Q4 2022: PFM Quarterly Commentary
From an investor’s standpoint, the best part about 2022 was that it ended. The S&P 500 lost 19.4% on a price basis and notched only its second losing year in the last fourteen. Although the drawdown proved less ferocious than that of the Great Recession in 2008, the S&P 500’s decline from last January still offers us some remarkable statistics as to its persistence and severity. For example, there were sixty-five days in 2022 where the S&P 500 fell by 1% or greater, a staggering one quarter of all trading days. Since 1993, only 2002 and 2008 had more. Additionally, 57% of all trading days in 2022 posted negative returns; spanning the last seventy years, only 1974 had more with 58%. Finally, it saw the fourth largest annual decline since becoming a 500-stock index in 1957. Only 1974, 2002, and 2008 recorded worse returns. We could continue but we’re confident you get the point: 2022 joins the ranks as one of the worst years for stocks in modern history, with an estimated forty trillion dollars’ worth of equity erased from the global balance sheet.
The stock market’s performance alone could have made for a truly dismal 2022, but the global bond market proved equally culpable. It experienced an unprecedented decline, the likes of which hasn’t occurred in over two centuries. Global bonds, as represented by the Bloomberg Global Aggregate Bond Index, fell 16% on a total return basis. For bonds, this sharp decline is difficult to comprehend. The fact that this was concurrent with the dramatic decline in equities is what made for a particularly challenging year. In fact, the combined nominal returns of U.S. stocks and bonds in 2022 resulted in the worst performance of markets in general dating back to 1871, defying the common convention that bonds do well when stocks fall. Even during the Great Recession, global bonds rose nearly 5% which cushioned losses in a diversified portfolio. In 2022, diversification provided almost no respite from the near constant declines as correlations between major asset classes turned positive.
Unsurprisingly, aggressive central bank intervention worldwide bore much of the responsibility for the moribund performance in the markets. As we chronicled throughout last year, sixty of sixty-eight central banks raised interest rates, led by the Federal Reserve which hiked them by 4.25% in total at the fastest pace in forty years. And Fed members continue to vocalize the plan for further rate hikes in 2023 in their effort to subdue inflation. We find that for the most part that the wider public accepts the Fed’s narrative at face value in error.
As investors, we believe it’s informative to compare the Fed’s forecasts with their ex-post actions. Let’s select a particularly illustrative time period as an example, late 2021: inflation was already running hot and on the verge of exploding to its highest level in four decades. At this critical juncture, the official assessment by half the members of the Fed’s policy setting committee was that there was no need for any rate increases in 2022; one member even expected rates to stay at zero percent in 2023. The lone hawkish dissenter suggested that interest rates could peak at seventy-five basis points (.75%). These influential people bestowed with arguably the most important task in all of finance – stewarding the world’s largest economy – could not have been more spectacularly wrong. Similarly, on May 4th last year, Fed Chairman Powell said at a press conference that “a seventy-five basis point increase is not something that the committee is actively considering.” At the very next policy meeting in June, the Fed raised rates by seventy-five basis points and did so again at the next three meetings.
The Fed spent most of 2021 arguing that there was no inflation, before changing their tune to say inflation was merely transitory, then subsequently following this with the most aggressive monetary tightening campaign since Ronald Reagan was in office. The Fed continues to argue that the spike in inflation was unforeseeable, an opinion we find disconcerting for a multitude of reasons. Anyhow, you can understand why we lack confidence in their forecasts.
While it’s hard to believe, the actual implementation of the Fed’s policy U-turn appears even more troubling. The Fed belatedly began raising rates by 25 basis points (.25%) in March of 2022 only after the Consumer Price Index (CPI) hit 8.50% and only after the Fed’s preferred measure of inflation, Personal Consumption Expenditures (PCE), peaked at 5.40% in February. Additionally, the Fed didn’t start its four consecutive seventy-five basis point increases until June, the month which actually marked the peak of inflation at the consumer level (CPI) and the producer level (PPI). Following this, the Fed went on to raise interest rates by an additional 2.75%. Our point here is that the Fed was so tardy in adjusting their monetary policy that inflation had in all likelihood crested by the time they took serious action. Moreover, given the six-month delay in which interest rate changes impact the economy, we think the Fed may have by now already over-tightened. We anticipate they will be late in realizing this misstep just as they were slow to identify the initial surge in inflation. While the Fed may follow through with their current plan for further rate hikes early in 2023, one could make a compelling case that rate cuts may be necessary later this year.
The Fed isn’t the only one whose expectations completely missed the mark. The median forecast by major Wall Street banks was for the S&P 500 to end 2022 at 5,075; it instead closed the year at 3,839. Fortunately, we understand the futility of making such precise predictions. Rather, we prefer to use history to help us make inferences about the future path of markets. For example, back-to-back market losses, while not impossible, are rare. Since 1950, the market has experienced consecutive annual losses only three times (1973 to 1974, 2001 to 2002, and 2002 to 2003). In each of those instances, the market loss in the next year was worse than the one that preceded it. For perspective, in any year where the S&P 500 is negative, the next year is positive nearly 80% of the time with an average return of 15%. The exception is when the S&P 500’s loss is greater than 10% (such as 2022), in which case the return the following year is higher only 63% percent of the time with an average return of approximately 8%.
Additionally, going back to 1928, the average bear market has lasted 283 days (the longest was 630 days ending in October of 1974). The current decline measures 362 days and counting through December 31. However, this bear market has not met the average decline in terms of percentage. On average, bear markets see losses of 35% in the S&P 500; the intraday peak to trough decline of this bear market measures 27% thus far. (However, it’s worth noting that specific sectors, such as technology, fell by a much greater amount than the broader market.)
Does any of this information ensure that the S&P 500 rises this year? Of course not, but this bear market will inevitably come to an end. As we often say, the investment markets are undefeated over the long run, having overcome every obstacle encountered. For context, an investment in the S&P 500 on the day before Black Monday (October 16, 1987), when the market experienced its largest ever single day decline, or on the day before the Great Recession began (October 9, 2007) – essentially among the worst possibly timed trades in history – would have resulted in average annual returns of 10% and 8%, respectively. The markets have proven time and time again that they are tremendous wealth generators and we expect this to continue. So, armed with statistics and historical perspective, we will keep the faith, focus on the long term, and invite you to do so with us.
Here’s to a happy, healthy, and prosperous New Year.
Peak Financial Management
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