Glass Half Full
2022 in review
The bear market of 2022 felt more painful than usual because of how broad the selloff was. From stocks and bonds to real estate and cryptocurrency, it seemed like there was nowhere to hide.
Global stocks ended the year down by -19%. Emerging markets had it worst, down -21%. Even the U.S. bond market, often seen as a "safe haven," suffered a -12% loss and one of its worst years in decades. Gold managed to end the year nearly flat, but was also down by about -19% at one point intra-year.
Figure1: Global Market Returns 2022
As far as stocks were concerned, the worst of the damage was done in areas that were exhibiting "irrational exuberance," something I wrote about in 2021. That included "work-from-home" stocks like ZM and "Robinhoodie" favorites like AMC and ARKK. And of course, there was the poster child of exuberance, TSLA. Judging by the magnitude of losses, we can say the exuberance has officially deflated.
Figure 2: 2022 Stock Returns
Are we finished yet?
After such a drawdown, the biggest question for investors in 2023 may be "are we finished yet" (with respect to the bear market)? It is impossible to know for sure. The best we can do is make an educated guess based on relevant data and available information.
One way to evaluate the bear market is with interest rates. Generally, we can think of rates as the price of money and the oil that keeps the economic engine running. When rates are low, money is cheap and economic growth accelerates. When rates are high, money is expensive and growth breaks down. Rates matter to the stock market because companies derive their revenues and earnings from the economy.
Specifically, we can look at the federal funds rate (FFR). It is a global benchmark rate controlled by the U.S. central bank (the Federal Reserve) and against which many other rates are priced. Suffice it to say it matters to financial markets. Figure 3 shows the FFR versus the U.S. stock market from 1985 to 2022.
Figure 3: Federal Funds and U.S. Stocks
Notice that the FFR (blue line) historically peaked before the start of recessions (grey bars) and before the end of bear markets (red line). For example, looking at 2000 (tech bubble) or 2007 (financial crisis), the blue line (FFR) reached a high point before the grey bar (recession) started and before the red line (stocks) reached a low point.
In addition, historically bear markets did not end until after the Fed was well into cutting interest rates (when the blue line declines).
In its December policy meeting, the Federal Reserve repeated its plans to continue raising interest rates in order to lower inflation. It also clarified that inflation remains its top priority and the Fed has no plans to pivot or reverse course next year. Despite that, markets still doubt the Fed's resolve and expect the central bank will cut rates in 2023. Figure 4 shows FFR expectations based on futures market pricing.
Figure 4: Federal Funds Rate Expectations
It may not even matter if the rate expectations are right or wrong. If expectations are right and the Fed cuts in 2023 that implies a recession. If expectations are wrong and the Fed does not cut in 2023 that implies a potentially even harder landing ahead
(economists see over-aggressive rate policy may result in a more severe recession). Either way, the implication is the peak in FFR is still ahead, which implies the end of the bear market in stocks is ahead as well.
A second way to evaluate this bear market is by looking at cyclical sectors of the economy. In other words, look at segments of the economy that are sensitive to expansions and contractions of the business cycle. The manufacturing sector is a good example because it leads wholesaling and retailing, and it provides early signals for changes in the economy.
The Purchasing Managers' Index (PMI) is a well-known measure of manufacturing activity. Readings above 50 indicate expansion whereas readings below 50 indicate contraction. U.S. manufacturing PMI readings have been declining since the spring. It breached below 50 in November and fell further in December.
Figure 5: US Manufacturing PMI
As shown in Figure 6, historically the stock market (red line) did not bottom until after the PMI (white line) falls below 50 and often not until the PMI reached more depressed levels closer to 40. In other words, PMI readings also imply this bear market is not over.
Figure 6: PMI and S&P 500
The last bear market measure we consider in this letter is the magnitude of market drawdowns. A decline of -20% or greater is commonly seen as the technical definition of a bear market. However, there is a wide range around that number.
Since 1928, the average bear market was down closer to -30%. The worst bear market was a peak-to-trough decline of almost -80% during the great depression. The mildest was -19.8% in 2018, assuming we count that as a bear. The S&P 500 reached a drawdown of about -26% in 2022, close to average in terms of magnitude.
So, was that enough, and are we done yet? Valuation is one way we can evaluate this. Reliable long-term measures like the Shiller P/E ratio, or CAPE, suggest current stock market valuation is still elevated.
Over the past 150 years, the CAPE has averaged about 17x with a low of 5x and a high of 44x. The CAPE bottomed around 15x in the financial crisis bear market. At prior major bottoms, the CAPE routinely fell to single digits.
The CAPE started in 2022 at the second-highest level on record. Although it has decreased to about 28x, the CAPE is still currently higher than it was at the peak of the financial crisis.
Figure 7: Shiller P/E Ratio
To be fair, valuation is not useful for marking-timing, short-term trading, or predicting tops and bottoms. Case in point, the S&P 500 gained +27% in 2021 despite starting the year with a very high CAPE of over 36x.
However, valuation is helpful for gauging the potential magnitude of market drawdowns when they happen. With the understanding that "what goes up...," extreme valuations readings to the upside are typically followed by extreme price declines to the downside, the clearest examples being 2000 and 1928.
Markets are difficult to time and I don't know when this downturn ends. That being said, a number of reliable indicators imply this bear has more room to run. Stock valuations, economic conditions, and interest rates are all still not where they typically have been near previous bear market bottoms.
Glass half full
Investing is often a matter of perspective, so let us pivot away from the gloom of the bear market and view the glass as half full. Since 1956 bear markets lasted about 13 months on average (based on the S&P 500). The longest bear was during the tech bubble, which lasted 31 months.
Figure 8: S&P 500 Bear Markets
All other bear markets bottomed within two years. For those keeping count, January 2023 is month 13 of the current bear market. That means we could be near halfway to the bottom of this downturn.
I realize "could be near halfway" may not sound encouraging. For what it is worth, I believe the first half will have been the hardest, at least for BCM clients. Not only will falling stock prices be less of a shock in 2023, but positioning in BCM's Macro Allocation (MA) strategy is also different from a year ago.
MA entered Q1 2022 by lowering risk exposure, down from overweight in 2021. MA continued to reduce risk exposure through Q1 and Q2 and reached maximum underweight in Q3 2022. That helped MA portfolios perform relatively better than the broad stock and bond markets (which were down -19% and -12%, respectively).
As we enter 2023, MA portfolios are substantially more conservative than they were this time last year. Even if we see a repeat of 2022 in 2023, we would expect only a modest drawdown in MA portfolios and an even wider margin of relative outperformance versus market indices.
And, of course, the further we are into this bear market, the closer we are to its end. Historically, the average bull market has lasted about 48 months, or about twice as long as the average bear market. Indeed, seeing the glass half full shows better looking times ahead.
As of now, MA's largest overweight is in high-quality, short-term, fixed-income (STFI) investments such as U.S. Treasuries and investment-grade corporate bonds. Current yields on these investments have risen above 4% annualized. Even money market funds are seeing yields above 3%.
A 3% yield may not sound exciting and some investors still insist "cash is trash" because inflation remains elevated. However, negative returns are also susceptible to inflation. In that sense, we believe cash and STFI investments still appear relatively attractive versus equities heading into 2023.
That will not be the case indefinitely. We will rotate back into risk assets. However, it is likely we will start by rotating into longer-dated bond investments first because the bond market tends to lead the equity market.
We can see the relationship between bonds and stocks in Figure 9. Bond yields (or interest rates, in blue) tend to rise before stocks (in red) fall. The reverse is also true, bond yields tend to fall before stocks rise.
Figure 9: 10-Year U.S. Treasury Yield vs U.S. Stocks
That relationship is not arbitrary. As noted earlier (Figure 2), interest rates are like the "oil that keeps the economic engine running." That oil does not work like a light switch, it needs time to seep its way in or out of the economy, businesses, and the stock market.
Since bond yields move inversely to bond prices, that means bond prices fall when interest rates go up and prices rise when rates go down. When the U.S. economy goes into recession (not a matter of if, only when), the Federal Reserve will be pressured to stop raising interest rates and pivot to lower them.
In that scenario, bond prices are likely to go up (due to falling interest rates) while stock prices continued to go down (due to recession). Simply said, we expect the blue yield line in Figure 8 to go down first (meaning bond prices go up) and the red line to follow later. In that case, it makes sense to rotate into longer-dated bonds first, before moving into stocks later.
Beyond tactical risk allocation changes, there are areas of relative value after 2022's pullback. But they may not be where people think. For example, even after their 2022 drawdowns, TSLA still trades at over 30 times earnings, and AMZN still over 70 times!
No, the most reasonable values do not appear to be in U.S. big tech, and not even in the U.S. at all. A summary view of global equity market valuations shows U.S. stocks are still the most expensive equity region across every measure shown in Figure 10.
Figure 10: Global Equity Market Valuations
On the opposite end, emerging market equities still appear to be the least expensive. In last year's letter, I singled out Brazil as being the most attractive within EM. In 2022, the Brazilian equity market gained +15% versus an -19% decline in global stocks, which helped with MA's relative performance.
Although EM remains relatively undervalued, one important change in 2023 is the likelihood of a global recession has increased significantly in the past year. EM equities generally do not perform well during periods of economic contraction as they are sensitive to commodities and exports, the demand for which decreases in recessions. EM also gets hits by repatriation of capital and flight to safety trades during economic downturns.
A safer pivot may be into foreign developed markets (DM) like in the EAFE region. Although DM does not look as undervalued as EM, it still looks relatively attractive to the U.S. and global markets. DM also tends to perform relatively better than EM in economic contractions.
Within DM, Japan in particular looks interesting. Valuation-wise Japan looks relatively attractive versus the broad EAFE market by most measures, attractive versus the global market by all measures except MC/GDP, and attractive versus the U.S. by every measure in Figure 11.
Figure 11: Relative Valuation for Japan
In terms of economic conditions, Japan also looks favorable versus its peers. Most developed economies are dealing with high inflation. That's causing central banks in the US and Europe to raise interest rates and tighten monetary policy even as economic growth is weakening, summarized in Figure 12.
Figure 12: Economic Data
In contrast, the Bank of Japan reiterated its plans to keep domestic monetary policy loose and stimulative several times in 2022. Meanwhile, Japan is one of the only countries where leading economic indicators are still pointing toward expansion (above 100) instead of contraction, as shown by the OECD's Composite Leading Indicators below.
Figure 12: OECD CLI
In addition, the Japanese yen is commonly seen as a safe haven during periods of global uncertainty. That could give Japanese assets a boost during a flight to safety, especially since the yen is already trading at multi-decade lows against the US dollar. A reversal of the downtrend would turn a headwind into a tailwind for Japanese stocks.
Figure 13: JPY vs USD
In the short run, diverging monetary policies between the Federal Reserve (tightening) and the Bank of Japan (loosening) may continue to put downward pressure on the yen. A comparison of hedged versus unhedged positions in Japanese stocks shows the impact of currency risk.
An unhedged position in Japanese stocks produced a loss of -18% year-to-date in US dollar terms. Meanwhile, a currency-hedged position produced a loss of only -4%. This is shown in Figure 14 by positions in exchange-traded funds EWJ (unhedged in red) and HEWJ (currency-hedged in blue), respectively.
Figure 14: Japanese Stocks
Most of the negative YTD returns in Japanese stocks were attributed to yen depreciation versus the dollar. In other words, Japanese equities meaningfully outperformed US equities, adjusted for currency effects. That implies markets have a favorable economic outlook for Japan versus the US.
The grey-ish bottom line
We enter 2023 with the potential for a global economic downturn, rising global geopolitical tensions, and the threat of yet another wave of COVID (remember that?).
Once again, there is no shortage of uncertainties heading into the new year.
We would all like absolute, black or white, yes or no answers to questions like will there be a recession in 2023 or will the bear market end this year? Unfortunately, the only thing we know for sure is that we do not know.
Markets and investing often work in relative shades of grey. The best we can do is develop reasonable approximations (roughly at that) based on available information. Based on current economic and market data, it appears the bear market in stocks has further to run and recession remains likely.
As such we maintain a conservative underweight of risk assets and favor high-quality short-term fixed-income investments. Not only will this help us weather remaining market volatility, but it will also provide the stability and liquidity needed to rotate back into risk assets as opportunities arise.
That final point is worth reiterating. Neither bulls nor bears live forever and every passing day is one closer to this bear's end. The exact timing remains obscured in shades of grey, but for those willing to maintain the right perspective, the glass clearly remains half-full.
As we venture into 2023, I want to thank clients, family, and friends for sticking with BCM through a challenging 2022. Your trust and support mean the world to us and it drives us to continue growing and improving every year. We look forward to a better 2023 and wish you all the very best in the new year.
Victor K Lai, CFA
Bellwether Capital Management LLC (BCM) is a registered investment adviser (RIA). It provides investment management and consulting services for people and organizations. Please visit www.bellwethercm.com to learn more.
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