The S&P 500 lost 19.4% in 2022, marking the worst year since 2008 and the fourth worst since World War II (behind 1974, 2002, and 2008). The big loser was the NASDAQ, which fell more than 30% thanks to large-cap tech and growth names lagging the overall market significantly. On the flipside, the Dow was down a relatively low 9%, as energy, health care, and staples performed much better. If anything, 2022 reminded investors not to chase leaders or hyped-up products, as money flows to different groups each year and going all in on leading stocks can lead to disappointing results.
- 2022 was a poor year for investors, as both stocks and bonds generated historically low returns.
- We anticipate higher returns for both stocks and bonds in 2023, as the economy remains stronger than expected and inflation may fall quickly.
- There can always be surprises, but those could include good news and better performance in 2023.
As we noted last year, it is quite rare for stocks to fall two years in a row. This happened only during the vicious recession of 1973/1974 and then three years in a row during the tech bubble implosion of the early 2000s. Fortunately, we don’t see similar scenarios in the current environment, so the odds favor a snapback in 2023.
As the table below shows, since 1950 the S&P 500 has been up 80% of the time following a down year, generating 15.0% on average. It gets interesting when the index is down more than 10%. The following year has been up 63.6% of the time for an average of only 8.5%. Lastly, it has been down 20% or more only three times, and those have been followed by positive years averaging 27%.
Will inflation stay high forever?
Despite investors’ concerns, the economy is expected to remain strong in the coming year due to easing inflation and rising incomes. Real personal consumption and real personal incomes have both increased in recent months. Consumption has been supported by rebounding vehicle sales, and rising incomes have provided consumers more disposable income.
The Federal Reserve has also acknowledged the deceleration in rent prices and used cars, which make up a significant portion of the core inflation basket. However, the Fed remains concerned about services inflation, particularly in categories such as medical care, insurance, and education, which make up about half of core inflation. This is due to the belief that these costs will ultimately depend on the labor market and wage growth. While wage growth has accelerated in recent months, the Fed remains concerned about its potential impact on inflation and the risk of overtightening and pushing the economy into a recession. The base case is that the economy is strong enough to handle the aggressive rate hikes for now, with the Fed expected to slow the pace of rate increases, which will allow more time for inflation to ease.
Why would I want to hold bonds?
Bonds are coming off their worst year ever (as measured by the U.S. Aggregate bond fund), having fallen approximately 13%. To put things in perspective, the previous worst year ever was a 3% loss in 1994. Adding insult to injury, bonds also fell two years in a row for the first time ever.
Why did bonds do so poorly? Bonds don’t respond well to inflation and higher rates, especially when they come as a big surprise. In September 2021, the Fed was only looking for one 25 basis point hike (0.25%) in all of 2022, so its unexpectedly aggressive rate-hike policy greatly hurt bonds.
The good news is higher inflation and potential future rate hikes are now expected. Should inflation fall more in 2023 than anticipated, the Fed might not be as hawkish (aggressive) as many expect. Bonds could gain 3-5% in such a scenario or return to more normal returns.
Bonds zig when stocks zag, historically. Some of the worst years for stocks were some of the best for bonds. In 2002 and 2008, stocks fell more than 20% but Treasury bonds gained double digits. We believe 2022 was an anomaly and expect this more normal pattern to return.
However, although bonds may offer gains this year, we are overweight stocks relative to bonds and expect stocks to perform better.
Lastly, we’ll leave you with this thought. Only twice in the past 50 years — 1994 and 2018 — did both stocks and bonds fall during the same year, according to data from The New York University. 2022 was the third time. But during the following years, stocks gained 34% (1995) and 29% (2019). It’s a small sample size and different environments, no doubt, but it’s a fact worth knowing.
Isn’t a recession a near certainty?
One of the biggest surprises of 2022 has to be the strength of the consumer. The consumer makes up close to 70% of the economy, so it’s hard to have a recession with a strong consumer.
We expect consumption will continue to be strong in the coming year due to a combination of easing inflation and rising incomes. This is supported by the fact that real personal consumption, which adjusts for price changes, has been increasing and is being driven by strong service consumption. Real personal incomes, which also adjust for price changes, have also increased over the past five months. This is allowing consumers to have more disposable income, and they are taking advantage of it. The fact that consumption makes up a significant portion of the economy and that consumers still have excess savings from the pandemic also suggest the economy is not close to a recession.
What could be the biggest surprise in 2023?
The truth is a lot of investors are hurt and scared. This makes sense after one of the worst years ever for well-diversified portfolios. Nearly everyone is expecting another rough year and particularly a weak first half.
One of the biggest surprises could be that we finally start to get some good news. Should inflation come back quickly, as we expect, the Fed may stop its historically aggressive hiking stance. Other potential positives are a weaker U.S. dollar, which helps multi-national companies’ profits, China reopening to stimulate the global economy, a breakthrough in the Ukrainian war, or continued supply chain improvements. All those factors were headwinds in 2022 and contributed significantly to the poor performance of stocks and bonds. Potential worries are always out there, and we aren’t ignoring them, but investors need to know how rare 2022 was and should not necessarily expect it to happen again.
We’ll leave with this chart. It turns out that the second year of a new president’s term is quite weak historically for stocks, which sure played out in 2022. But the third year of a new president’s term is historically the best scenario for stocks, as the S&P 500 is up more than 20% on average. We wouldn’t give up all hope just yet on 2023, as the stage could be set for much better times.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly-traded companies from most sectors in the global economy, the major exception being financial services.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
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