Q4 2022 Commentary

2022 will go down as one of the toughest years in investing history.

The S&P 500 fell more than 19% -- the worst year since the financial crisis, and the fourth-worst year in the last eight decades.  Broad-based bond indexes lost more than 10%, posting what may have been the worst year in the history of the United States.   

You did not need to go far out on the risk curve to see notably larger losses.  Broadly popular sources for excess returns in recent years were particularly hard-hit. The tech-heavy Nasdaq lost 33%, while long-dated Treasury bonds lost more than 30% for the year. 

The highest inflation rate in over forty years only made the losses more painful.

Things could have been worse.  The fourth quarter brought continued chaos to markets, but within that chaos was some relief.   

The good news all came in the back half of October. The S&P 500 rallied more than 10% from the early October lows to gain more than 8% for the month. That move would prove adequate enough to secure the market’s only positive quarter for the year. November and December added to the volatility, but November’s 5% gain was wiped out by a slightly larger loss to close out the year.

We have long-believed that patience and prudence would be rewarded, particularly in a high-valuation environment.  2022 provided a strong reassurance of the value in those virtues.

With stocks beginning 2023 well off of their October lows, there is a growing sense from the financial media that the worst of the market volatility is behind us.  Of course, there are plenty of naysayers, and no shortage of recession calls, but there is also no doubt that optimism is rebounding among the pundit class. 

We empathize with these sentiments to some degree. There is plenty to like in the macroeconomic picture, particularly within the dynamic of inflation and the labor market. Many economists (including the Fed) anticipated that rate hikes would necessarily damage the labor market. Instead, inflation has moderated dramatically, while the jobs data has been resilient. The latest headline CPI number saw prices falling month-over-month.  Core inflation over the last four months has been the lowest since early 2021.  The unemployment rate, meanwhile, is a remarkably low 3.5% (matching the pre-pandemic levels). Weekly initial jobless claims are close to 200,000 – also historically low – indicating no emerging weakness in the labor market.   

We also find encouragement among much of the data that had us buying throughout 2022.  Insider activity remains bullish while retail investors are still generally cautious.  Though retail investors are less worried than they were three months ago, this remains a dynamic that we believe favors market exposure. 

If it persists, this is the type of backdrop that will continue to encourage us to buy into market weakness, but it is not enough to make us optimistic about long-term market prospects. 

For years, our long-term outlook has been hampered by high valuations. Valuations hit a fevered peak in early 2021, reaching levels only ever eclipsed during the tech bubble.  At the time, we warned that corrections from such bubble-esque levels could be severe and drag out for multiple years. 

Though stock prices peaked early last year, we are really two-years into the valuation correction.  At their lows, stock prices were down 25% from their 2022 high, but Price/Peak Earnings multiples had contracted 40% since their 2021 high.  A nearly two-year, 40% multiple contraction is a rather historic move, and one that fell in line with our warnings.  At their October lows, equity multiples had fallen back within their sustainable historical range (albeit at the high end). It is not a stretch to assume that October could have marked the end of the struggle for stocks. 

However, equity prices have rallied well off of their lows, and earnings are not expected to set a new high until the end of the year.  This has already brought the S&P 500 Price/Peak Earnings multiple back to historically unsustainable levels. There have only been a few scenarios that have been able to temporarily sustain extremely high multiples: raging bull markets, low interest rate policy or historic corporate tax cuts.  Today’s market is not supported by any of these or similar factors.   

Adding to our long-term concerns is a hawkish Federal Reserve. Over the past year, the Fed has embarked on the most aggressive monetary tightening in a generation – making them the primary antagonist to investments in 2022.  Though the most rapid monetary tightening is behind us, the Fed has made it clear that they are not done.  The central bank anticipates three more rate hikes this year and plans on keeping rates high. 

Given all of the economic evidence that we could be experiencing a “soft landing,” we believe the Fed should be congratulating themselves for a job well done.  Instead, they want to prove their resolve by going further. We would like to give the Fed the benefit of the doubt, but Fed Chair Jerome Powell has firmly established a tendency to go too far in fighting the last fight. The consequences of his stubbornness include the recent bout of generationally high inflation and a 20% correction in late 2018. 

Between high multiples and a hawkish Fed, we believe that the struggles of 2022 could resonate well into 2023.  If that is the case, we anticipate remaining quite active.  If markets defy gravity and head higher, we are likely to return to high cash positions.  This is a far more attractive option than it has been in recent years, as we are finally getting a decent yield from money markets.