The benchmark S&P 500 posted an impressive 10.6% return during the 4th quarter. That mark would be noteworthy over a calendar year, let alone one quarter. The gains were largely front-loaded thru early November. After that the market moved mostly sideways before a modest rise into year-end. The most recent quarterly earnings results were more mixed across and within sectors as some companies appear to be dealing more deftly with supply chain logistics and input cost pressures. Earnings in aggregate continued to surprise to the upside, coming in 9% above analyst estimates and rising nearly 40% year-over-year. Those outcomes pale in comparison to the previous quarter’s 92% earnings growth and 16% surprise, but are measured versus a reopening economic backdrop rather than a locked down backdrop. Bottleneck inflation lingers stubbornly due to logistical issues, but slightly lower bond yields indicate investors believe those pressures will pass.
The U.S. economy grew a disappointing 2.3% during the 3rd quarter, but looks to be tracking at nearly three times that pace in the final quarter of 2021. The labor market continues a sharp recovery, with the unemployment rate projected to push back below 4% toward the middle of 2022. With that progress in mind and strong momentum in both goods-oriented and services-oriented areas of the economy, the Federal Reserve has begun removing emergency stimulus put in place last year to prevent lasting or lingering economic damage from the pandemic’s onset. While taking their overall policy stance to a more neutral stance in 2022 could mean higher short-term interest rates, longer-term interest rates that more directly impact mortgage rates and corporate borrowing remain very low by historical standards. Economists project the U.S. economy will grow around 4% next year after expanding around 5% in 2021. Growth had averaged right around 2% over the previous decade, so this sort of environment should bode well for consumer and business incomes.
The broad market advanced strongly for the 4th quarter, but returns varied widely across sectors. Technology returned nearly 17%, while Communication Services was slightly into negative territory. While many Technology companies found component shortages limited sales, many service-centric companies face fewer input cost pressures. Mega Cap Tech names, however, did seem to lose momentum during the quarter. Real Estate turned in a strong quarter as investors sought a historical inflation hedge and longer-term trends like e-commerce and Cloud logistics added additional support. Materials benefited from higher selling prices and exposure to future U.S. infrastructure spending. Consumer stocks benefited from healthy household balance sheets, with Staples also getting a lift from the ability to raise prices. Healthcare performed roughly in line with the overall market on solid earnings but no special catalysts. Utilities also shadowed broad market returns with investors drawn to healthy dividend yields. In contrast, Financials trailed as lower long-term interest rates tend to cut into earnings. Industrials will also benefit from infrastructure spending, but near-term supply chain snarls worried investors. Energy shares trailed the market in spite of higher oil and natural gas prices. Communication Services lagged as the impending 5G rollout has been slow to accelerate.
Earnings have indeed driven stock prices at the company level during this mid-cycle stage. Disappointing or “not impressive enough” earnings and guidance produced some sizeable share price drops. History has proven this phase is a stock pickers’ market, where which the specific companies a portfolio holds or doesn’t own can make a big difference in returns. It pays to own companies who deliver consistent earnings growth, provide realistic projections of what they’re trying to accomplish and lay out the path to those goals. Management teams demonstrate their worth via those metrics, and investors will want to own companies whose leadership shows an adaptability to improvise, adapt and overcome challenges. As the market enters a more mature portion of the cycle, earnings growth will likely slow and price gains be more modest for stocks overall. Investors, however, can choose from a market of stocks rather than simply owning “the market”, and shopping from that menu offers the chance to own sector and market leaders.