2022, the more diligent stock picking year

2021 has so far been another very good year for the U.S. stock market indices, the S&P500 increasing in value by 26.75% during 2021 so far, while the Nasdaq Composite has increased by 24.23% year-to-date (YTD). For clarity, the S&P500 index tracks 500 large-cap companies listed on stock exchanges in the United States while the Nasdaq Composite tracks the price performance of over 2,500 companies listed on the Nasdaq Stock Exchange, the second-biggest stock exchange by market capitalisation.

The year 2021 however was also characterised by a greater dispersion of returns between individual stocks. For instance, Google and Amazon, both technology constituents of the S&P500, have performed very differently on a YTD basis. Alphabet, the parent company of Google had a 68.91% positive stock performance YTD while Amazon’s stock price only increased by 12.35% this year.

Morgan Stanley (MS) Chief Investment Officer, Mike Wilson shared in a note that, the above developments fit very well into where MS positions the economy from a cyclical perspective. They call it a ‘midcycle transition’. MS use this term for a more mature phase of the economic recovery that they could identify in past economic cycles, specifically in 1994, 2004, and 2011. These periods proved to be choppy for stocks, with a 10%-plus correction materialising for the overall indices. MS expects financial conditions to tighten and corporate earnings growth to slow down, and therefore the index-wide P/E ratios are expected to be looking unattractive at these price levels. As a remark, the P/E ratio is a corporation's share price divided by its earnings per share ratio. It is a widely accepted measure to gauge whether a company or in this case a basket of companies, is overvalued or undervalued.

Therefore, MS do not expect the major indices to perform as well into the next year as they have been in the past period. Furthermore, the investment bank expects higher nominal GDP growth, which is expected to be in part supported by higher inflation figures. They say that such a situation however will generate plenty of good investment opportunities on the individual stock level, therefore their focus will be on stock picking rather than a sectoral allocation in the following period.

Goldman Sachs (GS), among others, has a somewhat different stance on the matter. David J. Kostin, Chief Equity Strategist at GS said this month that their institution projects the S&P 500 to rise 9% to 5,100 by the end of 2022, hence a smaller but still substantial upside is anticipated in the overall market index. “Real rates, while rising, will remain negative, and investor equity allocations will continue to establish record highs,” Goldman’s strategists wrote in a note to clients on Tuesday. “Corporate earnings will grow and lift share prices. The equity bull market will continue.” Therefore we can conclude that GS has less emphasis on stock picking in the following period, and they expect the overall U.S. market to perform well.

To conclude, there seems to be a widespread expectation among market participants that inflation will remain high going into the next year. The main difference between the above scenarios is how corporate earnings will turn out over the next period. If earnings on average are going to underperform expectations, the overall index will follow suit, and stock picking may be the optimal strategy. While in case corporate earnings on average can beat market expectations, i.e. will continue to be strong in the next period, the overall index is anticipated to perform well and index investing may be the preferred option. Thus, company earnings will surely receive a lot of focus in the following quarters.

We can also observe conflicting signs to both of the above views as we are seeing a worsening pandemic situation in developed countries. In the case that countries have to go in lockdowns again, we may see a completely different, less inflationary story develop over 2022, paired with lower nominal and real GDP growth. Such a scenario would present us with a completely different situation to analyse.

Disclaimer: This article was issued by Tamas Jozsa, Research Analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view, and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.