A Few Thoughts As We Head Into 2023! by Jack Moller, CFP®

Instead of making predictions – as they tell us more about the prognosticator than the future – I just thought I would share some of my many, perhaps random, thoughts at this time in markets.  At the end, I want to revisit my one prediction from last January’s letter and how it turned out.  (Quite well, actually!)

Closing the Books on 2022 – Investors Say, “Good Riddance”?

• No Place to Hide.  As we all know, last year seemed to be a particularly difficult and painful year in the markets as both stocks and bonds sold off resulting in one of the worst years in history for the classic “60/40” (percentage in stocks/bonds) portfolio.  There are so many different indexes that have been used to represent this strategy that it is difficult to be precise in determining last year’s place in history, but those hanging on know it was one of their more painful years.  It was not much fun.
• Inflation Rears Its Ugly Head.  The big story, of course, was the experience of having long-dormant inflation return with a vengeance to levels not seen since the late 1970s/early 1980s.  The challenging byproduct for investors was the fact that significantly higher inflation levels impact the relationships between stocks and bonds so that they became highly correlated.  When one goes up, so does the other and when one goes down the other does as well.  Unfortunately, it was much more down than up last year.  The positive correlation meant that we were not able to gain a great deal of protection from the diversification into bonds as noted in the first bullet point. 

Different Perspective: Maybe Not So Bad of a Year Afterall

• Great (Valuation) Reset (Part 1).  The extraordinarily low and sometimes negative interest rates of the prior decade-plus time period made it particularly challenging to develop balanced portfolios, as interest income mostly vanished.  It got to the point where the old “risk-free return” short-term bonds began sarcastically being renamed “return-free risk” instruments.  Unfortunately, it particularly hurt retirees as they were forced into riskier investments (high yield bonds, stocks …) to achieve their needed returns.  As investment advisors, we’ve been concerned for years that the need for the extra aggressive positioning was inappropriate for those in their senior years counting on a reliable stream of fixed income.  This past year’s aggressive Fed hiking of rates – with the fed funds rate moving from 0% to today’s ~4.5% - has restored the ability to receive income by investing in bonds, CDs, and even money market funds.  This is a good thing for retirees…as long as inflation eventually cools off. 
• Megacap Valuation Reset (Part 2).  The early Covid pandemic period drove the already successful and highly valued Big Tech(-ish) companies’ valuations into the stratosphere as they were able to thrive during the shutdown that hurt most of the rest of the economy – think Amazon, Netflix, Apple, etc.  Investors greatly valued these growth companies which were expected to generate consistent earnings/cash flow far into the future.  In a world (prior to 2022) where interest income was negligible, these companies’ consistency became very attractive.  However, their market fortunes sharply changed in 2022.  In fact, it reminds me of the oft-quoted Ernest Hemingway statement from his book, The Sun Also Rises about going bankrupt: “Gradually, then suddenly”.   Many of these companies began underperforming earlier in the year before extremely sharp declines in the last quarter for many of them.
• Many investors who had focused on these top Covid-era performers got burned severely last year, including one top, previously-popular, new-technology fund which will remain nameless.  However, for those investors who did not get carried away and maintained diversification across many asset classes and investment approaches, last year’s market decline was much milder. 
• Attractive Valuations. The key is that the decline in both stocks and bonds generally has resulted in much more attractive opportunities as we head into 2023.

 U.S. Stock Dominance to Take a Breather – Baton Passed to International Equities?

• Broken Record?  Okay, I have to admit that we’ve been commenting for quite a while that the shift in leadership into non-U.S. stocks may be taking place and, until very recently, U.S. stocks have always reasserted their leadership role.  But, maybe this is the time.
• Shift in direction for the U.S. dollar.  The dollar began a fairly steady advance against most currencies early in 2021 as the Covid markets began to sort themselves out.  It’s advance accelerated in 2022 on the back of the Fed’s rapid interest rate hikes.  Then, as we hit the fourth quarter and the pace of Fed rate hikes decelerated, the dollar has taken a sharp U-turn lower. I won’t say more than that we are at a possible turning point for long overdue non-U.S. stocks to catch up and possibly outperform.  Mums the word on predictions.

Some Other Bullet Points

While much could be written about each of these, in the interest of keeping you from falling asleep, I will be very brief.

• Recession vs. Soft Landing?  The answer is unknowable at this time but the continuing strength in the labor market leads me to conclude that a severe economic decline of the nature of the Great Financial Crisis is highly unlikely.  Perhaps there is no big difference to the markets as to whether we experience outright recession or just very slow growth.  Time will tell.
• Falling Inflation.  Markets tend to do well when inflation is falling.  Paraphrasing Schwab’s Chief Market Strategist, Liz Ann Sonders: it’s not “good vs. bad” that matters to markets as much as “better vs. worse”.  We might be seeing that play out again as inflation (depending on the index) peaked last summer (even though at still high levels) and since then the various market indexes have done well, albeit with significant volatility. 
• Yield Curve Inversion.  Inversion means that, unlike the normal relationship, yields on shorter-term fixed income securities are higher than longer-term securities as investors expect lower rates in the future.  Currently, the inversion is at its most extreme in over 40 years, dating back to the last major bout with inflation.  This is typically a very reliable harbinger of imminent recession.
• Bubbles Deflated with No Crisis (So Far).  Housing, cryptocurrencies, meme stocks and, to a lesser extent, the aforementioned megacap stocks. This would be an ideal situation for the Fed to be able to remove some speculative fervor from the markets without risking systemic issues. 
• Wind at Our Backs Based on Election Cycles.  Historically, the second year of presidential terms has seen the worst performance while the third year has been the best.  Maybe it will happen again or maybe it will be an exception.
• Power Shift?  With the dearth of workers leaving many job openings, perhaps after many decades, the workers, aka “Main Street” are taking power away from the owners, aka “Wall Street”.  While still at extremes, perhaps wealth inequality will shrink too.  Many tech millionaires and billionaires have seen their assets decline precipitously with the tech sell offs.    

My Prediction – Revisited from Last year

Last year, I wrote:

I’m sure that you are on the edge of your seat waiting to hear …

So here is my prediction:

Those people who:

• Tie their investment strategies to their long-term financial plans - yes
• Own diversified portfolios with specific allocation targets - yes
• Keep costs down - yes
• Don’t panic - yes
• Take advantage of volatility by periodically rebalancing - yes

will do just fine and can enjoy their lives without worrying about the market(yes)! They can turn off the news, get outside, read a good book (yes), or (like me) fret about how well the Bears’ next football coach will do … (not so much) !

Come to think of it, I will make a prediction for 2023 after all … a repeat of last year’s prediction.  However, of course, I have to add that I now predict the Bears make it to the Super Bowl (I’m a contrarian)!