To start this piece, I’d like to make one thing very clear: I am long-term bullish on the U.S. stock market. That is, over the next three to five-plus years, I believe stocks will power considerably higher.
However, stocks don’t go up in straight lines. They take two steps forward, and one step back. And that brings us to the topic of this piece…
The stock market has taken some huge steps forward over the past few years. Indeed, after rattling off three consecutive years of 15%-plus gains, the S&P 500 is tracking for its best three-year stretch since the late 1990s.
But now, the market is taking a step back, and I’m here to tell you that things will likely get uglier before they get prettier.
The new year is off to a rough start. Year-to-date, the S&P 500 is down nearly 3%, marking one of its worst starts to a calendar year in recent memory.
The culprit, of course, is the Federal Reserve. The so-called “masters of the financial universe” – because they control the key interest rate that determines the supply of money in the U.S. economy – has gone from providing a wall of liquidity for markets in 2021, to promising to pull that liquidity out of the markets in 2022 via rate hikes and balance sheet reductions.
It’s not good news. The stock market has expanded to ultra-rich valuation levels since the pandemic emerged on the idea that the Fed would sustain easy monetary policy. But, now that the Fed has changed its tune, the stock market needs to correct to lower valuation levels.
That’s the story. And the numbers tell us that stocks have lower to go before they’ve been fully “repriced” for higher rates.
The Fed is forecasting for three rate hikes in 2022. The market, however, is increasingly expecting four rate hikes this year. That would put the lower end of the Federal Funds Target Range at 1%. Based on our analysis, a Fed Funds rate that high should produce a 10-year Treasury yield in excess of 2.5%.
Over the past 20 years, the 10-year Treasury yield has often traded north of 2.5%. When it has, the S&P 500 has averaged a trailing earnings multiple of about 19X.
Analysts are forecasting calendar 2022 earnings for the S&P 500 at $225 per share. A 19X multiple on $225 in earnings per share produces a 2022 price target for the index of 4,275 – which is more than 10% below where the market entered the year, and about 7% below where the market currently trades.
In other words, if the Fed does hike rates four times this year, the stock market’s three-year party will end – and stocks will broadly drop.
Scary… but also exciting…
Because, as we like to say around here at InvestorPlace, it isn’t so much a stock market as it is a market of stocks.
The implication is that even if the stock market struggles in 2022, there will be certain stocks and sectors in the market that will still protect your wealth and generate huge returns.
So, the million-dollar question is: What are those…
Read more:This Controversial Group of Stocks Will Soar Even If the Stock Market Crashes in 2022