2023 Market Thoughts

Happy New Year! Good riddance to 2022! There were many good parts of 202–extremely low unemployment, less mask wearing, higher home values and strong commodity returns. However, for the stock and bond markets as a whole, it was a bummer year and I think we are all happy to put it behind us.

The S&P 500 Index ended the year with a total return of -19.5% and bond markets did not fare much better; the Vanguard Aggregate Bond Index ETF was down 13.0%. It is a rare year where both stocks and bonds fall. Going back to 1926, there are only two calendar years when this occurred, 1931 and 1969 (based on the Ibbotson S&P 500 Index, Ibbotson Large Company stock index and Ibbotson Aggregate Index). According to Callan Research, on a quarterly basis there have been 37 quarters where both stocks and bonds have fallen. Negative stock and bond returns tend to happen more often when rates are rising, as they did from 1966-1981.

Stock and bond markets were weak due to the threats of economic slowdown or recession. These concerns were driven by rising inflation and the Federal Reserve Open Market Committee rise in rates to try and slow inflation. While rising rates are designed to slow inflation by slowing economic activity, I’d like to propose a few reasons why I believe market prices may already reflect a slowdown and how the slowdown may be more muted than what we’ve been used to over the past 20 years.

• The Federal Funds Rate is still relatively low compared to historic levels.
• Employment remains strong, which can continue to fuel consumer spending.
• Banks and other corporations have been preparing for a slow down and are in good shape to continue lending.

The Federal Funds Rate rose from approximately 0% to over 4% in a fairly rapid time. While the pace of interest rate rise was strong the actual rate is still quite low when we compare it to historic levels in the chart below from the Federal Reserve Economic Data (FRED) web-site. This level of interest rates may continue to offer a nice opportunity for businesses or home owners to borrow without significantly hampering future growth.

Employment remains at very high levels. The Unemployment Rate released on 1/6/2023 indicated an unemployment rate of 3.5%. This remains an extremely low level. Additionally, as of the end of November 2022, the number of job openings versus unemployed persons remained extremely elevated. The chart below is from a J.P. Morgan Asset Management presentation with information from the U.S. Department of Labor. This high level of job openings versus unemployed persons and low unemployment rate indicate that we still have significant slack in the labor market. Even with a higher number of announced layoffs in recent months, we have a long way to go before there is real pain in the overall economy.

Lastly, banks were forced to ramp up capitalization ratios and lending standards following the 2008-2009 financial crises. FRED reports that as of July 1, 2020, loan loss reserves to total loans for all U.S. Banks was over 2%. Unfortunately, FRED is no longer tracking this data. However, JPMorgan Chase & Co. reported an allowance for loan losses to total retained loans ratio of 1.7% as of September 30, 2022. 

Jamie Dimon, the CEO of JPMorgan Chase & Co., was documented as cautioning investors regarding future economic conditions. He said this while also saying that in the third quarter they were not seeing significant signs, if any, of deteriorating quality. I appreciate major banks being cautious. Being prepared can help cushion any impact of economic slowdown. It is when banks are blindsided, overextended to risky loans and left with low reserves to handles bad loans that economic lending can freeze.

Given these historically strong and cautious conditions, I believe it is possible the stock market is already reflecting the economic slowdown that may occur in 2023. There is always the possibility of black swan events that none of us are expecting. However, there’s no denying that most stocks are on sale to the tune of 15-30%, or more, from their high prices. That’s a pretty attractive discount.