Dream On - 2023 Market Outlook

As the dust settles on 2022, it will likely be remembered as one of the most challenging years for investors in history. Not because stock markets declined, bear markets are a necessary part of the process. What set 2022 apart from other years was the simultaneous decline in equity and fixed income markets. For decades investors have been trained, and rewarded, to "buy the dips" in stocks and use bonds to preserve capital in volatile years. Neither worked in 2022. The chart below shows last year was the third year since 1871 (nearly 150 years ago) that U.S. stocks and bonds both recorded negative returns in a calendar year.

Total return in US stocks & bonds (1871 - 2022)

So what can we expect for 2023?

Probabilities tell us it won't be what the market "professionals" think. As Wall Street strategists look into their crystal balls, they see the S&P500 Index rising 6% this year. Of the 22 strategists surveyed by Bloomberg, just three have the market going down. Like every year, the forecast is approximately equal to the long-term average stock market return of 7%. Why is this problematic? Since 1900 the Dow Jones returned 5-10% in a calendar year just 9% of the time (or 11 times in 123 years). Historically, forecasters have a better chance of predicting the market to rise or fall by 20% or more. The average is made up of extremes!

Dow Jones calendar year returns (1900 - 2022)

For several reasons to be discussed, we have a hard time coming up with a macro backdrop that is conducive to the market rising by 20% or more this year. That leaves us in the camp of assigning a higher probability to potential extreme downside returns. To be clear, this is not our base case, but a risk that has a higher probability than investors appear to be prepared for.

Bullish market pundits appear to focus their thesis on some combination of the following:

·????Central banks will coordinate a soft economic landing

·????Declining inflation will allow for a Fed pivot

·????Declining asset prices in 2022 have discounted the coming slowdown

The Fed saying they can coordinate a soft landing is enough to convince us of a pending hard landing. It mystifies us why the market continues to react off Fed communication. This is the same Fed that tried, for over a decade, to get inflation above 2% with no success. The same Fed that has two primary objectives; controlling inflation and unemployment, and missed the largest increase in inflation in 40+ years. This same Fed is now calling for a soft landing after orchestrating the largest percentage rate hike in the shortest period of time. To quote Steven Tyler from Aerosmith, "Dream On"

?The historic tightening put into the pipeline in 2022 works with a lag. It takes 12-18 months for the effects to begin to show up in economic data from housing to employment. This means 2023 will be a year filled with macro surprises as growth and corporate profits slow.

S&P 500 YoY% (adv 6 months) vs US Real GDP YoY%

Stock market leads GDP by 6 months

Inflation has likely peaked, barring some exogenous event that causes a spike in energy prices. This doesn't provide cover for the Fed to pivot and cut rates in 2023. The market appears content to interpret every weak economic data point as a reason to pivot and send stocks higher. Our strongest conviction call this year is that will not happen. The Fed has been embarrassed by missing inflation once. They will not risk going down the path of the stop and go policy of the 1970's. The most likely scenario is pausing at higher rates for longer than currently expected, frightening investors.

If a Fed pivot does occur this year, history doesn't suggest it is all clear for equities. As highlighted by Strategas Research Partners, historically the S&P500, on average, has declined 24% and taken 195 days to find a bottom after the the first Fed rate cut (data since 1974). This can be seen in the chart below showing the S&P 500 Index after Greenspan and Bernanke's first rate cuts. On top of this, I am not sure we want to see what the macro environment looks like in a pivot scenario.

S&P 500 Index

Greenspan and Bernanke's first rate cuts

Far too often we hear the market has already "discounted" the bad news. S&P 500 earnings increased in 2023 meaning the market declines were entirely driven by multiple compression. 2023 sets up to be particularly problematic as the impact of tighter policy and inflation hit earnings. Recency bias leaves many believing stock markets can't go down two years in a row. History tells a different story. Since 1929 there have been 19 years the S&P 500 experienced double digit declines; 42% of the time, the following year was also negative.

Declining earnings, a stubborn FED, a desperate Putin, Washington (enough said) and a slowing economy are just a few of the potential headlines that may catch investors off guard in 2023. While we want to voice our worries and manage risk on the downside, it is equally important to position to deliver returns in such a backdrop.

While we have broad concerns we are also seeing opportunities in areas such as Health Care and Financials that offer relatively attractive valuations. Gold stocks have started to emerge in our work as a beneficiary of the macro world and offer high volatility for option-based strategies. The portfolio continues to be positioned towards Canada, with a focus on value, profitability and low beta stocks. We also took the opportunity in December to roll our equity hedge on the portfolio's U.S. exposure into 2023 as part of our focus on capital preservation. While it is more fun to be bullish and optimistic, we must respect our process and position the portfolio accordingly.