Despite a spike in volatility in the past two weeks, it has been another successful year for the stock market. Until Tuesday, December 7, the reference point S&P 500 (^GSPC -0.78%) had gained almost 25%. To put this number in context, the widely followed index has averaged an annual total return, including dividends, of around 11% since 1980.
They’re not beating around the bush: it’s been a good year for many big-name companies.
But history also shows us that stock market crashes and double-digit percentage corrections are common. As we prepare to move into a new year, the following seven factors stand out as the biggest threats to the stock market in 2022.
1. The Federal Reserve panics over inflation
Arguably the biggest concern for Wall Street in 2022 is how the Federal Reserve handles rapidly rising inflation (the rising cost of goods and services).
Throughout 2021, Federal Reserve Chairman Jerome Powell has described inflation as “transient.” But that terminology changed this month, with Powell acknowledging that higher prices could hold. Although some level of inflation is expected in a growing economy, the 6.2% rise in the consumer price index for all urban consumers in October marked the biggest jump in 31 years. Sustainable price increases of this magnitude will eat up wage increases, gobble up discretionary income from consumers and businesses, and could stop the economic rebound from the coronavirus-induced recession in its tracks.
The nation’s central bank may be forced to raise its target federal funds rate, which influences interest rates, sooner than anticipated. The concern is that if the Fed has moved too slowly, or provided too much help to the US economy with its record-low interest rates and bond-buying program, it could be forced to aggressively raise rates. interest rates. If that were to happen, growth stocks would be in deep trouble, as would the S&P 500, which has relied on growth stocks for most of its gains over the past 12 years.
2. Political gridlock
When in doubt, keep the policy out of your wallet. But from time to time, it’s impossible to ignore how actions in Washington, DC can affect your investment prospects. However, the biggest concern in 2022 is not what legislation might come out of Washington. Rather, it is what is not being done.
Next year, lawmakers will have to tackle another federal funding bill by February 15. We will also sail into the midterm elections in early November, and politicians could find themselves embroiled in another debt ceiling debate near the end of 2022.
In recent years, the ideological divide between the two dominant parties in the United States, the Democrats and the Republicans, has widened, and sometimes it seems impossible to find middle ground. With politicians focused on re-election campaigns, the lack of action in Washington could become a serious distraction on Wall Street.
3. Global “Variant Variation”
Another fairly obvious threat to global markets is what I call the “variant variation” of the coronavirus disease 2019 (COVID-19).
In May, the emergence of the delta variant of the SARS-CoV-2 virus that causes COVID-19 briefly sent investors for the hills. The same could be said for the omicron variant in the last two weeks. The mutability of SARS-CoV-2 suggests that we should expect new variants to emerge in the next year.
Variant Variance describes how, instead of having a unified approach to tackling the spread of COVID-19, we are witnessing a hodgepodge of campaigns and restrictions globally. While some countries are imposing few restrictions, others have mandated the vaccine or banned access to non-essential stores for the unvaccinated. These unpredictable and inconsistent responses to variants of COVID-19 threaten to disrupt already fragile supply chains and could seriously reduce US and global growth rates in 2022.
4. A margin debt settlement
A fourth threat to the stock market in 2022 is leverage.
Over time, we would expect the nominal amount of outstanding margin debt to increase. Margin debt describes the amount of money borrowed from brokerage houses at interest to buy or sell short securities. However, rapid increases in margin debt are much less common and have worrying implications.
Since the beginning of 1995, there have only been three instances where margin debt increased by at least 60% year over year, according to data from the Financial Industry Regulatory Authority (FINRA). It happened shortly before the dotcom bubble burst, just a few months before the financial crisis, and again in 2021.
While margin can be used to increase profits, it can also quickly multiply losses. A short-term, fear- or sentiment-driven event that pushes the S&P 500 lower in 2022 could lead to broad margin calls that sink Wall Street.
5. A crypto crash
Over the past two years, the cryptocurrency market has circled around the S&P 500. Since the coronavirus trough for stock markets in March 2020, the S&P 500 is up just over 100%, while the value aggregate of digital currencies has skyrocketed further. 15 times, from $141 billion to $2.34 trillion.
Making money in the cryptocurrency space has been easy, perhaps too easy. Crypto profits have, in some cases, been invested in highly volatile stocks, momentum games, and meme stocks, such as gamestop Y AMC Entertainment. If the crypto market, which is dominated in market cap by a handful of names, were to undergo a significant reversal, retail equity investors have been bouncing between digital currencies and volatile/momentum/meme stocks could dry up partially or fully.
As a reminder, in November, the Federal Reserve’s “Financial Stability Report” cited the actions of retail investors in meme stocks as a potentially destabilizing factor for the stock market. If momentum hunters get hit by crypto in the next year, Wall Street is likely to share the pain, to an extent.
6. Growth Stock Premium Reversal
Historically, value stocks have actually outperformed growth stocks. But since the Great Recession ended, low lending rates and a dovish central bank have rolled out the red carpet for growth stocks to thrive. Eventually, we will see some sort of reversal of this tug-of-war between growth and value, and it may come as early as 2022.
If the Fed raises interest rates faster than expected and makes good on its word to reduce or eliminate quantitative easing measures, access to cheap capital will decline for growth stocks. This is likely to mean less in the way of acquisitions, as well as fast-paced companies being more aware of where they put their capital to work with regards to new projects and innovation. In other words, it probably means slower growth rates across the board.
The problem, as noted above, is that growth stocks have been the wind in the S&P 500’s sails. If growth rates slow, it becomes that much harder for Wall Street and investors to justify paying 50x sales. of a cloud services company or 35 times the revenue of a cybersecurity action. A premium reversal for fast-paced companies could send off the S&P 500 and tech companies Nasdaq Composite in 2022.
7. Story (often rhymes)
Finally, the story looks like a genuine threat to the S&P 500’s seemingly relentless uptrend over the last 20.5 months.
Since 1950, there have been 38 double-digit declines in the S&P 500, which equates to one notable drop, on average, every 1.87 years. Similarly, there have been one or two declines of at least 10% in the 36 months after each of the last eight bear market lows, dating back to 1960. Although the stock market does not strictly adhere to averages, nor does it follow history with a “t”, it often rhymes with history. This means that the benchmark S&P 500 index repeats downward movements after certain events, although not always in the expected timeline.
Based on the numbers above, we appear to be in for both a natural downward correction and a setback as we recover from a bear market bottom. Although there is no way of knowing when this drop might occur, the story is pretty clear that moves lower are a normal part of the reversal cycle.
In other words, don’t be surprised if 2022 features a bigger drop than the miniscule 5% “drop” the S&P 500 faced this year.