Stocks head for a rare third-straight year of double-digit returns. What happens next?

Published Sat, Dec 11 20218:11 AM EST

The book on the 2022 market is yet to be written, or even started. But it seems right now that the working title could be "Sedate Expectations." Among Wall Street strategists, professional investors and retail traders, the consensus outlook now coalescing is for a less-rewarding, possibly more hazardous market next year. This is probably not a bad thing at a time of year when reflexive optimism is more typically in the air. Brokerage-house strategists canvassed by CNBC who have released a 2022 outlook see, as an average, the S & P 500 hitting 4925, up less than 5% from Friday's record close of 4712. Chances are, this average will move a bit higher as the rest of the handicappers weigh in, but quite likely the consensus will settle right around the long-term annual average gain just under 10%. On one level, this is simply an instinctive reluctance to assume the lavishly generous returns of the past few years will carry forward, with the S & P 500 up 25% in 2021 and having delivered a 23% annualized total return over the past three years despite a 35% crash interrupting the ride. As sensible and safe as this kind of forecast sounds, a quirk of the market's stream of returns is that in any given calendar year it has been surprisingly rare for the index performance to come close to that very long-term annual average. In only five years since 1928 was the S & P 500's total return between 8% and 12%. By contrast, the index has been negative five times as often, and has gained more than 20% in more than 30 separate years, with 2021 on track to join that roster. It's understandable that current forecasts assume lower but still positive returns: We are in a maturing economic and corporate-profit cycle, growth rates are likely to settle back, inflation is elevated and could hasten a tighter Federal Reserve. And the forces of mean-reversion always lurk, somewhere. Jessica Rabe, co-founder of DataTrek Research, noted last week that 2021 will almost certainly be the third straight year of double-digit S & P returns. Such a three-year streak has happened nine times before. In the year following those streaks, the index rose five times and fell four times – a lower win rate than all years. Yet the average S & P return across all the up and down years was 8.4%, with the five winning fourth years averaging 25% and the four losers averaging a 7% loss. How the markets react to Fed hikes How the markets act around a first interest-rate hike in a cycle is also relevant now that the Treasury complex is pretty assertively pricing in two or possibly three rate hikes in 2022, a response to tighter labor markets and more persistent inflation than anticipated. Ned Davis Research shows that stocks have done well in general in the six months ahead of an initial rate hike. How equities fare after that seems to depend on whether it becomes a "fast" tightening campaign, with a hike at pretty much every Fed meeting, or a slower one that allows for pauses along the way. (On this chart "non-cycles" are those when the Fed cut and then raised rates without a recession in between, such as in parts of the 1990s). While there's no way to tell what kind of tightening pace lies ahead – if indeed the market is correct that the Fed will be lifting rates in coming months – the bond market is now pricing in a rather low end point to whatever rate-hike campaign is to come. This chart from Morgan Stanley shows both certainty in a 2022 start of rate hikes rising and the market's estimate of how high short-term rates will ultimate get falling in recent months. This implies the Fed will be successful in restraining inflation while also perhaps risking an unintended hit to growth, as any rate hikes will be coming as fiscal spending pulls back, pent-up consumer demand is satisfied and the long-term demographic headwinds reassert themselves. Investor sentiment takes hit On a more immediate basis, the recent nerve-wracking shakeout in stocks – a 5% drop in the S & P 500 with far more pain felt across the majority of stocks – has left investors wary. Here is a side-by-side look at the equity exposure of the National Association of Active Investment Managers and the bullish percentage from the Investors Intelligence poll of professional investment forecasters – both not far above their 2021 lows in optimism. Jeff DeGraaf at Renaissance Macro Research on Friday said, "It's a little surprising to see sentiment turn this bearish this quickly," with his own composite sentiment gauge falling to a level that has historically shown a 74% chance if positive stock-market returns over the next 13 weeks. A decent explanation for this apparent overreaction to a pretty modest setback in the broad benchmark is the carnage in the typical stock – and nasty action in the most popular holdings of the fast-money crowd. In the past month, the Vanguard Extended Market Index – all stocks not in the S & P 500, from small-caps to huge growth names such as Square and Zoom Video – has lagged the S & P 500 by about ten percentage points in the past three weeks. And the adrenaline-juiced retail-trader favorites that overtook the market conversation in the early part of this year and had the aggressive amateurs drubbing the prudent professionals have soured. Whether the ARK Innovation basket of high-expectation growth stocks or meme-propelled GameStop and AMC or Robinhood Markets and CoinBase , all have become less fun and more treacherous, all of them down between 40% and 75% from their 2021 peak. All else held equal, this draining of enthusiasm from the market makes for a less-challenging setup for stocks than would the kind of overconfident momentum chase that the market seemed headed for back in early November. More muted sentiment and cleaner investor positioning following the purge of risk from portfolios into Dec. 3 allowed for last week's 3.8% S & P 500 gain. There is plenty to quibble about even in this. The S & P 500 itself has now closed above 4700 six times in the past four weeks, but never two days straight and never finishing higher than 4712. Corporate insiders have been selling shares in vast quantities – sure, in part for tax reasons but no one sells much if certain their stock is a lock to rip higher. It's a low-conviction market with more to prove, as deeply oversold broken momentum stocks pile up on one side and defensive behemoth Apple powers higher at the expense lately of hot-money proxies Tesla and Nvidia . It's reassuring, at least, that almost no one is still treating a year-end rally as some kind of Constitutional right, even as this seasonal tendency for late-December strength has not been repealed.

A trader works on the floor of the New York Stock Exchange (NYSE) December 9, 2021.

Brendan McDermid | Reuters

The book on the 2022 market is yet to be written, or even started. But it seems right now that the working title could be "Sedate Expectations."