Quarterly Market Perspective for 1Q23
Summary
The markets experienced as much volatility last quarter as we normally see in a full year, but it was mostly to the upside. Several of 2022’s most underperforming assets saw a remarkable comeback, most notably bonds and technology stocks. Largely this was a result of investors’ willingness to overlook persistent short-term inflation and the Federal Reserve’s determination to rein in that inflation whatever that may cost. Many investment professionals believe the Fed should stop raising rates as it is now clear that at least some banks were not able to successfully navigate the 475 basis-point (4.75%) of increases we’ve already had. Additional rate hikes risk making this situation even worse.
U.S equities rose 7.18% last quarter. The average S&P 500 stock rose just 2.93% but the market cap-weighted index was pulled higher by a handful of technology stocks like Meta and Nvidia. The Nasdaq composite soared 17.05%! Much of this occurred in the last three weeks of the quarter as the market figured that the crisis in the financial sector meant the Federal Reserve had to pause. The Fed, as it turned out, thought otherwise. The money that went to technology tended to come out of three main sectors. One obviously was financial stocks after Silicon Valley Bank collapsed. Financials lost -2.27%[i] last quarter, but that was still better than both the energy (falling oil prices, -4.37%) and the utilities sectors (-3.12%).
International developed markets outperformed the U.S. market. MSCI EAFE recorded an 8.02% quarterly gain. Breaking this down, Europe led the way with a 10.56% return, helped by cheaper relative valuations, lower-than-feared energy costs, and the return to a positive interest rate environment. Japan rose 6.19%, led by the appointment of a new leader of the Bank of Japan. Emerging markets rose just 3.96%. China’s re-opening is expected to provide a boost to the rest of Asia and to Latin America, but we really didn’t see much of that last quarter and we might not until later this year.
Bond yields declined last quarter on hopes that the Federal Reserve would adopt a more dovish policy in the wake of the banking crisis. The U.S. bond index finished 2.96% higher, slightly less than high yield’s 3.66% increase. Even short-term bonds were able to add 1.28%. Foreign bonds were aided by a modestly weaker dollar and slightly better-than-expected economic conditions[ii].
Commodities fell more than -3% last quarter, depending on the basket used. Falling energy prices were largely responsible. Gold, on the other hand, rose just under 8%. There are a number of possible explanations, including financial fears tied to the banking situation or perhaps concern about the coming debt ceiling circus negotiations.
Activity
Perhaps surprisingly, given the degree of volatility last quarter, we actually made very few adjustments. The more prices move back and forth, the easier it is to believe that any individual surge or drop is noise and not an important signal. For example, a dollar invested in the Nasdaq three years ago would have grown to $2.05 by year-end 2021 only to fall below $1.35 in both October and December of last year. It’s just under $1.65 today. In the context of January 2022 $1.65 seems cheap (as it is almost 20% lower than $2.05), but in the context of the 65% gain from April 2020 it still seems quite expensive. We believe we are in a “sideways” market right now, so we are not inclined in most cases to buy areas showing relative strength; we just don’t think the strength will last.
We should note that we have been willing to lock in yields on Treasury securities with yields in excess of 4.5% when market conditions have allowed. That has come to be a significant part of the fixed income component of portfolios for many of you. A 4.6% one year note only gives you 1.15% on a quarterly basis but the principal is guaranteed. After last year, having some of the return “locked in” just seems to make sense.
Outlook
The market expects three things – a mild recession, for the Fed to “pivot” from raising rates to cutting them, and for “growth” stocks to outperform. The Fed insists it has no plans to cut rates. Growth stocks have surged anyway whenever conditions have changed in such a way as to make a Fed pivot seem more likely[iii] – weaker retail sales or industrial production or home sales perhaps, or in mid-March it was the Silicon Valley Bank debacle. Eventually, some economic report, such as the employment, inflation, and housing prices, comes out stronger than expected which throws cold water on the pivot argument. As a result, the Fed hikes rates again. Growth stocks then sell off in disappointment. This is a “chase your tail” game and we’re going to be patient and not get caught up in it.
Corporate earnings declined in the 4th quarter of 2022 and they are expected to decline this quarter and next quarter as well. Simple math says that as long as earnings are declining, stock prices are getting more expensive, and time is not on your side. Over the long term, I am very confident that earnings as a whole will rise. They always have in the past, and the system is not broken. It is just a question as to whether investors can continue to see past the near term weakness.
If you have the fortitude to stay the course as annualized S&P 500 earnings fall from $228 to $217 to $208 to $199 (for example) before bottoming out and recovering to perhaps $220, $243, and then $265 by the end of 2024, then it makes obvious sense to hold on here – maybe even add if stock prices dip too far. My experience, however, is that investors tend to lose their nerve at some point as conditions continue to deteriorate. I just don’t think the next big bull market will begin from S&P 4100 (where we are today); I believe it will require a better value proposition (cheaper prices) or a drastically altered economic landscape in which earnings growth takes off like a rocket. The latter seems highly unlikely given the Fed tightening cycle and the recent bank failures. We can, however, continue to avoid any meaningful sell-off as long as investors remain relatively confident. The linchpin of that confidence is a near-term Fed pivot – investors won’t sell if they believe the catalyst to higher prices is close at hand. This is what we have to keep our eyes on.
Commentary – In a Trading Range You Do Things Differently
“Bull” markets behave in a classic way – a stock will go from $60 to $80 and then to $100 and above. The key for an investor during periods like this is to determine which parts of the investment universe are making that journey the fastest and look for a factor that is driving them that you can exploit. Maybe it’s that a particular market segment in the right industry, maybe that segment is boosting dividends or announcing share buybacks. An investor just needs to identify the catalyst fueling higher prices, and then believe that force is continue. Again, during typical bull markets corporate profits, and profit margins, are growing such that the “runway” for favorable conditions tends to be long. Occasionally there will be hiccups and adjustments will be necessary, but in general the trend is your friend and the best way to goof up and hurt your performance is to overthink it.
At the end of the economic cycle, however, the economy gets tired. Too much credit has been extended to non-worthy borrowers and interest rates have to be raised in order to purge the system of excesses so that a new expansionary phase can begin. During these periods the runway is short; stocks do not make new high after new high as they do during bull markets. They correct investors’ overenthusiasm by selling off, then they gradually work back toward their old highs only to fail to make new highs and sell off again. This is what is known as a trading range. Buying momentum in a trading range environment will not work; it will only lead to disappointment.
As noted above, corporate profits are falling today as the Federal Reserve’s tightening efforts are beginning to bite. Recessions typically begin about a year after the last Federal Reserve interest rate hike, and new bull markets tend to begin before the recession technically ends. It should be noted that the Fed hasn’t stopped hiking yet, so the bull market watch clock hasn’t even started ticking.
We’ve had economic environments somewhat similar to this one before. The ones I’m thinking of are the late 1980s and 2001 pre-9/11. In 1986 plunging oil prices created a speculative fever that led to a 35% spike and crash in 1987. Markets traded “choppily” in 1988 and 1989 as speculative excesses were wrung out. Similarly, we had a tremendous dot.com boom in 1999 partially fueled by the Federal Reserve dumping reserves in the system in case there was a system shutdown tied to Y2K. The rapid withdrawal of those reserves in early 2000 led to the dot.com crash that year and then choppy sideways trading in 2001. This go-round, the government and the Fed threw money at the economy to avert a broad economic collapse and market crash in 2020 tied to Covid-19 and largely kept the spigots open through 2021. 2022 was our “crash”, but I expect it to take at least another year of back and forth for the current excesses to be wrung out.
[i] Sector performance courtesy of S&P per Morningstar
[ii] Bond returns from Bloomberg via Morningstar. Commodities and Gold returns from Dow Jones via Morningstar.
[iii] Growth stocks tend to perform better when interest rates fall (to the extent that interest rates reflect inflation expectations) because the lower inflation is, the less a dollar earned in the future needs to be discounted from $1.00 to reflect purchasing power loss. Growth stocks derive more of their value from expected future earnings than value stocks (which are mostly valued on net present value).
DISCLOSURE
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