Thoughts from the Holy City – 2023 Year Ahead & 2022 Year Behind

“Academic finance is devoted to finding the mathematically optimal investment strategies. In reality, people don’t want the mathematically optimal strategy. They want the strategy that maximizes how well they sleep at night.”????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????~Morgan Housel

It has been nearly three years since the whole world began to shut down. As I look back to my commentary from the beginning of 2022, I am reminded that entering the year I was more optimistic that we as a country, and global economy, were beginning to transition back to a more “normal” environment.?The lethality of Covid was continuing to wane, the world economy was reopening, people were returning to work, and in general most individuals as well as corporate leaders seemed to be somewhat optimistic. However, we were once reminded that you can’t necessarily judge a book by its cover, and the economy can never be consistently forecast, nor the market consistently timed.?The events that subsequently took place in the coming months set up the coming year to be yet another one for the history books. Stocks logged their worst year since 2008 and bonds were hit by one of their worst selloffs in history which led to the long touted balanced 60/40 portfolio careening off course.

2022 and the Past 40 Years

As we enter 2023, the environment is much different as we face rampant inflation, a Fed determined to tame said inflation at any cost, and a much more pessimistic environment.?We are undoubtedly in the midst of a regime change, which frankly, may not necessarily be a bad thing.?It does, however, place more emphasis on portfolio and risk management. The DJIA finished the year down -8.78%, the S&P 500 -19.44%, and the tech heavy Nasdaq Index getting hit the hardest, down -33.10%.?Meanwhile, international stocks as measured by the MSCI EAFE, were down -16.79% and the Bloomberg Aggregate Bond Index was in the negative by 13.01%.?There was essentially nowhere to hide except cash, which one could argue was also negative due to inflation and the loss of purchasing power.?Not exactly a rosy picture.?We must take a step back to understand how we got to this place and prepare for the next chapter.

The buildup of the most recent decline started back in 2009 as we came out of the Great Financial Crisis (GFC), and was fueled by years of easy money and low interest rates.?However, the most recent regime arguably began back in the 1980s when interest rates peaked after then Fed Chair, Paul Volcker, brought inflation under control and a nearly four decades run of a declining interest rate environment took hold. Most investors have been the beneficiary of this phenomenon for much of their investing careers. There are a lot of positives that come along with a declining interest rate environment. As rates decline, the value of bonds increase, money becomes cheaper to borrow, thereby purchases of items like homes, cars, and much more become more affordable to more people.?I mean, can you imagine buying a home and taking out a mortgage at 12%! Many of our parents did. Another benefit of declining rates is that it is typically a tailwind for stocks.?To put that in perspective, the S&P 500’s average annual compound total return from the top in 1973 to the end of 2022 was 10.2%.?If you had of invested $10k and left it alone, it would be worth approximately $1,250,000. I point this out because as of the start of 2022, we are entering a new environment, one in which interest rates are going up, and may be so for quite some time.?I highly doubt we will see a sub 3% rate on a 30-year mortgage for a long time.

?2023 Ahead

The market was already down nearly 8% when Vladimir Putin invaded Ukraine at the end of February 2022, and the Fed did not raise rates until March of 2022. It was not until mid-June of 2022 that the Fed began to aggressively raise rates by .75% at each meeting and with a final hike of .50% in December to end at 4.25%.?While the current fed funds rates is not high by historical norms, it was the velocity at which it was raised that seemed to spook both markets and investors.?The Fed has indicated that they are going to continue to raise rates until inflation has dropped back to a level of around 2%, which I do not see as achievable in the near term.?I think a 3% - 4% range is more realistic. The reason this is relevant to you as an investor is because now that rates are going up, the value of fixed income is going down, so attention to portfolio construction is much more important than it has been in the past.?

Another headwind that we are facing in 2023 is the debt ceiling.?As I am sure most of you are aware, Rep. Kevin McCarthy was elected as House speaker.?It was like watching a boxing match with the opponent refusing to give up, and Ill be darned if he didn’t pull it off, but it took 15 rounds.?The reason his election is relevant is that it may be foreshadowing of the infighting that is to come in the year ahead, and one of the biggest challenges for congress to tackle is the debt ceiling. The debt ceiling is the limit on how much the government can borrow to pay its bills.?There are growing concerns that Congress will need to raise the debt ceiling again but that some of the Republicans that put up a fight against McCarthy, will also put up a fight on raising the debt ceiling which could be disastrous.?Now, I know that it seems to have been doom and gloom so far, but there are also several positives to consider moving into 2023.

Due to the rate hikes throughout 2022, the yields (rates) on many fixed income instruments such as bonds, cd’s, money markets, etc. are much more attractive.?One year ago, a one-year cd was yielding around 1%, and now they are hovering around 4% - 4.5%. Money market and savings account rates have also started to increase (albeit a bit slow), and rates on bonds have increased as well.?Investors are now able to purchase a corporate bond at a much more attractive rate now than even 6 months ago.?Also, with the rout in the stock market, valuations are much more attractive and are now near historical normal levels.?The Fed’s aggressive approach to hiking rates seems as though it is starting to finally tame inflation, which we have seen in the prices of gasoline, food, and other items that were much higher 6 months ago.

So, What Now?

The recession word has been tossed around everywhere by everyone for nearly a year now.?There is a likely chance that we will enter some sort of recessionary environment in the next 12 months (one could argue we are already in one), but that does not mean that you, as an investor, should make rash decisions and abandon your investment policy. Market declines do not destroy wealth, rather it is how we behave during those market declines that destroys wealth. I am not saying market declines or recession are comfortable or fun by any means, but they offer opportunities. Opportunities to re-evaluate your finances and buy assets at discounted prices. As the famous investor, Peter Lynch, said, “the key to making money in stocks is not to get scared out of them.” We must keep in mind that recessions are normal, healthy, and part of economic and business cycles. If we do end up in a slowdown, we will inevitably come back out of it.

The reasons behind the extraordinary gains in the stock market in 2020 and 2021 were due to the Fed and governments response to the pandemic, which was pumping trillions of dollars into the financial system and providing financial support to employers and sending stimulus checks to everyone. We have moved from bond and stock markets driven by liquidity to markets that are now driven by fundamentals – ultimately better, more stable model for growth and wealth creation.?Often, I feel my job is part investor part psychologist, which is perfectly normal.?Investing is emotional, and our job is to ensure that we help you maintain the correct course with the least amount of risk, so that you can sleep well at night and focus on all the other important parts of your lives.

I wish you all a wonderful and prosperous 2023.

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Be Well,

Grier

L. Grier Williford, CFP?, CPWA?

Financial Advisor

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