Annual Market Insights - The Optimizer & A Look Ahead
The summary below is provided for educational purposes only. Please let me know if you have any questions or would like to discuss any other matters.
2022 - Shifting Forces
The market had a banner year in 2021, with the S&P 500 Index advancing over 25%, according to data from the St. Louis Federal Reserve. But tailwinds that fueled gains in some sectors of the S&P 500 shifted dramatically in 2022. No longer were the economic fundamentals favorable for these sectors.
Our Optimizer process helped identify some of the headwinds in late 2021 which caused us to reposition the portfolio. While we were not immune to the headwinds, we feel good about weathering the storm that delivered -18.14% in the S&P 500. The results of this shift were -3.39% in the Optimizer A, -3.56% in the Optimizer B, and a portfolio comprised of a 50/50 mix between Optimizer A and B did -3.44%. You can see the performance results under the data section.
With inflation proving to be much more stubborn than expected, policymakers at the Federal Reserve hiked interest rates at the fastest pace in over 40 years, surprising investors and sending stocks into a bear market.
Higher interest rates pressure equities for two primary reasons. First, higher rates compete for investors’ cash. Second, higher rates eventually slow economic growth, which pressures corporate profits.
Rate-hike cycles are not created equally. In the past, rate increases began prior to a level considered to be full employment, proactively striking out against inflation.
Last year, the Fed’s posture was reactive, raising rates after the inflation genie was out of the bottle. And it did so forcefully.
Figure 1 illustrates the first-rate hike cycle following a recession, dating back to the 1981-82 recession.
The current cycle is by far the most aggressive—4.25 percentage points in just 10 months. Today’s cycle has only been topped once. In the second half of 1980, the Fed raised the fed funds rate by a whopping 10 percentage points in just six months.
Table 2 illustrates the return of the S&P 500 Index (without dividends reinvested) from the first rate increase to the final increase in each series of increases.
The two most aggressive cycles—1994 and 2022—created the stiffest headwinds for investors. Stocks performed best during the very gradual moves during 2015—2018.
In fact, the S&P 500 Index was up over 40% between December 2015 and September 2018 before shedding about half of its gain during the final three months, as recession concerns surfaced.
Looking ahead, the Fed expects to slow the pace of rate hikes this year but has also signaled that it could maintain a peak rate over a longer period, as it hopes to wring inflation out of the system.
But be aware that a glance into the future is murky at best. The Fed’s own forecast one year ago envisioned rates hikes totaling just 0.75-percentage points for the entire year. Even the smartest folks in the room aren’t exempt from a bad forecast.
While inflation remains high, the rate has moderated. After peaking at a 40-year high of 9.1% in June, the Consumer Price Index (CPI) slowed to 7.1% as of November.
The core CPI, which strips out food and energy, hit a peak of 6.6% in September and has eased to 6.0% as of November (U.S. Bureau of Labor Statistics).
But it remains well above the Fed’s annual goal of 2%.
Lessons from the past
Whether we agree or disagree that the Fed’s tough posture is the right medicine, its decisions are rooted in the lessons of the 1970s.
In the mid-1970s, the Fed sidelined its fight against inflation while prices were still rising between 6% and 7% per year. Inflation roared higher in the late 1970s and peaked at nearly 14% in 1980. Inflation was fully embedded in the economy, which required a massive response.
Inflation turned lower, but the cost was a steep recession. By acting forcefully now, the Fed hopes to avoid a repeat. However, do not expect prices to return to pre-pandemic levels.
A look ahead
Hard landing or soft landing
The Fed’s actions have raised fears that the economy is on a collision course with a recession—a hard landing.
“Usually, recessions sneak up on us. CEOs never talk about recessions,” said economist Mark Zandi of Moody’s Analytics. “Now it seems CEOs are falling over themselves to say we’re falling into a recession. ... Every person on TV says recession. Every economist says recession. I’ve never seen anything like it.”
If we slip into a recession, rate hikes would probably cease, and we might see a series of rate cuts. But corporate profits would turn lower.
Yet, a recession is not a foregone conclusion. A resilient labor market and a sturdy consumer, with borrowing power and some pandemic cash still in the bank, could help keep the economy on a gradual but upward path.
Long-term optics
As the economy expands over a long period, corporate profits rise as well. The S&P 500 Index has averaged a 12.6% annual return, dividends reinvested, since 1980.
Up years accounted for 81% of the period surveyed. Simply put, historically, stocks perform well over a longer period, but pullbacks are common, too.
Fourteen times, stocks ended a year higher after the S&P 500 had an intra-year peak-to-trough selloff of over 10%.
Notably, stocks performed exceedingly well in 1985, 1995, and 2019. These years marked the first year after a Fed rate-hike cycle when the Fed engineered a soft landing.
We may not avoid a recession next year, and sentiment heading into 2023 is primarily negative. However, if we were to take a contrarian view, any positive surprises could be a catalyst for gains in 2023.
For example, a sharp slowdown in inflation, without a recession, that encourages the Fed to adjust policy.
Investor’s corner
When stocks tumble, some investors become very anxious. When stocks are posting strong returns, others feel invincible and are ready to load up on riskier assets. Forbes does a nice job of putting emojis along all the different places during the “Cycle of Market Emotions.”
We caution against making portfolio adjustments that are simply based on market action.
Each one of these emotions stems from either confirming a behavioral bias or proving a bias wrong. This is why we whole-heartedly agree with ITR CEO and Chief Economists statement, “Ignore the headlines and focus on the data!”
We will continue to monitor the headwinds with the help of our friends at ITR Economics and will make adjustments when it is appropriate. If you have any questions, please email me at cbellin@bellww.com.
Clark S. Bellin, CIMA®, CPWA®, CEPA
President & Financial Advisor
Phone: 402-476-8844
E-mail: cbellin@bellww.com
