2023 Market Commentary: Bear vs. Bull

January 9, 2023

Like most investors, we are glad to view 2022 out of our rearview mirror. Last year, U.S. equities had their first annual decline since 2018 and their worst return since 2008. Fixed income was just as dismal and had its poorest performance in the last 50 years. The S&P 500 and U.S. Aggregate bond index declined 18% and 13%, respectively.  As a result, the traditional balanced portfolio of stocks mixed with bonds did not adequately insulate nest eggs on the downside, much to the dismay of investors.

Inflation and the Federal Reserve’s (Fed) aggressive tightening response were the primary challenges for the market to process last year.  Both issues remain front and center in 2023. While staying grounded in our core investment principles (which we revisit below), we would like to take this opportunity at the beginning of the New Year to share our bullish and bearish thoughts regarding the current economic climate and market environment.  

The Bear Case

We officially entered a bear market (defined as a 20% or more decline from the previous market high) beginning in 2022, and it is currently ongoing. As is typical when markets enter bear territory, there will be no shortage of worries for bears to sustain themselves. The bear case rests on (1) the Fed continuing to tighten at a rapid pace, thereby slowing the economy and increasing stress on corporate profit margins and spending, (2) further pressure on valuation levels due to higher interest rates and lower expected earnings, and (3) investor sentiment deteriorating as confidence declines.

Last year marked the end of the largest combined monetary and fiscal stimulus period in history as the Fed raised rates seven times, totaling 4.25 percentage points. While the Fed was initially criticized for reacting too slowly to signs of inflation, its recent messaging and actions have been consistently hawkish. Bulls fear and bears cheer that an extended period of higher interest rates will dampen demand and push the economy into a recession. Consensus forecasts are now one-sided in projecting a recession in 2023 or 2024. So far, corporations and consumers are holding up well overall. Large technology companies are proactively reducing labor headcount in anticipation of a slowdown, and other companies are keeping a close eye on the economic environment. Nonetheless, profit margins, while still good, have come down from record levels due to higher input and labor costs. Companies will do their best to pass along these costs, but consumers may be hard-pressed to maintain their spending if inflation doesn’t ease. 

Further pressure on valuation levels is a valid concern for the market in 2023.  The performance of stocks in 2022 (or lack thereof) was largely attributable to a de-rating in the price-earnings (P/E) multiple from 22X at its peak to 16X at the end of the year. However, valuation multiples may have more room to fall if earnings falter. Pessimistically, the previous five bear markets had an average trough P/E multiple of roughly 14.5X. 

Confidence among investors, businesses, and consumers undergirds our economy and health of our capital markets. The challenges of stubborn inflation (particularly wage inflation), higher interest rates that increase the cost of capital for individuals and companies, and geopolitical issues (to name a few) are worrisome and may undermine confidence this year. Just as bull markets benefit from rising confidence, bear markets feed off uncertainty, unease, and negative expectations, all of which may be in full supply in 2023.  

The Bull Case

The bull case for stocks is predicated on (1) a milder and shorter recession than expected, (2) the strength and resilience of consumer and corporate balance sheets, and (3) a recognition that the market has already priced in downside scenarios for many companies. It is important to note that attractive opportunities for investors are often found during bear markets.

The most discussed question in the markets today is whether the Fed can tame labor demand and rising wages without causing a sharp rise in unemployment or triggering a major recession.  Economists and strategists debate whether the Fed’s landing will be hard or soft and whether the recession will be mild or more severe.  A milder and shorter recession would be better for equities but may depend upon growth slowing just enough to keep the Fed at bay.  Rising rates affect the economy with a lag, so only time will tell how the markets will react in the coming months.

Consumers and businesses are both fairly well positioned to manage through an economic downturn and should be able to sustain spending and investment, in our view.  Collectively, U.S. households hold more than $1 trillion in savings (in part from pandemic-related fiscal stimulus) and are benefiting from the flipside of inflation through higher income/wages.  Investment-grade corporate balance sheets are similarly well-heeled as many companies took advantage and locked in low interest rate debt over the past few years. The combination of strong corporate and consumer balance sheets should help buffer economic weakness and bolster the market.

In 2022, there were scant places for investors to seek shelter, with virtually all of the broader equity and fixed income indices that we track posting negative returns. In addition, more speculative growth areas of the market such as recent IPOs, SPACs, and crypto were particularly punished.  The result is that a significant amount of excess has already been wrung from asset prices.  We expect the negative news drumbeat to continue in 2023, and it may come with proper justification.  However, as prices fall, opportunities will present to those with the ability to see through the noise and to maintain a longer-term investment horizon.

Core Investment Principles

At The Fiduciary Group, we focus on constructing portfolios that enable our clients to maintain their asset allocations throughout the market cycle, especially during the stressful periods when it matters most. In other words, we accept the fact that we cannot predict bouts of volatility or periodic downturns in the market. Instead, we devote our time and attention to preparing clients to weather changing market conditions, including bull and bear periods.

We invest in financially sound companies with strong balance sheets that can withstand tough times. We look for sustainable competitive advantages and the opportunity to partner with management teams who are trustworthy and capable. Changes in stock prices will ultimately be determined by the results of the underlying business. The ability to accept short-term market volatility with equanimity while remaining focused on what truly matters is critical to long-term success in investing.

We also believe in the importance of strategic asset allocation and diversification so that clients’ investment strategies are aligned with risk tolerance as well as their future cash needs. We focus on each client’s ability to bear risk and their capacity to withstand the swings that accompany changes in market values. Individual client circumstances always inform our investment decisions, and we understand that every client situation is unique. Ultimately, our goal is to intelligently balance the mix of stocks and bonds to adequately capture the benefits they provide for investors while also remaining cognizant of their shortcomings. Our objective is to set asset allocations so clients will have the conviction to stay invested throughout the market cycle and reap the benefits of long-term compounding.

As investors, our greatest strength lies in how we choose to react to market volatility. We affirm our belief that a balanced, diversified, strategic approach helps clients stay invested throughout a range of market and macroeconomic cycles and puts them in the best position to achieve returns and to accomplish their goals over the long run.

Please feel free to reach out to us with any questions. As always, we greatly appreciate the trust our clients place in us.