Buckle up and hang in there: a bumpy ride is the only sure thing in the New Year.
One thing about the stock market next year is becoming clear: Chances are better than good that the ride will be bumpy.
We’ve had a front row seat last week – top to bottom on Omicron, the Fed’s pullback on bond buying, spending policy in Washington. Wall Street just seems easier to scare off.
Even days that end in the green tend to start with tremors or take a midday bath and then come back. And who knows what stocks will do in 2022: maybe win, maybe lose.
Some strategists are looking for gains on the S&P 500, as analysts expect the index’s overall earnings per share to rise 9% year-on-year in 2023, which could keep stock prices roughly the same. same level next year.
But if the Fed raises interest rates three times to avoid inflation, earnings projections could easily fall. And investors won’t want to pay high multiples on those profits. So, in turn, stock prices fall. Morgan Stanley, for example, forecasts the S&P 500 to fall 4% from its current level.
So maybe there is money to be made. Maybe there isn’t. This is called uncertainty. But what is much more certain is that investors need to buckle up and hang on.
An indicator that pleads in favor of volatility: credit spreads are widening.
First, what it means: The price of corporate bonds has fallen enough that bonds are now earning an even higher interest rate than risk-free government bonds. This is because investors demand these higher returns because companies are now at a slightly higher risk of not making enough profit. to cover their debts.
In the United States, investment-grade bonds now earn about 1 percentage point more than government bonds, according to Wells Fargo, up from 0.8 percentage points at their lowest during the pandemic.
Now, why it matters: There is a historically close correlation between credit spreads and stock market volatility, according to Wells Fargo.
Wider credit spreads not only indicate weakening confidence in corporate earnings, but they also cause stock valuations to fall, as companies have to borrow money at higher interest rates.
“History suggests that flat-to-widening credit spreads should coincide with more frequent negative sessions,” wrote Christopher Harvey, head of equity strategy at Wells Fargo.
As spreads widen, the market experiences more pullbacks, which the bank defines as a 2% drop in the index in three days or a 3% drop in five days.
And there are plenty of reasons to believe that credit spreads will widen, not tighten, from here on out. First, the lowest spreads during the pandemic period were also the lowest since 2006, so they couldn’t go much lower.
Second, the spreads have hovered between 1 and 2 percentage points for most of the post-financial crisis period. Now, with the Fed making money less available to borrowers, the bond market will likely continue to reflect rising economic risk.
The good news is that a bumpy race can offer investors the opportunity to buy specific stocks that they see as potential market winners.
Write to Jacob Sonenshine at [email protected]