Market Commentary January 2023

Happy New Year!

For many, a new year brings positive thoughts and a sense of hope for the future. I tend to feel the same way. As difficult as 2022 was for so many, and as foreboding as the coming year may seem, I think there’s good reason to have a glass-half-full attitude as the calendar turns.

For the stock and bond markets in 2022, it felt as if the glass was drained to nearly empty early in the year. Stocks and bonds sank from the outset. They attempted to recover but could never regain the record-high levels we saw during this time last year.

As we’ll discuss below, true value creation occurs after market declines, not during all-time market highs. Recent declines can mitigate some of the risk inherent in record-setting stock rallies, especially when viewed from a fair value perspective. In other words, prices needed to come down to earth again, and they recently have.

Another positive development worth considering is that it appears we are coming into 2023 on the other side of the pandemic. That is certainly welcome relief after several very difficult years from both a psychological and health standpoint. From a planning standpoint, businesses large and small will have one less major thing to worry about.

2022 Market Review

One of the greatest boxers of all time, Mike Tyson, once said, “Everyone has a plan till they get punched in the mouth.” Iron Mike is not someone I typically look to for advice, but there is a lot of truth to his statement.

Market prognosticators came into 2022 predicting inflation to decline (it did), supply chain issues to ease (they did), and consumers to reemerge from the pandemic ready to travel and spend money (they did). However, there were very few who predicted that the stock market (as measured by the S&P 500) would fall by nearly 20%. There were even fewer who predicted that bonds would have their worst year on record. The chart below illustrates just how unusual 2022 was for bond prices.

The rare combination of poor stock and bond returns in the same year made 2022 one of the most difficult calendar years on record for diversified investors. Below, you can see 2022 turned in the third worst performance for a 60/40 stock/bond portfolio since 1950.

Busted Predictions

Market prognosticators are fun to follow, but they regularly miss the mark.

Last year, Goldman Sachs predicted that the S&P 500 would finish 2022 at 5,100. Morgan Stanley took the under at 4,400. The S&P 500 finished the year at 3,839.50.

According to FactSet, between 2002 and 2021, industry insiders’ average target price estimates missed their predictions by an average of 8.3%. In 2022, it was closer to 40%!^I

What happened in 2022 that was so unpredictable? To start, investors quickly realized that “transitory inflation” was a misguided pipe dream. Eventually, the Federal Reserve agreed, albeit a bit late. While investors could see that their everyday items were either out of stock or going up in cost, the Fed stayed patient until they were forced to play catch-up. As illustrated by the blue line below, the consumer price index increased to a level not seen in 40 years.

The Fed’s arsenal is limited when it comes to fighting inflation. Raising interest rates is really the only tool at their disposal. Given that reality, they haven’t been shy about using it. As shown below, they raised rates in 2022 by the greatest margin ever seen in a calendar year.

Some of the most susceptible assets in a rising rate environment are speculative investments, like technology stocks, startups, and cryptocurrencies. After leading the way in 2021, the tables were completely turned on many of these names last year. The tech-heavy NASDAQ lost 32.54% of its value, and bitcoin lost 81.02%. Talk about getting punched in the mouth!

Crypto advocates have long espoused the benefits of bitcoin and other digital tokens as a hedge against inflation. 2022 taught everyone that cryptocurrencies are not yet mitigating inflation risk. They’ve proven to offer zero diversification against risky investments like speculative small-cap tech stocks.

Outlook for 2023

The outlook for stocks remains murky due to a lengthy list of unknowns:

• Outcome of the Russia-Ukraine war
• China’s COVID-19 response
• Corporate profit outlook
• The Fed’s policy
• Inflation changes

There’s a good chance that the first half of 2023 will continue to be choppy for stocks. In fact, we wouldn’t rule out another test of the lows seen in October of 2022.

However, long-term investors with patience are typically rewarded when they continue buying during a downturn. Retirement savers who dollar-cost-average regularly into their accounts tend to see some of their biggest returns in years following a pullback due to low entry points.

Recession?

Patience will be tested in a major way as investors are bombarded with talk of a recession. The degree to which we do or do not experience a recession will depend on whether the Federal Reserve, once again, is late to change policy.

Most economists predicting a recession are doing so because they lack confidence in the Fed’s ability to successfully time those changes and to deal with the lag time between policy moves and economic impacts.

Our CEO, Mike Wren, wrote a blog post in late September about what it really means to be in a recession and why you shouldn’t confuse the economy with the market. I would highly encourage you to read that post as well, as it still holds true today.

What We’re Doing

As the calendar turns, we’re considering how long our defensive moves from 2022, such as adding healthcare and more dividend-paying stocks, need to remain in place.

At some point, the defensive trend will reverse, and the market will again favor companies with the highest growth prospects. We don’t expect that to happen in the near future. So, for now, we will continue to favor high-quality investments over those with higher growth potential.

The bond market should offer significant opportunities in 2023 with much less risk than the stock market. We’re as optimistic about bonds today as we have been in many years. In our view, the worst year in recent memory has created substantial value.

Money market mutual funds, for some clients, will also offer strong cash yields we haven’t seen in almost 20 years.

Final Thoughts

While back-to-back down years in stocks do happen, it’s very rare. It’s happened three times since World War II. Each instance culminated in huge market rallies.

It’s rare because declining prices create value that is often too attractive for investors to ignore. Have we gotten to that point? If we haven’t, I think we will very soon.

However, if 2023 does prove to be a down year once again, please remember that it could set us up for a tremendous rebound that you’ll want to buy in front of, not behind — as history has taught us time and time again.

With this in mind, 2023 may be a year to take advantage of recently announced retirement contribution limit increases. Over-funding accounts in the first half of the year may be prudent for some. History would suggest that even if a recession materializes, stock indexes may have already moved higher before the recession ends. Shares may be on sale, but that won’t last forever.

We wish everyone a happy and healthy 2023. As always, thank you for your trust and confidence!

Sincerely,

Chris Proctor, CIMA^®
Chief Investment Officer