Granted, bonds are fundamentally different from stocks but since most investors own bonds, and sometimes in large proportions, a superficial comparison is warranted. Core bonds (high quality, medium term) had a dismal 2021, returning around -1.8%, depending on the index. Short-term bonds lost less than a percent while longer-term bonds fared worse, down 5-6% for the year. This poor showing had mostly to do with the extravagant stock performance referenced above, which was itself driven in large part by the Federal Reserve.

In response to the pandemic in 2020 the Fed took short-term interest rates to zero and, with help from Congress, injected trillions of dollars into the economy. A natural result of all this cheap money and government spending was that investors got hungry for risk. This hunger has only increased since. Investors bought stocks, digital assets, houses, basically anything that was likely to grow in value. Bonds don’t grow in the same way as stocks. Instead, they act as a store of value that pays interest but the interest rate, or yield, offered (about 1.5% or less on the 10yr Treasury bond for much of the year) is far from exciting. Riskier parts of the bond market understandably performed better as some investors reached for higher yields. Lower credit quality, or “junk” bonds, returned about 4% for the year while preferred stocks, really a hybrid of bonds and stocks, brought in 7%. If past is prologue, this complacency about risk will come back to bite some investors.

Inflation-protected bonds also performed better than the bond market, up around 5-6% in 2021. This category is also riskier than core bonds because it relies on above-average inflation setting in. Well, that’s exactly what we saw last year. The nation’s CPI hit 4% in April, 6% in October, and ended November up 6.8%, an increase in consumer prices not seen in decades. And those are just averages. The price of gasoline rose nearly 50% from 2020, housing was up over 20% in much of the country, and many grocery items were up double digits. The Fed intended to stoke inflation in response to the pandemic and planned to allow prices to run hot for a while, but time will tell if the Fed can manage the inflation it created. Investors are expecting the Fed to raise short-term rates as much as three times in 2022. This would limit inflation but also risks broader negative economic consequences if not managed perfectly.

As we roll into 2022 many of the trends from last year are expected to continue. Pandemic uncertainty will reign supreme. Existing domestic and global political issues seem likely flashpoints this year. Bond returns are expected to remain subdued and could turn volatile in a rising rate environment. Asset prices are expected to keep rising but could get rocky for all of the aforementioned reasons and then some.

All things considered, 2021 was a great year to be a long-term investor. And that’s something to be grateful for during challenging times.

Have questions? Ask me. I can help.