Former Barron’s Roundtable member Felix Zulauf.
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Owing to the conventions of the Gregorian calendar, this usually festive time is taken up with prognostications for the year ahead. New beginnings bring hopes for better times, which surely beats dwelling on the disappointments of the year past, I suppose. Hope isn’t a strategy, however, according to the Wall Street maxim. So forecasts are published, if only to prove a bit of Yiddish wisdom: “We plan, God laughs.”
Annual outlooks for the stock market usually gravitate to an anodyne consensus calling for mid-to-high single-digit total returns, and predictions for 2022 fall into that pattern. An informal sampling of about a dozen major banks’ and brokerages’ forecasts shows them centered around a 5% price gain in the S&P 500 index for 2022, with dividends adding about 1.2% atop that. While positive, that would be well short of this year’s 27.11% total return for the SPDR S&P 500 exchange-traded fund (ticker: SPY) through Wednesday, according to Morningstar.
But that obscures a wide dispersion of prognostications, ranging from price gains above 14% to declines of more than 5%. At the low end of the sample are those from what in ancient times were called “wire houses” with a big individual investor customer base, perhaps to preserve their clients’ wealth against the constant blare of “Buy, buy, buy!” Institutional types must generate returns, to meet their clients’ bogeys and to earn their own keep. This is difficult in down markets.
Bonds again may not provide much cushion in the coming year, as has been the case in 2021. The iShares Core U.S. Aggregate Bond ETF (AGG) has had a negative return of 1.66%. The coming year could see a replay of the rare combination of positive equity and negative fixed-income returns, according to the 2022 outlook from the BlackRock Investment Institute. That would reflect what it calls the “new nominal” regime of inflation remaining above prepandemic trends, resulting in negative real (inflation-adjusted) yields and a delayed robust restart of global economies from persistent Covid-19.
For an independent perspective on the coming year, I rang up Felix Zulauf, the longtime former member of the Barron’s Roundtable and eponym of Zulauf Consulting, at his home base in Switzerland. It will come as no surprise to longtime readers that he departs sharply from the Wall Street consensus.
So, is Felix bullish or bearish? The answer is yes. He looks for the S&P 500 to soar to 6000—but only after a crash to 3000, a plunge of over one-third from here. “It will be exciting for traders, but bad for the passive buy-and-hold investor,” who may not have the stomach for the roller-coaster he foresees, he says.
The markets are about be slammed by a reversal of the extraordinary fiscal and monetary stimulus applied to fight the pandemic, he explains. While policies remain loose, what counts is the change in, rather than the absolute level of, stimulus. And monetary policies are about to shift from extreme ease to merely easy.
Beyond the Federal Reserve’s massive securities purchases since March 2020, which the central bank said this past week will be reduced and wound up more quickly than previously planned, Zulauf points to the largely unrecognized impact of the Treasury’s sharp drawdown in its balance at the Fed, which reflects the federal government bumping up against its debt ceiling. This reduction, from $1.8 trillion to under $400 billion, has injected liquidity into the private economy. That is about to reverse, with the rebuilding of the Treasury’s balances following congressional approval of a debt-ceiling hike. At the same time, China isn’t recycling its U.S. dollar holdings as it used to, further reducing global dollar liquidity.
Zulauf sees the markets fully positioned in risk assets and unprepared for tighter liquidity. “The dimension of these positions are tremendous,” he says, with record high holdings of stocks by U.S. households, and institutional accounts having their biggest long equity positions since 2000.
That sets up the markets for a correction bigger than the 5%-8% dips seen in the major American indexes. He sees a major decline of 30% in the U.S. market, with perhaps losses of five percentage points less in Europe, because the excesses there are more moderate. “After that decline, it will shake authorities. Instead of a taper and rate hikes, they will move back to stimulate to stop the selling panic,” he predicts.
As Sociéte Genéralé strategist Albert Edwards wrote in a client note this past week, the “Fed put” would still be in effect. (That is, an insurance policy to halt market crashes by pumping in liquidity.) But the Fed put’s strike price would be lower than it was in 2018, when the central bank pivoted away from tightening when the stock market had a near-bear experience in the fourth quarter, Edwards adds.
Zulauf sees the reversal to easy money triggering the resumption of the bull market in stocks, with the S&P 500 doubling off its lows. The dollar would also come off its peak, triggering the next wave up in commodities. That could send crude oil soaring as high as $200 a barrel by 2024, from the low of $50 he sees during the stock market’s downdraft.
To ride out the coming turbulence, he recommends that investors buy put options on the S&P 500 to protect their stock portfolios. And he also likes long-term U.S. Treasury bonds, which he sees rallying strongly in price. That would lower the yield on the 30-year maturity from 1.86% back to around 1% to 1.20%, near the nadir touched during the 2020 market crisis.
To be sure, Zulauf’s forecast isn’t the only non-consensus outlook for 2022. Far from being forced to revert to stimulus, the Fed may have to tighten policy strongly to bring inflation to heel, as Julian Brigden of Macro Intelligence 2 Partners told Barron’s Wednesday. The six quarter-point hikes envisioned by the Fed’s “dot plots” in its new Summary of Economic Projections for 2022 and 2023 released that day still would leave the real federal-funds rate in negative territory.
Negative real yields would continue to support risk assets such as stocks, as well as home prices. But a tightening of financial conditions would be necessary to purge inflation with the economy at or near full employment. And inflation has become the top concern for both Main Street and Washington.
Even after supply-chain constrictions ease, service prices—especially rents—will continue to put upward pressure on inflation. The only real cure is tighter money, even if the side effect is lower stock prices.