First Half of 2023 Market Outlook Part 1 | Stock Talk Podcast
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The Old Normal
I am Chris Perras, Chief Investment Officer at Oak Harvest Financial Group, we are a retirement planning and investment management advisor located in Houston Texas. Welcome to our 1st half 2023 Market Outlook, YouTube, Stock Talk “Keeping you connected to your money”. Today and next week, we will be covering our first half 2023 outlook.
I’m titling it, the “Old Normal”. Why? Because after close to 12 years of generous Federal Reserve monetary policies brought on by the Great Financial Crisis in 2008 and 2009, Central Banks around the world are reverting to their old ways of allowing business cycles, both good and bad, to play themselves out. In fact, more than any time in my 30-year career, global central banks spent 2022 trying to force a substantial economic slowdown in order to lower their own Covid induced, lax monetary policies, that induced the highest inflation in 40 years.
Before we get into the meat of our outlook, I have to say that 2022 turned out to be the most difficult year in the markets in my entire career. For me as a portfolio manager and investment officer, it was tougher than the Dot.com bubble. Tougher than the Great financial crisis and even tougher than anticipating the post Covid shutdown rally.
How tough was 2022? According to Nick Colas at Data Trek, only 5 days accounted for more than 95% of the S&P500 index losses on the year. Those days and declines were April 29th, -3.6% (Amazon earnings reduction), May 5th, -3.6% (Jerome Powell’s speech), May 18th, -4.0% (retailer Target’s earnings warning on inventory), June 13th, -3.9% (a hot CPI inflation number), and September 13th, -4.3% drubbing on another higher than expected CPI release. That concentration of downside moves, and volatility is a trader’s delight, and an investors nightmare. Good luck market timing those moves.
While we had expected the first half of 2022 to give us our first market correction since Xmas 2018, outside of the Covid “crash” in the 1st quarter of 2020, we did not anticipate both stock and bond markets to have joint Federal Reserve induced bear markets. They jointly have had the worst combined absolute performance since 1937, down -17.5% in 2022 and the first time that both stocks and bonds had double digit negative returns in the same year.
We have the Fed to thank for this one. Here’s the data compiled by Charlie Bilello on the 60/40 portfolio annual returns at year end. It’s improved a bit off its October lows, when the combined return was closing in on 1931 which was the worst year for a 60/40 portfolio, -27.3%. Thankfully we bounced in the 4th quarter, but it’s still ugly. The worst year in a “diversified” 60/40 Portfolio since 1937. That’s the bad news.
The good news is that looking at those horrible years for a 60/40 portfolio, 1931 and 1937, and looking at other bigger negative years like 1940/41, 1969, 1973/74, 2001/2002, and 2008, the blended return for a 60/40 portfolio had strong positive returns the next one to two years recovering most of their losses, 1933, 1938, 1942/43, 1970/71, 1975/76, 2003/04, and 2009/10. No guarantees, but starting from lower valuations and higher interest rates has historically enhanced, not lowered, your potential expected total return over the next 2 to 5 years.
For 2022, our investment team correctly expected much higher volatility with the Federal Reserve raising interest rates. However, from a macro perspective we 1- underestimated the Federal Reserve’s desire to fight inflation that they contributed too over the last 3 years, and 2 – underestimated the excessive demand that was pulled forward by government stimulus programs implemented to counteract the Covid shutdowns.
The title of our first half 2023 outlook? Return to the “Old Normal”. What do I mean by this? I mean investors should expect both the economy and stock markets to return to more normal cycles after close to 12 years of global Central Bank intervention. Since 2010, most global central banks experimented with the idea of running negative real interest rates in an effort to stimulate demand. At the end of 2020 over 18 trillion in debt globally traded with negative yields.
Here is that data from Bloomberg. Negative interest rates means that investors are paying borrowers to take their money. Of course, rationally speaking, this makes zero sense.
With most global economies having snapped back from Covid, this number of negative yielding interest rate debt now stands at only about $300 million at year end 2022. That’s the same level it stood 8 years ago in 2014.
Hopefully, that global money printing experiment is now behind us. This would in turn usher into a return to higher nominal interest rates, a higher cost of capital for investors and more rational investing behavior by investors. Back to an environment where asset diversification is a benefit to investors and TINA, there is no alternative, is finally laid to waste. Moreover, the economic experiment of MMT, modern monetary theory, taught by the purveyors of bigger or limitless government spending, would also be pushed aside over time.
Here’s a chart of 2-year Treasury real interest rates, also called 2-year TIPS. It’s the premium above inflation that bond investors require to hold a Treasury bond. Remember, the Treasury yield quoted on TV is usually a “nominal yield”. This is the one you get paid for holding government debt.
However, it has two parts. It has an inflation component, and a real yield premium component. If you add the two yields together, you get the nominal cash yield. Right now, the nominal 2-year Treasury yield is about 4.3%. The inflation component is 2.25% and declining due to the Fed’s actions on the economy, and the real yield or TIPS component is 2.05 and rising. Add the 2 components together, 2.25%+2.05% and you get? 4.3% or the nominal yield.
But Chris, I invest in stocks, why do I care about this bond stuff. Because the real yield component of the bond market almost directly translates into stocks by helping determine the markets P/E and overall valuation. Here’s a chart from Yardeni Research showing the multiple and valuation compression various market capitalization indexes have endured the last 18 months as real interest rates have risen. The large cap SP500 index has gone from a peak multiple of about 23x to 16.7x as of XMAS. The multiple in small cap stocks has compressed even more from about 22x in early 2021 to 12.6x currently.
Look at the chart below and think about the path of the S&P 500 the last decade and even more so since late 2018. In late 2018, the Fed pivoted back dovishly, real yields peaked at 2% on the 2-year Treasury, and the S&P 500 troughed right above a bear market, down -20% into XMAS eve 2018.
That was almost exactly 4 years ago. Fast forward to the late 4th quarter of 2021, and even though Chairman Powell was still worried about employment, the Fed committee behind the scenes started talking hawkishly on inflation. Back in late 4th quarter 2021, real yields troughed at -2.65% and began to pivot higher throughout the 1st quarter 2022 and in front of the Fed’s interest rate hikes and Chairmen Powell reversing 180 degrees to full inflation hawk.
If I had one real-time chart that I wanted to follow to help guide my decision-making on when should the stock market lows be in and headwinds turn into tailwinds for more than the staple stocks, utility names and energy stocks that performed ok in 2022? It would probably be this chart. So far, the high-water mark on 2-year real rates was? September 30th, around 2.36%. So far, the cash closing low for the S&P500 on Sept 30th, at 3585, has been within 8 points and 10 trading days of the absolute cash closing low.
The first half outlook of 2023 will be a push and pull between three things predominantly. First, global Central banks fighting inflation and where each bank is in their own cycle. Secondly, the extent of the first half 2023 global economic slowdown, and possibly recession, caused by the lag affect of 2022 rate hikes, the war in Ukraine causing a European economic slowdown, and China’s growth path caused by its Covid policy’s. These two negative factors, possibly offset, by the third factor that the selloffs in stock and bonds in 2022 compressed valuations in both assets.
This has now increased the long-term expected return of both assets versus late 2021 and early 2022 when the markets all-time highs were hit. Please listen to the precision of those words carefully again. The starting point for 2023 is much lower than the starting point for 2022. This mathematically increases the long-term “expected” returns. “Expected returns” being the key phrase. There are never guarantees, particularly over short-term holding periods, in public equity markets.
2022 brought with it the fastest tightening of monetary policies globally in nearly 50 years. Except for a few emerging market countries, our Federal Reserve has been ahead of most of the pack hiking often
and with large incremental moves. Here’s what they’ve already done.
Here’s a chart comparing this Fed 2022 cycle to previous ones. While the Fed was late to recognize the inflation issue in 2021, their actions since their first 25 basis point hike last March should be now labeled “Fast and Furious, Fed”. Only Greenspan in 1994 comes close.
Optimistically for stocks and the economy in 2023, post the 4th quarter 1994 interest rate hike peak, the markets and the economy did well in 1995.
Throughout 2022, our Fed has been ahead of most other major Central banks including the ECB and BOJ. This caused a major rally in the dollar throughout 2022. This served as a major headwind for most US large cap stock indexes given, they have so much international revenue exposure. Here’s a chart on the dollar, the DXY, versus a basket of other currencies.
Those circles at the previous tops in the DXY were also approximate lows in the S&P500 for the next 12 to 18 months. The headwind of a strong dollar against S&P500 earnings in 2022, should turn into a bit of a tail wind throughout 2023 given our Fed is likely in the process of slowing our rate increases as other global central banks accelerate theirs. On December 15th, European Central Bank President Christine Lagarde offered back-to-back interest rate hikes worth 50 basis points and stressed significant tightening remained ahead. She also laid out the ECB’s plans for their own QT, quantitative tightening, to drain cash from the financial system and fight inflation.
As we sit at year end 2022 heading into 2023, the economic backdrop is almost 180 degrees opposite late 2021 heading into 2022. Back a year ago, the Fed was easy on monetary policy but starting to up their hawkish tone. Jobs were plentiful. The consumer was carefree and rapidly spending. Stocks were at historic all-time highs led by large cap technology names. Treasury bond yields were near all-time lows. The landscape looks quite different now.
Today, heading into 2023, the Fed has tightened monetary policy at a historically fast pace. They are publicly full tilt hawkish. Jobs are plentiful, but job layoffs are accelerating. Due to inflation and confidence levels, the USA consumer is now much more cautionary on spending, now mainly buying what they need not what they greed for. The S&P500 is about-20% off its highs. The tech heavy Nasdaq composite is down almost -35% off its highs. In the bond markets, Treasury yields have risen 250 to 350 basis points depending on the length of maturity.
The slowing economy, combined with a still aggressive Fed has sent virtually every yield curve into “inversion” status. Historically this is a bad sign for the economy and stocks. Here’s a chart on the 10-year minus 3-month Treasury. It was one of the last yield curves to flip negative and is now deeply so.
It’s now inverted as much as it has been the last 40 years, and each time it was this inverted this much, an economic recession followed within the next year. Historically, bad news is coming somewhere out in the future,
Likewise, despite the resilience of the job market, the rapid decline in US Leading Economic Indicators the last 9 months points to the Federal Reserve’s actions slowing economic activity, especially housing and discretionary consumer spending. Many economists see this falloff in the LEI as projecting a recession starting in the first quarter of 2023 and lasting at least into mid-year. Historically, if these strategists are right, that’s not a great look for the first half of 2023 for stocks as historically the S&P500 troughs during a recession not before it.
However, according to data from Merrill Lynch, the median decline of the S&P500 for the 15 recessions the last 100 years around these periods is -27.1%. The average decline was -32.5%. So, the roughly -25.5% decline the S&P500 had in Jan 2022 through its October low, that took the S&P500 to roughly 3500, was already close in percentage terms to the median decline during a recession.
The length of those declines were 14.9 months and 13.1 months respectively. Triangulating that timing versus our early Jan 2022 peak, would place the recession timing in February through April 2023. But investors remember, there is no science too this and with employment as strong as it is, a recession in 2023 is not guaranteed. There is no exact answer. There are far too few data points to say, “This is the timing”.
There is some good news here behind the scenes. Given the magnitude of the drop in equity prices in 2022, we have likely front loaded a great deal of the stock market pain in price. Historically stocks aren’t down -20% for the S&P500 index and -35% for the Nasdaq this far in front of a recession. In fact, according to Merrill Lynch the average peak in the S&P500 to the start of the recession is only 5.7 months. And the average trough in the S&P500 to the end of the recession is only 5 months.
More simply stated, the stock market is a discounting mechanism sniffing out peaks and troughs in our economies and companies marginal ROIC well before the economists at the NBER , National Bureau of Economic Research, declare our economy in or out of a recession. As investors, if one waits on our government for data to make your investment decisions, you’ll be late.
Given the length of this outlook I’m going to stop here and pick up the second half of this content next week in our weekly Stock Talk YouTube release. I hope you return and tune in.
With the volatility that both stocks and bonds in the public financial markets experienced in 2022, our investment team recommends that you get on the phone and give our Oak Harvest team a call and ask to speak to one of our financial advisors and planners. Set up a meeting and sit down with our team and let us walk you through how the sequence of returns can affect your retirement plan every bit or more than the average investment return your current advisor is generating you.
Give us a call at ——– and give our whole team a chance to help you with your retirement allocation and have our financial planning team model your cash needs and greed’s into and through your retirement years. From myself, Troy and Jessica and the rest of our growing Oak Harvest team, we are here to help you navigate into and through your retirement years. Have a blessed week and a fantastic new year.
CFA®, CLU®, ChFC®
Chief Investment Officer, Financial Advisor
Chris is a seasoned investment professional with over 25 years of experience working with some of the most successful money management firms in the world. Chris has made it a point in his career to adapt as the market landscape changes, seeking to utilize the appropriate investment strategy for a given market environment. His transition from managing billions of dollars at the institutional level to helping individuals and families retire is guided by a desire to see first-hand the impact he is making in the lives of clients at Oak Harvest.