What level of returns could we see this year?

by Jurrien Timmer, Director of Global Macro, Fidelity Investments

Valuations and earnings are pointing to a modest stretch ahead for stocks.

Key takeaways

• The market may have already priced in the full extent of the upcoming rate cycle.
• Despite some high-profile earnings misses last week, most companies have been beating estimates so far this earnings season.
• Current consensus earnings estimates suggest the market may be on track for a year of high-single-digit returns.
• However, if estimates are revised lower and valuations compress further (as tends to happen at this point in the business cycle), we could instead see a sideways market.

Following another blockbuster employment report last Friday, the market's already-high expectations for an accelerated Fed hiking cycle were ratcheted up even more. But with market expectations now pricing in 1.4 hikes in March, 3.2 hikes by June, 4.4 hikes by September, and 5.4 hikes by December of this year, one has to wonder if the market has now fully (or mostly) priced in the rate cycle.

With yields moving higher last week, the gap between actual stock valuations and my estimate of their fair valuations has been closing. As I've highlighted in the past, the Fed's asset purchases during the pandemic had directly inflated stock valuations by around 25% on average, translating to price-to-earnings (P/E) ratios about 5 to 6 points higher than fair value.

With rates now rising, that valuation gap is closing rapidly. As of last week, the P/E ratio of the S&P 500^® is only one point higher than justified, according to my estimates using the discounted cash flow model (which discounts a company's expected future cash flows into a present value, using current interest rates).

Insiders seem bullish

As for the market's decline since the start of the year, I don't get the sense that there is anything more sinister going on than a mid-cycle correction.

It seems that corporate insiders may be agreeing with this thesis. According to some measures, last week insiders were buying their companies' stocks at the highest level since March 2020 (right at the early COVID bottom). Insiders sell for many reasons, but they typically only buy for one: They see value in their company's stock.

Follow the earnings

With the liquidity tide going back out to sea and the stock market no longer benefiting from low rates, the outlook for 2022 will largely come down to earnings growth.

We are about halfway through earnings season for the fourth quarter of 2021. Despite some notable misses last week, about 77% of companies have been beating estimates by an average of 5%.

The consensus earnings growth estimate for the 2022 calendar year is coming down a touch, but still shows an expectation of more than 7% growth, according to Bloomberg. Adding in a 1.35% dividend yield could put the market on track for a high-single-digit return profile.

But that's assuming valuations stay where they are, and that earnings estimates don't get revised lower. We are in that phase of the cycle where earnings growth is slowing and P/E ratios are compressing, so perhaps 2022 will be a more modest year than the above math suggests. After a more than 100% return since the March 2020 low, a year of sideways would not be the end of the world.

Debunking the January barometer

With the S&P 500 index down 5.3% in January, I am surprised I haven't seen more comments about the so-called "January barometer." The January barometer is one of those indicators that gives technical analysis a bad name, and holds that if January is a down month for stocks, somehow magically the year as a whole is likely to be down as well.

The table below shows the historical data going back to 1900 (just in case someone asks you at a cocktail party). It shows the average 12-month total return for the S&P 500 (or a proxy before its creation in 1957), using each month as the starting month, depending on whether that starting month posts a positive or negative return.

Sure enough, if January is a down month, history implies that the year as a whole is likely to be far below average, with an average historical total return for those years of 1.7% (and although that's positive in terms of total return—which includes dividends—it's negative in price-only terms). That compares to a 17.2% average historical total return for calendar years when January shows a positive return.

But here's the rub: This is true for several months, and is not at all an exclusive feature of January. For instance, if April is negative, the average total return for the next 12 months is 1.1%, and if November is negative, it's 1.3%.

So what the January barometer really tells is that markets tend to trend, and that if a particular month is up or down, then chances are that it's part of a trend and that the following months will look similar. There's nothing magical about January.

About the expert

Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.