Disciplined value investors look like pessimists, grumps, or old fogeys… until they turn out to be among the few who protected against losses -Howard Marks
Entering 2022, I warned that “the combination of extreme valuation and economic headwinds” set the stock market up for a significant drop. Headwinds such as rising interest rates moved to the forefront of investors’ minds as the US stock market closed the year down over 18% while the US bond index closed down 13%. Losses in the stock market hurt but the real challenge for conservative investors came from losses in fixed income. The US Barclays Aggregate Bond index had its worst year since the index was formed in 1976 (blue line below):
The combined losses in stocks and bonds was unprecedented for US investors. The following graph plots combined returns for stocks and bonds in the US going back to 1871. 2022, the red dot in the lower left hand corner of the graph, shows that we’ve never had such poor returns in both stocks and bonds at the same time.
Retail investors had an especially bad year, with the average portfolio drawdown exceeding that of the March ‘20 downturn:
I think a cautious investment approach remains the most prudent course of action. Stock market valuations remain elevated, the economy is at risk of entering a recession, and I think inflation will remain unacceptably high.
Stock Market Valuation
Stock market valuation remains high even after last year’s sell off. The following valuation chart shows an average of 4 different metrics that have historically correlated with future returns. High valuations in the past have led to poor future returns while low valuations have led to strong returns.
Based on this metric the market still trades at higher valuations than past peaks in 1929 and 2007. Significant downside remains in stocks based on the current valuation level.
The consensus view on inflation is that we’ve peaked and it will come down back to a normal level relatively soon. The market believes this will allow the Fed to pivot from hiking interest rates to cutting them. While I think there’s a good chance inflation has indeed peaked, I believe it will remain at a higher level than markets and the Fed currently predict. I think you will see sustained inflation significantly higher than the Fed’s target of 2% for at least the next year (barring total economic collapse).
If inflation remains in the mid single digit range it means interest rates will stay elevated, putting tremendous pressure on stocks and long term bonds. Here’s a look at recent inflation and its components:
Source: Bureau of Labor Statistics, FactSet, Federal Reserve Bank of Philadelphia, University of Michigan, J.P. Morgan Asset Management.
There are a number of reasons I think inflation will remain elevated. First, there are some technicalities in the way inflation is calculated that will prove sticky (for instance the shelter component is virtually guaranteed to be a significant contributor to inflation in 2023). Entitlements such as social security increase with inflation so retirees will receive a bump of 8.7% in 2023. Those increases, along with continued wage growth for workers, will likely continue to feed higher spending and inflation.
Finally I expect energy to contribute to inflation again in 2023. I think oil is likely to go higher as supply remains tight. Politicians remain unfriendly to oil and gas production and ESG policies have led to substantial underinvestment that has curtailed exploration and development. China, the world’s second largest economy, is reopening after Covid lockdowns which will add significant demand. The US is set to stop tapping our strategic petroleum reserves and may even start refilling them, switching from a supplier of oil to a source of increased demand. All of this adds up continued upward pressure on oil prices.
My outlook on inflation makes me wary of intermediate and long term bonds at the moment. Intermediate bonds don’t appear to be pricing in as many rate hikes as some Fed officials are forecasting for 2023. The Fed may raise rates as much as 100 additional basis points during 2023 according to some in the Fed. Such an increase would leave current long term yields extremely far behind short term rates unless they rise significantly. Additionally I think corporate bonds currently give an inadequate premium over safer treasuries.
There’s a high probability we will enter recession in 2023. The impact of the Fed’s rate hikes hit the economy with a lag, meaning the massive rate hikes that occurred during 2022 will impact the economy in 2023. Housing, probably the most important component of the real economy, is now in full contraction mode. Manufacturing numbers in the US are at levels typically seen during recessions:
The lone bright spot for the economy is the labor market. Labor market strength is the reason most wall street economists predict any recession will be very mild. For an investor I think valuation is more important than the severity of a recession. It doesn’t take massive economic disruption for stocks to get hammered as proved by the early 2000s recession. While that downturn was mild for the economy, the stock market was cut in half (and the frothy Nasdaq was down nearly 80%).
I think 2023 could be a year that traps many investors. The market has conditioned people to buy the dip in stocks. There hasn’t been a sustained market drawdown since the housing bubble popped in ‘08-09. Every subsequent drop in the market has been brief, typically followed by Fed easing and a rapid recovery to new highs. Investors have been taught to meet every 10-20% drop as an opportunity to get more aggressive (or at least not to sell).
Therefore the typical investor enters 2023 with a full or overweight allocation to equities in their portfolio. This time I think buying the dip may burn its followers. I think this stock market drawdown is only partially complete. Every historical bear market starting from extreme valuations like those of ‘22 resulted in drawdowns of 50% or more. Combine that with inflation and a weak economy and it makes stocks an especially risky proposition currently. What’s tragic is that if we do see the market drop another 20-30% or more, many investors will panic and sell right at the time that stocks are trading at attractive levels again.
The good news for investors entering 2023 is that we have a reasonable alternative. Short term government bonds yield as much as 4.7%. This allows a cautious investor to earn some yield while remaining defensive and looking for better future opportunities.
Scott Caufield, CFA, CPA