The continuing volatility in the stock market is troubling. It is likely signaling difficult times ahead as early as January or February 2022. As such, it is time to consider risk management.

 

After over a decade of steadily rising equity prices with few interruptions, investors have been lulled into believing that investing in stocks is a riskless game of never-ending profitability. Newcomers to the stock market arena, like your typical Robinhood investor, have been using stocks to supplement, or even replace, earned income.  Unfortunately, I believe we are entering an environment where the investment themes are changing to our detriment.

 

The most important change I see has been the pivot in the Federal Reserve Bank's monetary policy from dovish to hawkish. The Fed's focus switch from full employment to combating inflation is expected to reduce liquidity in the markets. That decline in liquidity, which has been supporting the financial markets for years, is going to impact the equity markets negatively. I believe that process has already begun. 

 

Inflation, one of the worst economic aftershocks of the pandemic, is the second variable that I see impacting stocks and bonds. Do I expect a hyperinflationary environment in 2022? No, but I do believe inflation will remain persistent throughout most of the year before subsiding. A little inflation, experts say, is good for stocks. That's probably true, but we are beyond "a little" at this point. Inflation is impacting corporate earnings, reducing profit margins, and forcing many companies and small businesses to raise prices.

 

That leads me to believe that in the first half of 2022, a lower level of corporate earnings will not be able to justify the present price levels of the stock market. As earnings and guidance weaken somewhat, so will the stock market. That is not a good environment for further market gains.

 

The economy will also suffer. Consumers, thanks to continued price increases, may reach a point where they curtail some of their purchases. They may focus on buying things they need, like consumer staples, as opposed to things they want. That will slow the economy. As a result, we could live through a few months that could best be described as "stagflation." That means a slowing economy and rising inflation.

 

I think that this stagflation, if it were to occur, would be a transitory event. By the second half of the year, we could see inflation begin to moderate (as supply shortages are resolved) and the economy grow, even if it is at a slower rate. If all the above were to occur, it would put the Fed between a rock and a hard place. They may be forced to choose between protecting Main Street from the crippling effect of further rises in inflation. But if they do raise interest rates, as they intend to, they risk precipitating a serious decline in the stock market.

 

What therefore should an investor do as we enter the New Year? In the very short term, nothing. We may still enjoy a somewhat abbreviated Santa Rally next week. I expect a possible pullback on Monday into Tuesday and then up again for a day or two. No different than what we have been dealing with for the last few weeks. Overall, therefore, I see a bigger chance that the markets will gain a little more between Christmas and New Year.

 

I expect that positive momentum to last through the first half of January 2022, but beyond that I am expecting trouble. A double-digit decline in the stock market (20 percent-plus) sometime in the first quarter would not surprise me. It could happen as early as the third week in January and last through February or beyond.

 

At the very least, investors should reduce risk. And there is no guarantee that "buying the dip" will work this time around. And even if it does, the equity rewards may lie elsewhere. International markets, for example, or commodities, or both may hold better promise than stocks in the U.S.

 

For those who have been managing money on their own, I advise you to seek out a professional investment manager and do it quickly. The coming environment will demand experience, knowledge, and a cool hand. If you need advice on how or whom, give me a call or send me an email.

 

In the meantime, have a happy holiday season and enjoy the last move higher in the stock markets.