Money Talk: Position your 2022 portfolio for markets and inflation

Despite brief pullbacks in September and November, investor appetite for riskier assets remained solid in the fourth quarter putting its return for all of 2021 at just under 29% and bringing the Index's batting average, or number of years with a positive return, at 74% since 1926.

The Index's average annual is back to 10%, but to achieve this average return, investors have had to steel their confidence despite three corrections of 5% per year, one correction of at least 10% annually, a 15% correction once every three years and a bear market (20% or larger correction) once every six years, on average. 

Bear markets coincide with recessions, so stock investors are constantly weighing the likelihood of a recession in the near term when they decide whether a stock's current price is fairly-valued. For now, the growth outlook is strong with expectations of 9% earnings growth for S & P 500 companies during 2022. Assuming no change in investor appetite for risk, this would translate into another year of near double-digit returns for stocks. 

One key economic variable for 2022 will be inflation, which has been clocking at record levels for the past few months. This begs two questions. One, will the elevated inflation rate persist? If so, what might the impact be on the economy and stocks, which, of course, depends upon how the Federal Reserve responds with changes in its interest rate policy. 

One view of the current inflation picture is that much of it has been driven by COVID-related disruptions in the supply chain. That is, there are enough goods being produced to meet demand, they are just having a hard time getting to the right place due to disruptions in the transportation system. No doubt, this is part of the problem but the massive amount of stimulus money that governments pumped into the economy in the wake of COVID surely also plays a role. Both of these factors suggest that higher inflation should be temporary once the imbalances work their way out of the system. 

That said, the Fed has taken note that high inflation readings have continued for several months and signaled that it is ready to back away from its bond purchase program and pegging the Federal Funds rate at near zero. Both actions kept interest rates low to bolster the economy. To control inflation, the Fed will push interest rates higher, though its efforts may be hampered a bit by low interest rates overseas.

Higher rates will likely trigger higher stock market volatility, but a bear market is not a foregone conclusion. On the contrary, stocks have tended to trend higher during periods when the Fed has raised rates. It is when the Fed pushes the short-term rates above long-term rates that stock markets run into trouble as such tightening of credit conditions generally precedes a recession. 

Bond investors should expect lower returns as rising rates mean lower bond prices, all else equal. Positioning for a rising rate environment in bonds means favoring shorter-term issues and those with higher income payments. However, one needs to be cautious about loading up on high-yield bonds as these carry credit risk that expose investors to significant declines early in a recession. Floating rate notes carry the same caveat regarding credit quality.

With stock and bond markets both seemingly near market highs, investors may be apprehensive about putting cash to work in the stock or bond markets these days. Such anxiety is understandable since the logical recipe for better investment returns is to buy low and sell high. But markets hitting new highs does not really give us any indication that the next move is likely to be down.

 A recent piece from Dimensional Fund Advisors Vice President Weston Wellington makes the case that this anxiety is misplaced. Looking at the 94-year period ending in 2020, Wellington finds that purchasing stocks at all-time highs has produced similar returns over the following one, three and five-year periods when compared to a strategy of waiting to buy until after a 20% decline. So, while we may be anxious about seeing short-term losses after investing near stock market highs, we are better off sticking with our well-laid investment strategy by continuing to put cash to work and rebalancing as needed when returns push our stock and bond allocations away from our targets. 

David T. Mayes is a CERTIFIED FINANCIAL PLANNERTM professional and IRS Enrolled Agent at Three Bearings Fiduciary Advisors Inc., a fee-only advisory firm in Hampton.  He can be reached at (603) 926-1775or by visiting www.threebearings.com.