2022 will go down as one of the worst years on record for the capital markets. The S&P 500 stock index fell 19.6% and the NASDAQ stock index dropped 33.5%. While the stock market has suffered worse annual returns, the -13.8% total return for the US Corporate/Government Bond Index was the worst in US history. In fact, the year just ended marked the first time the S&P 500 and the 10-year Treasury note both lost more than -10% on a total return basis for a full calendar year since 1872.
The highly inflationary, unprecedented monetary and fiscal stimulus in response to the Covid-induced economic shutdown led to central banks around the world dramatically increasing interest rates in 2022. Exactly one year ago, the federal funds rate was 0%. Since March 2022, the Fed has hiked interest rates a total of seven times. And there are likely a few more hikes on the horizon. But we are much closer to the end than the beginning.
Equity market performance was driven by valuation compression as bond yields adjusted sharply higher in response to tight monetary policy by the Fed and other central banks. The price/earnings ratio of the stock market peaked at 22x at the January 3 high and fell to a low of 15x at the October 12 low. Quality was a differentiator as stocks rated B+ or better fell 11.3% while lower rated stocks declined 27.7%. The year also saw massive outperformance of value stocks over growth stocks, and defensive equities over cyclical stocks. (Our recent podcasts have focused on the importance of buying quality companies with growing earnings and dividends at attractive valuations). Energy was the only sector to avoid negative returns as those stocks behaved as if there was no bear market at all, rising an incredible 59%.
Corporate earnings and dividends actually grew nicely last year. Companies in 2022 increased sale prices to offset higher costs for everything from freight to wages to raw materials such as lumber and steel. Net profit margins at S&P 500 companies hit 11.6% during the third quarter of 2022, down from 12.7% the same period a year earlier but still higher than the same period in 2020 and before the pandemic.
The key economic question for 2023 is whether central banks will be able to bring down inflation to acceptable levels without a recession. Last December the median forecast by Fed officials for the fed funds rate in 2022 was 0.75%-1%. In March it was 1.75%-2.0%, then 3.25%-3.5% in June, 4.25%-4.5% in September, and now it’s 5.0%-5.25% for 2023. The trend underscores how badly the Fed misjudged inflation and the actions required to break it. The most significant reason for economic growth to weaken is that the full effects of the substantial monetary tightening over the past ten months have yet to be felt. The main focal points for 2023 will be the Fed (and the recession question) and corporate earnings. The Fed’s median forecast for economic growth for both this year and in 2023 is a mere 0.5%. But corporate CEOs are nearly unanimous in anticipating a recession this year. One area of economic strength remains the job market. On Friday, the Labor Department reported that the headline unemployment rate dropped to a 50-year low and that nonfarm payrolls grew more than expected. Despite some well-publicized layoffs in the tech sector, there are still 1.7 job openings for every unemployed person.
The bottom line is that while stocks suffered last year from higher interest rates, the greatest potential headwind in 2023 could be lower profits. The consensus of analysts is for operating earnings of the S&P 500 companies to grow 3.2% in 2023 and another 10.2% in 2024. However, those estimates have been trending downward for several months. The fourth quarter earnings announcements, which will begin in the next couple of weeks, and the accompanying management guidance for 2023 will be very significant.
It is important to note that the stock market is a leading indicator, and the sharp decline in 2022 may have already discounted much of the potential negative earnings news. We may see a recession next year, we will certainly see more fluctuation in share prices day in, day out, and the financial press will continue to think that these entirely normal market fluctuations are ‘news.’ But if history is any indication, patience in the markets, and a strong stomach for bumps in the roller coaster, will be rewarded in the end.
There will always be another concern to focus on in the market (as we pointed out in the last market update letter). There are always potential risks to the economy, stock market, etc. But we have 122+ years of market data that suggests stocks provide value to investors over the long-term. Stock prices go up, and down, and up, and down more or less at random (in the short term) and consistently show incremental gains (in the longer term). Over time, the price of companies’ stocks will increase as the efforts of all the people who go to work in the offices (or, lately, in their homes) of all the publicly-traded companies will lead to consistently increasing long-term values. Eventually, problems get solved, consumers and businesses adapt, the incentives of capitalism will win, and, probabilistically, shareholders will be rewarded.
All of us at LVM wish you a happy, healthy and prosperous New Year!
2023 marks LVM Capital’s 35th anniversary and the 25th anniversary of opening our Naples, FL office. We will be celebrating these milestones in Naples on Wednesday, March 22 and in Kalamazoo on Thursday, June 29. Please save these dates and plan to join us.