Dear Clients and Friends,
Investors are eager to welcome a new year and forget a dismal 2022, which saw one of the worst performances for balanced stock and bond portfolios since the Great Depression. Savers, investors, and advisors are licking their wounds and wondering if we’ve just witnessed the death of the 60-40 portfolio, a widely used balanced allocation including 60% stocks and 40% bonds. Amid the daily noise of market moves, we are maintaining our focus on market cycles, bottoms-up investing, and behavioral finance, all of which support a less dramatic reaction to the events of 2022.
Recency bias refers to investors’ tendency to irrationally over-weight the gravity of recent investment experience on future investment decisions because they expect that recent events will continue to take place in the future. Understanding this concept helps us remain engaged in a longer-term narrative, while also weighing the pros and cons of balanced portfolios and the opportunity costs of considering other options. While the narrative has yet to conclude, it appears that 2022 was likely a turning point for stock and bond markets: The excess build-up in market valuations has begun to dissipate after a decade and a half of low interest rates has come to a rather abrupt end.
As we embark on a new year, we continue to favor balanced investment portfolios to achieve long-term savings and distribution goals. Following here, we will take a brief look back at themes from 2022 that may impact investment portfolios in 2023. The punchline here is that bonds now offer more attractive return prospects than they have in the past 15 years, while stocks most likely have a wider range of outcomes.
Bond pain in 2022 may lead to gains in 2023
Let’s start with some good news. Demand for goods and services remained red hot in the U.S. and many large economies last year, as Covid-related restrictions fell and consumer freedoms increased. However, a labor shortage, supply chain disruptions, and spiking commodity prices in the aftermath of Russia’s invasion of Ukraine drove global inflation to levels last seen in the 1980s.
Central banks including the U.S. Federal Reserve tried to rein in runaway inflation by throwing a wet blanket over the economy in the form of massive interest rate hikes. Fixed income valuations plummeted in response to this policy, as bond prices and yields tend to move in opposite directions. In some ways, a 13% decline in the broader U.S. bond market in 2022 marked the end of an era—or perhaps payback after 40 years of declining interest rates and generally favorable bond returns.
With last year’s step up in rates, bonds now offer more reasonable returns that could potentially offset long-term inflation. Consider longer dated U.S. government bonds with yields near 4% or blue-chip corporate bonds approaching 5% and above. Just 12 months ago, 10-year Treasury bonds paid a mere 1.5%. At current yields, we have greater conviction that bonds may resume their historical function as a slow and steady grower, offsetting the more volatile stock portion of a “balanced” 60-40 portfolio.
Stocks pricing in bad news
Both stock and bond markets experienced major upheavals last year. But the story for stocks is more complex than the simple price-versus-yield tradeoff we saw in the bond market. As we unpack last year’s more than 18% decline in the S&P 500, two main themes stand out: investor sentiment and company fundamentals.
Judging by the market multiple, which compares stock prices and company earnings, investors moods in early 2022 were rooted in optimism, bullishness, and hope. But as 2022 unfolded, investor sentiment plummeted; buyers and sellers began to worry about higher inflation, higher interest rates, declining corporate profits, and the possibility of a recession.
That brings us to 2023. We see a reasonable chance that investors remain on high alert in the coming months, because many of last year’s concerns continue to linger. In fact, new worries are moving up the leader board. Rising COVID cases in China may lead to a hard landing for the world’s second largest economy, amid a slowdown in manufacturing and housing and fears of rising unemployment in the U.S. Data supporting or refuting these concerns should come to light over the first two quarters of 2023. We’ll begin to get the first real-time data points from companies later this month as companies begin to report fourth-quarter earnings for 2022 and provide their operating and profit outlooks for 2023.
While some of last year’s baggage may weigh on stock returns in the near-term, we anticipate a glimmer of relief as we approach mid-year and beyond. Fading inflation and a loosening job market may prompt the Fed to hold or even cut interest rates, which could boost the economy and earnings. This inflection point may allow investors to look beyond the horizon at improving corporate profits, which may give way to more favorable sentiment and higher stock prices.
How are we positioning?
As we evaluate short-term market pressures and long-term opportunities, we remain committed to balanced portfolios and diversification. We continue to identify companies that are positioned to offer investors improving fundamentals at attractive prices. Some of our recent equity purchases have included defensive companies in the areas of premium beverages and self-storage real estate, as well as growth stocks such as global semiconductor manufacturers. Although each of these companies has its own merits for acquisition, themes for these investments generally include the following: market share gains, rising margins, and below-average stock prices.
The last three years have been a wild ride. We expect that the year ahead will continue to bring challenging market conditions, but we have been down this road before. No matter what lies ahead, we continue to manage portfolios with a steady hand and a disciplined approach. As events unfold this year and beyond, we return to our core investment principles, remaining ever mindful of your individual goals and objectives.
We wish you a joyful winter and a prosperous new year.
Michael Bailey, CFA – Director of Research
Michael Mussio, CFA, CFP® – President
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