The year 2022 was notably full of market surprises and volatility. We hope there is less drama in 2023, but there is no guarantee it will be any more predictable. There have been plenty of headlines documenting the issues impacting the global economy (we have also discussed them in our past letters linked here: Q1 2022, Q2 2022, Q3 2022). Our views on these topics have not materially changed, but it’s worth noting that although economic and market cycles are interrelated, they do not necessarily follow the same timeline or cadence.
Looking to the year ahead, we believe there are two important guiding principles to re-emphasize in this quarter’s market commentary: cycles are unavoidable and investment valuations matter.
The S&P 500 was down 18.1% for the year but is up 12% through January 13th from the October low. Time will tell if this rally is sustainable or if a subsequent downturn occurs. Regardless, we see opportunities for investors as valuations have become more attractive.
The following chart shows the valuation of major asset classes expressed relative to their 20-year history. Because different asset classes use different valuation measurements, they are standardized to each measurement’s historical average.
Fixed income and foreign equity valuations are compelling, and for the first time in decades, investors can earn a meaningful yield on safe-haven assets. The following chart shows how much yields have risen across the maturity spectrum for U.S. Treasuries in the past year:
It is uncommon for interest rates to rise as abruptly as they did in 2022, and it is equally uncommon for stocks and bonds to drawdown concurrently. Interest rates impact how both stocks and bonds are valued, and higher rates put pressure on both asset classes.
When the Fed raises the policy rate, it creates a ripple effect for all risk-oriented assets. A business, at its core, is worth the present value of its future cash flows. With each policy hike, the discounted value of those future cash flows is reduced. If the prevailing rate for fixed income increases, larger cash flows will be necessary to justify the current price of common stocks. Treasury yields should therefore be considered the opportunity cost for investing in other risk-oriented assets.
This has a profound impact on asset allocation strategies, especially for goals based investors. For this reason, portfolios are overweight fixed income today for many clients.
Domestic equity valuations broadly contracted throughout 2022, but remain above average. U.S. Large Cap Growth, the most significant component of the S&P 500 Index, as noted in the first chart was almost three standard deviations above its 20-year average entering the year.
Within U.S. Large Caps, value outperformed growth by 21.6% in 2022, the largest margin since the 2001 tech burst, driven almost entirely by losses in the largest growth stocks. Apple, (-26%), Amazon (-50%), Alphabet (-40%), Microsoft (-28%), Facebook/Meta (-64%) and Tesla (-65%) fell by a combined $4.5 trillion last year. Valuations of these growth companies were especially vulnerable to both the shift in Fed monetary policy and market sentiment.
The following chart shows relative forward price-to-earnings ratios for U.S. Large Cap Value vs. Growth since 1997.
When the gray line is below the green dotted line, it indicates that value is inexpensive relative to growth, and vice versa. Although value made a comeback in 2022, it remains more attractive than growth based on long-term averages. Note that the relationship is rarely in balance, and multi-year trends can persist during a market cycle. Today the momentum favors value.
Consequently, we have de-emphasized, or sold out of, passively managed indices in domestic equity that skew towards large cap growth companies. Berkshire Hathaway remains a core holding, complemented by dividend and factor based funds that target profitable companies priced at reasonable valuations – in our judgement, price and profitability are the most important factors for forwards returns today.
Looking at the history of market cycles, equity prices have typically bottomed before the economy. The following chart shows S&P 500 returns following a 25% decline looking out one-, three-, five- & ten-years following the drawdown.
Every single bear market in the history of the U.S. stock market has eventually reached a new all-time high. There are no guarantees in investing, but there are ample reasons for long-term investors to be optimistic about the future from here.
Despite well-documented risks, the case for a globally diversified portfolio remains strong. Foreign equity valuations are not only attractive compared to their historical averages as noted in the earlier chart, but remain well below their historical discount to the U.S., as indicated below.
Valuations abroad have been pessimistic for over a decade. When expectations are historically low, less bad news can move markets forward. This is true for all asset categories but was most relevant for foreign markets in 2022. Developed international equities were down 14.5% for the year, outperforming the U.S. by 3.6%, despite the strong U.S. dollar, war in Ukraine and severe energy crisis across Europe.
Risks of course remain, but low valuations discount these risks and we expect long-term investors will be compensated over time.
Globally, the majority of economists expect a recession both in Europe and the U.S. sometime in 2023. We will not be surprised if they are right. We also won’t be surprised if they are wrong.
We do not forecast macro-economic conditions and do not invest based on those considerations. We do attempt to quantify relative value and tilt portfolios in a manner that we expect to provide superior risk-adjusted returns. Most portfolios today have a defensive posture, and we will be nimble where we see opportunities.
We are grateful for your trust and confidence. Please let us know if you have questions, would like to discuss your financial plan or review your investment portfolio.
The JRM Investment Counsel Team
Jack, Phil and Lauren