January 2023 Market Commentary
Nowhere to hide
After two consecutive months of positive returns, markets reversed course in December to close out the year on a somber note. As detailed in the table below, 2022 was a terrible year across the board. The Dow Jones Industrial Average bested the other major U.S. equity indices and the bond market by delivering a negative 6.9% return.
While negative equity market annual returns are not unusual (they occur about once every four years on average), concurrent negative annual returns in the equity and bond markets are unusual. For historical reference, the Old Point Wealth Management team turned to NYU Stern School of Business professor, Aswath Damodaran, also known as the Dean of Valuation. Damodaran compiled and made publicly available via a website nearly one hundred years of annual investment returns on stocks, bonds, and real estate.Inflation data is also available to provide annual real returns.The information is fantastic and allows for historical perspectives.
Damodaran’s data shows that since 1928 concurrent negative bond and equity returns happened just three times. 2022 marked the fourth time. It is also the first time on record when long-term bond returns and equity market returns declined 10% or more respectively. For investors with a mixed allocation of stocks and bonds, there was nowhere to hide in 2022.
Solid long-term results
Despite the off year, longer-term results continued to be solid for U.S equity indices with 10-year and 40-year annualized returns ranging from 9% to 14%. Looking at the data more closely, S&P 500 Index investors made money in nearly every rolling 10-year period since 1940 with just two exceptions: 2008 and 2009. Equity markets are proven to be incredibly resilient over the long run.
2022 was more than just an off year for bond investors. It was the worst calendar performance year on record, and it was the first time the Bloomberg U.S. Aggregate Bond Index (the Agg) declined in consecutive years. The Agg’s negative 13% performance shook long-term investors to their core, dragging the 10-year annualized return to 1.1% from 3.8% in 2020. Said another way, in just two years 10-year annualized returns dropped 71%! How much worse could it possibly get?
For equity and bond investors alike, 2022 was a humbling year.Even though the Agg delivered a negative return in 2021, the trailing three-year annualized return was close to 5%.Over the same three-year period, the S&P 500 Index generated a 16.5% annualized return.Investors grew accustomed to solid returns and market strategists offered little in the way of caution heading into 2022. Over the course of two weeks in December 2021, 45 strategists were polled by Reuters for their year-end forecast for the S&P 500 Index.The median forecast called for the index to finish 2022 at 4,910, a 7.5% gain from the time the poll was conducted.The index finished the year at 3,839, over 1,000 points below the median forecast!Market forecasting is a tricking endeavor.
What comes next?
Looking ahead, the outlook is wide-ranging.Narrowing the field to 23 strategists, the 2023 year-end forecast for the S&P 500 Index varies between 3,400 (an 11% decline) to 4,750 (a 24% gain) with a median target of 4,080 (a 7% gain).Investors appear less optimistic.The CBOE Put/ Call ratio, a closely watched indicator of market sentiment reached a multi-year high last month.A level above one is an indication that investors are pessimistic with traders purchasing more Put options (expecting the market to decline) than Call options (expecting the market to rise). The chart below confirms extreme pessimism.
A second gauge of market sentiment, the CNN Fear & Greed Index, reflects a similar level of pessimism.The Fear & Greed Index is a compilation of seven different indicators which measures some aspect of stock market behavior. The graphic below reflects the year-end mood of the market.
A third gauge of market sentiment, the Goldman Sachs Non-Profitable Technology Basket Index, indicates interest dissipated in some of the fastest revenue growth companies. The index was created to track the performance of non-profitable technology companies like Pinterest, Teladoc, Peloton, and Roku.As you can see from the chart below, the price of the index dropped 75% from the all-time high reached in February 2021. It now sits at pre-pandemic levels.
What would Warren do?
“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” -Warren Buffett
The three referenced market sentiment indicators suggest limited interest in stocks at year-end. However, market sentiment gauges have often been great contrarian indicators. When investors experience a material and sustained downturn in the market, confidence suffers. Investors have faced similar challenges in prior years. The S&P 500 experienced double-digit calendar year losses 10 times since 1937 including 2022.Even though caution was warranted following a difficult year, patience and confidence were rewarded. The average subsequent year return was 18%. While we will abstain from making any market predictions, we do acknowledge that many asset prices are more attractive now versus a year ago.Irrational investor exuberance has clearly subsided.
Also in line with pre-pandemic levels is the Price/Earnings (P/E) multiple of the S&P 500, which remains at 17. While painful in the short-term, the 12-month decline better aligns expectations with economic fundamentals. Using year-end prices and current analyst estimates, the S&P 500 Index is trading below its 25-year average P/E ratio.
Outlook for equities
We welcome the lower valuations but remain cautious.With the most highly anticipated recession on record looming, we are mindful of the implications of an economic contraction. Earnings per share growth of 7% to 10% in 2023, in the face of a recession, seems ambitious. We doubt the market fully accounted for a meaningful decline in earnings estimates in 2023. If we do experience a recession in 2023, corporate earnings will likely be lower than anticipated.We would expect asset prices to adjust accordingly in the short-term.
Don’t fight the Fed
Turning our attention to the bond market, we do not anticipate a repeat of 2022 in 2023.The Federal Reserve Bank (the Fed) raised the Federal Funds rate 7 times in 2022, taking the benchmark target rate range from 0.00%-0.25% to 4.25%-4.50%.Given the inverse relationship of rates and prices, the rapid move higher in rates crushed bond prices. The pace of the rate rising was unprecedented as it was driven by the Fed’s pressing need to control inflation.The Fed’s actions, arguably long overdue, have been effective. The Consumer Price Index peaked in June last year and declined every month since then.Inflation may have peaked, but we have little to gain by declaring the Fed victorious.We continue to believe the best course of action is to not fight the Fed.
That does not suggest we avoid purchasing bonds.The speedy rise in interest rates provided much improved income opportunities. At the end of 2022, yields on medium term investment grade rated bonds ranged from 4.0% to 5.5%.For investors seeking steady income with limited risk of principal returned at maturity, the market is decidedly more attractive than a year ago.
We enter 2023 as we enter every year, with an unwavering commitment to our investment process focused on helping make client goals a reality. Our investment philosophy is deeply rooted in a belief that the market is emotional in the short-term, but rational in the long-term.We resist crowd psychology, addressing fears while others panic, and we stay grounded when others are greedy. We understand that trying to keep pace with the market in all environments leads to poor investment decisions. As has been the case in prior years, we expect irrational investor behavior will create superb long-term investment opportunities in 2023.We appreciate your confidence and support and hope you will reach out to an Old Point team member with any questions.Here’s to a happy and healthy New Year!
Old Point Wealth Management makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions which may be contained herein and accepts no liability whatsoever for any loss arising from any use of or reliance on this report or its contents. Old Point Wealth Management, its affiliates and/or their respective officers, directors or employees may from time to time acquire, hold or sell securities mentioned herein.