Thank you for your trust in us and we appreciate your patience as we navigate through one of the roughest periods on record for both stock and bond markets over the past year. Yale economist Robert Shiller and the Financial Times looked at returns since 1871 and both confirmed that there has never been a year when both stocks and bonds were down double digits, until 2022!
The typical 60/40 balanced portfolio was down -16.97% last year, which is how the Vanguard Balanced Index Mutual Fund finished the year. (VBINX). NYU looked at returns for 60/40 balanced portfolios going back to 1928 and only 2 years were worse than 2022 returns: The Great Depression in 1931 at -27.3% and the echo of the Great Depression in 1937 at -20.7%. Even during the Great Financial Crisis (2008-2009), returns for balanced portfolios were better at -13.9% (they used the 10YR Treasury as a bond proxy).
We were defensive for most of last year, and we remain defensive as we head into 2023. However, we believe it is likely that we will see more volatility to both the downside and upside this year. This will make 2023 a more difficult year to navigate the markets. Staying consistently conservative last year served us well, but there will be many narratives that will seem probable this year, both bullish and bearish, and we expect the data will point us in different directions multiple times this year.
The Fed, The Economy, and Interest Rates
We cannot overstate the extent of the effect of the rate hikes the Fed has utilized over the past year. Markets have never seen such a dramatic increase in rates. It is clear the Fed has decided that inflation is not transitory, as they believed last year. Moreover, they seem willing to risk a recession to get inflation back to their 2% target.
While we are still uncertain on the path forward, and how inflation will react, we believe that the worst of the rate hikes are behind us, barring an unexpected event. Inflation, and how quickly it will/can drop to the Fed’s 2% target will dictate the market’s path. The economy has been very resilient to these rate hikes and the strength of the economy will determine how long rates stay at current levels, or if the Fed needs to continue along the same path. The economy reacts to Fed hikes with a lag of around 12 months. By this rule of thumb, the very first economic reactions will not materialize until 1Q this year, and the full effects will not be apparent until 4Q.
There are obvious signs of a recession coming in the data, according to Bloomberg, and odds of a recession by economists are now at 70%. However, we also see areas of strength – the service portion of the economy is still much stronger than the goods portion, and due to the large fiscal stimulus and increase in house prices, consumers still have ample savings to tap into. The labor market is not showing much sign of a slowdown at all, and wage inflation shows no sign of abating.
Putting it all together, the potential for a soft landing must be acknowledged, but we believe the other 2 options – weakness in 1H 2023 OR continued strength and a tighter for longer Fed – are equally probable.
The outlook for fixed income is much more attractive than last year. We started the year with little exposure to interest rates and were able to start earning around 4% in the fixed income portfolios as the Fed raised rates up to the 4-5% area. While we still have a conservative interest rate view, due to the uncertainty of inflation, we are becoming more constructive for bonds and are actively researching opportunities.
Equities: Valuations, Earnings, and Sentiment
We anticipate additional volatility and uncertainty as the equity markets reprices the value of stock earnings against other investment options available in fixed income. We are not as attracted to the equity market as we start a new year, but we see multiple paths along the way.
The potential exists for the Fed’s actions to “break something” in the financial economy. As we said, this is unlikely in the actual economy but given how weak returns have been and the inherent leverage in the system and draining of liquidity, this is a risk. This would suggest more downside risk that would be inherently difficult to see ahead of time, or how the market would react if the Fed pivots to easing to combat economic weakness.
A second scenario is that the economy continues the path it currently is on – with pockets of weakness but also pockets of strength, and the Fed continues to tighten and hold rates higher and longer than the consensus thinks.
The third scenario is the elusive soft landing, where the economy slows, but not enough to cause a dramatic decline in earnings or in the economy. This is exceptionally rare, but given the uniqueness of this cycle, it does have some probability of occurring.
The eventual problem with scenario 2 or 3 is that the equity market is not cheap at current valuations, and investors can earn 4-5% in bonds, and possibly more, soon. The P/E ratio on the market is around 18X earnings, which translates to an earnings yield of 5.50%. This is an exceptionally thin margin over bonds in an environment with significant potential for volatility.
Our interpretation is that if the market does rally in scenario 2 or 3, at some point the upside is capped. But how much it could rally before it reaches the valuation cap is very much uncertain. This backdrop suggests equities should trade at more attractive valuations than current (13-15X). While some work was done this year on the most speculative areas of the market, there is still room for additional price compression. Earnings and inflation will remain the focus of the markets as we move into 2023.
We would be remiss if we did not mention market sentiment. Most measures of sentiment indicate that this year has turned investors overly cautious by many measures, and the rule of contrary opinion suggests that when everyone turns bearish, a low is likely. What is difficult now, is that we have not seen signs of capitulation like we had at major lows in 2003 and 2009. This is because while 2022 was one of the worst on record, 2020 and 2021 were above average. This suggests that 2023 could have the potential for above average volatility.
In conclusion, we feel we are still in the middle of a secular bear market. We remain cautious and are prepared to adjust our positioning as market action dictates. While the market could bottom out very soon, as the year before an election is usually positive, and a soft landing is possible, the fundamentals are very uncertain. We will carefully bide our time until our models turn positive. On a more positive note, unlike the last 12 years, there are now alternatives as short-term fixed income yields should approach 5% later this year, so we will get paid to wait! We hope that you and your families enjoyed the holiday season. We would also like to wish everyone a Happy New Year and hope that it brings good health and success to all of you!
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