Despite an uptick in volatility over the past couple of weeks, it's been another slam-dunk year for the stock market. Through Tuesday, Dec. 7, the benchmark S&P 500 ( ^GSPC 0.95% ) had gained nearly 25%. To put this figure into context, the widely followed index has averaged an annual total return, including dividends, of around 11% since 1980.
There's no mincing words: It's been a good year for many big-name companies.
But history also shows us that stock market crashes and double-digit percentage corrections are commonplace. As we get ready to steam forward into a new year, the following seven factors stand out as the biggest threats to the stock market in 2022.
Image source: Getty Images.
1. The Federal Reserve panicking over inflation
Arguably the biggest concern for Wall Street in 2022 is how the Federal Reserve handles rapidly rising inflation (the rising cost for goods and services).
Throughout 2021, Federal Reserve Chairman Jerome Powell has described inflation as "transitory." But that terminology changed this month, with Powell recognizing that higher prices could stick around. Although some level of inflation is expected in a growing economy, the 6.2% increase in the Consumer Price Index for All Urban Consumers in October marked the largest jump in 31 years. Sustainable price hikes of this magnitude will eat up wage increases, gobble up consumer and enterprise discretionary income, and could halt the economic rebound from the coronavirus-induced recession in its tracks.
The nation's central bank may be forced to raise its federal funds target rate, which influences interest rates, earlier than anticipated. The concern is that if the Fed has moved too slowly, or provided too much kindling under the U.S. economy with its historically low lending rates and bond-buying program, it could be forced to aggressively hike lending rates. Should that happen, growth stocks would be in big trouble -- and so would the S&P 500, which has relied on growth stocks for most of its gains over the past 12 years.
Image source: Getty Images.
2. Political gridlock
When in doubt, keep politics out of your portfolio. But every so often, it's impossible to ignore how the actions in Washington, D.C., can affect the outlook for your investments. Yet the biggest worry in 2022 isn't what legislation might come out of Washington. Rather, it's what's not getting done.
In the upcoming year, lawmakers will have to tackle another federal funding bill by Feb. 15. We'll also be navigating our way through midterm elections in early November, and politicians could be embroiled in another debt-ceiling debate near the end of 2022.
In recent years, the division in ideology between America's two dominant parties, Democrats and Republicans, has widened, and finding middle-ground solutions has, at times, seemed impossible. With politicians focused on reelection campaigns, the lack of action in Washington could become a serious distraction on Wall Street.
Image source: Getty Images.
3. Global "variant variance"
Another pretty evident threat to global markets is what I refer to as coronavirus disease 2019 (COVID-19) "variant variance."
In May, the emergence of the delta variant of the SARS-CoV-2 virus that causes COVID-19 briefly sent investors running for the hills. The same could be said about the omicron variant over the past two weeks. The mutability of SARS-CoV-2 suggests that we should expect new variants to arise in the upcoming year.
Variant variance describes how, rather than having a unified approach to tackling COVID-19 spread, we're witnessing a hodgepodge of campaigns and restrictions globally. Whereas some countries are imposing few restrictions, others have mandated the vaccine or barred the unvaccinated from nonessential stores. These unpredictable and inconsistent responses to COVID-19 variants threaten to disrupt already fragile supply chains and could seriously cut into U.S. and global growth rates in 2022.
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4. A margin debt unwind
A fourth threat to the stock market in 2022 is leverage.
Over time, we'd expect the nominal amount of margin debt outstanding to rise. Margin debt describes the amount of money being borrowed from brokerages with interest to purchase or short-sell securities. However, rapid rises in margin debt are far less common and come with worrisome implications.
Dating back to the beginning of 1995, there have been only three instances where margin debt climbed at least 60% on a year-over-year basis, according to data from the Financial Industry Regulatory Authority (FINRA). It occurred shortly before the dot-com bubble burst, just months prior to the financial crisis, and again in 2021.
While margin can be used to magnify gains, it can also quickly multiply losses. A fear-or-sentiment-driven short-term event that pushes the S&P 500 lower in 2022 could lead to sweeping margin calls that sink Wall Street.
Image source: Getty Images.
5. A crypto collapse
Over the past couple of years, the cryptocurrency market has run circles around the S&P 500. Since the coronavirus trough for equity markets in March 2020, the S&P 500 is up a little over 100%, whereas the aggregate value of digital currencies has soared more than 15-fold from $141 billion to $2.34 trillion.
Making money in the cryptocurrency space has been easy -- perhaps a little too easy. Crypto gains have, in some instances, been invested in highly volatile stocks, momentum plays, and meme stocks, such as GameStop and AMC Entertainment. If the crypto market, which is dominated in market cap by a handful of names, were to undergo a significant reversion, the capital retail investors have been bouncing between digital currencies and volatile/momentum/meme stocks could partially or fully dry up.
As a reminder, in November, the Federal Reserve's "Financial Stability Report" cited the actions of retail investors in meme stocks as a potentially destabilizing factor for the stock market. If momentum chasers are clobbered by crypto in the upcoming year, Wall Street will likely share the pain, to some degree.
Image source: Getty Images.
6. Growth stock premium reversion
Historically, value stocks have actually outperformed growth stocks. But since the Great Recession ended, low lending rates and a dovish central bank have rolled out the red carpet for growth stocks to thrive. Eventually, we're going to see some sort of reversion to this push-pull between growth and value, and it may come in 2022.
If the Fed does raise lending rates faster than expected and holds to its word of reducing or eliminating quantitative easing measures, access to cheap capital is going to diminish for growth stocks. This likely means less in the way of acquisitions, as well as fast-paced businesses being more mindful of where they put their capital to work with regard to new projects and innovation. In other words, it probably means slower growth rates across the board.
The problem, as noted earlier, is that growth stocks have been the wind in the S&P 500's sails. If growth rates slow, it becomes a lot tougher for Wall Street and investors to justify paying 50 times sales for a cloud services company or 35 times revenue for a cybersecurity stock. A premium reversion for fast-paced companies could sack the S&P 500 and tech-heavy Nasdaq Composite in 2022.
Image source: Getty Images.
7. History (it often rhymes)
Lastly, history looks like a genuine threat to the S&P 500's seemingly unrelenting uptrend over the past 20.5 months.
Since 1950, there have been 38 double-digit declines in the S&P 500, which works out to one notable dip, on average, every 1.87 years. Likewise, there have been either one or two declines of at least 10% within 36 months following each of the past eight bear-market bottoms, dating back to 1960. Although the stock market doesn't strictly adhere to averages, nor does it follow history to a "t," it does often rhyme with history. This is to say that the benchmark S&P 500 does repeat moves lower following certain events, albeit not always in the timeline that's expected.
Based on the above figures, we're seemingly due for both a natural correction to the downside, and a hiccup in bouncing back from a bear-market bottom. Though there's no way to know when this dip might occur, history is pretty clear that downside moves are a normal part of the investing cycle.
In other words, don't be surprised if 2022 features a bigger dip than the minuscule 5% "drop" the S&P 500 contended with this year.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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