Is the Story
Changing or Just Getting Longer?
January 10, 2023
by Jordan Hucht, CFP®, ChFC®, AIF®
Happy new year!
In my first newsletter of 2022, New Year, New Market, I considered whether 2022 would be markedly different than 2021, which in fact it was. So as we’ve rounded the corner into 2023, the question is whether the 2022 story is now changing or if it’s just getting longer.
First, let’s recap 2022 in a (way-too-small) nutshell:
In an effort to combat the highest inflation we’ve seen in decades, the Fed set off on a rate-hiking cycle that saw the Fed funds rate jump by a whopping 4.25 percentage points in 9 months. In response, stock valuations were slashed as money was no longer free, and bond values declined sharply as interest rates spiked. There were certainly other factors (most notably, war in Ukraine), but it was essentially a mathematically driven bad year in the markets. Think of it this way: in January, the S&P 500 traded at 21 times forward earnings, and the 10-year Treasury yielded 1.5%. By the end of December, the S&P 500 traded at 17 times forward earnings, and the 10-year treasury yielded close to 4%. Mathematically, that makes sense. Higher interest rates = lower valuations.
All told, the S&P 500 finished the year almost 20% lower, though the low point of the year, in October, marked a 27% decline. That’s a bad year by any measure, but also very much within the bounds of market declines we’ve seen many times in the past. On the other hand, the double-digit decline in the value of bonds in 2022 was not a normal occurrence, as investors took a meaningful blow to what’s generally considered a conservative asset class.
In short, the 2022 story was that of sharp inflation, which led to sharp rate hikes, which led to sharp valuation declines. And those events have now lead us into an environment very different than where we found ourselves a year ago. For those reasons, I think 2023 is likely to have its own, unique story to tell.
Whereas inflation and interest rates were the big stories in 2022, I expect recession and earnings to be the headlines of 2023. As I wrote in the last newsletter, monetary policy works with a lag, and we’re yet to see the real impact of the Fed’s 2022 moves. Save for perhaps the housing market (which has clearly slowed under the pressure of higher borrowing costs), the jury is still out on how much impact the Fed’s tightening will have on the real economy. And that’s what will answer the 2 key questions of 2023: will we have a recession, as many predict, and if so, how steep of a decline will we see in corporate earnings?
It’s important to remember that the market is a leading indicator, constantly discounting or placing a premium on future expectations. In other words, market prices are a representation of future expectations, as opposed to current realities. From my perspective, the consensus expectation among investors seems to be that we’ll experience a mild recession in 2023, with a limited hit to earnings. I’m not necessarily claiming that view as my own; instead, I’m suggesting that’s what is currently priced into financial markets. The way I see it is that the majority of the decline in stocks in 2022 was attributed to higher rates compressing valuations, and to a much lesser extent, a decline in earnings expectations.
What does that mean for stock prices going forward? All other things being equal (which in reality they never are), if we see meaningful markdowns in earnings expectations (as would be expected in anything more than a very mild recession), stocks are probably overvalued at current levels. If we see earnings hold up to current expectations, stocks are probably fairly valued or slightly undervalued at current levels. To clarify, I’m referencing the stock market as a whole, not every stock in the market. There will always be unique opportunities, regardless of the macro environment.
Most importantly, let’s think about how we should approach 2023 from a financial planning and portfolio construction standpoint. In this regard, I think there’s real reason for optimism. Let me explain. Stocks are long-duration assets, intended to provide meaningful real return (i.e., growth in excess of inflation) over time. But with that growth comes volatility, exactly as we saw in 2022 and have seen many times in the past. The short-term price changes in stocks are unpredictable, which is why money invested in stocks should not be money that’s going to be called back in the near term. That’s a fundamental tenet of portfolio construction and the reason that even though 2022 was an unpleasant year for stocks, it shouldn’t roil a well-built financial plan.
So let’s turn our attention to the other two primary asset classes in a portfolio: bonds and cash. As I mentioned already, bonds had an historically bad year in 2022, driven by the sharp rise in interest rates and corresponding decline in bond prices. As a result, I believe bonds are poised to have a much better year in 2023. First, with significantly higher interest rates, bondholders are now receiving significantly more income than they were heading into 2022. Second, I think it’s reasonable to expect that the Fed is close to the end of the current rate-hike cycle, meaning further declines in bond prices would be limited. And if we do enter a recession in 2023, I think it’s also reasonable to expect that rates could fall, which would be a tailwind for bond prices. When you put all of that together, I think it’s likely that bonds will do in 2023 what they’re intended to do in a portfolio – provide income and relative stability. That’s very good news, as unlike stocks, bonds are generally a source of capital for shorter-term cash flow needs. And finally, cash – obviously the most conservative of the three primary asset classes – provides meaningful interest for the first time in years. In addition, certain alternative asset classes continue to offer unique opportunity sets and further diversification.
Only time will tell the true story of 2023. The short term is murky at best, so the aim should be to have a financial and investing plan that can lead you to your long-term goals regardless of what 2023 brings. In particular, stay resolute in the face of volatility and protect near-term capital needs (which should be the staple of any sound financial plan).
Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.
Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results.