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What factors drove stock market performance in 2021?

Robust earnings growth not only drove performance but helped to rein in frothy valuations coming out of 2020.

S&P 500 sources of return

Equity market performance was exceptional in 2021, led by U.S. large-cap stocks, which returned nearly 29% for the year. This performance comes on the back of strong years in both 2019 and 2020, when the index returned 31% and 18% respectively. To put these results in context, the average annual total return for the S&P 500 index over the past 50 years was about 12.6% — less than half of the average over the past three years.

Against a backdrop of a global pandemic that has disrupted economic activity both in the United States and abroad, what explains these strong returns? Starting in late March 2020, stock markets rallied as significant fiscal and monetary stimulus and surprisingly rapid economic reopening boosted market sentiment. Investors looked ahead to a robust rebound in earnings expected in 2021, which particularly stretched equity valuations based on trailing earnings. However, in 2021, earnings rose by more than 50% over the prior year, easily surpassing expectations. Consequently, index price/earnings (P/E) multiples actually improved considerably. Despite the outsized 29% return for the index, earnings growth was even stronger.

As shown in the chart above, the reduction in the P/E multiple last year was somewhat of an anomaly in recent years. Over the past three- and 10-year periods, P/E expansion was a meaningful contributor to overall performance, as contrasted with long-term market returns, which were overwhelmingly driven by earnings growth and dividends.

As the Fed shifts toward tightening, equity valuation multiples will face a new headwind, as higher interest rates typically put downward pressure on market P/E multiples, all else being equal. Earnings growth will likely need to carry the baton in the next phase of the cycle, with dividends also playing a more important role as well. Should projections of above-trend economic growth be met, solid earnings growth should provide a key fundamental support for equities, even in the event of an uptick in market volatility.

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.

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