EQM Capital 4Q 2022 Market Review and Outlook – Will 2023 Be the Antidote to the Trifecta of Pain?

Posted on Jan 8, 2023

Most investors are happy to get 2022 behind them, as the S&P 500 Index experienced its worst year since 2008’s financial crisis, down 18.1% on a total return basis. High-growth tech stocks fared even worse, with the NASDAQ Composite experiencing a 32.5% decline and Small Cap Russell 2000 stocks were down 20.4%.

There were a few places to hide in the stock market. The Dow Jones Industrial Index was down only 6.9% and the Energy sector, helped by a spike in prices exacerbated by the Russia-Ukraine conflict, was a top-performing sector with the Energy Select SPDR Fund (XLE) up a whopping 64.2% for the year.

Investors hoping that diversification into bonds would help hedge their equity losses were disappointed amid a rising interest rate environment that resulted in the worst bond market performance ummm, ever.  The Barclays Aggregate Bond Index was down 12.5%, providing not much of a “save haven” for investors.

Last year marked a trifecta of pain of High Inflation, Surging Interest Rates, and Fear of Recession, combining to create the market’s first bear market (down 20% from its high) since the brief Covid “baby bear” market decline experienced in March of 2020.

Historically, the average bear-market length is 9-14 months in duration, and on average, they occur every 3.5 years.  Do bear markets always coincide with recessions?  Not necessarily.  According to Investopedia, of the 25 bear markets that have occurred since 1928, only 14 (56%) have been followed by a recession.

Based on the inverted yield curve, many are predicting a recession in the coming year.  But Duke Professor Campbell Harvey, the original researcher behind the premise that an inverted yield curve was the harbinger of the last eight recessions, thinks that will not be the case this time. Harvey thinks the strong labor market and heightened risk aversion may help us “dodge a bullet”.

What causes recessions – usually one of three things:  1) oversupply, when economic demand weakens, 2) uncertainty and loss of confidence (like those created by wars and pandemics and an overly hawkish Fed), and 3) speculative bubbles– such as tulips in the 17th century and the housing market in 2008.

Campbell Harvey is not the only economist or investment bank in the “soft landing” camp. Here is a nice synopsis of how divided market pundits are on the prospects for a recession.

Indeed, there are many positive catalyst scenarios that could spare the economy from recession and propel financial markets back into bull market territory in 2023.

1. Bear Market Recoveries – According to the Wells Fargo Investment Institute study, the average 12-month return after the end of a bear market is 43.4%.

2. Inflation Cooling– There is rising evidence that inflation is abating, easing to 7.1% over the past 12 months through November, seeing the smallest increase since December 2021.

3. Fed Pivot – Based on inflation data improvement, the Fed slowed the pace of rate increases to 50 bps in December, after four 75 bps increases in a row. If this continues in 2023 and the Fed “pivots”, both the bond and equity markets would rally.

4. Global Economy WildcardsShould we see a resolution to the Russia-Ukraine conflict that further eases pressure on energy and commodity prices and/or if China’s abandonment of its zero-Covid policy spurs an economic recovery there, those could re-fuel the global equity markets, especially Emerging Markets.

5. Improved Corporate EarningsCorporate America faced significant headwinds in 2022 such as cost pressures amid high inflation and a still-disrupted global supply chain. Plus, many companies over-earned during the pandemic, so some reversion to the mean had to occur. Lower inflation could help boost profit margins and corporate earnings growth above expectations.

6. Reasonable ValuationsU.S. stocks have rebounded off their cheapest levels, but ended 2022 the most undervalued since March of 2020. According to Morningstar, there have only been three times when valuations were as low as they are now: the pandemic crash of 2020, 2011′s eurozone crisis, and the global financial crisis of 2008.

Looking ahead, there is still plenty of uncertainty, but there are also many reasons for optimism. That said, market forecasting is notoriously difficult. After all, few predicted last year’s bear market due to a combination of high inflation, rising interest rates, and the Russia-Ukraine conflict which further exacerbated inflationary pressures.

Would the Fed’s transitory inflation thesis have been correct had it not been for the Russian invasion of Ukraine? The inverted yield curve is the manifestation of the market’s confusion, feeling more confident about the future than the near term.

What about Stocks?

Although past performance is no guarantee of future performance, as the saying goes, bear markets don’t last forever. In the few instances when the S&P 500 has dropped consecutive calendar years, it has been due to a major economic event, such as the Great Depression between 1929 and 1939, or a geopolitical shock, such as World War II and the oil crisis in 1972, or both, in the case of the early 2000s when there was the bursting of the dot-com bubble, Sept. 11, 2001, terror attacks and the subsequent U.S. invasion of Iraq. Since 1980 to present, annual returns for the S&P 500 were positive in 32 out of 42 years – that’s 76% of the time. A good reminder that equity investors who stay the course over the long term will be ultimately rewarded.

How about Bonds?

Another consternation for investors in 2022 was the worst market on record for the U.S. bond market as the Federal Reserve’s unprecedented pace of rate increases, clobbered bond prices, especially on the long end of the yield curve.  Bond’s historic role as a boring shock absorber, helping buoy portfolios when stocks plunge, broke down last year, as bonds were not boring at all.  Inflation is kryptonite to bonds, but as it abates, we could see a nice rebound in bond markets as well.  Indeed, some are predicting that bonds could even outperform stocks this year. Even cash alternatives are now paying 3-5%.

If things are looking up for both stocks and bonds in 2023, this could be a happy new year for investors, offsetting last year’s trifecta of pain.


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