Markets Economy and Portfolio Management January 2023
The U.S. equity market and bond market simultaneously entered a bear market last year – an uncommon event. Behind both Bear markets are inflationary supply side constraints and government Fiscal and Monetary Policy mistakes. The Federal Reserve (Fed) is closer to the end of its rate tightening cycle, the fastest ever, aimed at slowing economic growth which in turn should lower inflation that reached a 40-years high. This Bear market ends when the Fed stops hiking the Federal Funds Rate (FFR) this quarter. Every Bear market is followed by a Bull market. Investors are close to the shore…stay invested.
The S&P 500 nearly declined -20% in 2022%, the worst year since 2008. What does history tell us about the end to past Bear markets. History suggests a rebound is probable. Research by CFRA shows that after all 21 down years since 1945, the S&P 500 gained an average of 14.2% in the following year, 81% of the time. The stock and bond market signaling that inflation has peaked. S&P 500 returns are usually positive over the next 12 months after inflation peaks. Markets also have rallied based on the narrative that the Fed is nearing the end of its historic tightening cycle.
Markets were hit last year with the fastest tightening cycle on record. The Bear market low may or may not be in. That depends on further action by the Fed which would overtighten financial conditions in my opinion. Recession fears are ratcheting down but remain elevated. The economic impact of ultra-aggressive Fed tightening has yet to fully impact economic growth. It is touch and go whether or not there is a mild recession or a uncommon soft landing. If U.S. economy slips into a recession, there could be a little bit more downside to the S&P. My downside level is 29% drop in price from S&P high was reached last year. It will be a V bottom this time as many long-term investors would buy at those valuation levels given a second chance. Also, the recoveries from smaller recessions have been quick.
The ISM Service Index and Manufacturing Index have fallen into contraction territory which suggests weakness in earnings growth this year. Analysts have sharply revised earnings projections and are becoming less pessimistic about future earnings. Many strategists are calling for a bottom in earnings contraction sometime in the first quarter. The S&P 500 Index tends to bottom around a bottom in ISM Indexes. When yields peak, stock indexes valuations stop declining, and analyst downward earnings revisions should stall. Analysts are still projecting earnings growth of 4.6% in 2023 according to FactSet. That only happens if the economy has a soft landing.
If U.S. economy does slip into a recession, it could be shorter-lived and less severe, based on the resiliency of the labor market. There are 1.7 job openings per every unemployed worker in the U.S. according to the U.S. Bureau of Labor Statistics. Moreover, today’s rates are not high enough to cripple credit growth. Consumers and businesses are still borrowing. Earnings may not decline as much as in a normal recession. The U.S. consumer is still spending. supported by a resilient labor market with jobless claims still relatively low. While slowing, and lower, there is continued job growth. Which is key because Consumer spending accounts for almost 70% of GDP. It all bodes well for corporate earnings to shrink by a smaller percentage, about negative 5% in 2023 and not 15-20% which is more normal for a recession with ISM Indexes at 45 level. S&P 500 Index rises before a bottom in earnings. It also rises about mid-point in a recession. Given forward valuations for S&P 500 Index, I am buying investment grade bonds over S&P 500 stocks.
The U.S. economy remains in a late-cycle expansion phase with broad concerns of a recession. The Federal Reserve rate hikes have not had enough time to impact economic growth yet. Companies are laying off workers, however there are still plenty of jobs available. Unemployment is incrementally rising, and consumer spending for the moment is holding up. A significant rise in unemployment is the telltale indicator of every recession. The economy is far off from unemployment levels found in a recession. There is hope that any recession will be mild and short-lived because unemployment may not reach a level normally associated with a recession.
The GDPNow estimates real GDP growth last quarter at 4.1% - strong expansion figure. However, a variety of recession indicators are signaling a recession is coming. The Yield curve has inverted, notably in the most reliable part, 3 months – 10 Years, which signal a recession ahead. The ISM’s Services Index, another fairly reliable recession indicator, is in contraction territory now. Leading Economic indicators (LEI), a composite of economic activity that leads the economy, were down about 5% year-over-year. All previous declines of that magnitude since the 1950s have ended in recession according to The Conference Board. Similarly, the ratio of leading indicators to lagging coincident indicators peaked and rolled over. That too is a strong indicator of looming recession.
The Fed, as expected hiked 50 basis points again, it also boosted its rate target for next year to 4.94%. It’s now at a 15-year high of 4.25% to 4.5%. Its mission in 2023 is to prevent inflation from becoming embedded in the economy. To do that the Fed believes it must create conditions for sufficient job layoffs which in turn should soften wage pressure and consumer demand thereby driving inflation down.
Overall inflation has peaked. Inflation has declined for six straight months. CPI rose 6.5% from a year ago, lower from its peak of 9% last year according to the Labor Department. Many components of inflation have peaked and are rolling over: Commodity, Goods, Wage, Rent. It's the service sector inflation that seems stickier. One Year Treasury Inflation Protected Bonds (TIPs) imply the Fed will be successful in lower inflation over the next year – TIPs 1-Year Expected inflation rate is 2.67%. The Producers Price Index (PPI), a leading indicator for inflation, declined from a peak last March of 11.7% to 8.0% Y-O-Y. ISM Services in contraction means inflation has peaked, earnings should decrease, and lower economic growth is headed our way.
The Labor market remains resilient in the face of an onslaught of rate hikes. Initial Jobless Claims is bouncing at exceptionally low levels not associated with even a slowing economy let alone a recession. December’s Job’s report shows the economy is moving in a slow growth path not a contraction. Moreover, wages grew slower than expected, supporting a developing trend of lower inflation pressure. Wage growth in December fell to 4.6%. The Federal Reserve believes it must fall below 4% for inflation to drop towards its goal of 2% PCE inflation.
For now, the U.S. economy is in its Late cycle phase characterized by Fed tightening financial conditions to curb inflation, tighter credit conditions, slowing sales, and rising inventories.
The late-cycle economic phase with stagflation conditions and high recession risk calls for a balanced diversified portfolio. With the path of the economy highly uncertain, an asset allocation that addresses both recession scenario and slower economic growth is the prudent portfolio strategy. Bonds offer better risk-adjusted returns than equities for the time being. Although selective economically sensitive stocks offer greater long-term growth potential. Stay balanced with a laddered approach towards investing in investment grade bonds, and own quality dividend growing stocks both defensive and cyclical ones.
The S&P 500 Index forward 12-month P/E ratio is 17.3, which is below the 5-year average, and trading at a valuation associated with economic expansion. The S&P 500 Index is not cheap by any means. The S&P 500 Index normally trades at a P/E of 14-15 times in a slow growth economy and much lower in a recession. I would rather buy quality bonds over stocks for the time being out of concerns for further cut to earnings in a recession.
There are other parts of the global equity markets that are trading at cheaper levels discounting a mild recession already. Foreign Large cap equities and U.S. Mid-Small-cap equities are two areas that come to mind. I am dollar-cost-averaging in both areas now. The stock market low, if not already in, should be sometime this quarter, presenting the best buying opportunity for economically sensitive stocks in years. Fed policy is a headwind for stock earnings until the Fed is finished hiking FFR. Cyclical stocks outperform Defensive stocks mid-way through a recession when the Fed starts cutting interest rates according to NDR.
The yield curve is deeply inverted signaling a recession this year. The spread between the yields on the 10-year and 3-month U.S. Treasuries reached a level where a recession is a highly likely event this year according to Bespoke. Quality Long term bonds had one of their worst years on record in 2022, as higher rates deeply discounted into prices lower coupons of seasoned bonds. The rise in rates and spreads has vastly improved bond valuations back to more normal levels. History shows that investment grade bonds had positive returns during recessions and Late cycle after Fed stops hiking rates based on research from Capital Group. The accounts fixed-income component has a laddered approach towards bond portfolio construction. Assets are now spread across short-term bonds, intermediate bonds, and long-term bonds. I am tilting away from short-term bonds toward long term bonds this year. Last year it was the opposite. I’m only buying investment grade bonds…no junk given recession risk.
What areas of the stock market are attractive to me? Quality cyclical value stocks that are growing dividends. It was a record year for S&P dividend payments. S&P Global projects that 2023 will be a banner year too. Dividends represent as much as 40% of long-term total returns from the S&P 500 index according to S&P Global. Dividend growing stocks are in favor because many are low P/E cyclical value stocks that investors prefer over high P/E Growth stocks in an environment of declining earnings. Investors can’t overpay for company earnings in a tight monetary environment. Historically Cyclical Value outperforms Growth after market bottoms unless Growth is cheaper based on NDR research. I continue to invest in Energy, Material, and Financial stocks, all cyclical value stocks, appear cheap based on current price-to-earnings and free cash flow. Energy is also a buy because China’s economy is opening. When yields peak, other cyclical sectors such as Consumer Discretionary, and Technology should be a buy, and rally.
Hold on to Technology and other sectors that have fallen. Following down years, with expectation of an up year ahead, investors should buy what has underperformed and sell what outperformed. Technology and Consumer Discretionary stocks have underperformed Utilities and Consumer Staples. Since 1990, when the market had a down year, the four worst-performing sectors went on to beat the S&P 500’s typical gain of 14.0%, 56% of the time according to CFRA. Consumer Discretionary, Information Technology, and Communication Service sectors are expected to see the largest price increases among all S&P 500 sectors in 2023 according to FactSet.
What else is attractive to buy in equities? Besides Small-caps, Mid-cap stocks are a buy since poor fundamentals appear to be priced into current valuations. Price-to-earnings of Mid-cap versus Large-cap stocks are at bottom-decile levels not seen since the early 2000s according to Fidelity.
The US Dollar Index is in a down trend which I expect to continue as Fed hiking cycle is nearly finished. Developed Foreign stocks to outperform versus US large caps when the U.S. Dollar declines. Foreign stocks have outperformed U.S. stocks since early December. Foreign stock valuations have priced in a lot of bad news and are selling at an historical discount. I am increasing exposure to developed market foreign stocks in accounts to a neutral weighting from extreme underweight position.
I continue to invest cash-equivalent holdings in investment grade ultra-short bonds, and floating rate notes. Those investments offer the best combination of current income, low interest rate risk, and capital preservation.