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2021 Market Review

Markus Muhs - Jan 10, 2022
Past returns are not indicative of future expectations
Well, since I’ve been doing this every year since I started blogging, I guess I’ll write another “Year in Review” for the markets in 2021. To be totally honest, it feels like I just wrote my 2020 piece and for the most part 2020 and 2021 just felt like one big year (that still hasn’t ended!).
Anywho, this time of year you’ll probably find countless years in review and 2022 “projections” out there, so I’ll try not to bore you with just another detailing of what all the market indicators did. You can literally just read the numbers below and see for yourself and I included links to a much more interesting review and outlook at the bottom of this post.
I will note that U.S. markets went up a lot. Again. For the third year in a row. This isn’t sustainable, however we have no idea when such a streak could end. January 1998 was preceded by three even stronger years on the S&P 500: 34%, 20%, and 31%, and stocks by that point were as overvalued then as they are now, with trailing price/earnings ratios in the high-20s. They became even more overvalued though, with returns of 27% and 20% in 1998 and 1999 respectively.
Whether frightened of the markets during a correction, or worried that they’re too overvalued, one should never go to cash with their long-term portfolio, per my recent piece Why I’ll Never Sell to Cash. An investor in January 1998, who thought the markets were too expensive and correctly predicted the impending tech bubble, got out of U.S. stocks when the S&P 500 was at 1100, and watched from the sidelines as it went to over 1500 in the next two years.
Moving on, another thing apparent in the numbers above is that we had a reversal of leadership from 2020 to 2021. Canada, a laggard in 2020, actually beat Nasdaq in 2021 on the backs of recovering financials and energy stocks. 
The above chart is one I've shared before, comparing the relative performance of major factors in U.S. stocks. I decided to do a 10 year to show just how out of wack growth (red) has become relative to small cap stocks (purple) and value (blue). It looks like at least the spread has stopped. Mega cap growth names had a so-so year, and the smaller trendier growth names (Zoom, Teladoc, etc) got absolutely wrecked last year. Check out Charlie Bilello's 2021 Charts, at the bottom of this post, for more.

Past Returns...

I want to focus my review this year on one main issue and one bit of advice to all the investors out there, which we advisors have repeated like clockwork for as long as there have been professional advisors, and retail investors typically have ignored only to buy whatever shiny object had the highest past performance most recently.
Past returns are not indicative of future returns.
Me, early on in my career at the bank: “we should put your RRSP contribution into this mutual fund…” Customer (every time): “how well is it performing?” 
Back then (2007ish) clients were eschewing U.S. and global funds because they had performed so poorly after the tech bubble burst and the Canadian dollar surged. Everyone only wanted Canadian stocks: resource stocks and banks in particular. Those were doing—or rather, had done—well up to that point. They were then the hardest hit when the Great Financial Crisis (GFC) hit.
All the way up until around 2012 I remember trying to get clients to diversify out of Canadian stocks (in particular the big banks and energy) and into the rest of the world. Canadian stocks represent 3-4% of global market cap; it’s unconscionable that they should represent 90% of your portfolio. No, the 10% pity allocation to global is not diversifying!
Then, as U.S. stocks started surging through 2013 and 2014, it was far less difficult to convince people to diversify. After years and years of U.S. stocks beating the pants off Canadian stocks—with 2016 the only exception year—keeping an allocation to Canadian stocks started to be the harder sell.
We’ve now seen nearly a whole decade of outperformance of large/mega cap growth stocks; the FAANGs, or MAANGs, or whatever the latest incarnation of the acronym is. (My submission: MANAMANT for Meta, Alphabet, Netflix, Amazon, Microsoft, Apple, Nvidia, Tesla)
Prior to 2021, Canadian stocks languished, same with International developed markets, and Emerging Markets seemed to be going nowhere. Value stocks were cheap and stayed cheap, while small caps regularly go from unnoticed whenever the markets are strong, to most hated whenever they get pounded down in a correction.
It’s remarkable how completely different the world was in the mid-2000s. Emerging Markets, Canadian, and small cap funds were all the rage. You didn’t want to touch a U.S. equity fund unless it was a good value strategy, devoid of technology, with a currency hedge to avoid losing due to the tumbling Greenback. Back in 2020 I wrote this post on the top mutual funds back then, trying to track how they ended up doing. Pretty much all the best performers—in turn the funds attracting the most dollars—were exactly precisely the funds you did not want to be in over the past decade and a half.
Will the future be any different? Is there any reason to believe that U.S. megacap growth will continue to lead for the next ten years? Or might we see a “phase shift” in the economy, and a change in leadership?
In the mid-2000s the economy was on the mend after the early-2000s recession. Interest rates were dropped to what were then considered historical lows, and started rising again around 2003/2004. Commodity prices were surging, causing inflation, which was compelling central banks to normalize rates again.
Growth stocks benefited greatly from declining and almost permanently low interest rates over the whole period since the GFC. Not only is cheap capital conducive of their financing needs, but low discount rates mean that future profits are discounted less. In layman’s terms, when the discount rate (or, what you could otherwise earn on money risk free) is less than 1% then a billion dollars of profit in 2025 is worth nearly a billion dollars in 2020. When the discount rate is higher, those future profits aren’t worth quite as much. The market starts favoring profits in the present tense more when rates are higher and rising.
So, with economic circumstances (higher commodity prices, higher inflation, expected rising interest rates) looking more and more similar to the mid-2000s than they do to 2020 (or the 11years prior), and with certain asset classes already at tippy-top valuations, is there any reason to expect those certain asset classes to continue outperforming?
The Wall Street Journal pegs the S&P 500’s trailing 12 month price/earnings valuation at just below 29 as I write this. The historical average was more around 15. The NASDAQ is currently at a p/e of over 38. Yes, stocks are overvalued. U.S. stocks are overvalued; in particular growth stocks.
According to Morningstar, the S&P 500 Value index’s p/e is around 15-16, the TSX Composite’s is about 14, international developed markets are below 14, and emerging markets are below 12. Look back at the table near the top of this post how those asset classes did last year (and in 2020, and in the decade prior). It's like comparing Edmonton and Toronto real estate right now. Which house has a better chance of seeing price appreciation over the next decade: a $400,000 house or the exact same house in a different city for $1.4 million?  
I’m not predicting that the above undervalued asset classes are now set to outperform, nor that the overvalued past winners are to be avoided. Remember that I mentioned a bit earlier that someone could have called stocks overvalued in January 1998, would have been 100% correct, but would have slaughtered his long term portfolio return if he cashed out (unless he had the discipline to stay completely out until the lows in 2002 or 2009, which is impossibly unlikely). 
Being diversified in all asset classes continues to be the best time-tested investment strategy. That’s what I’m getting at with all of the above. If you want to be at all proactive, then recognize that the outperforming assets could be tilting your portfolio toward more risk and lower expected returns. U.S. stocks now make up almost 70% of the cap-weighted global index (just like Japanese stocks in the late-80s!). Technology, Commmunication Services, and Consumer Cyclicals are three out of eleven sectors, but they now make up half of the S&P 500.  Rebalance by tilting away from them. 
Deliberately tilting your investment asset allocation toward whatever performed best in the recent past and avoiding whatever performed worst is completely and utterly the wrong thing to do, so please stop doing it!

Some more reading

Having put in my 2 cents on the current status of the markets, here are the very best reviews of 2021 and outlooks for 2022 I’ve read of late:
If you only read one of these, or rather prefer to mostly scroll through a plethora of charts, check out Charlie Bilello’s 2021: The Year in Charts. This pretty much answers every question you might have about every asset class in 2021.
Even though I always say trying to predict the markets is pretty useless, Capital Group’s yearly Outlook slideshows are top-notch, covering the here and now and what trends we could see this year.
That's it! I think there will be plenty more "2022 Market Outlook" pieces in the next little while, but all you need to know as a long term investor is to be a long-term investor.
While the markets have been kind to us these past 3 years, let's hope that in many other ways 2022 is a much better year to all of us than the past two. Even if it means it ends up being a one-in-three year (historically) that happens to be negative.
Markus Muhs / CFP, CIM
Senior Investment Advisor & Portfolio Manager
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