2022 Wrap-Up
It is almost Christmas as I am writing these lines and I wanted to take a moment to give a “brief” summary of the year 2022 and what happened in the last twelve months from a financial perspective.
Boy, it was quite an eventful year. At times, very exciting and fascinating. Maybe it was just as dreadful as exciting, depending on what assets you are (or were) invested in.
There are far too many factors that can influence financial markets to talk and analyze in one article. Here, I will discuss the ones that seem most significant to me. I would like to touch on what happened in the stock and commodity markets, explain what influence the Federal Reserve had on them, and give an outlook on what to expect in 2023. You might have formed your own explanation of why the year turned out how it did. If so, you are more than welcome to discuss your opinion in the comments or reach out to me directly. Now, let’s dig into it!
1. Stock Market
As of today, the S&P 500 fell by 19.84%, the DJIA by 8.63%, and the Nasdaq obliterated roughly one-third of its value and is down by 32.90%. The long-hoped-for Santa Claus rally did not materialize, stocks overseas fell by similar margins, and there are no relevant indices that are significantly up YTD. If you were invested in technology giants like Meta, Amazon, or Tesla it does not even paint the whole picture for you. You are looking at losses of way over 50%. Small-cap tech and crypto investors probably stopped checking their portfolios by the middle of the year unless they had the stomach to digest losses of sometimes 80% and beyond.
For buy-the-dip’ers and DCA’ers it was an abysmal year since these techniques felt like throwing money into a fire pit over and over again. In my opinion, they are on the right track, however. The American economy held up relatively strong and buying good companies at declining prices makes sense in this environment. In the chart below one can observe the P/E ratio of the S&P 500 and how it declined to historically more “reasonable” levels.
In numbers, the S&P 500 declined from a P/E of 28.85 to 18.61, the DJIA from 22.37 to 20.66, and the Nasdaq from 36.93 to 23.79. The decline indicates that earnings per share stayed strong in the last twelve months, but stock prices fell. What we have experienced was a multiple compression. As of today, an investor gets more actual earnings for the same dollar invested compared to the year before. The underlying companies, at least most of them, have not done terribly and stock prices became more attractive. But what is the reason behind this trend?
2. Central Bank (Fed) Policy
The Federal Reserve was an investor’s best friend in 2020 and 2021. Loose monetary policy with zero percent interest rates and quantitative easing helped inflate asset prices and pushed our portfolios to ever-new highs. Chairman Jerome Powell became a “memeified” God-Like figure. The Lord and Savior of the bull market who destroyed the short-sellers and their put options.
Much has happened since then. In 2022, Mr. Powell became infamous for dropping red candles on all of us every time he spoke in public. The Federal Reserve initiated the second-fastest rate hike in its history. The federal funds rate reached 4.5% in December and is supposed to grow even more in 2023. Rising interest rates work like gravity for investments and are mostly responsible for the decline in the stock market. Watching Mr. Powell’s press conferences was a painful experience and the stated predictions of little actual value for the investor. In 2021 we have been repeatedly told that inflation was “transitory” and major interest rate hikes were not necessary. The Federal Reserve gave us an outlook on a targeted interest rate of 0.9% in 2022 and 1.6% by the end of 2023. It sounds laughable today, but that was the actual information we got out of the press releases. Then, in early 2022 the given outlook and verbalized vocabulary of Mr. Powell changed, and we got to hear that interest rates need to be raised “expeditiously”. Interestingly, as the Wall Street Journal reported in October, many Fed Officials made large-scale trades just before major policy changes in 2020 and 2021. But digging into that topic would go beyond this article.
The actual takeaway for the investor must be that listening to the Federal Reserve’s predictions has had as much value as consulting a magic 8 ball for advice on monetary policy. Most, if not all the predictions, have been inaccurate. It does not matter whether we have been misled or if the Federal Reserve is simply not capable of making reliable calls on its own policy. The Federal Reserve has shown to be a reactive force rather than a proactive one. That makes the issue simpler than it might appear in the first place. Until Q4 in 2021 CPI data was high but it still looked manageable. Then, inflation got rampant, and the Federal Reserve needed to act more quickly. Now, inflation seems to come down and Mr. Powell started already to soften his tone.
My best guess is that the Federal Reserve will pivot and lower interest rates in 2024. Also, keep in mind that US Treasury debt rolls over very quickly.
https://www.newyorkfed.org/data-and-statistics/data-visualization/system-open-market-account-portfolio
All the interest-free pandemic debt must be steadily refinanced. The weighted average maturity was roughly seven years in 2020. No matter what administration takes over in 2024, it will not refinance the entire debt at 4.5% or even higher levels. A deal will be made if the issue will not be resolved by that time.
3. Currencies
Despite the inconsistent actions of the Federal Reserve, the US dollar was the only game in town. It has outperformed all other major currencies and with falling asset prices, it appeared to be one of the best “investments” in 2022.
https://www.marketwatch.com/investing/index/dxy
This fact is remarkable, especially since the currency got inflated by the highest margins ever recorded.
https://fred.stlouisfed.org/series/WM2NS
The recouped strength shows that in years of crisis or economic troubles the dollar is still considered a safe haven. Investors around the world rather sold their assets in 2022 and held US dollars instead. To put it differently, they bought US dollars. As long as the interest rates stay at these high levels, US Treasury Bills or basic bank deposits like CDs will continue to be an attractive alternative for risk-averse investors.
Bitcoin and other cryptocurrencies have shown that they are still far from being considered a viable alternative and other fiat currencies or their governments do not seem to gain the trust of investors. For these reasons, the US dollar will remain the most dominant currency for foreseeable future.
Interestingly enough, this will also give the US government leverage to keep up its spending without suffering severe consequences. The US economy would benefit from a weaker dollar, so we can assume that the current administration will feel incentivized to keep spending high. Maybe the US consumer would have rather wished for price stability and low gas prices in 2022, but that is not for me to evaluate.
4. Commodities
We can say with certainty that gas prices (crude oil), natural gas, and other commodities have definitely outperformed the US dollar and security markets in the first half of 2022. Obviously, the war in Ukraine was the leading factor in that surge since it decreased the global supply of crude oil and natural gas. However, prices have been in decline for a while now and they have reached pre-war levels.
https://www.marketwatch.com/investing/future/cl.1
https://www.marketwatch.com/investing/future/ng00
This does not seem to make sense if we follow the narrative of limited supply from Russia and Saudi Arabia. In Europe, particularly in Germany, the natural gas supply is the number one issue. Public buildings are heated at a minimum to get through the surprisingly cold winter and energy bills for businesses as well as consumers are through the roof. Politicians try to teach their citizens how to save energy at home, often in an unwillingly funny way. But why, if energy prices are actually going down? And why are they going down?
The most valid explanation is that the artificially limited supply meets an even lower demand. We are already in a global recession driven by weak economies in Europe and Asia (particularly China). The only reason why European economies nevertheless experience high energy prices is due to the dependency specifically on Russian natural gas. There are just not enough terminals to get a sufficient amount of liquified natural gas from other suppliers into the continent. Most European countries have abandoned alternatives such as coal and nuclear energy. For that reason, the problem is homemade and has nothing to do with global supply anymore.
Other commodities such as corn, wheat, and lumber are all significantly down from their 2022 highs. For producers that might help in obtaining better margins, but it seems more like a deflationary force due to a lack of demand. I expect that trend to continue since most developed economies outside the US struggle to grow and may even experience a prolonged decline in economic output.
5. What to expect in 2023?
Going into 2023 we are confronted with rising inventory levels. The times of supply shortages are over, and businesses struggle to turn over their goods.
https://fred.stlouisfed.org/series/BUSINV
The US consumers held up very strong during this inflationary cycle, but they are running out of buying power. The savings rate is at its second lowest ever recorded and credit card debt has reached an all-time high.
https://fred.stlouisfed.org/series/PSAVERT
These factors are the perfect cocktail for an economic downturn, or simply, a recession. One thing holding up against it is the stubbornly low unemployment rate.
While this makes us hope that 2023 might not be as bad as former recessions, we must assume that many businesses will struggle in this environment. Investors should be prepared for more downside in the stock market. As I mentioned earlier, 2022 brought stocks overall to a lower base independently from the underlying earnings. Now, we can expect many disappointing earning calls, revised forecasts, and many institutional downgrades since most price targets by analysts (who were still caught up in the post-pandemic euphoria) will be far off. The days when you could buy almost any stock and make decent money are over.
However, these are not necessarily bad times to invest. One must just be aware of what kind of market we are in. A new era of stock picking and value investing has begun. Businesses with low multipliers, high margins, and recession-proof products are very attractive right now. Also, various high-growth companies have fallen to their lowest levels in over five years. Growth has not been that cheap in a long time. For investors with the right stomach and enough patience, this market can make the foundation of life-changing wealth. Even if you do not feel comfortable buying stocks right now, you can still pick up some nice, risk-free treasury bonds at 4-5% to buy some time and earn a decent return while observing the market.
Whatever you do, I wish you the best in your future endeavors. Merry Christmas!
