U.S. and global stock markets experienced solid gains in the fourth quarter but remained significantly in the red to end 2022. The S&P 500 Index gained 7.5% in the quarter including dividends, recouping some lost ground but ending the year down 18%. U.S. stock market performance was bad in 2022 no matter how you cut it. However, it is interesting to note that the Dow Jones Industrial Average, which is a stock price-weighted index of only 30 large companies, returned a solid 16% in the fourth quarter and declined only 6.9% in 2022, faring much better than the S&P 500. At the other end of the spectrum, the Nasdaq Composite Index, consisting of more than 3,000 stocks, many of which are technology- oriented, declined in the quarter and fell 32% for the year. While no index is a “perfect” gauge, we prefer to focus on the S&P 500 Index as it consists of 500 of the largest U.S.-based, publicly traded companies spanning eleven industry sectors and is therefore more broadly diversified and representative of the overall market.
Stocks declined in 2022 mostly due to the Fed’s aggressive actions to bring inflation under control by raising interest rates and tightening monetary policy. These actions in part caused investors to fear that a U.S. recession looked increasingly likely, and that corporate profits were at risk. Rising interest rates causing downward pressure on stock valuations was also a factor.
Over the course of the year, the market experienced a few periods of strength driven by investors incorrectly concluding that Powell and the Fed were set to back off and adopt a more “dovish” stance on rates and inflation. These hopes were then dashed by the Fed reiterating its commitment to aggressively address inflation even at the expense of the economy and stock market. Strong stock performance in the fourth quarter was one such example of investor enthusiasm increasing on renewed hopes that inflation had truly peaked, and that the Fed was nearing the end of its tightening. The jury is still out, but we are seeing some promising signs as outlined in the economic section above.
International stocks, as measured by the MSCI All Country Worldwide ex-U.S. Index, returned an impressive 14% during the quarter including dividends, bringing the full year 2022 total return to -16%. Emerging markets as measured by MSCI’s Emerging Markets Index did not get quite the same lift in the final quarter, gaining nearly 10%. For the year, emerging markets fared worse, down 20%. Ongoing global challenges, including Russia’s war on Ukraine and major issues afflicting China, weighed more heavily on the emerging markets, whose economies are more dependent on exports. Despite all of the factors impacting non-U.S. economies across the globe, it is interesting to note that 2022 is the first year since 2017 where non-U.S. stocks outperformed their U.S. counterparts, albeit by a slight margin.
Despite international stocks outperforming their U.S. counterparts in 2022, these days we are often asked: “Why invest in international stocks at all?” Moreover, while the performance of this asset class in recent years is certainly testing our resolve, our answer is threefold: first, because we see compelling long-term capital appreciation opportunities driven by secular growth trends such as the emergence of middle class consumer populations across the world. Second, because valuations are at multi-decade lows, dividend yields are at multi-decade highs and no trend lasts forever. International stocks are not dead and the U.S. market’s reign is not un-ending (as we just saw in 2022). Finally, the U.S. dollar is elevated versus foreign currencies. Should the dollar begin to depreciate against other currencies, cheaper dollars will enable many countries to pay their debts more easily and will help heighten returns for international stocks. So, while international stocks have been a drag on overall performance in recent years, our commitment remains intact, though at a lower target allocation as compared to U.S. equities.
Outlook
Shifting our focus back to the United States, we wish we could say with confidence that the market’s dark days are over and that stocks will rise in 2023. At this stage, the markets could go either way. The reality is we just do not know and there are many cross currents clouding the near-to-medium term outlook right now.
The bottom line, as we have written frequently throughout this year, is that the market’s direction comes down to corporate profit trends, or earnings. Stock prices tend to follow forward earnings estimates, and the outlook for earnings is unclear. As of now the S&P 500 Index earnings per share (EPS) for 2023 are expected to be $230, representing 6% growth over 2022 earnings. We will not know actual 2022 earnings until fourth quarter results are reported in the next few months. $230 EPS in 2023 puts the current S&P 500 Index valuation on a price-to-earnings (P/E) basis at 16.8x, which is line with the long-term 25-year average. If earnings estimates turn out to be true, we think the market looks fairly priced with an undemanding valuation, and we are optimistic that stocks can rise from here.
For now, the Fed continues to increase short-term interest rates as inflation remains stubbornly high. Corporations are cutting back spending and laying off employees. It iscertainly possible that expectations for future earnings are overly optimistic. If this is the case and earnings turn out to be a lot lower in 2023, then the market looks expensive on a would not be surprised to see stocks fall depending on the magnitude of the earnings estimate reductions. For instance, if earnings were to decline twenty percent (or greater) in 2023 to $175, that would put the market valuation at an expensive 22x, and we believe the broad market indices would fall. We are also aware of the fact that historically, the stock market does not bottom until the Fed starts cutting interest rates. This time may be different, but we are always mindful of the lessons history teaches us.
While it is difficult to get a precise handle on all of the different factors affecting our economy today, we have seen some credible S&P 500 Index earnings downside scenarios in the $190 range, which would put the market at 20x earnings – not cheap but also not worrisomely high in our view. As a base case, we think 2023 EPS in the range of $200-230 makes sense if the Fed can bring inflation under control while the U.S. consumer remains on strong financial footing, house values remain resilient, and the employment picture stays strong. In this case, we would expect the market to muddle along in a +/- 10% range before starting to rise again as earnings recover and begin to climb at a more steady, predictable rate.
Taking a step back, this is a painful period and losing money in stocks never feels good. 2022 was particularly difficult but comes on the back of three extremely strong years of double-digit performance. That said, the Fed is doing what is necessary for the long term – for inflation, the economy, consumer sentiment, and the stock market. Interest rates cannot remain at zero forever and those who witnessed the destructive double-digit inflation of the 1970’s would agree that inflation must be brought under control.
Healthier economic times are ahead. The U.S. economy will likely emerge stronger and healthier from this period of adjustment, even if the Fed overshoots and the market falls more in the near term. Eventually markets recover, which is why our recommendations for continuing to weather the current storm remain unchanged. Plan for and communicate cash needs. Do not panic by selling stocks unnecessarily at depressed prices. Stay invested in accordance with your long-term goals, and please feel free to reach out to Howland Capital if there is anything we can be doing to help.
