“Money often costs too much” – Ralph Waldo Emerson
As we enter 2023, we begin the New Year with glimmers of hope for investors. Consider that stocks have not been down in the year after mid-term elections in over 70 years (source: Yardeni Research). Or, that the S&P 500 has had only eight instances of consecutive down years (source: Goldman Sachs). Hopefully, this year will contrast with last year’s broadly disappointing results (the S&P 500 with dividends was down about 18%), including an historically poor year for bonds (the Barclay’s Aggregate Index was down just over 13%). But 2022 was a year of significant inflation, global conflict, and monetary tightening. And while progress has been made on each of these fronts, they continue into the New Year. Unlike last year, however, markets should not be caught off guard. These underlying concerns are now recognized by both investors and policy makers, and significant actions have been taken to temper them. Even as we make progress, economic and geo-political concerns will still abound as we go forward, but to be fair this remains true even in the best of times. Here are where things stand from Cutler’s point of view:
- Equities entered a bear market in 2022. We anticipate earnings will erode further in what we view as a mild recession, but that stocks will begin to price in a recovery as the year progresses. Will technology once again be the market darling? This is hard to say as valuations have come back to Earth, but subsequent bull markets rarely have similar leadership.
- We believe bonds will have positive returns this year. Short-term bonds (under 5 years) remain relatively attractive as the Fed will be reluctant to pivot lower until inflation abates (even if they should take action sooner).
- Will this be the year international assets maintain upside to domestic markets? If the Fed maintains their hawkish posture as we believe, the dollar is likely to continue to favor domestic equities. But, China is once again open for business and we believe international equities are under-represented in investor portfolios. We would recommend holding these as a hedge against US market softness.
There was heavy debate in 2022 about whether we had reached mild recession after experiencing two straight quarters of negative GDP growth. Strong GDP numbers at the end of the year assuaged these concerns, but the yield curve remains inverted (long-bond yield less than short-term bonds). This inversion has historically been a nearly failsafe recession indicator, so that remains our baseline assumption as we head into 2023. With such strong wage data however, the likelihood is not that of a catastrophic recession (which has been the norm this century), but perhaps a mild reset. For markets, a key question will be whether the drops experienced to date have fully “priced in” this level of recession. The 25% drop in stock prices from the peak to trough may suggest “yes”, but this drop did not push PE (Price to Earnings) ratios below long-term averages. Nor can investors ignore the negative impact on stock valuations of the higher rate regime (for the first time in a long time, cash has attractive returns). In our view, investors should continue to bias value stocks versus growth stocks, as market risks remain (at least in the short-term).
We view the key to the whole puzzle next year as interest rates. Inflation was
the hot button issue of 2022, especially after over 40 years of sanguine price increases. The Fed went from declaring inflation only a transitory phenomenon to the complete other end of the spectrum, as they tried to regain credibility to fight inflation. Short-term interest rates went from 0% to 4.25%, meaning we saw the equivalent of 17 quarter-point rises during the year. Bond markets were whipsawed after the Board of Governors had previously maintained ultra-low rates into early 2022, despite what their eyes and ears were telling them.
The good news is that we have seen some progress, which helped support a year-end rally for stocks (the S&P 500 was up 7.5% in Q4) and bonds (the Barclay’s Agg was up 2% in Q4). We saw a reduction from the 9.1% Headline CPI (Consumer Price Index) peak in the summer to 7.1% for November. Current estimates by the Cleveland Fed continue this downward trend with December CPI currently at around 6.5%. Many have declared peak inflation behind us, but the Fed is looking to “break the back” of inflation and CPI is still well above their 2% target. We believe investors should expect the Fed to maintain higher rates until the inflation dragon has been slayed, even in the face of weaker economic data. If a recession arrives, the calls for a Fed rate “pivot” will remain loud. But 2023’s inflation may prove to be stickier than last year, as we have seen a rotation out of goods (think gas and groceries) into services (think airfare). Service prices may be much stickier and harder to alleviate. We would caution being too optimistic about the Fed lowering rates, and instead prepare portfolios for a higher for longer possibility. Raising rates has been a tough pill to swallow, but persistently higher rates is also impactful for both Wall Street and Main Street. In our view, this means a focus on valuations, dividends, and cash flows in client portfolios. Our allocation recommendations for 2022 were prescient, and we are not convinced that we are at the end of the cycle just yet.
Asset Class Review
The biggest bias we maintain as a firm is favoring Value stocks versus Growth stocks. This was a difficult discipline to maintain as Growth outperformed in recent years, but 2022 saw the Value style of stocks with one of the largest years of outperformance versus Growth in this century. The Large Value Index was down roughly 6% (Russell 1000 Value) while the Large Growth Index (Russell 1000 Growth) was down closer to 30%. As a reminder of the mathematical benefits of protecting downside risk, this means that Value stocks only need to gain 6.4% to get back to even, while Growth would require almost 43% to get back to 2021 levels.
For the full year, only the Energy (+65.5%) and Utilities (+1.5%) sectors provided positive returns. Both are traditional Value sectors. The biggest drags were Communications (-40%) and Consumer Discretionary (-37%), led down by mega-cap Tech-related names hit hard by overvaluation concerns and rising costs for leverage.
Our fixed income positioning was also favorable in 2022, as we suggested keeping portfolios shorter duration than the indexes. While we have seen a large increase in short-term rates, long-term rates have not increased commensurately (thus the inverted curve). We believe bond investors continue to be well served by maintaining a shorter portfolio than the Aggregate benchmarks, although with an average duration slightly longer than where we began the previous year.
Foreign developed stocks staged the strongest rally of all major classes for the final quarter, finishing modestly ahead of the S&P 500 for the year. We continue to believe international diversification is prudent for most investor portfolios. The Emerging Markets class also had a solid final quarter, with some boost from the hope that China will actually open their economy- and stay open this time.
Alternatives allocations continued their place as a true diversifier, and as a volatility dampener versus both stocks and bonds this year. Our standard “alts” recommendation, the Goldman Sachs Absolute Return Tracker fund, was down for the year but lost less than half as much as aggregate bonds (Barclay’s Aggregate) and roughly a third as much as large domestic stocks (S&P 500). We continue to appreciate the diversification aspects of this class. Oil futures saw a continued drop from the peak levels reached earlier in the year, but prices did rally back up over $80 as the quarter ended. Agricultural commodities showed some strength as concerns about food scarcity re-emerged and drove up many prices. Gold was down for most of the year but had a solid rally in the final quarter to end the full year modestly negative. Bitcoin continued to show very poor results, with yet more drag from the FTX collapse scandal, and that coin ended the full year down almost 65%.
Past performance is not indicative of future results. Strategies referenced herein may be materially different than actual positions held in client accounts. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be profitable or suitable for a particular investor's financial situation or risk tolerance. Investing involves risk, including loss of principal. You cannot invest directly in an index. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses. Neither Cutler Investment Counsel, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.
The S&P 500 Index is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
The Barclay's Aggregate Bond Index (Taxable Bond) is a broad base, market capitalization weighted bond market index representing intermediate term investment grade bonds traded in the United States.
Headline Inflation is the raw inflation figure reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics.
The Bloomberg Commodity Index (Commodities) is an index of the prices of items such as wheat, corn, soybeans, coffee, sugar, cocoa, hogs, cotton, cattle, oil, natural gas, aluminum, copper, lead, nickel, zinc, gold and silver. The index is calculated on an excess return basis and reflects commodity futures price movements.
The MSCI EAFE Index (Foreign Developed Index) is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
The MSCI Emerging Markets Index captures large and mid-cap representation across 27 Emerging Markets (EM) countries. With 1,392 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Bitcoin Each crypto index is made up of a selection of cryptocurrencies, grouped together and weighted by market capitalization (market cap). The market cap of a cryptocurrency is calculated by multiplying the number of units of a specific coin by its current market value against the US dollar.
Source: Morningstar All opinions and data included in this commentary are as of
December 31, 2022 and are subject to change. The opinions and views expressed herein are of Cutler Investment Counsel, LLC and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This report is provided for informational purposes only and should not be considered a recommendation or solicitation to purchase securities. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed.
