2022 in Review
Ouch! It was the worst year for global stock markets since the 2007-2009 global financial crisis. We’re not surprised. After the rampant speculation of 2021 in cryptocurrencies, “meme stocks,” and “disruptive innovator” companies, 2021 ended with stock valuations near the highest on record, ending the longest and perhaps greatest bull market in history.
Since starting-point valuation is crucial in determining future returns, it was extremely likely that coming stock returns would be well below average—even negative—for years to come. So, the near 20% drop in the S&P 500—a 45% drop in an index of ten large growth stocks, and a 70-90% drop in 2022 for cryptocurrencies and the most speculative stocks—made sense and began a return of reason.
What we did not expect was the worst year on record for bonds. As consumer price inflation remained high into the spring, in March the Federal Reserve abruptly ended its policy of easy money and record-low interest rates that had lasted for years. The Fed raised its benchmark federal funds rate seven times, from a starting rate of 0.25% to 4.5% at year-end. The yield on the benchmark 10-year U.S. Treasury started the year at 1.5% and peaked at 4.25% in October. The aggregate U.S. Treasury bond market index returned -12% in 2022, and some preferred stocks (which act like long-term fixed income securities) fell more than twice that.
The Current Situation
We assert that we are deep in a great reckoning after the broadest global speculative frenzy across asset classes since the 1920s. This purging could restore a healthier balance between the real economy and the financial economy, which has been out of whack for years.
The Fed’s pretext for the surge in interest rates has been to raise the cost of borrowing to reduce spending and thereby curb consumer price inflation. The rate of inflation spiked due to the COVID pandemic, a once-in-a-century phenomenon. This disrupted global supply chains and reduced supply, while massive government spending increased consumer demand, leading to the highest inflation in four decades.
That pretext is no longer valid. Various measures of inflation peaked months ago, and inflation has been decelerating rapidly. Instead, it seems that the Fed’s goal now is not to curb consumer price inflation but to curb inflation in asset prices (e.g., stocks and real estate) and to squelch reckless speculation.
We have great respect for financial market history, and this cycle is worrisome. Though no two periods are identical, there are often strong similarities. The market mania of recent years strongly resembled the mania over technology stocks in the late 1990s. Though the recession that followed the stock market peak in 2000 was mild, stocks endured a severe bear market, with index declines of 50% or more.
The market bubble of 2005-2007, on the other hand, was in residential real estate, not stock prices. The financial crisis and recession that followed were severe, as was the drop in stock prices (also about 50%).
The economy and the stock market are not the same, and those two cycles show that whether an economic recession is “soft” or “hard,” the stock market can still have a severe bear market. Keep this in mind as you hear pundits talk about a mild recession and only a moderate bear market this time.
The current cycle has an ominous portent. Unlike the 1990s or 2005-2007, there was a bubble in both the stock market and in residential real estate. The combination of a return to more normal valuation levels in both would have a massive impact on households and their spending. An era of greater consumer frugality seems a likely consequence.
Employment conditions are not helping, despite recent job growth overall. For example, it’s not the number of jobs added each month, but the type. The net jobs added in each of the last two months were part-time, not full-time. There also was a big jump in “self-employment,” which is very different from a full-time job with benefits.
The Year Ahead
Employment, corporate profits, and inflation will likely be much weaker than most observers expect.
The result will likely be an economic “landing” that is hard, not soft. In response, the Fed will cut its benchmark interest rate sooner than the Fed itself and most observers expect. Be skeptical of the Fed’s forecasting ability, though. Forecasting the economy and inflation is very difficult, but even the Fed’s record of forecasting the federal funds rate (which it controls!) is poor. After all, it was just a little over a year ago that the Fed forecast in its “dot plot” that the benchmark rate would rise from 0.25% to 0.90% by the end of 2022. It ended the year at 4.5%. The Fed simply had to respond to changing circumstances as 2022 progressed.
When the Fed inevitably suggests that the benchmark rate has peaked, investors will almost surely respond with excitement. Recall last autumn, when in response to a hint that rates had peaked, stock prices jumped by more than 5% in one day. Beware. Like then, we expect any rebound to be short-lived. (Bear markets have reached bottom on average 16 months after, not when, the Fed “pauses” its cycle of rate hikes.)
The corporate profit outlook won’t help. Despite obviously weakening business conditions (note the large layoffs at technology and financial companies), the consensus forecast for S&P 500 profits is 7% growth in 2023! In a normal recession, profits have fallen by about 20%. Which outcome would you put odds on?
Regardless of what the Fed does or what the headline employment total is over the next few months, we think the Fed’s severe tightening of financial conditions last year set the economy on a path of contraction this year, as monetary policy affects the economy with sizable lags.
Similarly, we expect inflation to become yesterday’s news. Though inflation comparisons versus the year prior remain historically high, the trend has been downward. Since the peak last June in key inflation measures, the annual rate has been only about 2.5%, which is close to the Fed’s stated target. Market-based expectations also are for inflation of about 2.25%. Instead of inflation, the focus of investors this year will be on rising unemployment and sharply falling profits.
Though prices of most stocks have already fallen significantly, for the market overall, there are none of the historically reliable signs of a market bottom—whether in the stock market, the fixed-income market, or the economy.
Unlike for stocks, we expect a far better year for bonds. Inflation has always fallen in recessions, as have interest rates. In fact, most bond yields already peaked last October (and bond prices bottomed). We expect fixed-income investments (including preferred stocks) to have a good year, not just in generating much higher income than over the last five years, but in generating capital appreciation (especially in long-maturity bonds and preferred stocks).
Strategy
As the bear market continues in terms of magnitude and time, we expect better prospects for stocks to emerge later in the year, assuming a normal bear market trajectory. Of course, a sharp drawdown sooner could accelerate the end of the bear market. Whether more widespread opportunities arise gradually or abruptly, we intend to be ready.
Despite overall bear market conditions, we have been finding pockets of opportunity in stocks that we think might already have completed their bear market. We are eager to add to stock holdings more broadly, not just primarily in defensive sectors, with an emphasis on high dividend yields. But it must be at the right price.