A funny thing happened on the way to the recession – the stock market rebounded. There was no shortage of depressing economic news during the fourth quarter of 2022. Predictions of a recession were ubiquitous, inflation remained elevated, the Federal Reserve was aggressively raising interest rates, financial experts were warning of tough times ahead, and control within the government remained uncertain as mid-term elections came and went. Yet, all the major stock indices generated their best quarter of 2022 in the fraught-filled final three months of the year. With the NASDAQ being the only exception (-.78%), stock indices produced solid gains in the fourth quarter. International stocks “sprang” back with a quarterly return of 17.40%. The Dow Jones Industrial Average (The Dow) was almost equally as impressive with a total return of 16.01%. The S&P 500 (7.55%) and Russell 2000 Small Cap Index (6.20%) participated nicely as well.
Even with the fourth quarter rebound, stock indices recorded their first negative yearly return since 2018. However, this was not unexpected. Previous D’Arcy Capital Market Perspectives had identified the increasing risk in large-cap technology stocks. This risk materialized in the collapsing value of technology companies in 2022. This is most evident in the NASDAQ index that ended the year with a twelve-month loss of 32.15%. Small Cap stocks (Russell 2000) and the S&P 500 closed-out 2022 with 20.46% and 18.13% declines respectively. The Dow offered a smidgen of defense, as the 30-stock benchmark only declined 6.86% for the entire year.
Bonds only added to the negative year as the most popular benchmark (Bloomberg US Aggregate Bond Index) lost 13.02% in 2022. Rising inflation and increasing interest rates clobbered bond prices for most of the year. The usual ballast provided by fixed income did not exist in 2022 and there were few places investors could hide. Even investors holding cash saw significant purchasing power declines as inflation ended the year 6.5% higher when compared to 2021.
The lesson from the fourth quarter is clear. The stock market is a leading indicator and not a current indicator. The stock market is a present value calculation of future revenues. Analysts are pricing stocks based on the anticipated environment 12 to 18 months in the future. For the investors who sold stock or remained in cash because of all the uncertainty listed in the first paragraph got left behind. The fourth quarter of 2022 is the best example, in a long time, of how difficult it can be to “time” the stock market. It also quantifies how expensive it can become when the timing is just a little off.
By the end of 2021 many investors were convinced that investing was simple. Just invest in a fund that replicated the S&P 500 Stock Index and everything would be fine. This is because during the previous 10 years (December 31, 2011 to December 31, 2021) the S&P 500 had an annualized return of 16.52%. A great outcome for any investor. However, this conditioning of behavior left investors complacent and over concentrated entering 2022. The last twelve months have been a “wake up call” for individuals to revisit their investment choices. In 2023, and beyond, the outperforming asset classes remain unclear for now. However, it is unlikely to be the same group of stock as the previous ten years. Investors should enter 2023 fully diversified with exposure to many different asset classes. This approach will allow investors to participate regardless of which sectors appreciate first.
D’Arcy Capital continues to favor value stocks over growth stocks and believes high potential opportunities exist in international financial markets (both developed and emerging). Active portfolio management also appears more capable of navigating the current economic environment than passive portfolio management. For more targeted opportunities, D’Arcy Capital likes biotechnology stocks as the massive injection of capital during the Covid pandemic should begin to materialize in commercially viable pharmaceutical solutions. For conservative investors, U.S. T-Bills have become a “no brainer” as these highly secure, short-term securities are yielding in excess of 4%. For investors in high tax brackets, municipal bonds remain a competitive alternative as rates continue to increase. Savers who prefer to remain in “cash” should consider short-term money market solutions such as T-bills now that yields exceed 4%.
Investors should not be focused on the recession probabilities of 2023, the timing of the cessation of FOMC rate hikes, or current inflation levels. Investors should try to anticipate what the economy will be like in 2024 and make allocations accordingly, because this is what stock markets are already doing.