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Home / Markets / Stock Markets /  Five reasons why the stock market might be weaker in 2022

History tells us that the second year of a new U.S. president’s term can be tough on stocks. That could hold true next year.

Can US stocks avert a “sophomore slump" in 2022?

Over the past 75 years, in the second year of a new U.S. president’s term, stocks have tended to fall short of their long-term average annual performance. The pattern, evident in data from S&P Global Market Intelligence, may reflect a tendency by the party that holds the White House to enact—or try to enact—less-market-friendly policies well in advance of the elections midway through each presidential term.

Some researchers doubt that this finding is statistically meaningful. But whether or not this particular bit of history is a good forecasting tool, there are reasons why the market’s performance next year may be far less impressive than it has been since the low reached in March 2020, a period in which the S&P 500 index has about doubled.

Among the headwinds the market faces are the expiration of government aid programs to offset the impact of Covid-19, rising interest rates, and supply-chain glitches that have caused shortages of goods and helped fan inflation.

For those who want a better understanding of what might drive returns just ahead, here is a list of issues to track.

1. The rush from Covid relief programs is fading.

Although Congress enacted trillions of dollars in pandemic relief programs, those are expiring. The result will be “a radical downshift in income growth for pretty much the whole country" in 2022, says Brad McMillan, chief investment officer of Commonwealth Financial Network, an adviser and broker-dealer.

Because consumers amassed savings during the pandemic and have shown signs of being eager to spend, analysts see scant risk of a recession. Still, next year’s U.S. GDP growth, which is projected at around 3% to 4%, might feel tepid after an estimated expansion this year of about 6%.

2. Fed policy probably won’t be as easy.

To keep the economy from going into a tailspin, the Fed last year cut its benchmark interest rate to near zero and began large purchases of government bonds. Bond yields move the opposite way as bond prices, so the buying depressed yields, making it cheaper to borrow.

But inflation in recent months has been hanging around 5% annualized. And although Fed officials say that pace will slow, they have announced a tapering of bond purchases. Markets also expect the Fed to raise its benchmark bank lending rate twice next year, perhaps by a total of 0.5 percentage point, further tightening policy.

These steps would remove a large amount of liquidity from the financial system, says Steve Sosnick, chief strategist at Interactive Brokers. It remains to be seen how the bond market reacts, he adds. But in recent months, rises in bond yields have sparked selling in equities.

3. Corporate profit growth may lose steam.

Corporate profits—a key ingredient in investor enthusiasm for stocks—are estimated to surge about 43% for 2021 versus last year. That has helped propel the market. But profit growth is slowing because of rising wages, soaring freight costs and higher materials prices. It is estimated at only around 7% for 2022, says Sam Stovall, chief investment strategist at data provider CFRA.

“Virtually every company will experience some form of cost pressure," says Eddie Perkin, chief equity investment officer at Eaton Vance Management, an asset-management company. He adds that the impact could vary significantly for different sectors and companies, making stock selection a challenge.

4. Market valuations are lofty.

After recent gains, the S&P 500 has a broad valuation of around 22 times 12-month forward earnings, 30% above the average of the past two decades, according to Mr. Stovall of CFRA.

Investors tend to ignore such flags when underlying conditions are favorable and there’s a lot of willingness to take risk. But next year, with inflation possibly lingering and the Fed draining liquidity from the economy, investors may decide that stocks are overly expensive, says Timothy Murray, a capital-markets strategist at T. Rowe Price.

The market also may prove less resilient in the face of new shocks, such as the possible emergence of a more virulent version of Covid-19. So while there’s a chance that 2022 could be a “decent" year for stocks, any flare-ups of the virus clearly pose a risk to the market, says Ryan Detrick, chief market strategist for LPL Financial, an investment-advisory firm and broker-dealer.

5. Stocks simply may be unable to repeat.

So far this year, the S&P 500 up 25%. But when analysts track how the market has fared on a rolling basis in past decades, the data shows that strong stretches usually are followed by more-lackluster periods, says Mr. Stovall of CFRA. Based on how the market has been doing recently, the odds favor a gain of perhaps just 6% in 2022, he says..

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