Fourth Quarter 2022 Market Commentary

Happy New Year!

The stock market ended a difficult 2022 on a negative note, as the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite all closed lower on the last day of the year. This marked the end of the worst year for stocks since 2008, with all three major indices suffering their worst year since 2008, and ending a three-year winning streak. The Dow fared the best, down 8.8%, while the S&P 500 dropped 19.4% and the Nasdaq tumbled 33.1%. Factors such as “sticky” inflation, aggressive rate hikes from the Federal Reserve, and geopolitical concerns weighed on investor sentiment throughout the year.

2022 was a difficult year for both professional and individual investors in the economy and financial markets, as there were few safe places to invest, aside from cash, energy stocks, and certain commodities. This was due to the long-term effects of quantitative easing, a central banking strategy that led to inflation in financial assets and a preference for financiers over savers. The Federal Reserve attempted to combat inflation by raising interest rates, which resulted in a significant re-rating of stocks and a potential recession in 2023. However, there were also opportunities amidst the challenges. Supply chains improved, COVID-19 cases declined in the United States, and prices for key raw materials fell sharply from their post-war highs.

While inflation was the biggest story of 2022, there are significant signs that it may be cooling.  The US Consumer Price Index (CPI) fell 0.1% in December, meeting expectations, for the biggest drop since April 2020. One of the most notable trends in 2022 was the sudden shift in prices for key inputs like gasoline, crude oil, and wheat. These commodities all saw prices surge by at least 50% in the first half of the year, only to decline by at least 36% in the second half. This trend, known as a “roundtrip,” suggests that prices may continue to fall in 2023.

The December employment report showed strong but slowing job growth, with 223,000 jobs added and the unemployment rate falling to 3.469%. This is a positive sign for the labor market, but the pace of job creation is expected to slow in the coming months. Additionally, the report showed a greater-than-expected slowdown in wage gains, with average hourly wages increasing 4.6% on an annual basis, which is less than the 5% economists expected. The report sparked a stock market rally to start the new year, and encouraged investors who hope slower wage inflation means the Federal Reserve will not have to continue raising interest rates. Economists disagree, however, on whether this will lead to a soft landing for the economy, with some warning of a potential shallow recession.

This debate over tight labor markets and other “stickier” components of inflation may lead to long-term interest rates remaining elevated for longer than the market would like. The transition from quantitative easing to quantitative tightening is expected to have a significant impact on monetary policy and business models. Companies that can increase cash flows organically are expected to fare better in this new era. The Fed is not likely to pivot to easier monetary policy until the labor market cools, and interest rates are positive in real terms. Investors should be patient, and remember that during a previous market downturn, there were several counter-trend rallies.

As we look ahead to 2023, it is important to prepare for the possibility of a sideways, volatile market. While no one can predict the future with certainty, there are several factors that may contribute to choppiness in the coming year.

One of the major risks on the horizon is the potential for declining earnings. With estimates coming down and an increasing number of companies seeing earnings downgrades, there is a growing consensus that earnings have peaked. This could be a temporary slowdown within a broader earnings growth cycle, as has happened in the past. However, there is one key indicator that suggests this slowdown may be more significant – the yield curve.

Normally, the yield curve is upward sloping, with higher yields for longer-term bonds and lower yields for shorter-term bonds. However, in the lead-up to a recession, this relationship often flips, with short-term rates higher than long-term rates. This is known as an “inverted” yield curve, and it is often seen as a sign of a coming recession. The yield curve is currently inverted to a degree that has not been seen since the early 1980s. While it is possible to try to explain away this signal, it is worth noting that it is now inverted, regardless of how you slice or define the yield curve.

If a recession does occur, it could lead to a prolonged period of declining earnings. Historically, stock prices have bottomed out well ahead of earnings, with a recovery starting around two quarters before earnings begin to recover. However, if an earnings decline persists throughout 2023, it could mean that the bear market will also stick around through the end of 2023, and the recent low in October will not end up holding as the low point for this bear market.

Another risk that could contribute to market choppiness is the potential for the Federal Reserve to stay the course with interest rate increases. Currently, the market is expecting the Fed to raise the federal funds rate to around 5%, and then start cutting rates almost immediately, bringing them down to around 3% in 2024. Fed Chairman Powell has indicated, however, that the Fed may stay in the restrictive zone for some time, and the Fed’s recent “dot plot” shows that most FOMC members expect to maintain a relatively high interest rate environment in the coming years.

Higher interest rates can make it more difficult for companies to borrow and invest, which can slow down economic growth and lead to lower earnings. Additionally, higher interest rates can make bonds more attractive to investors, leading to outflows from equities and putting downward pressure on stock prices.

While these risks may seem daunting, it is important to remember that the market has faced challenges in the past and has always found a way to recover. First and foremost, it is important to remember that much of the bad news is already priced into the market. While there may be more negative developments to come, it can be argued that the market has already factored in many of the worst-case scenarios.

Additionally, there are opportunities to be found, even in a choppy market.  When it comes to bear markets, everything tends to go bad all at once. We have seen this in the current market, with all sectors, both large- and small-cap stocks, and both domestic and international indexes suffering similarly. This means that there are opportunities to be found across the board, and not just in one specific area.

With interest rates higher than they were a year ago, bonds may provide better support to investors’ portfolios in 2023 than they did in the past year. Additionally, quality companies that can survive a recession, and even thrive by extending their competitive advantages, may be a good investment opportunity. Value stocks, which have historically performed well during rising rates or falling markets, may also be worth considering.

The heavy sell-off in technology stocks over the past year has created a buying opportunity for those willing to take a long-term view. The digital transformation of businesses is still in its early stages, and technology companies that are at the forefront of this trend will be well-positioned for future growth.

Small-cap stocks also present an interesting opportunity for investors. These stocks are often hit hard during economic downturns, but for patient investors, small-cap stocks can provide strong returns as the economy recovers.  Currently, small caps look pretty cheap, selling at an average price to earnings ratio (P/E) of 12.5x, offering solid long-term potential.

Some of the important technical indicators that we incorporate into our investment strategies are also providing reason for optimism as we begin 2023.  Specifically, money flow analysis – which measures stock price action on a volume-weighted basis – has been trending in a positive manner since June of last year.  Divergences in money flow trends can help identify major turning points in markets, and have been historically reliable as a leading indicator.  Thus, while price trends have yet to turn positive, there are signals below the surface that suggest a more favorable environment for investors ahead.

As always, we will continue to focus on our long-term investment strategy, and will not be swayed by short-term market fluctuations. We are confident that by staying disciplined and remaining patient, we will be able to identify and capitalize on opportunities as they arise.  We strongly encourage you to take advantage of all the capabilities that our firm brings to bear, which will help you to live with increased financial confidence.

Please feel free to reach out to us to review your personal situation, so we can ensure that we have built your portfolio to accommodate your various needs, and address any concerns that you may have.  We appreciate the opportunity to serve you, and appreciate the trust and confidence that you have placed in our firm.

Scott A. Goginsky, CFA®
Partner, Research Analyst, Portfolio Manager


Sources: Index returns, CPI, Employment report – CNBC; 2023 outlook – Fidelity; Commodity prices – FSI Insight; Bear markets – WSJ; P/E ratio – Bloomberg

The information set forth regarding investments was obtained from sources that we believe reliable but we do not guarantee its accuracy or completeness. Neither the information nor opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Past performance does not guarantee future results.