New Year, Same Story
Expect more volatility and pressure on stocks in the first half of 2023
The market hasn't priced in a recession but we're positioned for it
We see great opportunities to invest at some point in 2023
The Cliff Notes
We may have turned the page on the calendar year, but we’re dealing with many of the same issues and will face some new ones. In our view, the stock market has a lot to overcome near-term:
The Fed and higher-for-longer interest rates
A likely recession that has not been priced in by the market
Poor appetite for stocks, risk assets when risk-free bonds are paying 4%+
The evolving landscape may lead to more portfolio changes throughout the year. We expect that this market will call for patience and selective investments instead of a broader market, index approach.
For now, we are sticking with our defensive approach to stocks but expect to see great opportunities to invest in 2023 – we just don’t know when.
The Long Story
Inflation became an issue during the pandemic when supply and demand became imbalanced. The economy stopped and supply chains were shut down (low supplies) at the same time when massive amounts of stimulus were pumped into the system (high demand).
To calm stubbornly high inflation, the Fed has been on a path of raising interest rates with the GPS set to “Overtighten,” just to be sure inflation doesn’t come back.
There are three problems with the Fed’s tools:
1. The Fed cannot repair supply – it can only destroy demand. Removing money from the system and increasing borrowing costs destroy consumer demand. We’ve been seeing this for months, and it will get worse.
2. The Fed’s tools are a sledgehammer, not a scalpel. There’s a lot of collateral damage and certain areas of the economy feel it a lot harder and faster than others.
3. The tools have a lag effect. It can take six to 12 months to feel the full effect of a single rate hike – both on inflation and the economy. Go back six months, the Fed raised rates in June by 0.75% which was the first of four consecutive 0.75% rate hikes.
My main concern in 2023 is the Fed being slow to identify problems and take action – like it was in 2021. After almost a year of saying that inflation was “transitory,” the Fed finally realized in November 2021 that inflation was a real problem. The Fed then waited until March 2022 to start raising interest rates.
If the Fed goes too far, my fear is that it will be slow to cut rates, resulting in a longer, deeper recession.
Stocks were hit hard in 2022 – particularly on the growth side – and we see that trend continuing initially.
We don’t think that the stock market has truly priced in even a mild recession yet. Most people don’t know this, but stock price targets are driven by two things – estimated earnings and a premium (multiple) paid for those earnings. Here’s an example:
Estimated S&P 500 earnings: $220
Current market multiple: 18x
220 x 18 = 3,960 target for the S&P 500, about where we are right now.
We think this earnings estimate is generous because it’s basically the same as 2022. As for the multiple, investors paying 18x during a recession is high, and it’s very high when inflation is 6% or more. We see both of these numbers coming down as a recession gets priced in.
Couple that with the fact that investors now have real alternatives to investing in stocks. Savings accounts are paying almost 3.5% and risk-free bonds are paying 4% or more – there’s really no incentive to buy stocks right now.
My crystal ball is as foggy as everyone else’s, but here’s my guess for 2023:
I think we’ll see stocks move lower in Q1 and possibly into Q2 with a lot of volatility. My hope is that by Q3, we’re able to gauge the severity of a recession and, if mild, end 2023 close to flat and have a stronger outlook for 2024.
By keeping our defensive approach, we’ll avoid most of the downside and have more flexibility to invest at better price points.
A welcome change for investors is the bond market.
For decades, investors haven’t been able to count on bonds for meaningful income, but now they can. While bonds are now paying very attractive yields (interest rates), we are mindful that these yields are not coming from the traditional places.
In the past, investors had to take on more risk – long term and lower quality bonds – to generate any kind of meaningful income. Now, as the bond markets have priced in near-term risks to the economy, income on very short-term, risk-free bonds is 4% or more.
We have maintained a diversified approach with our bond strategy, with most of our allocation in short-term positions currently yielding 5.42%.
More declines are likely near-term, but we’re always mindful that markets are forward-looking, which means that sentiment and markets will rise before the data shows the economy is improving.
With so many factors in play, we’ll stay patient and cautious in preparation for the next 12 months and focus on maintaining flexibility in the strategy.
Frank Iozzo, CPWA®
President, Private Wealth Advisor