The cheerleaders of passive indexing have fallen quiet after a decade of yelling that passive indexing is the only way to invest money. As I have stated many times, passive indexing looks great in bull markets. However, it can be a very quick way to destroy capital in bear markets. And, of course there is a place for passive (and, active) investment strategies in your portfolio.
For the first time in more than a decade, broad market indexes handed investors double digit losses to finish the year. The S&P 500 fell -18%. Bonds didn’t do much better sliding -12%. And, the tech heavy NASDAQ declined -33%. With traditional asset allocation out of favor, a passive 60/40 portfolio ended the year down -16%. Many big name actively managed balanced portfolios ended the year with losses between 15-20% or more.
In 2022, the average retail investor experienced a drawdown of 35%. With nowhere to hide, the flight to cash was — an avalanche. Investors hoped that the Fed would limit further interest rate hikes or even reverse course. With stocks seemingly on sale, investors tried to “buy the dip” only to lock in successive losses as the market made new lows. There were a few bright spots…
The energy and utility sectors in the S&P 500 posted positive returns for the year. In addition, dividend-paying stocks, especially those with higher yields, outperformed the S&P 500 by a large margin closing the year flat. The S&P 500 Value Index ended the year down -5%. We feel value oriented dividend paying stocks will continue to do well in 2023. Also of note, many active strategies designed to improve security selection (i.e. smart beta) or reduce loss performed very well last year.
It seems the Fed is determined to increase rates and keep them elevated for some time to bring inflation down to the 2% target. And it’s not just the Fed, central bankers around the world are hiking rates aggressively. Don’t forget…the Fed engineered the economic recovery by stimulating consumption through policies designed to drive a “wealth effect”. Now, they are trying to reduce price and wage inflation. The sharp rise in interest rates is designed to destroy demand. With demand destruction happening in front of our eyes, it’s only a matter of time before the trailing economic indicators show a slowing economy. As companies lay off workers and unemployment rises, the Fed will have crushed wage inflation too.
Once again, investors learned the lesson in 2022…”Don’t Fight the Fed”. We think that this should be the mantra for investors in the first half of 2023 as well.
Here’s the million dollar question everyone has been asking…Will the Fed’s policies push us into recession or a soft landing? If last year’s market declines were any indication of what is to come, it surely did not feel like a soft landing. The whole concept seems to be more of a political catch phrase rather than one based in solid economic theory. In fact, the U.S. economy already posted quarter-over-quarter GDP declines in Q1 and Q2 of 2022. This seems to have been glossed over by nearly everyone in the lead up to the mid-term elections.
Since GDP is weakening, we are likely already in a recession right now. You have to ask yourself…How much worse does the data have to get before the Fed yields? Historically, the Fed has always raised rates too much and too long. It usually takes 6-9 months for the rate hike to work through the economy. This means the data that they are looking at in the rearview mirror is stale and they can only guess at how far they should go. Unfortunately, successive hikes have a cumulative effect on the economy and will only become apparent after the carnage has occurred.
The magnitude — 1,700% — of Fed’s interest rate hikes is unprecedented. And, they aren’t done yet! We fear that most people, including members of the Fed, may not be taking into account the full magnitude of these increases. The last two rate hike cycles from 1993-2000 (with a few moves lower before finishing higher) and 2003-2006 saw increases of 117% and 425% respectively.
It wasn’t so long ago that the economy was mired in stagnation with a growth rate of under 2.0%. This was with rates near 0% to 0.25% for almost a decade. Then, the Fed got even more aggressive with “Quantitative Easing”. The Federal government followed on with a massive amount of fiscal stimulus to help the economy recover from COVID-19. Now, the Fed is in the midst of the fastest rate hike cycle in history and at the same time reducing the size of their balance sheet — a double whammy. This surely does not seem like a prescription for a soft landing.
In the best case, we would expect the economy to stall and corporate profits to fall pretty hard. The good news is that the inflation story should fade quickly and become a deflation scare by the end of 2023. Somewhere around Q3, the Fed will likely be forced to ease quickly to bring back economic growth. Let’s also not forget…2024 is a Presidential election year. So, policy should become quite supportive of economic growth and as a result we expect a strong bull market recovery. I have omitted other negative economic and geopolitical risks from this narrative because the main knowable driver of the American stock market will be Fed policy.
We expect that value-oriented stocks, dividend payers, and defensive sectors will continue to outperform. Growth and technology stocks are highly dependent on supportive policies and will continue to underperform until the Fed pivots. At WBI, we believe that the most important aspect to investing is to protect capital. Over the past 5 years, the company has continued to invest heavily in our investment and wealth technologies. Our mission is to provide investors with better investment performance and more successful client experience. I believe our strong performance last year is indicative of the time, money, and effort put forth to serve you better.
In 2023, I encourage you to take a look at all that we have to offer. We have dramatically expanded our capabilities over the last few years. Thank you in advance for taking a look! In closing, I would like to wish you, your family, and your business family a joyous and prosperous New Year!
DISCLOSURES
Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is the S&P Dow Jones Indices Index Dashboard as of 12-30-22 and Bloomberg.
Past performance is not a guarantee of future results.