Risk occurs when market participants have an abnormally high degree of confidence in a particular outcome that does not materialize.
The risk arises from the market’s disappointment with what was previously priced in. Investors will be taken aback by the market’s repricing to reflect “reality.”
These risks are nothing more than the reversal of previously supportive forces in the stock market. If these forces continue to be supportive, markets should resume their bullish trend.
However, if those supports revert, weaker markets should logically follow.
So. What exactly are these dangers?
The Federal Government has engaged in a tsunami of monetary policies over the last couple of years, flooding the financial system. These monetary interventions dwarfed those seen in the aftermath of the financial crisis.
A critical distinction between the 2008 and 2020 monetary injections was the direct checks sent to households. It took approximately nine months for increases in the money supply to have an effect on the economy.
2022 is likely to be a year in which deflationary pressures resume. Regrettably, the return of deflation may occur precisely during the period during which the Federal Reserve intends to raise interest rates.
They have never succeeded in achieving a “soft landing,” despite repeated hopes. Rather than that, they have a history of creating booms and busts.
Reversal of Liquidity Flows
Not only fiscal policy, but also monetary policy, has inflated asset prices over the last couple of years.
The Federal Reserve’s “quantitative easing” and “zero-interest policy fostered a market appetite for speculative risk-taking.
Not only has the Federal Reserve’s monetary policy aided in the rise of asset prices, but also corporate share repurchases and a record inflow of foreign liquidity into US markets in pursuit of returns.
Historically, a tightening of Fed policy has slowed stock buybacks and dampened stock market returns.
Second, the capital inflow into global equity funds may also slow. Risk appetites may revert if monetary policy becomes less accommodative. It is improbable that the current rate of equity inflows will continue in a weaker economic and market environment.
Disappointment with Earnings
Earnings disappointment is almost certain. However, as is customary in a bull market, analysts’ estimates are excessively optimistic.
According to a 2010 McKinsey Group study, analysts have been persistently overconfident for 25 years. Throughout the 25-year period, Wall Street analysts forecasted earnings growth of 10-12 percent per year when, in fact, earnings increased at a rate of 6% per year, which is consistent with the economy’s growth rate.
As is customary, the event that alters one’s “bullish psychology” is never known. However, market reversion is almost always a result of changes in liquidity or earnings contraction.
Thus, as we approach 2022, it is acceptable to be optimistic; however, it is more critical not to be impatient.