The year 2023 will mark my 28th year of living in the South. Along with the friendly people and great food, the South can provide some extreme weather. Other than a direct (or near) hit from a hurricane, the most extreme weather occurs when a warm front is overtaken by a cold front. The environment becomes unstable, and some violent weather that lasts several hours is almost always involved.
This scenario may be the best way to describe what the stock market endured in 2022. We had a low-interest rate environment overtaken by a high-interest rate environment, and severe price adjustments occurred. And unlike the weather event, the unstable environment can stick around for a while. At the end of 2022, we feel like we are closer to the end of the instability, but we are not out of the woods.
After three consecutive years of super-size returns for equity prices, 2022 was the end of the party. It was a particularly difficult year for the stocks that benefitted the most from 2019 thru 2021 – growth stocks. Stocks, similar to bonds, are interest rate sensitive. Growth stocks are much more interest-rate sensitive than value stocks for a few reasons. First, low interest rates allow companies that are growing faster with a low cost of capital to fund their expansion.
Next, companies with much higher growth rates will have higher earnings expectations well into the future. With low interest rates, those future earnings are discounted back into today’s dollars with a smaller discount rate, making future earnings more valuable.
Finally, low interest rates make bonds a less desirable investment option, and growth stocks are allowed a higher valuation multiple.
These tailwinds allowed growth stocks to have a significant advantage going all the way back to the end of the “Great Recession” of 2008, but especially from 2019 thru 2021. The six largest stocks in the S&P 500 by the end of 2020 were all growth stocks. Their returns for 2019, 2020, and 2021 were astonishing:
By the end of 2021, those six companies accounted for 25% of the value of the S&P 500. The market was too top-heavy, and the returns of the market for those three years were “dragged up” by the performance of these largest handfuls of stocks.
In other words, the economy was not nearly as strong as the return from the S&P 500 would have suggested. The dramatic move up in interest rates in 2022 reset the valuations for these companies, and their 2022 return reflected the new environment.
Apple and Microsoft, with returns of -26% and -28%, respectively, were slightly below that of the overall market.
Amazon (-49.6%), Alphabet (-49.6%), META (-64.2%) and Tesla (-65.0%) were, to use an old phrase, taken behind the woodshed.
You could say that the opposite of 2019-2021 was the case in 2022: The economy is not nearly as weak as the return from the S&P
500 suggests.
Stocks had a better 4th quarter, but not enough to stave off an ugly year of returns. The trend of value stocks outperforming growth stocks continued in the 4th quarter. International had the best quarter of all major indices. Unusually warm weather in Europe is helping with the natural gas shortage that was feared to have a dramatic impact throughout Europe.
Looking at economic sector performance, the energy sector continued to be the standout performer, with a 22.7% return in the 4th quarter. Oil, as an investment vehicle, has fallen out of favor with the growth of Environmental, Social and Governance (ESG) investing.
We started 2022 with the entire energy sector accounting for only a 2.67% weight of the S&P 500. Don’t be surprised if this sector continues to be very volatile, considering the ongoing war in Ukraine, slowing domestic production and unusually large swings in global demand.
The rest of the sectors that outperformed the overall market were the more defensive sectors, including utilities, consumer staples and healthcare. Utilities were the only sector besides energy that showed a positive return for 2022.
On the other side of the coin for 2022 were the technology, consumer discretion, and communication services sectors.
Consumer discretion had a particularly difficult 4th quarter. Historically high inflation caught up with consumers by the end of the year. Higher wages, coupled with the inability to have the correct products that consumers demanded due to continued supply chain issues, were also problems for the sector. Both the technology and communication services sectors are dominated by some of the largest growth stocks mentioned above.
LOOKING FORWARD
The Federal Reserve raises interest rates in an effort to slow the economy to bring inflation down to its target of 2%. There is a lag time between when the Fed increases interest rates and when the effect of those higher rates shows up in the economy. Even though we have some evidence that the economy is slowing, all of the effects from the rate increases in 2022 are not yet showing up in the data.
The good news is that the stock market is a leading economic indicator, meaning it will move down before we see weaker economic data, and back up before we have the evidence the economy has recovered. The 2022 equity returns have priced in some pretty ugly economic numbers. Did it price in enough of the downside?
The best-case scenario for equity prices is that the Fed raises slows the economy enough to bring inflation down, but not slow enough to cause a recession. If the stock market sees inflation coming down enough for the Fed to stop raising rates before we go into a recession (what is called a soft landing), 2023 will be in much better shape than the mess we called 2022.
Even if that happens, it is difficult to envision this new year bringing much better corporate earnings than we enjoyed in 2022. Couple that with higher interest rates, and it is also difficult to believe that we can have the S&P 500 trade much above 17 times earnings, which is where we finished 2022 (with 4th quarter earnings still outstanding).
The point is, we don’t see a catalyst for a 15%-20% bounce-back year for the equity markets. We also don’t see, with a strong job market and a strong balance sheet for both corporate American and the U.S. consumer, a reason to believe a deep and ugly recession is in the cards.
Going back to the weather analogy, the environment for equity returns will become more stable when we all have clarity on when, and at what level, the Federal Reserve is going to stop raising interest rates. That will allow the stock market to have a clearer understanding of how to value the equity markets and take out some of the incredible volatility we have been forced to live through in 2022.
Equity investing may be more dynamic in a low-rate environment, but that does not mean we just sit on the sidelines until the Fed moves rates back to zero. The total return of an equity portfolio may be lower in a high-interest-rate environment, but that does not mean it will be negative.
Expected stock returns may drop from 10%-12% down to 7%-8% over the next five to 10 years, but most investors will still be able to meet their long-term goals. That said, their portfolios may look a bit different than they have for most of the past 20 years.
Overweighting stocks to bonds and overweighting growth stocks over value stocks has been an easy call. With the fear of missing out on oversize 20%+ returns from growth stocks in the rearview mirror, and with a 2% or 3% dividend from a value stock important again in the total return calculation, having a slight overweight of value stocks may finally be in order.
Bonds, paying investors a higher yield than they have in decades, may hold a larger piece in a diversified portfolio (more on that in our Allocation section). Just like changing out your wardrobe as summer moves to winter, it is now time to make some changes to your stock portfolio.
We have not seen a high-interest rate environment for 20 years. Imagine moving from Maine to Hawaii and enjoying summer every day for 20 years. When you move back to Maine, that first winter is going to be cold! We can take the cold; we just need a stable environment. We hope, and believe, that 2023 will give us that.
