By Jim Reardon | January 2023
The year 2022 ended with the stock market delivering its largest yearly losses since 2008. The fourth quarter of 2022 saw new bear market lows in the S&P 500 index, Nasdaq Composite, and Bloomberg Agg Bond Index.
The Dow Jones Industrial Average (Blue) was the best performer, down only -8.78%.
The S&P 500 index (Green) finished the year down 19.44%, after being down nearly 25% at its lowest point in the year on October 12.
The Nasdaq Composite (Red) finished the year down 33.1% with its lowest point being down almost 35% on December 28.
The Bond index (Purple) finished down 13% for its worst calendar year performance in many decades. The previous worst year on record wish 1994 with a 2.9% loss.
The traditional allocation of 60% stocks and 40% bonds used by typical passive money managers was down approximately 17%. Conversely, many of our actively managed client retirement accounts ended the year with small YoY gains. In our more aggressive accounts, reducing the magnitude of drawdowns held the losses to mid-single digits, which should provide a much quicker ride to recovery.
The main theme driving markets in 2022 was inflation
Inflation has taken a big toll on the markets in 2022. You have to go back to the 1970’s to find bigger price surges. Supply chain and labor disruptions from the COVID-19 shutdowns, pandemic stimulus, and the impact on energy prices from Russia’s Ukraine invasion were among the primary causes.
Inflation has also meant higher costs for materials, inventory, and labor. Also, raising the cost of capital for individuals and businesses slows, or defeats spending or expansion plans. This erodes the value of current and future earnings. Since stock prices are based on expectations of future earnings, a lengthy inflation period is highly undesirable over the long term.
The Fed moved in record fashion to raise interest rates, making seven consecutive rate increases totaling 4.25%, but inflation is still too high, and the Fed has indicated that more rate increases are needed to get inflation to their desired goal of 2%. As we’ve pointed out in previous newsletters, the Fed typically doesn’t stop raising rates until something breaks in the economy or markets.
When considering the trade-off between the short-term pain of tightening financial conditions and the long-term positive of having inflation under control, the latter is preferred by the Fed—even if it leads to a recession.
The rapid monetary tightening aimed at bringing down inflation will ultimately succeed, but the cost will likely be a global recession in 2023. The story for 2023 will continue with inflation as the main theme but will likely be dominated by recessionary conditions.
The drop in the stock market during 2022 improved equity valuations some, but the market is still overvalued by most estimates. The growing likelihood of a recession is a big risk to corporate earnings. A recession would mean revenues decline, and profit margins compress from their current cyclical-high levels.
We have said recently that another leg down in the stock market (and possibly the bottom of the bear market) may come as corporate earnings reckon with a global recession.
The treasury yield curve continues to show trouble ahead for the economy. The rate hikes from the Fed have caused the short-term rates to spike this year at a much faster pace than the longer-term rates. When you get an inversion (short-term rates higher than long-term rates), an economic recession has typically been imminent.
Given the high likelihood of a recession, it might seem wise for us to continue sitting in cash as our best option right now, but without a disciplined approach for re-allocating capital when the investing environment improves, most investors will inevitably stay in cash far too long and miss out on the superior growth potential that often comes after bear markets have beaten down stock prices.
While our strategy remains defensive, we are aware that not all stocks are losing money and in fact, some stocks such as energy stocks are making new highs.
We have become a bit more positive in the short term, and the intermediate term picture looks better for some market sectors. However, our long-term indicators remain skeptical at best. We believe our sensitive market indicators will help us protect client accounts if a further selloff is experienced in the stock market.
As the chart (above) indicates, coming out of the last several bear markets since the 1987 crash, we have seen the market bounce back an average of more than 20% within 12 months. We believe the hardest part of risk management is staying aware of changing market conditions and being prepared to reallocate quickly in response to an eventual market recovery while still focusing on defensive measures to protect client capital if the bear market worsens.
We are mindful that stock market conditions are different than economic conditions and, historically, stock market conditions begin to improve well ahead of the economy during a recession. In fact, the stock market is one of the leading economic indicators. We are also aware that back-to-back yearly losses have rarely occurred in the stock market.
Our time-tested risk management strategies have provided good results during a tough market environment, substantially beating Morningstar benchmark returns in 2022.
While we will attempt to participate in market rallies when they occur, our focus will always remain on risk management and downside protection. Compounded returns over time are greater if losses are kept small during bear markets.
We have stated several times in our Situation Reports, no one can know for sure that a bear market is over until the positive trendlines become clearly established. Allocating investors' capital based on guesses that the "bottom is in" is a foolish game and a recipe for disaster.
We think the best approach is to identify and participate in improving market sectors when appropriate, while always maintaining downside protection if this bear market worsens. So far, our recent increases in improving equity sectors and in short-term bond exposure has been rewarding.
Risk management and downside protection are critical to generating long-term performance and we believe our clients can come out ahead by minimizing their losses during bear market and being prepared for the eventual return to bull market conditions.
Our disciplined, rules-based, quantitative approach to investing is robust, has been time-tested, and has delivered mostly satisfactory results across many market environments, including protecting investors from much of the substantial drawdowns that occurred this past year.
That is what our strategies delivered in 2022 and that’s what our company has been known for.
Please contact us if you have any questions about our strategies at any time.
SECURE ACT 2.0
On December 29th, as part of a budget bill, the retirement savings legislation named Secure Act 2.0 was signed into law. The provisions passed build on changes made in 2019 with the original Secure Act. Below are some highlights of the legislation that may affect you.
- Required Minimum Distribution Age: The required age for beginning distributions from retirement accounts increases to age 73 effective January 1, 2023. It further increases to age 75 on January 1, 2033.
- The penalty for failing to take a required minimum distribution decreases to 25% of the RMD amount from the 50% currently.
- Catch-Up Contributions Expanded: Beginning in 2025, catch-up limits for employees in employer-sponsored retirement plans that have attained age 60 through age 63 can increase their contribution by $10,000. Catch-up contributions for IRA’s are currently $1,000 but will now be indexed to inflation, meaning they could increase each year.
- 529 Plan Changes: After 15 years, 529 plan assets may be rolled over to a Roth IRA for the named beneficiary, subject to annual Roth contribution limits and an aggregate lifetime limit of $35,000. Rollovers cannot exceed the aggregate before the 5-year period ending on the date of the distribution. The rollover is treated as a contribution towards the annual Roth IRA contribution limit.
We are excited to announce that as of 12/31, our CEO Cory McPherson became 100% owner of the firm.
Jim Reardon is a financial planner and advisor, and the Chief Investment Officer for ProActive Capital Management, Inc. He has over 20 years of experience pro-actively managing assets for clients and non-profit organizations. A Certified Financial Planner™, Jim is a graduate of Kansas State University and Washburn University School of Law. He holds licenses in law and securities and was admitted to the Kansas Bar in 1973.
Certifications and Licenses: Series 7/63/66 Securities Licenses, Certified Financial Planner™ (CFP®), J.D.