The Year In Review | ETF Trends

By Roman Chuyan, CFA

  • Our 6-month Equity model’s forecast for the S&P 500 drops to -8.4%, and the Short-Term Risk model continues with a Sell signal. Both models dictate continued defensive positioning.
  • I review the 2021 highlights and offer my thoughts on what lies ahead in the new year.

I hope you and your family had a safe and relaxing holiday. As we enter the new year, I focus today’s comments on the highlights of 2021, and what we think lies ahead.

At the top of the list of course is the tremendous, even if surprising, stock market rally – the S&P 500 gained 27% in 2021. I wrote extensively about this throughout the year as it unfolded from simply an overvalued market to bubble proportions. According to Shiller’s P/E Ratio (which accounts for earnings cyclicality), market valuation is now at its highest in 150 years outside of the 1999-2000 dot-com period. Clearly, this is one of the biggest bubbles in market history.

The US economy rebounded strongly after the 2020 pandemic-induced downturn, due largely to monetary stimulus. Growth has moderated more recently, however, as evidenced by only 2.3% annualized real GDP growth in Q3-2021 – positive, but not strong by any measure. Yet, market valuation has rocketed well above pre-pandemic highs. Clearly, fundamentals didn’t drive the upside. As with all bubbles, easy money inflated it this time as well, and it’s now an “everything bubble” in stocks, bonds, real estate, and commodities. The Fed’s bond purchases (which amount to money-creation) and federal stimulus money have each reached around $4 trillion. The tremendous amounts of new money found their way into financial assets.

The second exceptional development last year was the remarkable surge in inflation. Consumer (CPI) inflation jumped to 6.9% (see chart) – its highest in 39 years, since 1982. Core inflation, excluding food and energy, rose to its highest since 1991.

It’s clear that the new money created inflation. The Fed, which was responsible for half of the money-creation, willingly ignored inflation even after it surged and became a clear problem around April-May. They began talking about it only in mid-December, after Fed Chairman Powell’s reappointment for a second term. The Fed is now projected to end its bond-buying in March of 2022, but will continue fueling inflation until then. The Fed’s “tapering” seems to be too little, too late. It took above-10% Treasury rates to win the fight against inflation in the 1980s; it is currently around 1.5%.

Rising prices reduce real buying power – the amount of goods and services that people can afford. This erodes confidence, and it has already affected consumer sentiment. The University of Michigan’s sentiment index, which includes inflation in its survey, dropped in November to its lowest in 10 years, despite apparent economic growth.

What lies ahead? The Fed’s support is ending, with bond-buying projected to end in March, followed by some rate hikes. Because the Fed is the primary bond buyer at near-zero yield, without it Treasury yields will likely spike – with dire consequences for cost of credit, financial markets, and our entire finance-based economy. No positive scenarios can be seen. In the end all bubbles burst, which means that the downside is expected to be larger than in a typical bear market.

Market Outlook  

The 6-month return forecast for the S&P 500 by our fundamentals-based statistical Equity Model decreased to -8.4% from -6.8% last month. The model’s Valuation effect continues to be the most negative factor. A forecast below -5% continues to indicate “Negative Fundamentals.”

As part of our regular annual model development, we updated the Equity model last month with a new factor, M1 Money Supply. A model update makes comparison with earlier periods somewhat difficult.

The S&P 500 Price-to-Book Ratio jumped to 4.9 as the index rebounded, matching its multi-decade high reached in October. The Valuation effect at ‑21.2% continues to indicate an extremely overvalued stock market.

The overall effect of the Economic category increased slightly in December, to 9.0%. The deactivation of Median Home Price contributed a negative change, but this was almost entirely offset by increases in the effects of Consumer Confidence and CPI Inflation.

The overall effect of Market factors increased slightly, to 3.8%. The contribution of the Institutional Investor Sentiment dropped sharply in December, but this was almost entirely offset by increases in the effects of Investor Liquidity (Cash Balances), Fund Equity Allocation, and 3-month Treasury.

Our Short-Term Risk model looks for technical patterns that preceded previous sharp market declines. The Momentum component of the model gave a closing Buy signal on Dec 3. However, the weekly Volatility component gave a Sell signal on Dec 17, so this model continues to indicate an elevated chance of a market correction.

The Equity Model’s most negative and positive factors are shown below in historical context (assuming their current weights). The S&P 500 Price-to-Book Ratio jumped to 4.9 as the index rebounded, matching its multi-decade high reached in October. The effect of this factor decreased to -21.2% and continues to indicate an extremely overvalued market.

Individual investor liquidity rebounded slightly last month after a sharp decline in the second half of 2021. The effect of this factor increased to 6.5%, and it continues to be the most positive single factor in the model.

About Model Capital Management LLC

Model Capital Management LLC (“MCM”) is an independent SEC-registered Investment Adviser, and is based in Wellesley, Massachusetts. Utilizing its fundamental, forward-looking approach to asset allocation, MCM provides asset management services aimed to help other advisors implement its dynamic investment strategies designed to reduce significant downside risk. MCM is available to advisors on AssetMark, Envestnet, SMArtX, and other SMA/UMA platforms, but is not affiliated with those firms.

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