2023 1st Quarter Investment Bulletin
2022: A Reversion to The Mean
Over-valuation in equities a driver for retreating stock prices
Federal Reserve rate hikes a detractor for bond prices
Macroeconomic headwinds abound, but the market and portfolio allocations look to the future
Market Decline: Connecting the dots between Inflation, Rates and the Bear Market
2022 began the year on the heels of three historic years of market expansion from 2019-2021. As stock valuations, predominantly driven by Tech, stretched well past their historical norms, supply chain issues indicated that the global scarcity of materials was driving up the prices for common goods. High inflation triggered the Fed to embark on 7 rate increases that pushed overnight lending rates up to 4.5%. Higher interest rates increase costs of capital for businesses which puts a strain on operations. When you couple this with higher costs of goods and a drop in consumer spending, corporate balance sheets are negatively impacted, and a market repricing unfolds.
Technology
As we had noted in our 2020 Commentary (click here), the bull run for technology stocks was a huge contributor to overall market performances since 2020.
As we can see below, the reversion to the mean is well underway.
And Bonds?
While bonds lost less than stocks, in comparison to historical declines, the loss in bonds was extremely steep and rare in 2022 at -13.06% for the Aggregate bond index. Since 1977, the index has only suffered five calendar year declines and the most significant prior to 2022 was a loss of -2.92% in 1994.
The silver lining in the very aggressive Fed policy is that short-term savings vehicles such as money market funds, CD's and short-term Treasury bonds present an attractive return and security profile for fixed income investors and those holding cash.
The Value of Process
Avoiding losses when there is widespread contraction in the market is difficult, however there was some respite for Compass clients in 2022. Our gameplan entering the year was to start with a reduced stock allocation which emphasized value over growth and an actionable process to add to equities as better values materialized.
As noted in our Q4-2021 Market Commentary (click here), we had outlined a framework for adding to equities which we were able to execute in 2022. During the year we also saw two short-lived market rallies that buoyed portfolio performance.
Taking positions in hedged equities that utilize call option strategies also bolstered performance as a fixed-income alternative.
Looking Forward
The stock market is a leading-indicator of trends to come and with high inflation and decelerating economic activity, there are now more than whispers of a possible recession in 2023/24. As is evident with the sell-off in stocks, the market is pricing in lower corporate earnings in the near-future. That said, lower prices present better buying opportunities for the eventual economic recovery. We expect the volatility to continue which is common for bear markets, but we also believe a recovery is inevitable. Our current portfolio allocations reflect that sentiment and we are slightly above market-neutral.