There was no Santa Claus rally in 2022, as stocks (as measured by the S&P 500 index) finished the month of December down 6% for the month. Historically, the month of December is one of the strongest months of the year, so the drop came as a bit of a surprise to bullish investors who were hoping that stocks would continue to build on the gains of October and November, then carry that momentum into 2023 to help reverse the dismal fortunes of the past year. However, with stocks stumbling into the new year, many investors are feeling uncertain about the prospects for a rebound.
For the year as a whole, it was the worst year for stocks since the 2008 financial crisis. The table below shows how several popular indices fared—and it wasn’t pretty. For investment-grade bonds (both corporate and government), it was the worst year on record. These assets are usually the safe port in the storm when stocks are falling, but with the Federal Reserve increasing short-term interest rates in the face of rising inflation, high-quality bonds fell over 10% for the year. Their more aggressive brethren, high yield bonds, were also down double digits, though the result was not so surprising as this asset class tends to move in the same direction as stocks. There was simply no place to hide in 2022.
The silver lining in last year’s difficulties was that as interest rates rose, the yields on money market funds climbed. For money kept in the Schwab Value Advantage for the whole year, the return was 1.5%, with the current yield now over 4%.
While all this presents a pretty dismal picture, it’s important to keep in mind that bear markets are necessary to clean out the excesses from the prior bull market. They also set the stage for the low-risk, outsized gains that are likely to occur when the Federal Reserve abandons its tight monetary policies and shifts to policies designed to promote economic growth and investment. It is possible that the Federal Reserve could make that shift at some point in 2023, especially if the stock market continues to slide and economic growth deteriorates.
Within the FSA accounts, we reacted to the rally in October by cautiously moving some assets back into the stock and bond markets. While the overall trend in both stocks and bonds remained downward, there was enough encouraging shorter-term improvement, from a technical perspective, that we began moving the portfolios off the beach and back into the shallow area of the ocean.
Across all strategies, we now hold about 30% in equities, 10% in bonds, and 60% in money markets. Among our equity holdings, we favor more conservative value funds, and we recently added some funds that focus on smaller companies. In addition, in our more conservative strategies, we have invested in more eclectic areas, such as merger arbitrage, market neutral, and managed futures funds, which have held up relatively well this past year. We see these areas as good places to ride out the choppiness until stocks—and bonds—can finally break into a new uptrend, whenever that might be.
Prospects for 2023
Market participants have had a year to consider the impact of rising inflation and rising interest rates on corporate earnings and economic growth. As we enter year two of this new era, the big unknown is whether the U.S.—or indeed, the global—economy will enter a recession. From our perspective, it seems that many of the big Wall Street firms believe the U.S. will experience at least a mild recession by the end of this year. Short-term interest rates are yielding more than longer-term interest rates, which is a reliable harbinger of a future recession.
From the chart below, you can see that after peaking at the beginning of the year, stocks worked their way lower through the end of September and then attempted to break out in November, only to stall out in December. Stepping into 2023, stocks are clearly in a downtrend, but the rebound in the fourth quarter, which amounted to 7% for the S&P 500 Index, was strong enough to open the possibility that further gains could be ahead.
To be sure, we continue to hold high levels of money markets in most of our strategies. Some of our long-term clients may remember the year leading up to the financial crisis and the challenges of that year (2007) as we tried to react to the markets’ actions. By the end of the year, we were holding high levels of money markets, but our strategies did not perform very well in relation to the major indices. However, as the stock market gave way in early 2008, due to already high money market levels, we had our best year ever, in relation to the broad stock market. Of course, we didn’t know back then that the stock market was on the cusp of a 50% drop that year (at its low point), but our disciplined process requires us to react to the signals we get from the market, regardless of the financial news of the day.
The final chapter of this latest saga is not yet written, but as we enter the new year, the dry powder we hold (as high money market levels) is earning interest while we wait to take advantage of new opportunities when they develop.
Portfolio Update
Keep in mind that because we manage clients’ portfolios individually, the holdings in your specific accounts may differ somewhat from the averages.
Strategies That Employ the FSA Safety Net®
Income (Strategy 1)
Even though this strategy posted negative returns for 2022, given the double-digit losses in high quality and high yield bonds, this strategy held up quite well. In the fourth quarter, both high quality and high yield bonds began to rally, so we continued to wade back into the waters with the purchase of an intermediate-term bond fund in December. This strategy remains quite defensive with 30% in short- to intermediate-term bond funds, and 70% in money markets.
Income & Growth (Strategy 2)
While this conservatively balanced strategy finished in negative territory for 2022, we are pleased with the results given the double-digit losses by both stocks and bonds. In response to the rally in the fourth quarter, we added a balanced fund and increased our allocation to the merger arbitrage fund and added a high quality bond fund to the portfolio. At year’s end, these portfolios held 20% in equity funds, 30% in bond funds, and 50% in money markets funds.
Conservative Growth (Strategy 3)
Despite the significant losses in both the stock and bond markets, Conservative Growth accounts managed to hold up relatively well. From a fully defensive position at the end of September, these accounts have slowly been wading back into the waters, as stocks (and bonds) tried to recover in the fourth quarter. In most accounts, we added two defensive equity funds and a high yield bond fund. Currently, these portfolios hold 30% to 35% in defensive equities, 10% in high yield bond funds, and 55% to 60% in money markets.
Core Equity (Strategy 4)
Within the 18% drop in the S&P 500 Index in 2022, there were three rallies of greater than 10%. Those whipsaws played havoc with this more aggressive strategy as it attempted to stay in sync with the prevailing market trend. During the fourth quarter, as the market tried to rebound, we added a small-cap fund and a mid-cap fund and increased the weighting in the health care fund. At year’s end, the Core Equity portfolios held 50% equities and 50% in money markets.
Tactical Growth (Strategy 5)
As with Core Equity, the unrelenting choppiness of the stock market in 2022 made the going difficult for our most aggressive strategy. As stocks rallied in the fourth quarter, we added the following funds to these portfolios: small-cap, foreign, energy, industrials, and long-term government bonds. Currently, these portfolios hold 20-50% in U.S. equities, 10-15% in foreign stocks, and 35-60% in money markets.
Strategies WITHOUT the FSA Safety Net®
Sector Rotation
The Sector Rotation strategy performed relatively well in 2022. Despite its aggressive mandate, it held up well thanks to holding energy for a good part of the year, as well as an inverse S&P fund. For January, the portfolio is aggressively invested, holding the following funds: energy, precious metals, industrials, health care, and consumer staples.
Global Rotation
The choppiness of 2022 played havoc with our newest asset rotation strategy. During the fourth quarter, these portfolios went from 84% in money market down to 36%. As we enter the new year, these portfolios hold 48% in U.S. stocks and 16% in foreign stocks.
Strategies That Remain Fully Invested Through ALL Market Cycles
Global Moderate
This strategy holds a constant 70% allocation to equities, with 30% allocated to bonds. While the small allocation to gold helped for the year, the allocation to real estate and emerging markets hurt returns.
Global Growth
This strategy maintains a 90% allocation to equities, with a modest 10% allocated to bonds. While the small allocation to gold helped for the year, the allocation to real estate and emerging markets hurt returns.
Please remember to inform your advisor of any changes in your life that might affect your investment objectives and how we manage your money.
Ronald Rough, CFA
Chief Investment Officer
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