Markets in Review
Finally, we close the books on 2022 which was the worst year for financial markets since the “Great Recession”. The S&P 500, Dow Jones Industrial Average, and the Nasdaq Composite all posted their biggest annual losses since 2008. This also ended a three-year winning streak for the major indices. The writing was on the wall back in November 2021 when the Federal Reserve finally recognized it was time for easy monetary policy to come to an end which it had kept in place for over a decade. Exponentially increasing interest rates, the highest inflation since 1981 and fears of an economic recession were some of the primary causes of this year’s pain.
After initially hitting new bear market lows in October, the fourth quarter proceeded to catch a bounce. Potentially oversold markets and seller exhaustion brought on a new bear market rally that started in mid-October and continued until the end of November. However, further signs of sky-high inflation, additional interest rate hikes, and an increasing probability of a “hard landing” and recession in 2023 or 2024 smashed all hope.
The bear market rally helped almost every sector produce positive gains for the quarter, but year to date returns were still ugly across the board. The S&P 500 bounced 7.08% for the quarter to end the year down -19.44%. The tech-heavy NASDAQ still fell -1.03% during the quarter and ended the year down -33.10% as the former “tech darlings” of the past decade continued to get dumped by institutional and retail investors alike. The Dow Jones Industrial Average had an impressive 15.39% bounce in the quarter, but still ended the year down -8.78%.
The Russell 2000 Index, which includes 2000 of the smallest companies in the market, also bounced off its yearly lows rising 5.80% this quarter to end up down -21.56% for the year.
Value-based investing, which focuses on buying companies that exhibit quality fundamentals but appear to be undervalued, exhibited slightly better returns on a relative basis this quarter following closer to the Dow Jones Industrial Average. The Russell 3000 Value Index rose 11.52% for the quarter vs. the broader Russell 3000 Index which rose only 6.72% for the quarter. Value-based investing seems to finally show some signs of life again, after many years of growth-based investing dominance, as the Russell 3000 Value Index closed out the year down -10.01% whereas the broader Russell 3000 Index doubled that loss and closed out the year down -20.48%.
Fixed income traders continued to deal with tighter monetary policy this quarter including one more 0.75% rate hike followed by a slightly more moderate 0.50% rate hike in December. This sent yields – which move in the opposite direction of prices – soaring higher and increasing several Treasury yield curve inversions where long-dated rates fall below short-dated rates. With the background of tighter monetary policy, higher inflation and fears about future economic growth, fixed income in general continued to offer almost no protection for investors looking for cover. The Bloomberg US Aggregate Index, which includes a broad cross-section of U.S. fixed income assets overall, ended the year down -13.01%. So, for the average investor who had passive exposure to the broad equity and fixed income markets in a “60/40” equity/fixed income type portfolio this year, losses of -15% or much more were to be expected.
Outlook for 2023
The cheerleaders of passive indexing have fallen quiet after a decade of yelling that passive indexing is the only way to invest money. As we have stated many times, passive indexing looks great in bull markets. However, it can be a very quick way to destroy capital in bear markets. We continue to believe there should be a thoughtful balance between both passive and actively managed strategies in your portfolio that is dynamic and adjusts over time given the market outlook.
In 2022, the average retail investor experienced a drawdown of 35%. With nowhere to hide, the flight to cash was — an avalanche. Investors hoped that the Fed would limit further interest rate hikes or even reverse course. With stocks seemingly on sale, investors tried to “buy the dip” only to lock in successive losses as the market made new lows. However, there were a few bright spots.
The energy and utility sectors in the S&P 500 posted positive returns for the year. In addition, dividend-paying stocks, especially those with higher yields, outperformed the S&P 500 by a large margin closing the year flat.
As mentioned above, the Russell 3000 Value Index outperformed the broader Russell 3000, and similarly, the S&P 500 Value Index ended the year down -5.25%. We feel value-oriented dividend paying stocks will continue to do well in 2023. Also of note, many semi-active strategies designed to improve security selection or reduce loss (e.g. smart beta) performed very well last year.
It seems the Fed is determined to increase rates and keep them elevated for some time to bring inflation down to the 2% target. And it’s not just the Fed, central bankers around the world are hiking rates aggressively. Don’t forget that the Fed engineered the economic recovery by stimulating consumption through policies designed to drive a “wealth effect”. Now, they are desperately trying to reduce price and wage inflation. The sharp rise in interest rates is designed to destroy demand. With demand destruction happening in front of our eyes, it’s only a matter of time before the trailing economic indicators show a slowing economy. As companies lay off workers and unemployment rises, the Fed will have crushed wage inflation too.
Once again, investors learned the lesson in 2022: ”Don’t Fight the Fed”. We think that this should be the mantra for investors in the first half of 2023 as well. The million-dollar question that everyone has been asking is whether the Fed’s policies push us into a full-blown recession or a “soft landing”? If last year’s market declines were any indication of what is to come, it surely did not feel like a soft landing. The whole concept seems to be more of a political catch phrase rather than one based in solid economic theory. In fact, the U.S. economy already posted quarter-over-quarter GDP declines in Q1 and Q2 of 2022.
Since GDP is weakening, we could already be in a recession right now. The question is how much worse does the data have to get before the Fed realizes it has done enough, or possibly too much, to lower price and wage inflation. Historically, the Fed has always raised rates too much and too long. It usually takes 6-9 months for a rate hike to work its way through the economy. This means the data that they are using is stale and does not include the full impact of their policy changes to date, so they can only guess at how far they should go. Unfortunately, successive hikes have a cumulative effect on the economy and will only become apparent after the carnage has occurred.
Additionally, the magnitude — a 1,700% increase from 0.25% to 4.50% — of Fed’s interest rate hikes is unprecedented and they aren’t done yet! We fear that most people, including members of the Fed, may not be taking into account the full magnitude of these increases. The last two rate hike cycles from 1993-2000 (with a few moves lower before finishing higher) and 2003-2006 saw increases of 117% and 425% respectively.
It wasn’t so long ago that the economy was mired in stagnation with a growth rate of under 2.0%. This was with rates near 0% to 0.25% for almost a decade. Then, the Fed got even more aggressive with “Quantitative Easing”. The Federal government followed on with a massive amount of fiscal stimulus to help the economy recover from COVID-19. Now, the Fed is in the midst of the fastest rate hike cycle in history and at the same time reducing the size of their balance sheet — a double whammy. This surely does not seem like a prescription for a soft landing.
In the best case, we would expect the economy to stall and corporate profits to fall pretty hard. The good news is that the inflation story should fade quickly and possibly become a deflation scare by the end of 2023. Somewhere around Q3, the Fed will likely be forced to ease quickly to bring back economic growth. Let’s also not forget, 2024 is a Presidential election year. So, policy should become quite supportive of economic growth and as a result we expect a strong bull market recovery.
We expect that value-oriented stocks, dividend payers, and defensive sectors will continue to outperform. Growth and technology stocks are highly dependent on supportive policies and will continue to underperform until the Fed pivots.
At WBI, we believe that the most important aspect to investing is to protect capital. Over the past 5 years, the company has continued to invest heavily in our investment and wealth technologies. Our mission is to provide investors with better investment performance and more successful client experience. We believe our strong performance last year is indicative of the time, money, and effort put forth to serve you better.
In 2023, we encourage you to take a look at all that we have to offer. We have dramatically expanded our capabilities over the last few years. Thank you in advance for taking a look! In closing, we would like to wish you, your families, and your businesses a joyous and prosperous New Year!
Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is Bloomberg.
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