What Can Go Wrong in 2022

You’ve undoubtedly already seen more 2022 predictions than you care to digest, so I won’t assault you with some arbitrary thoughts about what’s going to happen over the next 12 months. That said, in last week’s “The Deep Woods,” we did speculate on some of the things that could go right in the market in 2022.

That issue was extremely well received by readers, and in a testament to the intelligence and intellectual curiosity of our tribe, the logical follow-up inquiry was — what can go wrong in 2022?

Like I wrote last week, I am an optimist at heart, but I’m also a realist. That means I know there that are always plenty of things that can go wrong, especially when it comes to the markets and the economy. So, what can go wrong in 2022?

As I did last week, this week I am going to provide an excerpt from the Dec. 29 issue of my daily market briefing, “Eagle Eye Opener.” This publication is a joint venture between me and my “market insider,” a macro analyst who provides institutional research to many of the top pros on Wall Street, but who also allows me to share some of his insights each trading day in the “Eagle Eye Opener.”

So, here is what can go wrong in 2022.

There are essentially two major risks to the market as we start 2022. First, the market multiple drops from 20X to something lower. Second, corporate earnings drop.

However, both of these risks would be the effects of actual events, and they can only happen if something causes them to happen. So, let’s identify those events or causes that would lead to either of those outcomes. If we can recognize the events, we can potentially get defensive ahead of any pullback.

What Could Go Wrong 1: COVID-19 Doesn’t Go Away. Key Indicator to Watch: Case Counts. Markets are fully pricing in that COVID-19 will essentially “go away” in the next several months, either in an actual sense or in a practical sense where people just ignore it, and it doesn’t change daily life. But that is not the reality right now. While Omicron isn’t as dangerous as other variants, it’s still screwing up the economy. Growth will decline in Q4 because of Omicron, due primarily to worker shortages and cancellations of trips and other gatherings.

Additionally, Omicron will only extend the supply chain issues that are one of the main causes of inflation.  Here’s why that matters: Unlike before during the pandemic, it’s unlikely the Fed will relax tapering or planned rate hikes due to COVID-19 spikes, unless COVID-19 is a major economic threat. Right now, it’s an economic nuisance, not a threat.

To put it differently, the threat to the economy from COVID-19 now has to far outweigh the potential inflationary impact. Unless that happens (and it’s not happening now), the Fed will keep tapering quantitative easing (QE) and hiking rates even if Omicron is a headwind on growth. That could lead to stagflation, which would be a major headwind on stocks.

What Could Go Wrong 2: Inflation Doesn’t Subside. Next Key Event: Consumer Price Index (CPI) on Jan. 14. Even if Omicron subsides as expected, inflation will have to come down to remove the possibility of the Fed getting too aggressive and tightening too quickly. And while COVID-19-related supply chain problems are part of high inflation, there are other, non-COVID-19 factors pushing inflation higher.

Additionally, if inflation stays high enough for long enough, companies will see margin compression. If inflation is going to come down, then we must see COVID-19 go away to ease supply chain issues.

But even if that happens, it’s still not a guarantee that inflation will suddenly fall back close to pre-COVID-19 levels. Stubbornly high inflation could lead to 1) The Fed tightening too quickly and 2) Earnings dropping, which would obviously be negatives for stocks.

What Could Go Wrong 3: Fed Commits a Policy Mistake. Key Indicator to Watch: 10s-2s Yield Spread. The sudden hawkish turn in the Fed over the past two months has been nothing short of historic. In December, Federal Reserve Chairman Jerome Powell abandoned the use of the term “transitory” for inflation, and instead doubled the pace of tapering. Meanwhile, the Fed consensus went from one rate hike in 2022 to three!

While not likely, the Fed’s sudden hawkish turn could lead to a policy mistake whereby the Fed hikes too quickly to end inflation, yet those rate hikes snuff out the economic rebound.

The 10s-2s yield spread will be the best indicator of this, as we’d see it invert much sooner than we’d normally expect (which is likely going to be in the first half of 2022).

What Could Go Wrong 4: The U.S. Economy Loses Momentum. Key Indicator to Watch. Is there an economic hangover looming in 2022? There’s no question that the U.S. economic recovery is strong, but it’s not clear how much of that growth has been driven by government stimulus.

Moreover, the decline in fiscal support for the economy in 2022 is substantial and we don’t know how much damage that will do to consumer demand. Additionally, it’s reasonable to assume a lot of the wage increases that are going to happen, have happened, given the improvement in the labor market.

But if inflation remains this high, we could easily see demand destruction if wages level out and there are no more stimulus checks coming from Washington. If that’s the case, the Fed will be hiking into an economic hangover/natural economic slowdown, and we’re looking at stagflation.

As we have consistently said, a 20X multiple is usually a “best case” multiple for the market, and clearly if any of these events happen, the market multiple will drop to something lower and more normal.

In an environment of slowing economic growth or stagflation, the market multiple can drop all the way to 15X, but we think that’s too extreme for these scenarios. So, we think a reasonable multiple if we have any of these negative events is 18X.

The current 2022 S&P 500 earnings per share (EPS) expectation is $226. That gives us a target of 226*18 or 4,068, about 15% lower from here. Now, if we also see expected S&P 500 earnings drop, using a 5% earnings decline, then we are looking at $215*18 = 3,870, or about 19% lower from here.

Now, these are clearly pretty negative scenarios, as it implies a material decline in the macroeconomic outlook. But the bottom line is that real risks are present as we start the coming year, and while the negative outcomes for this market aren’t the most likely ones, at the same time, we need to be watching carefully for them. If we see a scenario where the market multiple starts to decline or expected earnings drop, we will need to get defensive and fast. You will hear that from us loudly and clearly.

For more on how you can be forewarned about the “what could go wrong in 2022” scenario, then I recommend subscribing to my “Eagle Eye Opener” daily market briefing today.

Think of it as a market-based, intelligence insurance policy to help you navigate the coming year, and well beyond.

******************************************************************

Battle Buddies, Gold and Exposing Fraudsters

One of the best things about having the Way of the Renaissance Man podcast is that I get to have great conversations with the some of the smartest people in the world.

And on the latest episode, I do just that, as I welcome my friend, fellow U.S. Army veteran, West Point graduate and the premier expert in the field of precious metals investing, Rich Checkan.

Rich is the President and COO of Asset Strategies International (ASI), which is the only dealer of physical gold, silver, and other precious metals that I recommend.

In this episode, we discuss the importance of being a critical thinker, and the importance of talking about ideas and exposing oneself to all opinions. It is through the process of filtering out the good from the bad ideas, and knowing when you can, and cannot, compromise, that you become a better decision maker.

Other topics in this wide-ranging discussion include the Jan. 6 insurrection, the importance of rational arguments, the virtue of rational persuasion, the role of passion in the world and the critical need to do something meaningful in life.

Plus, no discussion with Rich Checkan would be complete without his expert view on gold and precious metals.

I always enjoy my conversations with my “battle buddy” Rich Checkan, and I know you will too.

*****************************************************************

Unlearning the Untrue

“The most useful piece of learning for the uses of life is to unlearn what is untrue.”

–Antisthenes

The ancient Greek philosopher is understandably overshadowed by the giants that are Plato and Aristotle, but his work contributed much to the lexicon of Hellenic ideas. In this quote, Antisthenes reminds us that it’s important to shed beliefs, assumptions and erroneous thinking that turns out to be untrue. In 2022, I want you to do the same thing. Challenge your ideas of what is true, and if you find you have no good evidence for holding a belief, let it go. It might just be the most useful piece of learning you can have.

Wisdom about money, investing and life can be found anywhere. If you have a good quote that you’d like me to share with your fellow readers, send it to me, along with any comments, questions and suggestions you have about my newsletters, seminars or anything else. Click here to ask Jim.

In the name of the best within us,

Jim Woods