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Another pandemic year over. And another record year for the stock markets.

It seems incongruous that equities would keep climbing while the world is experiencing the greatest plague in a century, but these are unprecedented times.

A year ago, I wrote in this space that I expected 2021 to be a modestly profitable year for stocks, and a bad one for bonds. I was right on the latter but not bullish enough on the former. Here’s what I projected at the time.

Tech will slow. I noted we had seen huge gains in information technology companies in 2020 as demand for in-home entertainment and communications surged. I suggested these companies would continue to grow but that price gains of that magnitude were not likely to continue. I predicted Nasdaq growth in the 10- to 15-per-cent range. I was directionally right but too conservative. The Nasdaq Composite ended the year up 23.2 per cent.

The Dow will rebound. The Dow lagged the other major U.S. indexes in 2020. I felt it should do better in 2021 and forecast a gain in the 12-per-cent range. Again, I was too conservative. The Dow ended the year up 20.2 per cent.

The TSX will do better. Energy and financial stocks dragged down the TSX in 2020. I felt 2021 would be much better for Canadian stocks and projected a gain of 8 per cent to 10 per cent. The gain was more like 21 per cent.

Green energy companies will continue to prosper. These stocks did remarkably well in 2020. I felt that would continue in 2021, with the Democrats in power in Washington and a new emphasis on climate change and the environment. It didn’t work out that way. These stocks got ahead of themselves and pulled back. I expect them to recover in 2022.

Bond prices will weaken. I advised reducing holdings in bonds, which would be hit by rising interest rates. That happened as expected.

Looking ahead

So much for the postmortem. What happens next?

After two consecutive years of gains, the temptation is to forecast more of the same. But the stock market will face increased pressure in 2022 and, at some point, investors are going to relearn that there’s a direction other than up. The headwinds include:

– Interest rate hikes. The U.S. Federal Reserve Board is forecasting three rate increases this year. The market has already priced this in, but if the Fed decides it needs to be even more aggressive to tame inflation, investors may be spooked.

– Inflation. Cost of living increases are in a range we haven’t seen in four decades and, so far, have shown few signs of slowing. The latest U.S. number was 6.8 per cent, compared with 1.4 per cent in 2020. Moreover, our central bankers are no longer using the word “transitory” to describe the situation. If they’re worried, we should be, too.

– Overvaluation. Home prices are in bubble territory in many areas. So are most stock prices. The price-earnings ratio of the S&P 500 was at 30.02 as of 2021 year-end. It’s been higher in the past, but the current level is about twice the median, according to tracking that goes back to the 1870s.

– Earnings. Corporate North America generally reported better-than-expected earnings in 2021, providing fuel for rising stock prices. But that was from a low base in 2020, when the world economy was locked down for a period. It will be much harder to replicate that performance in 2022.

– War. No one wants to envisage this, but China’s increased harassment of Taiwan and Russia’s troop buildup on the eastern border of Ukraine are keeping some diplomats awake at night. A conflict involving one or more of the world’s superpowers would send stocks tumbling.

There are some potential tailwinds that could offset these negatives. Most important is the course of the pandemic. Two years of the coronavirus have taken a huge toll on everyone’s mental health. If Omicron turns out to be the last big wave, as some medical experts say is possible, the global sigh of relief could spark another huge stock market rally. Supply chain problems would gradually ease, offices would reopen and the hospitality industry could resume its recovery.

Another potential plus would be a pullback in the inflation numbers, which in turn would allow the central banks to ease back on rate hikes.

So, bottom line, what should you look for? My expectation is that we will see a correction in the market in the first quarter, with stocks falling 10 per cent to 15 per cent. After that, assuming we finally get the pandemic under control, we should experience a strong rally. By year-end, we should be looking at a stock market gain in the mid-single digits.

But, given all the uncertainties, any scenario is possible. So be defensive in managing your portfolio in 2022. Specifically:

Avoid high-risk stocks. This is not a time to go out on a limb.

Focus on blue-chip securities in stable industries. Utilities, banks and telecoms are your best friends right now.

Take some profits. If you are overweight in technology, energy, materials or any other volatile sector, trim your positions and reduce exposure.

Review your asset mix. Ask yourself how your portfolio would fare in the event of a sharp market sell-off. If you aren’t comfortable with the answer, reduce your equity exposure.

Be cautious with bonds. The coming interest rate hikes will continue the downward pressure on bond prices in 2022. Bonds can offer stability when stocks fall but to keep risk low stick to short-term issues.

It appears 2022 is going to be a roller-coaster year. Make sure your seatbelt is fastened.

Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.

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