January 12, 2023
Valued Clients and Friends,
We wish you a happy New Year and hope you were able to close out 2022 with friends and family.
The beginning of a calendar year is often the time when the previous year’s reflections transition to a new year’s hopes. Given the market’s continued instability during 2022 and a resulting tough period for stock and bond prices, everyone is hoping for a fresh start. The S&P 500 Index fell nearly 20% and bonds had their worst year on record as investors feared the impact of high inflation and a Federal Reserve (Fed) intent on rapidly raising interest rates to combat it.
History, however, gives us cause for optimism following a difficult year. While each new year brings its own unique circumstances, bad market years are often followed by good ones. This is especially the case following a mid-term election year.
Since 1950, there have been 18 mid-term election years, and in each instance, the S&P 500 Index has been higher in the subsequent year. Not only have stocks been positive in those cases, but the Index has been higher by 14.7% on average. Stocks also typically perform well when two parties share power in Washington, D.C., and November’s election ushered in a Republican majority in the House, balancing the power once again.
If we look at all calendar years following negative S&P 500 Index outcomes, the S&P 500 Index had back-to-back negative years in only four instances since 1930. Those occasions occurred during the Great Depression, World War II, the 1970s, and the dot-com bubble (early 2000s)—perhaps more economically dismal periods than what we face today. So while we can’t rely on history repeating itself, it does give us a reason for optimism.
We remain mindful that the coming year will not be without fundamental challenges. While falling, inflation remains high, and a mild U.S. recession is anticipated sometime in 2023. Corporate profit growth is expected to be flat, and consumer spending should also slow. Meanwhile, deteriorating U.S. relations with China and the ongoing Russia-Ukraine conflict add risks for the economy and markets. But these challenges are offset by healthy consumer and corporate balance sheets, a persistently strong labor market, and the potential that the Fed will stop hiking interest rates in the first half of 2023, which may give stock prices a boost. The volatile market in 2022 lowered stock valuations relative to their earnings, suggesting many of the above concerns may already be priced in. The outlook for bonds has improved due to higher starting yields and the potential for interest rates to drop as inflation moderates and economic growth slows.
Last year saw a changes in market leadership that may persist in 2023. After a decade of dominance, growth stocks underperformed value in 2022 as investors adjusted to a higher interest rate environment by favoring companies with high current earnings and cash flow in sectors such as energy, industrials, and materials. This trend benefited our factor-based strategies which have a value tilt. International stocks also experienced a resurgence relative to the U.S. after many years of underperformance due to more value-based names and attractive multiples. In addition to this potential secular shift towards value stocks, alternative investments appear poised to continue to perform well, especially those that benefit from elevated inflation and rates such as select private real estate and credit strategies.
Given the volatility of the past year and uncertainty surrounding inflation, Fed rate hikes, and a potential recession, it is not surprising that investor sentiment is negative, although it is interesting to note it has fallen to levels worse than during the Great Financial Crisis in 2008. In fact, based on a rolling 51-week average of bearish sentiment from the AAII Investor Sentiment Survey, investor sentiment was at its lowest level on record coming into this year since the survey began in 1987. Historically, the S&P 500 Index has gone on to realize above-average returns during the 6- and 12- month periods following unusually low sentiment readings.
Despite the challenging economic and market environment, we see opportunities in 2023 as investors continue to adapt to a new set of parameters. While volatility will likely persist due to a wide range of potential outcomes, history suggests that the winds may be a bit more in our favor.
As always, we invite you to reach out with any additional questions regarding our outlook and your portfolio.
Best regards,Gallacher Investment Committee