Review
During the past year the stock market experienced unprecedented volatility. Inflation reached a 40-year high while the Federal Reserve raised interest rates at the fastest clip since 1980, which resulted in negative returns for most asset classes. After setting a stock market closing high on January 3rd, the first trading day of 2022, the S&P 500 proceeded to decline by 25% through the third quarter. Despite a solid fourth quarter return of 7.6% for the S&P 500, the index lost 18.1% on a total return basis, including dividends, for the full year, its worst year since 2008. The Dow Jones Industrial Average and NASDAQ Composite also had their worst years since 2008, posting declines of 6.9% and 32.5%, respectively. Making it even more difficult for investors, the bond market did not provide a safe place to hide as the U.S. Aggregate Bond Index was down 13.0% for the year.
The weak stock and bond markets in 2022 resulted in unusually poor performance for a traditional balanced portfolio of 60% stocks and 40% bonds. A balanced 60/40 portfolio of the S&P 500 and the 10-year Treasury bond posted an even lower return than experienced during the financial crisis in 2008. Only two years since 1928 have seen lower annual returns, both occurring during the 1930s. Only four times have stocks and bonds simultaneously been down over the last 95 years, with 2022 as the worst of them all. Government bonds typically serve as a negatively correlated diversifier to stock holdings, thereby providing ballast to a portfolio during poor stock market performance periods. But the rapid inflation experienced during 2022 created an environment where that was not possible.
The Federal Reserve raised interest rates by a total of 4.25% in 2022 from a range of 0% – 0.25% in January to 4.25% – 4.50% as of year-end. This was the largest annual increase since 1980. And it came after projections from the Fed in late 2021 that they would increase rates only three times in 2022 to a level of 1.25%. The Federal Reserve capped off the 2022 interest rate hikes with an increase of “only” 0.50% in December after inflation reports slowed in October and November. The December rate increase came after a stretch of four consecutive 0.75% increases, which were the first 0.75% increases since 1994. Despite the fed funds rate reaching 4.50% at year end, the 10-year Treasury bond was yielding 3.88%, almost two thirds of a point below the overnight lending rate, indicating the bond market expects short term rates to fall.
With the Federal Reserve now projected to slow down the magnitude of rates hikes, the discussion has shifted to when the Federal Reserve will stop, or potentially need to decrease them if the economy weakens. In addition to current inflation numbers, the Fed is paying very close attention to the job market. The concern is that with a tight labor market, and increasing wages, consumers will not need to cut back on their spending, thus contributing to the inflationary pressure. Most economists recently surveyed by The Wall Street Journal expect higher interest rates will push the unemployment rate from 3.7% in November to above 5% in 2023, which would still be low by historical standards. This would potentially give the Fed a reason to take a more dovish stance on interest rate policy. Currently, the market consensus is anticipating that the Federal Reserve might have to cut interest rates as early as the third or fourth quarter of 2023 depending on the anticipated weakness of the economy.
One of the key inflation metrics to follow during 2023 is the monthly Consumer Price Index (CPI). The trend for CPI has been down over the last several months, which helped the stock market advance during the fourth quarter of the year. The CPI figures released in mid-December for the month of November showed an increase of only 0.1% from the prior month, and a year-over-year increase of 7.11%. Of course, 7.11% is a very high level compared to the Fed’s goal of 2%, but it is down from over 9% reported in June. If the trend continues at just 0.1% monthly increases, the annual CPI would drop below 4% by March of 2023 and below 3% by May 2023. Even if we experience slightly higher increases of 0.3% per month going forward, we would still see the annual CPI drop to 3.7% by May of 2023 and 2.6% by June 2023. If these levels are achieved, the Fed should be able to hold interest rates near current levels, which would likely be well received by the stock market.
Outlook
With each new year comes a myriad of market projections. It is not hard to find reputable analysts reporting either bullish or bearish predictions in any given year. But despite those predictions, based on long-term historical returns, the stock market averages an annual increase between 8-10%. Peter Lynch, the retired famed manager of the Fidelity Magellan Fund, gave a speech many years ago where he said:
Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs… Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points – I don’t know which way they’ll go. So, the market ought to double in the next eight or nine years. They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That’s all there is to it.
Despite the long-term average of 8-10% annually, the market rarely does that in any one year. Data reported by the Bespoke Investment Group shows that 8-10% returns are not very common at all. Since 1928, the market has been positive 64 out of 95 years, or 67% of the time. But the market has returned between 8-10% on only 4 occasions, and between 6-12% on only 10 occasions. Therefore, the 8-10% average is calculated from many years of returns that were much higher or lower than the norm.
The broad consensus by many market strategists is for a mild recession, or at the very least weak growth, with the damage to corporate earnings offset by the Federal Reserve cutting interest rates by the end of the year. Sam Stovall, CFRA Chief Investment Strategist, notes the following in the CFRA 2023 Annual Forecast report:
We expect a mild recession, based on the strength of employment. AE (Action Economics) sees the unemployment rate averaging 4.0% in Q4 2023. In addition, while we are bracing for a volatile first half of 2023, as investors await the ultimate magnitude and duration of the FOMC’s rate-tightening program, we see the market recovering in the second half as we project the Fed to finish raising rates by late Q1/early Q2, and pausing through Q3 2023, before contemplating its next rate reduction cycle. Historically, the market was propelled by an expected easing of monetary policy, as the S&P 500 gained an average 3.5%, 6.9%, 10.8%, and 14.5% in the 1-, 3-, 6-, and 12-month period after the start of a rate-reduction cycle since WWII, well above the average returns for all rate cycles of 1.5%, 2.6%, 6.0%, and 9.7%, respectively. Even better, the S&P 500 typically surged 47% in the 12 months after the end of bear markets with recessions since 1949.
The American consumer will play a large role in how well the economy performs during 2023. Currently, consumers continue to spend, unemployment remains low, wages continue to rise, middle and high-income earners have not fully spent down their savings from the Covid period, and low-income families have only recently started to increase their credit card balances. Several indicators confirm that initial huge spikes in various costs began declining for much of 2022, such as the cost of shipping a container from China to California or the national average gas price falling toward $3/gallon. Goldman Sachs does not expect us to enter a recession because they expect the consumer to remain resilient with inflation figures declining in 2023.
Jeremy Siegel, retired Wharton Business School professor and author of Stocks for the Long Run, one of the most well-regarded investment books, is more bullish for 2023 than most market prognosticators. His following comments made at the end of December garnered considerable attention within investment professional circles:
“My bottom-line year ahead outlook: I think we should have a very good year for equities, with U.S. markets up 15-20%, which would be surprising. Most think these gains have to wait for the second half of the year, but I can see this happening in the first half. I expect interest rates to be down with the Federal Funds rate to be between 2-3% by year end and the 10-year interest rate to be 50-100 basis points below where it is today.”
Sincerely,
Marietta Wealth Management, LLC
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