When the chapters of history are written, 2022 may be viewed as one of the most pivotal years in modern financial times. You and I witnessed firsthand the repercussions of a grand economic experiment conducted over the past 20 years. Interest rates across the US (and the world) had been kept at artificially low levels for extraordinarily long periods of time and the added glut of massive government spending produced a highly flammable monetary concoction.
For the past decade, this concoction was received with glee. Investors cheered that asset prices (stocks, real estate, land, etc.) were ballooning to all time levels. But, underneath the surface lurked an inflationary iceberg.
The Federal Reserve came face to face with the iceberg in 2022 and were forced to make significant evasive maneuvers to avoid economic calamity.
In previous communications, we’ve talked about how markets reacted violently to these evasive maneuvers (i.e. interest rate hikes), resulting in significant declines in stocks, bonds, real estate, and other assets last year.
So, what’s next? Are we headed for a recession? A depression? Will it take years to recover investment losses? Here are three important considerations to help you evaluate these questions clearly and logically.
1) Historical Returns
Since 1928, the return of the S&P 500 has averaged approximately 10% per year. Many people are familiar with that statement, but few have a historical perspective on how it occurs. I even chuckle at times when top analysts at major Wall Street firms write long and thorough commentaries, only to end by predicting, for example, a positive return in the stock market of 8-10%.
Would it surprise you if I said that based on history, your odds of achieving an 8-10% return in a calendar year are only 1%? Look below. Here is a chart showing every calendar year return of the S&P 500 since 1928 (the past 95 years). What’s striking is that you can easily see that a calendar year return of 8-10% almost never happens! In fact, only one calendar year in the past 95 years has the S&P 500 returned between 8-10% (see chart). Now, granted, there have been a few other close years, but you get my point. So why should anyone ever expect annual market returns to be in this range?
Here’s another interesting observation over the past 95 years: Nearly 36% of the time the market has had a calendar return greater than 20%, yet only 16% of the time it has returned between 0-10%.
The conclusion? Price swings substantially. Large swings in calendar year returns are not out of the ordinary. In fact, they are the norm, so don’t be alarmed over a -18% year such as 2022, and don’t be over-exuberant the next time markets are up over 20% in the future.
2) Sentiment
Sentiment is just a fancy word for emotion, and it serves as a contrarian indicator. It represents the collective expectations of the investing public about what the market will do in the future. One common sentiment indicator which you can follow is the weekly AAII Investor Survey. Remarkably, most times respondents feel the worst (bearish), are near lows in the market. Why is that? Because I believe . . .
Price determines sentiment, not the other way around.
I believe price is the head, sentiment is the tail. Fear increases after watching price decline… and candidly, it’s irrational.
Why is it irrational? Here’s a simple analogy. Suppose you’re climbing a ladder. As you climb higher, your risk of severe injury increases. Conversely, as you descend risk decreases. Stocks are very similar. Risk of future loss builds as the market goes higher, while risk of future loss decreases as markets fall.
Based on multiple indicators, sentiment is currently very low which is a great environment for market recoveries to be born.
3) Trend
Ultimately, any company’s stock price is determined by fundamentals (i.e. the overall business health, growth prospects, and proper management of a company). Yet, every investor should also pay attention to trends in price movement, which is remarkably helpful when evaluating future direction.
The overall market (as defined by the S&P 500) has been in a pronounced and defined downtrend since the beginning of 2022. It was formed over the past 12 months and as you can see is quite clear. Yet look at what’s happened over the past couple weeks. There has been a clear breakthrough above this trendline.
I’ve learned through experience that any time a long term trendline is broken, you need to pay attention.
This could prove to be the first innings of a shift in trend. Remember, price moves before sentiment. There’s an old saying on Wall Street, “bull markets climb a wall of worry.” Investors who wait for “evidence” the coast is clear before investing are usually very late to the party.
Summary
While no one can predict the future, here is a summary of our 2023 view:
- Inflation peaked in 2022 (see our July insights article).
- The market lows in October 2022 were likely the lows of this bear market.
- The economy has shown resilience and may avoid a recession. If we have a recession, it should be mild and short.
- The bond market is predicting the Fed will pause rate hikes sooner than the Fed currently forecasts. History suggests the bond market is very good at predicting outcomes.
- Investor positioning is very defensive and may catch people flat footed if stocks rally sharply.
- Ultimately, we think there are a lot of reasons to believe equities can have a strong positive year.
In closing, I’ll remind you of this. Your investment success is not determined by yearly performance. Chapters of your life do not start and stop on 1/1 and 12/31. You must look through a longer lens, one that aligns with specific seasons of your life, not the calendar. Stocks, bonds, and other investment vehicles are nothing more than tools used to accomplish a financial purpose. I encourage you to allocate your time and energy towards defining and fulfilling that purpose, not the shifting crosscurrents of the investment markets.