Not-so-great expectations for the year ahead?

It's the season for predicting 2022. I'm currently burdened  by huge piles of paper as every analyst out there comes up with their own estimates for where we will be by the end of next year. They're very useful. A lot of bright people work in the investment industry, and the exercise of trying to arrive at their most likely scenario for 2022 helps them to organize their thoughts and ask and answer important questions. I'm very grateful for their efforts, which I'm finding useful for my own job.

However, the endeavor has to contend with two problems. The first is the infuriating statistical concept of the "expected value." One of the first notions introduced in business school statistics classes, it's simple enough. If you have two probable outcomes, you multiply each by their probability and add together to get an expected value. If there's a 50% chance that you will win $1, and a 50% chance that you will win $2, then the expected value of your winnings is $1.50. This is true even though there is zero chance of your winning that amount.  

That's the problem with scenario analysis. Any sensible analyst accepts that there is uncertainty and produces a range of risks, with the outcomes if they come to pass, and a probability for each. Once you move from this thoroughly sensible exercise to derive a single forecast or expected value, however, you find yourself predicting something that you don't think can possibly happen. 

A second problem is that the break-off of a calendar year is arbitrary. Some aspects of markets follow an annual cycle, but others don't. A big rise or selloff in December can transform the following year's returns. And of course markets tend to overshoot in both directions. In the long run they get it right, with stock market growth tracking economic growth closely. In the shorter term, returns look far more like a random walk. Stocks tend to stage lengthy rallies with occasional brutal selloffs to correct themselves. An "average" year, in which stocks trundle upward by about 8%, is actually quite unusual. 

The following chart was produced by Aneet Chachra of Janus Henderson Group PLC, and covers all the the S&P 500's annual price returns since 1928:

This is nothing at all like a bell curve or a normal distribution. The most common outcomes are returns between 10% and 30%, while a loss of up to 20% is considerably more likely than a positive return in that central range of 0 to 10%. The average outcome that it might make sense for us to expect is about 8%, but that outcome in itself is very unlikely, given markets' tendency toward over-excitability.

This leads us to the forecasts for 2022. There is a long-established Wall Street tradition that equity strategists should pretend to see the future, as OMD put it, and come up with a number for the index at the end of the next year. Chachra compiled the following list from reports available on Bloomberg, and I thank him for doing the work:

On Dec. 3, when he carried out the exercise, the S&P stood at 4,538. Assuming it stayed at that level until the end of the month, the average end-year forecast of 4,909 implied a 2022 return of 8.2%. That is almost exactly the long-term average. It's the classic "expected value" which nobody in fact expects.

Two hectic days of bullish trading later, the S&P stands just under 4,700 at the time of typing. That makes our forecasters far less bullish for 2022, with an average return prediction down to only 4.5%. The number of houses in Chachra's list predicting an outright fall next year has risen from one (Morgan Stanley) to three (including Bank of America Corp. and Cornerstone Macro LLC.)

That in itself demonstrates the folly of looking at the market in calendar-year increments. It also explains why balanced portfolio investing continues, despite the well-established tendency for equities to outperform in the long run. 

Beyond that, it's interesting that Wall Street is perceptibly less bullish than usual. It's rare for institutions as big and influential as Morgan Stanley and BofA to be predicting an outright negative return, both because sell-side research departments have an interest in the market continuing to go up, and because the market does indeed usually go up. This year's increase in inflation is a big deal, and it might require higher rates to cope with it. There will be much more to write about this between now and New Year's Eve, but the clearest message from all the predictions is that inflation has clouded the picture. That might help a bigger return, or it might presage a major regime change. For now, the main point is that uncertainty is higher than usual.

Scattergraph of Hope

If one chart sums up the reason for resurgent animal spirits, it's this one (produced by Deutsche Bank AG):

We all know the caveats by now. We've learned a lot about epidemiology in the last two years, and how little we or anyone else knows about epidemiology. But the basic point, at this early stage, is clear. In South Africa, there is a well-established relationship between the number of new Covid-19 cases that are reported, and the number of deaths that will occur from the disease 12 days later. Omicron has been identified for long enough that we can now look at how its lethality compares to pre-omicron lethality. And the two pale blue dots far below the cluster of dark blue dots above them suggest that something has changed, and that omicron is significantly less deadly than its predecessor variants.

Not only is this good news in the sense that we needn't worry too much about catching it. There's even a chance, as omicron does indeed appear to be more transmissible than other variants, that it will crowd them out to become the dominant form of the virus. That would entail more people getting mildly ill and having some degree of natural immunity, leading to Covid-19 as a whole becoming a less dangerous disease. For a really optimistic parallel, consider the Spanish Flu of 1918, which died down because it had steadily morphed into a less dangerous but still highly contagious virus. As this Washington Post piece shows, the descendants of that dreadful pandemic are still around today. 

Does this mean we can be sure the pandemic is about to end? Of course not. We all now understand the fallibility of medical science (making those of us who earn a living from economics, which everybody already knows is fallible, feel a bit better). For a reminder that even cancer research can be very ambiguous, and that researchers can lead themselves badly astray, I recommend this report by the Reproducibility Project, a massive effort to replicate key experiments from more than 50 influential breakthrough papers. The bottom line to their findings, published this week, is that 46% of the effects that had previously been identified in the literature could be replicated successfully on more criteria than they failed. Or in other words, the results of more than half the experiments didn't stand up when people tried to repeat them. So we shouldn't assume that omicron is our savior just yet. But when it comes to daily trading in the stock market, the South African scattergraph is a good reason for prices to go up. And that's why they did. 

Labor, Productivity and Inflation

A key issue for 2021 involves the very heart of capitalism. Who is going to get the better in the battle between labor and capital? And if labor succeeds in extracting a better return, will capitalists respond by accepting lower profits, or by raising prices? The issue is important to the question of whether 2021's resurgence of inflation turns into a secular increase in inflationary pressure.

The effect of the Global Financial Crisis was to crush workers' negotiating power, particularly for the poorest paid. In the chart below (which I adapted from a chart in Pimco's asset allocation outlook for next year), the proportion of small businesses finding it hard to fill jobs and the average wage increases for the lowest-paid 25% of workers are mapped on separate scales. The low-paid had a terrible time of it in the years after the GFC, but their power had been steadily recovering even ahead of the pandemic:

This is an unambiguous upward trend, and is in line with the experience of past pandemics, in which the power of labor tended to increase in the aftermath. Meanwhile, Tuesday also saw publication of new productivity data for the U.S. Unit labor costs rose much faster than had been expected in the third quarter. 

Looking to the longer term, unit labor costs have risen roughly in line with growth in gross domestic product for much of history, but this has contained big swings in the trend. In the following chart, unit labor costs for all non-financial corporates is shown as a share of constant-currency GDP, rebased to 1950:

Companies got a great deal in the 1950s and early 1960s as productivity steadily improved. Labor enjoyed the upper hand until the early 1980s, when a combination of Reaganomics and the determined anti-inflationary monetary policy of Paul Volcker at the Federal Reserve saw unit labor costs diminish sharply. Since the GFC, the relationship has been constant, with GDP and unit labor costs moving in line with each other (barring a very brief upward blip in productivity during the mass layoffs in spring last year). 

This relationship has been flatlining at a level that is a great deal for companies and capital, and lousy for workers and labor. It's also a level that has helped keep prices low. Are we seeing the first signs of a belated reversal?

Survival Tips

On the subject of vaccine hesitancy, vaccine inequality, vaccine nationalism and deep-seated distrust of science, I recently re-watched a movie that plays to the themes of today with startling relevance. The Constant Gardener, the film version of the John le Carre novel with Ralph Fiennes and Rachel Weisz in the leading roles, is a great thriller, shot through with all the classic le Carre themes of doubt, distrust and betrayal. Fiennes is brilliant, as are many of the others. Set mostly in Kenya, it's also a sumptuously beautiful film to watch.

The particular reason to see it now is that the central plot concerns the attempt by Weisz's character to get to the bottom of a dastardly plot by a big pharmaceutical company, aided and abetted by the British government, to test new drugs on poor Kenyans forced to be guinea pigs, and cover up evidence of the harmful side effects that result. There's more to it than that, but like all great fiction it was written for one moment, and captures another perfectly — which is to say that its themes are eternal. I strongly recommend catching up with it. 

John Authers is a senior editor for markets. Before Bloomberg, he spent 29 years with the Financial Times, where he was head of the Lex Column and chief markets commentator. He is the author of "The Fearful Rise of Markets" and other books.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.