Happy New Year and welcome to 2023. As you are all too aware, 2022 was an extremely difficult year in the investment markets, with stock prices, measured by the S&P 500, down 19.4% for the year. For some perspective (according to Bespoke Research) S&P 500 data dating back 94 years to 1928 shows only six years where the returns on stocks were worse than in 2022 – all of them infamously disruptive periods in the world and the markets. Bonds, measured by the IEF (iShares 7-10 Year Treasury Bond ETF) were down 15.1%. It was a rare year when the traditional non-correlating behavior of stocks and bonds evaporated.
Out of the 42 years since 1980, stocks have been positive 32 years (76% of the time). Over that span, the average intra-year drop in prices (aka the volatility) was 14%. In 2022, the maximum drop we experienced was 25% (compared to 34% in 1987, 2002 and 2020, and 49% in 2008). While the long-term returns to stocks are attractive, they can become so volatile that investors turn the other way and exit the market at the point of maximum discomfort, when the market is at its low.
There is a lot to consider as we move into the New Year. Stock market bulls point to a decline in inflation indicators, the anticipated slower pace of Fed rate hikes, optimism around a soft-landing scenario, resilient earnings due to cost cutting, normalized supply chains with a weaker dollar, and a much faster-than-expected China zero COVID pivot. The bears are concerned the Fed remains higher-for-longer and earnings/margin expectations for 2023 are overly optimistic. These naysayers worry over the upside risk to the terminal Fed Funds rate, sticky services inflation, and risks of a broader liquidity (systemic) collapse.
These are all things we know and can attempt to measure and actively bet on or against. In my opinion, if we encounter a new disrupter (a black swan, or an unknown unknown) in 2023, it will not likely come from the list above. A new global balance is taking shape, in this post Bretton Woods II world. Niall Ferguson recently wrote in Bloomberg about the changing world order and the possibility of war and global disruption on a much larger scale than has been the case over the last 60 years. China, logistics, commodities, manufacturing, and advanced technologies are all rising factors that could tip the balance. Further, Zoltan Pozsar of Credit Suisse has pointed to efforts by China and Russia to tilt the global reserve currency toward the renminbi. The devil in the details in these scenarios is disruption and inflation.
On a more granular level, I expect analysts to lower estimates for 2023, as they have historically done without fail. With all the talk of a recession looming, this is inevitable; analysts watch one another and do not want to be too far outside the safety of the herd. During 4Q 2022, (according to FactSet Research), analysts have decreased EPS estimates for 2023 by 4.4%, from $241 to $230 a share for the S&P 500. This in turn has led to an increase in the forward P/E ratio from 15.2 to 16.5 at year end.
According to JP Morgan Research, there is statistical precedent for positive returns from stocks from the current levels. Consensus analyst estimates for 2024 remain in the $255 range. At a 17.5 P/E that would equate to an S&P 500 in the 4,400 range, approximately 12-14% higher than the current 3,900 level. Bonds are offering attractive yields too, for the first time in years. This will encourage investors to return to fixed income as the traditional “safe haven.”
All investment strategies go through periods when they “break” or do not work, for one reason or another. Typically they recover and get back on track, and this is what I expect from a balanced portfolio of stocks and bonds in 2023. We have to be careful not to become overly emotional, and to trust in our research to select quality stocks and bonds that allow us to own them through challenging periods. Please feel free to reach out to us to schedule a review of your asset allocation and your portfolio as we step into the new year.
Take good care.
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are as of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation. This note contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.