The fourth quarter ended on a positive note with stocks and bonds rallying to end what was otherwise a difficult year for investors. Stocks staged a strong comeback in November in response to the Federal Reserve (Fed) indicating that its pace of policy tightening would slow along with signs that inflation is cooling. 2022 was one for the history books as this was the worst-performing year for the S&P 500 since 2008. Balanced portfolios (60% stocks and 40% bonds) saw their biggest drawdown since the 1930s because the bond market has seen its worst annual performance since the bond indexes were started. Not the type of history we like seeing!

Most sectors performed well in the rally to wrap up the year. Energy and industrials were the top performing sectors in the quarter. The energy sector rallied 21.5% after most companies posted record profits. The defense contractors were the standout among industrials. The government spending bill passed just before Christmas had a generous increase in defense spending. Industrials added 18.6% in the quarter. The consumer discretionary sector was the only group to see losses. Amazon (-25.6%) and Tesla (-53.5%) are two of the heavyweights in the sector, which sent it lower by 9.3%.

Investment Strategy

We are maintaining our neutral strategy with our stock, bond, and cash allocation. We remain conservatively invested within your stock allocation. Our tactical move of overweighting value and low volatility stocks has helped outperformance in the quarter. Our value holdings were up 13.6% and low volatility added 10.5% during the last three months. Both outpaced the S&P 500 this quarter and for the entire year.

Following our December Investment Committee Meeting, we refined our checklist of indicators we are looking for to shift away from our conservative stock allocation to one that should perform well in a stock market recovery. Our strategy to shed large cap low volatility stocks in favor of small-cap stocks will be our first tactical move. Small caps have performed extremely well in the first year of a new bull market. The only periods where small caps did not outperform large cap stocks were 1998 and 2018, when technology stocks had massive rallies. Given the correction in the tech sector, it is unlikely to lead the market in this recovery, strengthening our belief this should be a positive tactical move.

Our checklist is more defined but similar to what we wrote last quarter. The first item on our list is to ensure that inflation has peaked. There have been steady signs that inflation is retreating. We also need to see an additional two or more from this list:

Valuations get cheap: We have set a target valuation range based on our expectations for earnings over the next 12 months.
Interest rates start to decline: 10-year bond rates pull back to around 3.25%.
Manufacturing surveys bottom: The ISM survey of manufacturing purchasing managers is one of the best coincident indicators of a bottom in the stock market. When it has reached its lows, stocks have usually seen their market lows within a month or two.
The Fed changes its stance: The Fed is focused on slowing inflation by using restrictive monetary policy. Once the Fed stops raising rates and signals they are confident inflation is no longer a risk, it will be reviewed as a positive for investors.
The economy starts to recover: This is the most unlikely of our indicators in the next year. If the economy bounces back or avoids recession altogether markets should bounce.

Outlook

Looking ahead into the new year, the outlook continues to be complex. The risk of a recession remains elevated with several early recession signals flashing red. While this is concerning, it is not something to panic about with your investments. The markets have priced in a lot of bad news already. The Fed is expected to end its interest hiking cycle in the next six months. This is a positive for investors and is contributing to expected returns looking attractive in the next 12 to 18 months.

Several key indicators are pointing toward a recession looming on the horizon. The Leading Economic Indicators Index has declined for nine consecutive months and is at levels that have preceded recessions in the past. The yield curve is inverted, which is when short-term interest rates (either the three-month T-bills or two-year Treasury rates) are higher than the 10-year Treasury interest rate. An inverted yield curve signals that economic activity is weakening and the Fed will need to cut interest rates to stimulate the economy. This signal has had a good track record, albeit with a lag in predicting recessions. Lastly, banks have tightened lending standards and lending has softened to levels typically seen in the lead-up to an economic contraction. With recession risk increasing, it is likely but not guaranteed that we’ll see a recession in 2023. Expectations are that we’ll see a mild recession because the job market remains strong and there are no systemic risks similar to the Great Financial Crisis in 2008.

The Fed is committed to squashing inflation by increasing short-term interest rates. However, the end of the Fed’s current cycle will likely occur sometime in the first half of 2023. The Fed is expected to moderate from 0.75% and 0.5% increases to smaller 0.25% moves this year as long as the trend of lower inflation continues. The Fed pausing its interest rate increases is a positive because it typically occurs within a few months of bear market bottoms. The market is projecting that May will be the Fed’s final rate increase this cycle with rates peaking around 5% to 5.25%

Despite the information above, expected returns for stocks, bonds, and cash are all positive over the next few years. This is the first time at year end we have written this since the early 2010s. This is largely because of the pullback in stocks and bonds this year and interest rates resetting to higher levels. We anticipate that the first half of the year will be volatile and we could retest the market lows in stocks seen in mid-October. The news flow is worsening with job cuts and companies reducing their earnings estimates. Markets typically start to rally two to six months before the economy reaches its bottom. We are optimistic that in 12 months, we’ll be discussing the start of a new bull market. We need to remain patient and not make any drastic changes. We are closer to the end of this bear market than the beginning.

US Market Viewpoints - Q4 2022

Investment Strategy

Outlook