Market Outlook: Stealth Correction

U.S. 2021 market performance was strong, masking significant underlying market weakness. With extreme outlier high market valuations (by most measures) and the reduction/removal of fiscal/monetary supports, significant uncertainty about future market performance exists.
Stealthy Bear

The CWM team has been warning about the dangers posed by high, extreme outlier, stock market valuations and how they represent heightened potential for sharp market declines. Looking back at the strong index performance numbers of major U.S. stock indices in 2021 (international and more diversified indices are a notably different story), these warnings could appear faulty in hindsight. However, significant price decay underlies the strong headline performance of the major U.S. stock market indices. The solid gains of a relative few highly concentrated stock positions have been masking the “stealth” market correction currently in progress; a correction that is becoming more evident just weeks into 2022.

The Grisly Story Beneath the Surface

If a U.S. stock market index, like the S&P 500, is viewed purely by its 2021 end result, it would appear to have had great overall performance . However, a little digging beneath that glossy sheen shows substantial decay amongst the indices’ components, which suggests markets are much weaker than they appear on the surface. For instance, at the end of 2021, the number of new 52-week (one year) lows was roughly triple the number of new highs in the New York Stock Exchange (a broad measure of U.S. stocks)1. Per the table below, the indices shown had relatively minor drawdowns from their year-to-date (YTD) highs. This obfuscates the large percentage of components in each index that failed to provide a positive return for the year (37% of companies in the NASDAQ) and that the average component was well off highs for the year (an average drop of -43% in the NASDAQ).

Source: Sonders, L. (December 20, 2021). Update to Our Average Drawdowns Table. @LizAnnSonders Twitter.

In fact, as of January 11, 2022, ~40% of NASDAQ listed companies were down 50% or more from their trailing year highs. In the last ~22 years, whenever this has occurred, there has also been a significant overall market correction (1999 – 2003, 2008 – ’09, 2020), whereas currently (and unusually) the NASDAQ remains close to its all-time highs. The deck on a house may look to be in great shape, but it will undoubtedly collapse if termites have eaten away the supports.

Source: Roberts, L. (January 11, 2022). "Passive ETFs" Are Hiding the Bear Market. RIA Advice.

The reason this underlying decay has been possible without a commensurate decline in the value of the overall indices is related to the way in which they are constructed using a capitalization weighted method. Under this method, the largest companies (by market value) obtain the greatest weighting in the index. This can allow a relatively small number of strongly positive performing stocks to mask overall weakness of a large number of other companies. Currently, the market concentration of the major indices (S&P 500 & NASDAQ) is higher now than in 1969 and 1999, two major market peaks in the past.

Source: Kelly, D. et al. (December 31, 2021). Guide to the Markets. J.P. Morgan.

This “narrow stock leadership” in today’s markets has a direct parallel with the time just before the dotcom bust where Cisco, Dell, Intel and Microsoft were the major components of major U.S. stock market indices. These companies later became known as the “four horsemen of the apocalypse” post the early 2000s market collapse. Today’s top five S&P 500 companies (Facebook, Amazon, Apple, Netflix, and Alphabet a.k.a. Google ) provided over half the total return in the S&P 500 from April through the end of 20212 -not a healthy sign for future stock market performance expectations if history is any guide.

Fiscal and Monetary Drag Approaches

In addition to the concerns about narrow market leadership and underlying stock market weakness described above, there is also the question about how the economy and stock market will respond to the reduction/elimination of fiscal and monetary supports coming from global governments.

In the United States, persistently high inflation data appears to have convinced the Federal Reserve governors (who oversee monetary policy) that not only do they need to both shutdown asset purchasing programs and raise interest rates but do so faster than previously expected in order to stymie future price pressures. The quantitative easing asset purchasing program is now tapering off each month twice as fast as when originally planned and announced on November 3, 2021. In addition, interest rates (previously not expected to see hikes until 2023) are now thought to see increases as soon as the March 2022 Federal Reserve meeting, with the possibility of more than four hikes by the end of 2022.

Source: Hatzius, J. et. al. (January FOMC Preview: Preparing for Liftoff and Runoff. Goldman Sachs Economics Research.

Historically, the S&P 500 tends to be neutral/weak just before and after the beginning of a rate hike cycle (see chart below), with an average drawdown of ~6% for the S%P 5003.

Source: Kostin, D. et. al. (November 16, 2021). Positive Return in a Negative Real Rate World. Goldman Sachs Portfolio Strategy Research.

In addition to reduced monetary policy, it is also expected that global governments, the U.S. in particular, will significantly reduce fiscal spending and support programs put in place to provide aid during the COVID-19 pandemic. These programs were a huge boon to economic growth in 2020 and 2021 and their removal is expected to be a significant drag on global domestic product (GDP) growth going forward. Lower economic growth is not typically good for stock market valuations.

Source: Oppenheimer, P. (January 2022). Strategy Outlook for 2022: Getting Real. Goldman Sachs.

What Does the Data Tell Us?

The factor groups that the CWM team utilizes in decision making are a real mixed bag of strengths and weaknesses presently. Valuation, as mentioned previously, continues to be at outlier high levels and is the main source of future return risk for the overall stock market; overvaluation being driven in large part by an overly enthusiastic (greedy) investing public that has become enamored with strong price momentum and historically low interest rates. As mentioned earlier, interest rates at the very least are about to begin climbing higher, which will have some impact on the economy eventually. It remains to be seen if these extreme outlier high valuations and upward price momentum can be maintained as rates rise and government economic support fades.

Source: CWM Factor Groups. (January 6, 2022). CWM Data Analytics.

Taking a deeper look at valuation, it can be seen that merely to get back to a lower extreme level (two standard deviations), stocks as a group would have to decline by ~22%. For a full mean reversion (return to the average) event, that decline would be ~57%. Markets may continue to move higher in valuation yet, but to chase that performance seems akin to running out to pick up dollars in front of steam roller.

Source: The Federal Reserve Bank of St. Louis. (January 6, 2022). CWM Data Analytics.

In addition to all of the other items highlighted above, it is also a midterm election year. Since 1950, midterm election years tend to have the highest downside volatility of the 4-year presidential cycle, but also tend to rebound strongest after the bottom occurs. Based on the current data environment and upcoming fiscal/monetary changes, there is potential that this year’s midterm drawdown could be above average. If so, once that occurs , there may be an excellent buying opportunity for the patient investor.

Source: Detrick, R. (January 11, 2022). Midterm Years Pullback 17.1% on Average. @RyanDetrick Twitter.

A Strategy Based Response

The proper response to the current environment varies greatly on an investor’s needs, wants, and ability. Over the last few years CWM has rolled out more traditional investment models that seek to provide static exposure to markets (i.e., buy and hold investing). Used primarily for those clients early on in their investing careers who have the capability of making new contributions during adverse market environments, this strategy is also available to households who simply prefer a more passive versus an active investment style. These wealth accumulation models , as we refer to them, are widely used in CWM’s Starting Strong program, as well as more financially established clients as a compliment to their risk-managed accounts. The response with this strategy varies greatly from the CWM Risk Managed models that the firm has always provided. The recommended action, based on model type, is outlined below.

Starting Strong/Wealth Accumulation Clients

While the aforementioned market concerns are worth noting, the only response for clients in the wealth accumulation models is to gird oneself for a potentially sharp market drawdown. Traditional investment models require the fortitude to ride the market both up and down. Mentally preparing ahead of time enables the ability to stave off panic responses and potentially poor behavioral decision when a drawdown occurs. When that drawdown does occur, it is vitally important to stay disciplined, avoid fear-based portfolio changes, and continue to make new contributions (assuming ability) as based on the plan established with your advisor. This will not feel comfortable in the midst of a large stock market decline and amidst the ensuing media frenzy. Stay disciplined and on plan.

Risk Managed Clients

The response for risk managed models is more complex as the current data setup continues to require conservative action be taken. As a result of outlier high level valuations, among other datapoints, CWM’s risk managed models have sharply reduced risk exposure (i.e., correlation with the stock market) at this point. This does not mean “no risk,” but that clients should expect muted portfolio movement, either up or down, when compared to the overall S&P 500. These models continue to be fully invested in assets that historically gained value or hold up well during market declines.

Some of these investments are traditional bonds and U.S. treasuries, which may seem worrisome in context of potential rising interest rates, and even a small loss for those categories in 2021. To allay those concerns, it is worth noting that since 1926, there is no 4-year period of time in which U.S. bonds have lost money. That timeframe includes several rising rate regimes, in some cases sharply rising (ex. The late 1970s – early ‘80s under Fed Chairman Paul Volcker). It also worth noting that back-to-back negative performance years for bonds is highly unusual and there hasn’t been an occurrence of that since the 1950s. Additionally, bonds historically tend to perform well after a year of weakness.

Source: Student of the Market. (April 2021). Student of the Market. BlackRock.

Summing it Up

The response to the current investment environment depends upon the investment strategy being utilized. In either case, it is important to know that despite the strong recent performance of (especially U.S. centric) stock markets, there are a number of worrisome abnormalities under the surface that suggest a significant risk-off event (i.e. market decline) is possible in the near future. The disciplined investor either needs to take steps to limit market risk or gird oneself to ride out the coming market storm, continuing to follow the disciplined reinvestment and contribution strategies that historically have led to longer term success.

Please pass this article on to anyone you know who may be interested in or might benefit from the information. We are always looking for more great clients like you and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me or, if you are interested in more regular financial tidbits, follow me on Twitter.

P.S. For a little fun with numbers consider this: the twenty second day of February, is the second day of the workweek, of the second month, of the second year, of the second decade, of the second millennia AND is on a Tuesday (Two’s…day).


1 Sonders, L. (December 20, 2021). Update to Our Average Drawdowns Table. @LizAnnSonders Twitter.
2 Sozzi, B. (December 13, 2021). 5 Giant Stocks Are Driving the S&P 500 to Records. Yahoo! Finance.
3 Kostin, D. et. al. (November 16, 2021). Positive Return in a Negative Real Rate World. Goldman Sachs Portfolio Strategy Research.

Past performance is no guarantee of future results. The S&P 500 is an unmanaged index comprised of 500 widely held securities considered to be representative of the stock market in general. You cannot directly invest in the S&P 500 index. Dollar Cost Averaging does not assure a profit or protect against a loss. Such a plan involves continuous investment in securities regardless of fluctuating price levels.

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