Mean Reversion

“Prediction is very difficult. Especially about the future.”
— Niels Bohr

As we bid farewell to 2021 and chart a course for 2022, we seem to be sitting at inflection points for the pandemic and financial markets. We are certainly not epidemiologists, but the Omicron variant seems to exhibit characteristics, highly contagious yet less virulent, that point to a
pathogen that is evolving into an endemic part of our landscape. It seems likely that future economic disruptions from COVID will be limited as society continues to adapt. The virus will remain a health threat, but one that we will have to manage. As Marco Cavaleri, a senior official with the European Medicine Agency (EMA), said on January 11th, “we need to think about how we can transition from the current pandemic setting to a more endemic setting.”

The inflection point for markets is the change in posture from the Federal Reserve (the Fed). The Fed began adjusting its accommodative monetary policies by reducing purchases of mortgage and treasury bonds in December. The reduction in stimulus has been augmented by a significant change in rhetoric indicating the Fed could begin raising interest rates as early as March. This change in approach is likely to translate into more volatile financial markets as investors adjust their expectations for the path of interest rates. As discussed in previous letters, low interest rates have supported relatively high valuations for a variety of asset classes, especially public equities. As that balance is called into question, it is natural to see more uncertainty in markets. The first few weeks of the new year have certainly shown this to be true.

These inflection points provide an opportunity to take a step back and consider a broad survey of where markets have been, where they are today, and where they may be headed over the medium term. Investors in equity markets in the United States have enjoyed tremendous returns for the last three years, a cumulative 100% from the S&P 500, and above average returns since the end of the global financial crisis in 2009. The above average returns could mean that index performance in the near future, will disappoint.

Mean reversion is a powerful force in financial markets, but it is not gravity. It doesn’t automatically pull returns to a permanent
average over every cycle. We do think returns are likely to be lower over the medium term, especially in fixed income, but it is not a
certainty. As we think about portfolio allocations this view will be critical to navigating the next few years. Predicting the future is
certainly a challenge, but we can make some reasonable assessments of how our current circumstances could impact our direction of travel.

Market Update

The S&P 500 Index returned 11% in the fourth quarter, its seventh consecutive quarter of positive performance. It was another great year for US equity markets with the S&P 500 returning 29% and the broader US market as represented by the Russell 3000 Index returning 26%. Consumer spending continued to be robust, and corporate earnings beat expectations driven by sales growth and resilient margins.

Earnings growth was strong, with nearly two out of three S&P 500 companies citing improved profitability since the start of the pandemic as a result of pricing power and strong demand. Burgeoning demand, wage inflation, and supply chain disruptions pushed up prices for goods and services across the
board, but these price hikes did not deter consumers. The charts to the left and below from J.P. Morgan highlight the impact of increased margins, which drove the majority of earnings per share growth for 2021.

The US outperformed key international markets in 2021, supported by a strong US dollar. Developed international markets, as measured by the EAFE index, returned 740 basis points higher in local currencies (19.2% vs 11.8%), reflecting a 7% decline in the value of the Euro vs the USD. India was the standout within emerging markets, posting a 26.7% return for the year. China’s equity markets continued to be held down by geopolitical and regulatory uncertainties. The FTSE China 50 Index declined -21.6% with Ali Baba as the largest detractor, dragging the index down 522 basis points after declining 49% in 2021. Looking forward into 2022, we note that the world markets are near a 20-year peak in P/E ratios, but are supported by record high earnings.

The next few months are likely to be bumpy in equity markets as the Fed tapers bond purchases and we distance ourselves from the extraordinary stimulus measures enacted during the pandemic. The re-rating of many “pandemic stay-at-home” stocks was already well underway by the end of 2021: Peloton ended the year down -76%, Zoom down -45%, and DocuSign down – 31%. However, a wider reassessment of many growth stocks has accelerated in early 2022 as the prospect of a rising rate environment spurs investors to reassess risks and growth assumptions. Netflix has served as a headline example of this phenomenon after it reported its slowest year of growth since 2015 and revealed a disappointing growth forecast for 2022. As of January 25, 2022, Netflix shares were down 47% from its 2021 high as investors moderated their growth expectations.

The combination of anecdotal observations and wider underlying market dynamics reinforce our belief that investors should expect lower returns from equities over the next 5-10 years than they have experienced over the past 5-10 years. However, despite the unknowns, it is important to remember the benefit of a long-term investment horizon. Below we outline the 15-year rolling returns for the S&P 500 for the past forty years. This demonstrates that if you had invested in the S&P 500 on the last day of the year in any year since 1966 and held your investment for 15 years, you would never have experienced an annualized return below 4%. This should provide reassurance that staying invested through volatile markets is ultimately a rewarding exercise.

U.S. Economic Update

After the astonishing loss of 22.4 million jobs between February and April 2020, the US unemployment rate has almost come full circle. Closing out 2021, nonfarm payroll employment rose by 199,000 in December and the unemployment rate fell 0.3% to 3.9% as total unemployed persons decreased to 6.3 million. As a comparison, in February 2020, just prior to the coronavirus pandemic, the unemployment rate was 3.5% with 5.7 million people unemployed.

As the economy continues to open, surging demand for labor has caused a shortage in labor supply. Some economists conclude labor supply has been slower to recover due to enhanced unemployment benefits (which have now ended), lower immigration, higher costs of childcare, and lingering pandemic fears. This tug-of-war between labor demand and labor supply has driven wage growth to an annualized rate not seen since the early 1980s. Wage inflation is an important issue for the Fed as higher wages feed through to more persistent inflation. The Fed projects that as pandemic fears subside, this labor imbalance should find an equilibrium that reduces wage pressures. That dynamic will go a long way in determining how aggressive our central bank needs to be when raising rates this year.

Inflation increased significantly in 2021 as consumer demand collided with supply chain issues across a number of sectors. The December inflation reading of 7% was the largest 12-month increase since 1982. While supply chain bottlenecks have been part of the issue, year over year gains have also been amplified by pandemic-depressed prices from a year ago. For instance, energy rose 29.3% year over year and gasoline rose 49.6%. As these comparisons normalize, we expect to see more manageable inflation readings later this year. In short, prices should begin to level off.

With inflation running much hotter than the targeted 2% average inflation rate, the Fed is on high alert. Since the start of the pandemic, the Fed has provided significant support by cutting interest rates and implementing a bond purchase program of $120 billion per month. At the November FOMC meeting, the committee cut the monthly bond purchase program to $105 billion, recognizing that the economy needs less support as the situation evolves. Minutes from previous Fed meetings released in December revealed a board worried about the pace of price increases and unwilling to tolerate “sticky” inflation in 2022.

Looking Over the Horizon

Investors have enjoyed a robust return stream from US equities over the past ten years. The 16.5% annual return on the S&P 500 is almost twice the historic annual average from the US equity market. However, the 20-year returns of 9.5% are only about 1% higher than the historical expectation of approximately 8.5% for US equities. From a diversified portfolio perspective, it is important to remember fixed income. The aggregate US bond market has been able to produce solid returns over the past twenty years, although they have underwhelmed in the past decade. While equities benefit from earnings growth and broader trends in the economy, bonds are captive to the current level of interest rates. With treasury and high quality municipal ten-year bonds yielding well under 2% today, it is difficult to envision much return from fixed income over the next 5 to 7 years. This will have an obvious impact on expected returns from a diversified portfolio that holds bonds.

An expected increase in interest rates will directly impact fixed income returns, making them negative in some circumstances, and will also impact returns from the stock market. Markets have been “expensive” from a price/earnings perspective for at least the past five years. This extended multiple has been supported by low interest rates, so it is natural to expect that higher rates will lead to a decrease in the multiple investors are willing to pay for future earnings. We have already seen some multiple adjustment in 2021. If we breakdown the drivers of returns for the S&P 500 last year, we see the forward price/earnings multiple declined. Earnings growth was robust, so the market produced excellent returns. Earnings are expected to be strong again in 2022, which would allow the market to grind higher despite multiple compression. This would be a healthy outcome for investors. The adjustment to slightly higher rates does not have to result in a lasting pullback in the stock market, but it will certainly cause volatile price swings in short bursts.

In taking a slightly longer-term view of potential broad market returns, it is helpful to survey forecasts for index returns from the investment community. Many firms publish these reports annually, and we have briefly summarized some data from JP Morgan, Goldman Sachs, and AQR below:

Equity returns tend to attract headlines, but fixed income returns have a significant impact on the performance of a diversified portfolio. A simple 60% stock / 40% bond portfolio, a reference point for many investors, has earned annual returns of 7.1% over the long term and 8.1% in the past fifteen years, but it will only earn 3.5% based on JP Morgan’s forecast. This represents a substantial reduction in expected returns, below the level that many investors require from their portfolios.

Investors have options to consider given these expectations, but most revolve around taking additional risk to achieve a respectable return. The choices include:
1) Accept lower returns and budget accordingly
2) Use leverage to enhance returns
3) Add more active management of existing asset classes in an effort to beat the broad market index
4) Add strategies such as long/short equity, activist, and macro trading
5) Add alternative asset classes

Investors are likely to choose some combination of the menu above to position their portfolios. We are advocates of underweighting low-return fixed income, using some active equity management, and allocating to alternative asset classes such as private corporate credit and real estate credit to navigate through this landscape. We feel those recommendations still hold and are exploring other areas including emerging market equities, private equity, select hedge fund strategies, and real estate equity for additional investment.

Predictive Power

Making precise predictions about the immediate future is a challenging prospect, but with thoughtful analysis of the road behind us and attention to current conditions, we can attempt to anticipate the path ahead. We will not make definitive statements on where markets will settle 365 days from now, but we are comfortable reminding everyone that the equity market does not gain 28% every year. It is almost certain that some lower return years lie ahead, but with preparation we think these choppier waters can be navigated successfully.

We hope you had a wonderful holiday season and look forward to seeing you in 2022. We hope you have a safe, healthy, and profitable start to your new year.


Steve Sprengnether
President & Chief Investment Officer

Brad Bangen
VP, Head of Private Markets

Laurence Unger
VP, Head of Public Markets