Manley Market Memo January 2023

Summary

• Stocks and bonds performed poorly in 2022 because the Fed aggressively raised interest rates to slow economic growth and fight inflation, which reached a forty-year high. The sharply higher interest rates pushed down the valuations of all financial asset classes. In fact, stocks and bonds declined for only the 5^th time in the last 100 years.

• The stock market has started 2023 on a solid note. The S&P 500 and Nasdaq 100 have appreciated by 4.6% and 8.0%, respectively. The S&P 500 has rallied 15% off its October low, which is consistent with previous mid-term election rallies. The strong mid-term rally – which we wrote extensively about this summer and early fall – is due to technical factors (oversold market, passive 401k flows, corporate buybacks, and systematic trend-following strategies) and not a change in the fundamentals.

• Last year, leading economic indicators showed that the economy was strong and inflation would be a problem. Unfortunately, the Fed ignored these indicators and continued its unprecedented monetary stimulus, which created asset bubbles, and drove inflation to a 40-year high. We believe that the Fed is making another monetary mistake by focusing on inflation and employment measures – which are lagging economic indicators – and again ignoring the leading economic indicators that have sharply deteriorated and point to a mild recession this year.

• Despite a 27.5% drop last year, stocks are vulnerable to another significant decline this year. Stocks are overvalued, and Wall Street earnings expectations seem unrealistic. While leading indicators point to a recession this year, Wall Street analysts forecast corporate profits to grow by 12.5% this year. This growth estimate seems exceedingly unlikely since profit margins are near a record high and vulnerable as interest rates rise and growth slows, and S&P 500 earnings typically decline by about 20% in a recession.

• Stocks are in a bear market, and we estimate that the economy will enter a mild recession this year. In this challenging economic environment, we expect safe havens (gold and long-term U.S. treasury bonds), defensive stocks (healthcare, utilities, and consumer staples), and high-quality bonds to perform well.

Market Review:

2022 was a difficult and challenging year. Stocks and bonds performed poorly because the Fed aggressively raised interest rates to slow economic growth and fight inflation, which reached a forty-year high. The sharply higher interest rates pushed down the valuations of all financial asset classes. In fact, stocks and bonds declined for only the 5^th time in the last 100 years. The S&P 500 fell 19.4% for the year, which was its worst year since the 2008 Great Financial Crisis, while the Bloomberg U.S. Aggregate bond index dropped 13% -- its worst year on record. The stock and bond markets poor performance led to the 60/40 balanced portfolio's worst return since the Great Depression.

Source: A Wealth of Common Sense

2022 was a bad year for investors because the Fed's monetary mistakes created asset bubbles which deflated once interest rates rose sharply. To support the economy and financial markets during the pandemic, the Fed set interest rates at 0%. The artificial level of interest rates coupled with the Fed's printing $120 billion each month to buy Treasury and mortgage bonds drove stock, bonds, and the housing market into an asset bubble. The bubble continued to grow because the Fed refused to remove its emergency measures despite a stout economic recovery and rising inflation.

In March, inflation reached 8.6%, so the Fed terminated its QE bond buying program and raised short-term interest rates to 0.25%. By early summer, the Fed realized inflation was not "transitory" and increased interest rates at the most aggressive pace since 1981. In nine months (from March to December), the Fed raised short-term interest rates from 0.00% to 4.50%, which drove all financial assets (stocks, bonds, and crypto) significantly lower.

Despite strong economic growth and inflation at a 40-year high, the Fed failed to remove its emergency monetary measures because it incorrectly believed that inflation was "transitory."

Source: Fred

By the summer, the Fed realized its mistake and aggressively raised short-term interest rates, which led to a bear market in financial assets.

Source: Fred

In this difficult investing environment, Energy was the only positive sector of the S&P 500. The Russell Growth sector fell by 29.9%, while the Russell Value sector declined by only 9.7%, which was the value sector's second-largest outperformance since 1979. According to S&P, the technology sector's 28.4% decline accounted for nearly 44% of the S&P 500's decrease in 2022.

While our model portfolio outperformed our 60/40 benchmark in 2022, we are disappointed by our portfolio's loss. We were defensively positioned in 2022, and in hindsight, we were invested in the strongest sectors of the market – Energy, value, and the defensive sectors of the market, gold, commodities, and Treasury Inflation-Protected Securities (TIPS). Unfortunately, there was no place to hide --  even gold (the ultimate safe haven) had a negative year.

Financial Market Performance

Economic Outlook:

The stock market started 2023 on a strong note. The S&P 500 and Nasdaq 100 have appreciated by 4.6% and 8.0%, respectively. The S&P 500 has rallied 15% off its October low, which is consistent with previous mid-term election rallies. The strong mid-term rally – which we wrote extensively about this summer and early fall – is due to technical factors (oversold market, excessive investor pessimism, passive 401k flows, corporate buybacks, and systematic trend-following strategies) and not a change in the fundamentals. We believe that we are still in a bear market. The first leg down was due to sharply higher interest rates and their negative impact on asset valuations. While higher interest rates negatively impacted financial assets in 2022, we think they will adversely affect the economy and corporate profits in 2023.

To justify the mid-term election rally, Wall Street has crafted a narrative that inflation has peaked, the Fed is poised to end its tightening cycle, and a soft economic landing is probable because China is reopening from its Covid lockdown, and Europe avoided an energy crisis because of a warm winter.

Instead of crafting optimistic narratives or focusing on lagging indicators (inflation and employment) like the Fed, we utilize market history, leading indicators of the economy, and market-based tools to determine the likely path of the economy (growth and inflation) and corporate profits.

Market history does not point to a soft economic landing this year. Most Fed tightening cycles led to recession, and since 1960, a recession has occurred every time inflation breached 5%. In fact, most Fed tightening cycles end in crisis because the Fed focuses on lagging economic indicators (inflation and employment) and ignores the money supply and other leading economic indicators.

Most Fed tightening cycles led to a recession. Since 1965, every time inflation rose above 5%, a recession occurred.

Source: Fred

Historically, to fight inflation, the Fed tightens until something breaks. This isn't surprising since the Fed focuses on lagging economic indicators (inflation and employment) and ignores the money supply and other leading economic indicators.