2022 Was a Punch to the Face

Everyone has a plan until you get punched in the mouth

Those were famous words spoken by Mike Tyson, one of the most feared fighters of our generation, when asked about his opponent’s plan to use his longer reach to keep Tyson from getting close enough to unleash his deadly punches. ?

Going into 2022, we had a plan. We knew technology stocks were looking frothy and performance of the S&P 500 was being driven by a handful of companies. We shifted away from those areas of the market that were fraught with downside risk and focused on more defensive themes, along with the assumption that fixed income would provide some balance to a <tongue in cheek> balanced portfolio even if rising rates would dampen returns.

What very few saw coming was the pace and magnitude of the Fed’s rate hikes – a Mike Tyson right uppercut – said to be his most dangerous punch and the equivalent of getting hit by a moving vehicle. We didn’t stay down, however. We kept fighting, making adjustments to portfolios, rebalancing, and harvesting tax losses that will benefit client portfolios in the future.

Which brings up another famous quote, this time by Jaime Escalante,

Life is not about how many times you fall down. It’s about how many times you get back up

We’re up. And we still got some fight in us!!

2022 recap

Despite the decline in the last month of the year and a disappointing Santa Claus rally, most asset classes were up in Q4, led by International and Emerging Market equities. However, during a year in which both equities and fixed income returns declined together for the first time in decades, there weren’t many places to hide. ?The biggest challenge, however, was how the market kept bobbing and weaving, giving us very little indication of it’s next direction. Fundamentals were thrown out of the ring and all that mattered was Fed rhetoric. Any indication that the pace of rate hikes would slow would drive the market up, leading to disappointment when inflation readings remained pesky, or Fed governors gave speeches indicating their resolve to punch out inflation.

For Q4, the S&P 500 was up a strong 7.6% to end the year but it wasn’t enough to reverse losses that started almost as quickly as we awoke from the 2022 New Years celebration. A series of bear market rallies gave investors hope on several occasions throughout the year but the end result was a loss of 18.2% including dividends. The best performing index was the DOW, the bluest of the blue chips, which has a value tilt and is generally more defensive than the broader market.

Overall, Value held up much better than Growth throughout the year and although it generated a 13.5% return in Q4, could not reach the level at which it started the year. For the full year, the S&P 500 Value Index was down 5.4%, outperforming the S&P 500 Growth index by roughly 25%.

Among US Equity Sectors, only Energy provided a meaningful return although it was accompanied by heightened volatility caused by a spike in energy prices, with WTI Crude reaching $115 in July and then slowly declining for the rest of the year to end at $76. The only other sector to generate a positive return was Utilities with a 1.4% return.

Bonds also performed well during the 4th quarter, led by an 8.4% return in Emerging Market bonds, but the pace and magnitude of the Fed’s rate hikes – the fastest rate hikes in history – had a damaging effect on fixed income as well. As rates rise, the price of fixed income declines and the broad fixed income index was down over 10% for the year, with some longer dated bonds down over 30%!

Meanwhile, the US Dollar was steadily climbing throughout the year until October, when inflation finally started showing signs of easing, and with it, a slower pace of rate hikes by the Fed. The strong dollar hurts multinational companies with a high proportion of sales outside the US, which when combined with slowing demand overseas, was a headwind for the larger cap companies in the S&P 500.

Our Portfolios

While we were disappointed that our portfolios declined along with the markets, they held up quite well relative to their respective benchmarks, our baseline of comparison for portfolios of a given risk/return combination. In boxing parlance, we went the distance, we didn’t get knocked out.

Our shift to value from growth in late 2021 as well as the shift away from market-cap weighted indexes was enough to outperform each of our respective benchmarks from anywhere between 2.6% to 5.4% The risk we saw then was that the Top 10 Stocks in the S&P 500 made up approximately 25% of the index and they were primarily in technology and communications, some of the most sensitive sectors to rising rates, which were also trading at lofty valuations.

We also made tactical allocations to energy, infrastructure, and short-term real estate rentals, three areas that tend to do well in an inflationary environment. While the first two investments performed well, the real estate position was hampered by the broad selloff of income generating assets.

The Risks

For 2023, we see two major risks to portfolios.

1. The biggest risk for a sustained recovery in equities is a deep and prolonged recession driven by Fed overtightening. With inflation seemingly having peaked, we turn our focus now to how quickly inflation will revert back to the Fed’s long-term target and more importantly, how patient the Fed will be to allow rate hikes to filter through the economy. The last few inflation reads have indicated a trend of declining inflation, but the overall inflation numbers remain exceptionally high. Two areas remain stubbornly resilient: The labor market, which although has shown signs of weakness, still remains tight and could now be the Fed’s biggest concern; and owners equivalent rent, which tends to lag housing prices. If job growth doesn’t slow enough to dampen demand or rental rates remain hot, interest rates may have to rise more than anticipated or remain higher for longer, the latter having already been communicated by the Fed.
2. The second major risk for the markets is dour expectations for earnings growth. As 2023 earnings estimates continue to decline, lower valuations that have resulted from a pullback in equity prices look less compelling than they would have if accompanied by robust earnings growth projections. The S&P earnings per share estimates for 2023 are now $225.35, down from $249. With a forward PE ratio of 17.7, the market doesn’t look as appealing as it did before earnings downgrades, when the PE ratio was around 15.

Will we avoid a knockout punch?

With the Services PMI recently dipping below 50, economists are even more convinced now of an imminent recession if we aren’t already in one. A PMI below 50 indicates contraction and while the manufacturing PMI dipped below 50 back in November 2022, the services PMI had remained in expansionary territory until last month. The latest reading indicates that Fed tightening is having it’s intended effect even if it is occurring at a slower pace than many Fed governors would like.

The latest wage growth data also shows slowing wage increases as well as a decline in weekly hours worked, both indicators that the increase in rates are having their intended effect on the labor market as well.

Whether the US economy enters a recession is anyone’s guess, with economist probabilities ranging anywhere from 5% to 75%. But the majority of prognosticators expect a mild one if and when one occurs.

Portfolio Positioning

When we look at the broad investment universe that includes global markets, we see more attractive opportunities in Non-US equities despite potential risks from an extended or expanded Ukraine/Russia conflict. Valuations are at extremely low levels and earnings growth is comparable to that in the US. Most international stocks also pay higher dividends than their US counterparts, which adds an element of return diversification, safety, and cash flow to portfolios. However, risks remain due to the Russia/Ukraine war while some economies in Europe and the UK are likely to experience a deeper recession than the US economy.

On the fixed income side, bonds are finally paying a decent yield that for years drove investors into equities under the TINA (There is no alternative) theory. We particularly like municipal bonds within taxable accounts as they have sold off along with the broader fixed income market despite solid fundamentals from the governments and municipalities that have issued them. With attractive yields and a potential snap back in prices, muni bonds are one of our favorite asset classes heading into 2023.

Bye Bye 2022, Bring it on 2023

Just when we thought we had closed the door on one of the worst years for investment returns since 2008, we now face the possibility of a US and global recession. Not a rematch of the previous fight, but a fight nonetheless. ?The good news is that a mild recession is widely expected – and while economist forecasts are often wrong – a consensus view translates to asset prices already reflecting that possibility. If a recession does occur, the base case is for a mild contraction given the strength of corporate balance sheets, consumer savings, and a renewed corporate focus on cost-cutting and efficiencies – as evidenced by the many announced layoffs in the first couple of weeks of the year.

While earnings might be pressured in the early part of 2023, we believe CEOs have begun to mitigate risks and that there could be a positive surprise to downward revised earnings estimates. You will hear talk about how PE ratios are still too high and valuations haven’t come down enough, but when earnings decline, the PE multiple expands – and the stock market usually hits bottom during - not after - the recession. That means that if we are already in a recession or one is imminent, we may have already seen the market bottom. ??

In any case, we remain cautious on portfolio positioning and will slowly adjust exposure as visibility improves on inflation, earnings, labor, and Fed policy. It won’t be an easy bout, but we have a plan.