The U.S. stock market continues to astound with its resiliency, overcoming obstacle after obstacle like a gold-medal track star clearing hurdles. Pandemic? No longer much of a problem. The highest inflation since the ’90s? Not a deal breaker. Record-high stock prices? We’ll pay up – and buy every dip that comes along, no matter how minuscule.

The S&P 500 index logged 64 new highs in 2021 (as of early November), the second-highest annual total in index history. Since our January 2021 outlook a year ago, the broad market benchmark has returned 35.8%, including dividends. We said at the time to expect low-double-digit returns, but that if we were off, it would be because we were too conservative. At midyear, the upper end of bullish 2021 price targets for the S&P 500 among Wall Street strategists reached the 4,600 mark. On Nov. 5 (the date for prices, returns and other data in this article), the index closed at 4,698.

Will the juggernaut continue in 2022?

Our answer is a qualified yes. It has proved to be a mistake to underestimate corporate America, and the market enjoys some strong fundamental underpinnings. But the old challenges remain, and new ones have surfaced.

So, once again, we encourage investors to moderate their expectations. You can only reopen an economy once (fingers crossed), and we are likely at or past peaks for growth rates in the economy and corporate profits.

“We head into the new year with a glass-half-full outlook,” says Eric Freedman, chief investment officer at U.S. Bank Wealth Management. “But like most market environments, this one is a mosaic of risks, some forecastable and some not.”

For 2022, we expect more-normalized stock market returns. That means something in the high single digits, plus between one and two points in dividends. Think somewhere a bit above 5,050 for the S&P 500, or north of 39,000 for the Dow Jones Industrial Average.

For now, in broad terms, we prefer stocks to bonds and U.S. markets over international offerings, and we like the looks of small companies, value-priced fare and companies that do well when the economy does and can cash in on supercharged consumer spending. Later in the year, in a more temperate post-COVID economy, look to larger-capitalization healthcare and technology names for long-term, stable growth.

Investors will have to pick their spots carefully in 2022 and may not be able to rely on a rising tide lifting all boats – either in broad index terms or even within a particular investment style or sector. “It will be a decent year for stocks if you’re a stock picker, a more modest year if you’re an S&P 500 investor,” says Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management.

The U.S. Economy is on Solid Footing

Economic growth, although deceler­ating from a strong reopening bounce, is expected to remain robust in 2022, with the U.S. leading global developed economies.

The health of the American consumer is a big part of the story, says Ross Mayfield, investment strategy analyst at securities firm Baird. “I’m bullish on the U.S. economy and U.S. stocks,” he says. “Our economy is consumer-driven and consumption-based, and we emerged from the recession with consumers in a better position than they’ve been in long-term memory.” Debt in relation to income is down, and debt service is manageable with still low, albeit rising, interest rates, he notes.

The Conference Board, a business and economic research group, forecasts U.S. gross domestic product growth of 3.8% in 2022. That’s down from an estimated 5.7% in 2021 but well above the pre-pandemic trendline of 2.2% from 2010 through 2019. Kiplinger’s forecast of 4% growth in 2022 is more optimistic than the Conference Board’s. By 2023, many economists expect GDP growth to fall back to the 2% to 3% range.

With the economy on solid footing, the Federal Reserve has begun to peel away the crisis measures it instituted when the pandemic first hit. The Fed announced in November that it would start scaling back its massive bond-buying program, a process likely to conclude next summer. The last time the Fed tapered a bond-buying program aimed at shoring up the economy, in 2013 and 2014, the stock market dipped in a so-called “taper tantrum” but recovered nicely.

The central bank will likely start raising rates in the second half of 2022. Kiplinger sees two quarter-point hikes in the Fed’s short-term benchmark rate in 2022, with hikes continuing into 2023. Look for the yields of 10-year Treasury notes to reach 2.3% by year-end 2022, up from 1.5% recently.

Rising rates put fixed-income investors in a bind, because bond prices typically move in the opposite direction of rates. You’ll do best by venturing beyond plain-vanilla Treasuries.

“Most of our fixed-income picks are what we call non-core,” says Shalett, “in areas like bank loans, preferred shares, convertible bonds, select mortgage-backed securities – a lot of it is very nontraditional.” 

Given today’s challenges, corporate profits are surprisingly strong, despite the trials of the pandemic, rising production costs, supply chain snafus and labor shortages.

U.S. companies recorded a brilliant third quarter, with an earnings growth rate for companies in the S&P 500 expected to be 41.5% when all the reports are tallied, according to earnings tracker Refinitiv. Nearly 81% of companies beat analysts’ estimates – in a typical quarter, only 66% do so.

When the books close on 2021, analysts expect profits to be up 49% from 2020 levels. Earnings will come back to earth in 2022, with analysts expecting annual growth more along the lines of 7% to 8%, closer to the long-term historical average. Expect the strongest growth in industrials and energy stocks, plus the consumer discretionary sector (companies that make or provide nonessential goods or services).

For investors worried that a stock market at all-time highs is too pricey, the strong earnings support should allay some fears. The market “melt-up” in 2021 (the opposite of a meltdown) has been led by a melt-up in earnings rather than by the inflating price-earnings ratios that drove stocks in 2020, notes economist and market strategist Ed Yardeni.

“An earnings-led bull market is much better than a P/E-led bull market; it’s less prone to sell-offs because it is supported by fundamentally strong earnings,” he says. The S&P 500’s P/E has drifted down from a high of more than 23 to just over 21 recently, even as the index keeps climbing.

“That tells you how great earnings growth has been,” says Tony DeSpirito, chief investment officer of U.S. Fundamental Equities at investment giant BlackRock. “That’s been kind of lost on people.”

Inflation: The Elephant in the Room

Perhaps the biggest risk facing the market this year is one with a long reputation as a bull-crusher: inflation. Inflation erodes the value of financial assets and ushers in higher interest rates as central bankers try to tamp it down.

In October, inflation measured by the consumer price index was up 6.2% from a year earlier, the highest annual rate since November 1990. It marked the sixth straight month above 5%. Kiplinger expects inflation to hit 6.6% by year-end 2021 before falling back to 2.8% by the end of 2022 – above the 2% average rate of the past decade.

“Inflation is in the air, and it risks becoming a market issue, an economic issue and a political issue,” says Katie Nixon, chief investment officer at Northern Trust Wealth Management.

The run-up in prices is a result of surging demand from consumers with plenty of savings to spend colliding with stubbornly persistent supply-chain bottlenecks. It’s exacerbated by labor shortages putting upward pressure on wages, as younger workers remain slow to return to the post-COVID workforce or change to better-paying gigs while an increasing number of older workers opt out for good.

Some of that will resolve with the end of the pandemic – or our acceptance of living with it. Nixon is confident that inflation will ultimately revert to the low-level “stuckflation,” as she calls it, that characterized the pre-COVID era. But longer-term demographic trends and a movement toward deglobalized trade and supply chains “may coalesce in an extended period of steadily rising prices,” conclude Conference Board economists.

Keep an eye on corporate profit margins in 2022; they’ll be a key measure of how companies are coping with rising costs. For now, solid economic and earnings growth seem the most likely model for the near future, says Yardeni. A darker scenario would play out if price hikes and wage increases were to start to feed off of each other in a wage-price spiral reminiscent of the 1970s, especially if economic and earnings growth rates are pinched by continuing parts and labor shortages.

“I hate to say it, but ‘stag­flation’ is a relevant word here,” says Yardeni. He currently assigns a 65% probability to a growthy, “roaring ’20s” scenario and only a 35% probability to the stagflation story.

Where to Invest

The first order of business in 2022 is to protect your portfolio from inflation, if you haven’t already. If you bought Treasury inflation-protected securities early in 2021, congratulations, you’re ahead of the curve.

Now, TIPS are “massively expensive,” says Morgan Stanley’s Shalett. “We’re sellers of TIPS.” One alternative: Series I savings bonds, paying a rate of 7.12% through April 2022.

Because of their growth potential, stocks are a good long-term hedge against inflation – especially if you zero in on companies with pricing power. They can either control costs to keep profit margins plump or pass on price increases because of strong demand for their products.

Companies with a Buy rating from BofA Securities that sport growing sales, healthy margins and expanding market share include farm equipment firm Deere & Co. (DE, $355), streaming giant Netflix (NFLX, $646), chipmaker Qualcomm (QCOM, $163) and Prologis (PLD, $147), a real estate investment trust (REIT) that is also a member of the Kiplinger ESG 20, the list of our favorite stocks and funds with an environmental, social and governance focus. Investment firm Capital Group notes that Netflix has raised subscription rates in the U.S. four times since 2014 while maintaining robust subscriber growth.

Firms with low labor costs are also a good bet. According to Goldman Sachs, healthcare distributor AmerisourceBergen (ABC, $128) rings up an average of $9.6 million in sales per employee. For context, the median S&P 500 company can chalk up $400,000 in revenues per worker.

As hypersonic stock-price returns start to trail off, dividends will be a more important contributor to total returns in 2022 and beyond. “We see dividend preservation and growth as the single most important criteria for stock selection, which could potentially be the difference between a flat-to-negative and a positive return over the next 10 years in the S&P 500,” write strategists at BofA Securities. They also make the case that in terms of inflation protection, stocks with growing dividends are in the sweet spot between commodities (all inflation protection, no yield) and bonds (all yield, no inflation protection).  

You’ll have plenty of dividend payers to choose from. Companies are restoring payouts that were curtailed during the pandemic.

A proposal in Washington to levy a 1% charge on corporate buybacks could sway cash-rich com­panies to favor dividend payouts, says BlackRock’s DeSpirito, who also manages the firm’s Equity Dividend Fund. And companies are increasingly responding to investors’ thirst for income. “We continue to be in a yield-starved world. Demographically, the need for income is the highest it’s ever been,” says DeSpirito.

Stocks in the Kiplinger Dividend 15 (the list of our favorite dividend stocks) with a history of rising payouts include pharmaceutical firm AbbVie (ABBV, $117, yield 4.8%) and defense contractor Lockheed Martin (LMT, $340, 3.3%). Stocks that BofA recommends with yields that can stand up to inflation include a number of energy firms, including Chevron (CVX, $115, 4.7%) and Marathon Petroleum (MPC, $66, 3.7%).

Dividend-growth funds worth a look include Vanguard Dividend Growth (VDIGX) and T. Rowe Price Dividend Growth (PRDGX). The latter is available in an exchange-traded version (TDVG, $34).

A Two-Tiered Market in 2022

Like Janus, the ancient Roman god of transitions and dualities, the stock market will be two-sided in 2022, says Freedman, from U.S. Bank.

In the first part of the year – through the second or third quarter – cyclical stocks, or those most tied to the economy, should dominate, including consumer dis­cretionary stocks, such as leisure and hospitality names, and financials. Small- and mid-cap stocks should shine, says Freedman, as well as stocks with a value orientation.

In the back half of the year, says Freedman, as COVID shifts from “pandemic to endemic” and the economy settles into a steadier but slower growth mode, look for tech and healthcare to lead. Those sectors are supported by long-term trends not easy to reverse, such as the demographics of an aging global population and the search for productivity gains in an increasingly digital economy.

Financials, and banks in particular, should profit from a yield curve that is expected to steepen, with long-term rates rising faster than short-term rates, allowing banks to charge more on loans than what they pay to borrow.

“Banks are our number-one sector preference,” says Morgan Stanley’s Shalett. The potential savings as banks transition from a branch-oriented business, heavy on employees and real estate, to more of a digital model is not yet reflected in stocks’ prices, she says. Consider Invesco S&P 500 Equal Weight Financials (RYF, $66), an exchange-traded fund that gives as much weight to smaller, regional banks as it does to big money center institutions (it’s also a member of the Kiplinger ETF 20).

Gain broad exposure to consumer discretionary companies – those providing goods or services that consumers don’t have to buy but want to – with Vanguard Consumer Discretionary (VCR, $356), but be warned that Tesla (TSLA) and (AMZN) account for one-third of the portfolio.

With a recovery in travel gaining momentum, analysts at investment firm Jefferies say online travel-services firm Booking Holdings (BKNG, $2,619) is “a solid value play.” Research firm CFRA is high on air travel, with Strong Buy ratings on Alaska Air (ALK, $59), Delta Air Lines (DAL, $44) and Southwest Airlines (LUV, $52). Among casinos, Jefferies recommends MGM Resorts International (MGM, $50) and Caesars Entertainment (CZR, $106), citing strength in digital gaming and historically high profit margins.

Small-company stocks have taken the market lead and lost it more than once during this recovery.

“They face some unique headwinds emerging from COVID,” says Baird’s Mayfield. Bigger companies have more workarounds in a COVID-constricted environment, with employees able to work from home or the ability to shift to more e-commerce, whereas many smaller firms are customer-facing and hospitality-focused. “Relative performance has not been what we expect coming out of a recession,” says Mayfield. “Small caps have room to play catch-up, and it’s likely they’ll do so.” 

For a slug of small caps, try iShares Core S&P Small-Cap (IJR, $120), an ETF 20 pick. Or call in a pro with actively managed T. Rowe Price Small-Cap Value (PRSVX), a member of the Kiplinger 25, the list of our favorite no-load funds.

Tech stocks are likely due for a bout of turbulence as interest rates rise. And after warnings in recent earnings reports from Apple (AAPL) and, we learned that they’re not immune from supply-chain woes or rising-wage pressures. But as 2022 rolls on, you might hear tech and healthcare names, instead of utilities and packaged food firms, touted as a new breed of defensive stock.

“Tech is the new staple,” says DeSpirito. “It’s remarkably resilient.” Healthcare stocks can count on stable growth as society ages and requires more medical care, he says. Making the most of a flexible approach, T. Rowe Price Global Technology (PRGTX), a Kip 25 fund, is a good choice.

The boom in semiconductors has legs far beyond today’s supply crunch. Research from investment management firm Capital Group notes that chips are used in everything from phones and laptops to refrigerators and ovens (new cars require as many as 100 chips) and are essential to technologies such as artificial intelligence, cloud computing and 5G wireless. Cash in with Fidelity Select Semiconductors Portfolio (FSELX). Our healthcare picks include UnitedHealth Group (UNH, $456) and Kip 25 fund Fidelity Select Health Care (FSPHX). 

By Sia