Current Investment Outlook

Stocks were down 19% in 2022 and long bonds provided no safe haven. The first three quarters of the past year saw the worst market decline since the Financial Crisis of 2007/2008. We had turned negative on market prospects at the beginning of 2022, but we took a more positive view at mid-year. In addition to earnings and valuation, the primary issues for the market at its year-ago peak had been money supply (too much), inflation (too high), and debt (way, way too much). These problems have not been resolved, but market pessimism had grown so high last Summer that we thought more favorable performance might be at hand. Our call a year ago was very well timed, but our mid-year outlook was a little premature. Today, for reasons we outline below, we stay with our forecast that the market is more likely to rise than to fall from current levels.

When the stock market completed back-to-back years of strong performance in 2020 and 2021, with valuations that seemed stretched, we turned cautious on the outlook for stocks. We were also concerned that the Federal Reserve was printing way too much money, Congress was spending by trillions too much money, and the attack on fossil fuels would not end well. The year-ago view that stocks were no longer rising interrupted our consistent prediction over fourteen years that we were in a secular bull market following the Financial Crisis. Our outlook last January did not alter our expectation that we might still be in a long term rising market - just that it was going to suffer through a cyclical decline of some significance. We believe that the 2022 bear market could have been minimized if the Fed had reacted sooner, if our government had not kept spending so much, and if energy policy had been more enlightened.

In the 14 years since the Financial Crisis, the Federal Reserve had increased its balance by a remarkable 30-fold. Think about that. Imagine if a home-owner took out a $200 thousand mortgage to buy a $300 thousand house - and then went back to the bank and asked if they could increase the borrowing to $6 million. That's pretty much what our Federal Reserve did - with us picking up the tab. In addition, the Fed established a free-money policy, with rates barely above zero, and a program of mortgage asset purchases. When inflation began to run out of control, the Fed (too late) realized that it had to reverse these policies. A series of 75-basis point increases in rates and asset sales has ensued, and it remains to be seen if it has been enough to tame inflation. The Fed forecasts that Fed Funds rates will rise to 5.10% before declining 3.10%, while the bond market sees the peak at no higher than 4.59%. Current Fed Funds rates are in a 4.25-4.50% range, with increases of 25 basis points each expected in February and March.

The prices of many commodities have dropped back from wildly higher levels to near where they were pre-Pandemic. This is true for lumber and copper, energy prices, agricultural goods, food, and electricity. Overall, inflation gives signs of having peaked, as it seems that it is rolling over from a peak at 9% to 6.5% today. The question is whether or not this decline will continue.

While slowing dramatically in some sectors, our overall economy remains in good health, and the debate persists as to whether or not it will head into recession. The Institute for Supply Management (ISM) manufacturing index is in contraction, indicating a decline in industrial activity. Home sales have slowed, allowing mortgage rates to decline off their 7.3% peak. Wage increases continue to come in well short of inflation, so wage earners continue to lose ground in real terms. But, the supply chain picture has improved, and unemployment remains low at 3.5%, with many jobs unfilled. Many employers are reporting significant job cuts, so that healthy picture may begin to change.

The Federal Reserve policy of higher rates has begun to slow economic growth. The fourth quarter is estimated to have grown 2.6% versus a gain of 3.2% in the third quarter, with personal consumption expenditures (PCE) up 1.7% versus 2.3%. It is unclear if this environment will push us into recession, but we are clearly facing a slowing economy, and with rising cost pressures, many companies will find earnings under pressure. A soft landing or "stagflation" seem quite likely. We think the market has mostly anticipated this prospect.

Energy markets remain distorted by the attack on fossil fuels and the war in Ukraine. Prices have risen as a result and remain vulnerable to any shocks from supply disruptions or cold weather. Within a few years, we expect a more welcoming view toward energy producers but we are not there yet today.

In recent years - in fact for decades - there has been too much growth in debt outstanding. U.S. Federal borrowings stand at 120% of GDP. This is way too high, but still less than the burden carried by many other nations. U.S. corporate and household debt equals another 153% of GDP. All of this represents a huge repayment obligation and a significant exposure to higher interest rates. The IMF estimates that world debt has reached a record $235 trillion, or 247% of world GDP.

A separate but similar risk lies in the amount of options and derivatives outstanding. These tend to cancel each other out for the most part, but not totally. Because the amount of this financing is over $1.2 quadrillion, we can see the possibility of expensive errors and mischief. We should expect periodic financial crises as a result.

Russia remains bogged down in its war in Ukraine, with the U.S. and NATO providing over $100 billion in aid. This catastrophe is likely to remain for a long time. China has reopened after its long period of Zero COVID. With the Chinese New Year and travel to the countryside, we expect a huge increase in COVID cases and it is unclear how Xi will respond and how it will affect their economic recovery. We do not know if or when China will invade Taiwan, but they clearly see an opportunity before there is a different administration in charge in Washington.

Corporate earnings for the S&P 500 are expected to come in at $220 for 2023, essentially flat for two years, and $250 for 2024. This would put the price-earnings (PE) ratio at 16.7 times. Some 67% of companies are beating estimates on earnings and 64% on revenues. The best performing sectors in the fourth quarter were energy, industrials, and materials.

The stock market has established a series of lows in June, September, October, and December. This is a normal bottoming process but no guarantee that the market can't go lower. Importantly, the breadth of the market established a double low in June and October, with only 14% of stocks above their 200-day average. That figure has now risen to 66%, suggesting a broad rising trend in the market. At present, we are cautiously optimistic, with a diligent focus on stock selection. Our strategy has not changed that much from the one we have employed over the fourteen years since the Financial Crisis. We try to find good companies with strong management teams and prospects for consistent and reliable growth in earnings, and with healthy returns on capital. If these stocks can be bought at reasonable valuations, they belong in client portfolios, even if the short term action may seem unrewarding.

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