By Eric Parnell, CFA on January 5, 2023 What begins as tragedy . . . Whereof what’s past is prologue; What to come, In yours and my discharge Antonio, The Tempest, William Shakespeare, c. 1610-11 We are currently in the midst of a storm across financial markets. Global stocks remain mired in a bear market, and bonds failed to ballast investor portfolios by falling sharply in their own right over the past year. Even precious metals provided middling returns at best that came with a healthy dose of volatility in 2022. While the investment climate is likely to remain unsettled as we enter 2023, opportunities across the broad asset class spectrum may increasingly improve over the course of the coming year. And all that has taken place across capital markets over the past several decades leading up to today, provides investors with valuable insights in preparing how to capitalize on attractive opportunities in the year ahead. The Tempest Stocks remain at the heart of the investment market storm. After peaking at the very beginning of the year on January 4, U.S. stocks, as measured by the S&P 500 Index, began their descent. And over the course of the next twelve months, the S&P 500 officially entered into bear market territory that has included a peak-to-trough decline of as much as -27% along the way. While the stock market decline that started in 2022 has been gut wrenching for many investors, a few positives can be taken away from the experience thus far. First, the decline in stocks has been orderly so far, thus showing that financial markets have much greater resilience today than had been expected by many policy makers that previously felt compelled to intervene aggressively with stimulus during the post Great Financial Crisis period in order to stave off any potential financial instability. Next, technical analysis has proven highly predictive so far in identifying inflection points both in upside and downside stock market moves. Not only has the S&P 500 responded accordingly by falling back at key moving average resistance levels throughout 2022, it also failed on four separate and generally evenly spaced attempts to break out above its downward sloping trendline resistance. Conversely, the S&P 500 bounced strongly on several separate occasions upon arriving at trendline support. Such consistent and predictable market behavior is constructive from a technical analysis perspective, as it provides investors with reliable markers of when they should expect bottoms on short-term pullbacks and tops on short-term rallies. Lastly, if the recent trend patterns throughout 2022 persist into early 2023, this implies a baseline expectation of a drop in the S&P 500 into the 3300 to 3400 range by February followed by a subsequent bounce toward 3800 by April ceteris paribus. Of course, we know all too well that not all else is equal at any given point in time, but at least we have baseline targets to consider in the early months of 2023. But why should we expect the U.S. stock market to continue lower in this downward sloping trend channel in the near-term? What’s to say that the stock market couldn’t find its footing and breakout to the upside. This is certainly a possible outcome, but a key looming force is standing in the way of a stock market reversal at least in the early part of 2023. Recession Ahead After notching two consecutive negative quarters of real GDP in the first half of 2022, which to some is the technical definition of a recession, the U.S. economy returned to positive economic growth in 2022 Q3. And while the current quarter is not yet officially in the books, U.S. economic growth is projected to come in at a more than respectable 3.7% in 2022 Q4 according to the latest Atlanta Fed GDPNow forecast. This suggests that the economic outlook may be advancing in the right direction as we enter 2023. Unfortunately, a number of key economic indicators are signaling that an economic recession may lie ahead in the upcoming calendar year. The first is the yield curve, which historically has had a strong ability to predict future recessions. Such prescience takes place when the U.S. Treasury yield curve becomes inverted. This is when the interest paid to investors from short-term bonds, say a 3-month T-Bill or a 2-Year U.S. Treasury, exceeds the interest from their longer duration counterparts such as the 10-Year or 30-Year Treasury bond. Why would an investor be willing to accept a lower interest rate at some point in the future when they could receive a higher interest rate on a Treasury maturing sooner? Because investors believe short-term interest rates may soon start coming down, so they want to lock in the longer term rate now to mitigate their reinvestment risk. And what would cause short-term interest rates to come down? An economic recession that induces the Fed to cut interest rates. How effective has the inverted yield curve been in predicting future recessions. Consider the chart below that shows the 10-Year U.S. Treasury yield minus the Federal Funds Effective Rate or its equivalent dating back to just after the advent of the U.S. Federal Reserve in 1915. While various other yield curve spreads have been negative for some time, this reading finally turned negative in December. And in 13 out of the last 14 instances when this inversion occurred, the U.S. economy subsequently fell into recession. The only exception was in 1998, when the near collapse of Long-Term Capital Management induced the Fed to inject emergency stimulus and helped fuel the final phase of the tech bubble to close out the millennium. In this case, it could be argued that this inversion reading was not necessarily wrong in predicting a recession, but instead postponed for what eventually unfolded starting in 2000. Another indicator signaling a looming potential economic contraction is bank lending activity. After having become increasingly loose with their lending activity once all of the Covid-induced liquidity was injected into the marketplace, banks have tightened lending activity sharply in 2022. For example, roughly 40% of banks reported tightening lending activity to large and mid-sized firms in 2022 Q3. Put simply, if banks are increasingly curtailing lending activity to firms that wish to borrow money to finance capital expenditures and fixed investment, this will have a measurable slowing effect on economic activity. A third signal of mounting economic pressures ahead is high yield spreads relative to U.S. Treasuries. More specifically, the lowest rung of credit quality among CCC-rated bonds and below. As economic weakness accumulates, investors are increasingly less willing to take on the risk of lending money to those firms that are likely to struggle most during an outright recession. As a result, CCC and lower spreads start to steadily widen before the recession finally arrives. And this has been the case dating back to mid-2021, as CCC and lower spreads have been steadily rising for nearly 18 months now. The only time similarly widening spreads did not ultimately lead to an economic recession was in 2016 when the saving grace was the Federal Reserve abandoning their planned interest rate hikes in support of the economy. Steadfast Fed This leads to a key question. For more than 35 years, the U.S. Federal Reserve has intervened swiftly with monetary policy support for the economy and financial markets. Could we reasonably expect the Fed to do the same again, leading to a 1998 or 2016 type scenario? Despite the repeated hopes in 2022 that the Fed would relent with hiking interest rates and instead turn to cutting rates to stave off an economic recession, the Fed is unlikely to reverse course and start lowering interest rates any time soon. Past is prologue, and the U.S. Federal Reserve continues to apply the lessons from its economic past to address the persistently high inflation battle that it continues to fight today. And if history is any guide, the Fed has to see monetary conditions tighten considerably further from where they are now to fully extinguish the current inflation problem, and then has to keep conditions tight for a period afterwards to make sure that pricing pressure embers do not reignite. In the chart below, this would be implied by a Fed Funds rate that is measurably higher than the inflation rate, which is far from where we are today. Why would monetary policy need to remain relatively tight even after inflationary pressures have largely abated? Let’s consider the lessons of the 1970s and early 1980s as shown in the chart above. During this time period, policy makers were battling a growing inflation problem. But when the economy fell into recession and pricing pressures eased, the Fed would abandon their focus on inflation and slash interest rates to battle economic weakness. And in the aftermath of the 1969-1970, 1973-1975 and 1980 recessions, inflationary flames came back to life even bigger than they had been previously. By the early 1980s, the U.S. Federal Reserve under the leadership of Paul Volcker finally learned its lesson and kept interest rates high to completely eliminate the inflation problem despite underlying economic weakness. This monetary policy discipline helped set the stage for the Great Moderation of steadily easing inflation pressures that continued over the next four decades, and today’s Fed is keenly aware of these past mistakes. And if one operates under the premise that price is truth and considers what the market is predicting for the future path of interest rates over the coming year, we see that another 50 bps of rate hikes is expected through early 2023 before the Fed brings their relatively short but aggressive rate hiking cycle to an end and keeps interest rates at this high level through much of the next year. It’s not until the very end of 2023 when the market is starting to consider the possibility of Fed rate hikes, and the baseline forecast would only bring the Fed Funds rate back down to where it is now. Hardly stimulative to say the least. Premium Valuations The good news is that stock valuations have become measurably more reasonable during the current bear market. The only problem is that at 20 times trailing 12-month earnings on the S&P 500, valuations are still trading at a roughly 20% premium versus their long-term historical average. Historically, stocks have ultimately traded at a historical discount during economic recessions, and we remain far from any such discounted levels today. Adding to the valuation challenges confronting stocks today, corporate earnings on the S&P 500 Index continue to hover at the high end of their long-term historical range. During periods of economic recession, corporate earnings also typically recede at a much higher rate than the overall economy. And if history is any guide, it would not be unreasonable to see corporate earnings fall from its current level of over $190 per share on the S&P 500 to as low as $110 to $120 per share. Such a decline in corporate earnings would be problematic for the stock market in the short-term for the following reason. Stock valuations are often measured by the price-to-earnings, or P/E ratio. If we enter into a situation where corporate earnings start to contract (the denominator “E” in the P/E ratio), this means that the P/E ratio on the S&P 500 could meaningfully expand even if broader market stock prices continue to fall. In other words, if the “E” in the P/E ratio starts falling faster than the “P” or price, then stocks could conceivably be falling, but becoming more expensive from a valuation perspective. Weathering the Storm Such are the challenges confronting capital market investors as we enter 2023. The U.S. stock market remains mired in a bear market as the threat of an economic recession looms in 2023 with a U.S. Federal Reserve that will likely be limited in its scale of support for the economy due to its still raging inflation battle at a time when valuations are already at a premium and corporate earnings are running at the high end of their range. While this broader reality may sound troubling as we enter the New Year, it remains as important as ever to remember two things. First, just like storms, bear markets eventually come to an end. Second, that capital markets are almost always filled with attractive total return opportunities even if the broader market indices are out of favor. …evolves into comedy. Be not afeared. The isle is full of noises, Sounds, and sweet airs, that give delight, and hurt not. Sometimes a thousand twangling instruments Will hum about mine ears, and sometime voices, That if I then had waked after a long sleep Will make me sleep again; and then in dreaming The clouds methought would open and show riches Ready to drop upon me, that when I waked I cried to dream again Caliban, The Tempest, William Shakespeare, c. 1610-11 Be Not Afraid Sure, we remain in the midst of a stock bear market. But we are well into the storm and have survived it so far, and eventually it will come to an end. When could we anticipate such a bottom finally taking place? While any number of unexpected developments could meaningfully alter the eventual timeline, it would not be unreasonable to see stocks bottoming by mid-2023 in the 2900 to 3000 range on the S&P 500. By this time, the economy will likely have already descended into the anticipated recession, and inflationary pressures that have already been fading for much of 2022 will likely have subsided or be well on their way toward renewed price stability in the 2% to 3% range as almost continuously projected over the past couple of years by the 5-Year Breakeven Inflation Rate. Higher inflation than before, but arguably healthier for the long-term economic outlook. So although the economy itself may still be struggling a half a year from now under this scenario, financial markets that historically look six to nine months into the future will likely start anticipating the sustained recovery and potentially lower interest rates getting underway potentially by the end of next year and into 2024. Overall, I am much more constructive heading into 2023 than I was entering 2022. Navigating a Market Filled with Noises OK, Parnell. You’re anticipating a potential stock market bottom by mid-2023, so what is an investor to do in these volatile markets in the meantime? Much of the playbook that worked in 2022 still applies as we head into 2023 in my view. Energy Staying with the stock market, let’s begin with the energy sector. If one was a dedicated energy analysts, the natural question would be “what bear market exactly?” Energy stocks have been ripping higher for much of the 2022 calendar year, as the sector, as measured by the Energy Select Sector SPDR (XLE) has gained over +50% in a broader market that is down roughly -20% over the same time period. While oil prices have been declining sharply as of late and a period of consolidation among energy shares certainly should not be ruled out in the short-term to intermediate-term, the fundamental outlook for the sector remains constructive looking out over the next few years for a few key reasons. First, the increasing global shift toward deglobalization and nationalism will make securing one’s own resource supplies more critical in the future. Next, one of the world’s largest suppliers of oil (Russia) has essentially become ring fenced with their invasion of Ukraine, while the geopolitical environment in the Middle East remains unpredictable at best in terms of their relations with the West. Also, while the policy maker determination to shift away from fossil fuels to green energy is certainly well intentioned, the repeated reality is that this transformation is likely to take longer and will proceed in the meantime more gradually than desired politically by some and anticipated by the market, thus requiring energy infrastructure to be maintained and potentially expanded for the foreseeable future. One additional factor favors energy shares going forward. Over the past several decades, the top and bottom of the sector returns performance table has been dominated by two particular sectors – energy and technology. Whenever technology has been leading such as the late 1990s and the late 2010s, energy has typically found itself in the cellar in terms of stock performance. Conversely, when energy has been leading the way such as in the early 1980s, the early to mid-2000s and in the last couple of years, technology has found itself toward the bottom of the sector performance table. Every few years these shifts in leadership take place, and we may very well likely just passed a key inflection point into a new constructive phase of energy leadership going forward. Health Care – Big Pharma Another segment set up well for the coming year is the health care sector in general and big pharmaceutical stocks in particular. Major pharmaceutical companies have performed well relative to the broader market over the past fourteen months since November 2021 having posted a marginally positive return versus the double-digit decline on the S&P 500. Despite this relative outperformance, big pharma stocks continue to represent an attractive value both on an absolute basis and relative to the broader market, as several major names have high single digit to low double digit price-to-earnings ratios. Couple these discounted valuations with attractive growth prospects along with healthy and growing dividend payouts, and the big pharma sector offers much to like looking ahead to 2023. Consumer Staples – Food Consumer staples have provided investors with a favorable defensive allocation during the turbulent markets dating back to late 2021. Overall, the sector has gained over 8% over the past fourteen months during a time when the broader market has fallen by double-digits. Leading the charge to the upside has been the food industry, which has gained over 9%, based on the Invesco Dynamic Food & Beverage ETF (PBJ), over this same time period. Looking ahead, the consumer staples sector in general and the food industry in particular is well positioned to benefit from ongoing trends. First, given the wider economic moats and higher barriers to entry, the consumer staples sector in general and food companies in particular remain better positioned relative to the broader market in their ability to pass along higher prices associated with persistent inflation to consumers. Second, it could be argued that the consumer staples sector had been overlooked in recent years in favor of opportunities in other higher beta market sectors like information technology. As a result, valuations within the consumer staples sector remain historically reasonable, with food stocks in particular continuing to trade at notably deep discounts relative to historical multiples. Lastly, while it has increased somewhat, the weighting of the consumer staples sector in the S&P 500 Index remains very low versus its historical average. Given the discounted valuations in many cases coupled with its defensive demand characteristics suggests the future probability of the consumer staples sector continuing to regress back to its historical index weighting going forward. These are just a few of the numerous attractive opportunities that continue to exist for investors in a broader market that continues to cope with the ongoing downward trend of a bear market that got underway more than a year ago now. Look thou be true; do not give dalliance Too much the rein: the strongest oaths are straw To the fire i’ the blood: be more abstemious Prospero, The Tempest, William Shakespeare, c. 1610-11 Bottom Line While the storm continues to swirl around investment markets as we enter 2023, it is important for investors to keep several points in mind. First, remain committed to your investment philosophy and do not give into the temptation to stray from your discipline just because the market environment has become more turbulent and volatile. Second, remain temperate with any shifts in your portfolio allocations at any given point in time. As I have often said in recent years, it is often best not to make major investment moves when a market hurricane is swirling around you, and this remains true in the current market environment. If your portfolio was not already prepared in advance for the market storm that finally arrived in 2022, it is likely best to stay on course and work to navigate the portfolio waters carefully. If changes are necessary in your portfolio allocation, they are best made gradually and at the margins at any given point in time, particularly if the stock market is in the midst of its next leg lower. Lastly, remain calm and recognize that attractive upside opportunities are likely increasingly on offer the further the market may fall into 2023. One of the most challenging aspects of investing is that the psychology gets turned completely upside down. In most any other realm, falling prices draws enthusiasm and encourages people to buy. After all, who doesn’t like a good sale – Black Friday specials anyone? But when it comes to investing, falling prices induce panic for many and the compulsion to sell. Remember that many bear markets have come and gone over the course of the longer-term uptrend of stock market history, and bear markets provide a healthy cleansing process that ultimately result in more discounted valuations and attractive prices to be found. If you as an investor were waiting for a good sale to buy stocks, more and more bargains may be on their way in 2023.