Stair Climber: 4th Quarter 2022 Commentary

Stair Climber

I fell off the stair-climbing machine at the Dowd Y this week. It happened on January 2, my first workout of the new year. I couldn’t have picked a better day for this embarrassing debacle as the Y was absolutely packed with people getting a start on their New Year’s resolutions.

Not to be confused with the more commonly known “StairMaster,” this stair climber has five actual stairs rotating on a looping conveyor. The goal is to steadily climb the stairs, keeping pace with the tempo you’ve selected. The action is similar to walking up the down escalator. I like the climber because I can’t ease up or I’ll get dumped on the floor—the stairs don’t wait for anyone.

Unlike about two-thirds of the newbies at the Y at the beginning of each new year, I’m a regular there and can often be found sweating profusely through my 30-minute stair climb with the tempo set on Level 12. Sure, there are higher levels, but for a 54-year-old guy, I think it’s a respectable if not impressive pace. And to be sure, I’m always the guy dripping the most sweat. My shirt and machine are always drenched when I complete my climb.

A few months ago I decided to mix it up a bit by alternating between climbing forward up the stairs and climbing sideways up the stairs. Climbing sideways requires some fancy footwork, crossing one foot over the other, right over left, then left over right and so on while moving up the stairs the whole time. And still on Level 12 tempo mind you.

It’s a dreaded thirty minutes. The side stepping always leaves me gasping for breath as I desperately try to keep up the pace while simultaneously focusing on getting one size 12 shoe over the other and onto the next higher step.

To distract myself from the pain, I’ve begun listening to podcasts—I love them! Maybe you, too, are addicted. The podcasts require that I have my phone and earphones. The kids working out around me all have the high-dollar wireless earbuds. Too tight for that, I’m a tangle of wires. So that’s me: Large, graying guy, lumbering up the stairs, pouring sweat, fiddling with his iPhone 6, earpiece wires swinging as he dances side to side trying to plant his big feet. What could go wrong?

I blame the sweaty steps. One minute I’m on the march, burning 400 calories an hour, nailing my criss-cross footplants and being regaled by the insights of another economics podcast and the next minute…whoosh! I’m airborne! Left foot hit wet step and in a split second, this big ox was bouncing down the moving stairs and landing in a heap behind the machine. My wired earbuds jerked my phone from the machine console, sending it airborne as well. It followed me down to the floor and smacked me in the forehead before settling in a puddle of sweat. I was not hurt. Physically, anyway. The millennials on nearby machines turned and stared. I’m guessing they were trying not to laugh as I scrambled around on the floor trying to regain my composure. A bearded kid about the age of my oldest son looked down at me from his climber and without breaking stride just said, “You good, man?”

Benton climbing stairs at the YMCA

Welcome 2023! If my first workout of the new year is any indication, 2023 is a lot like 2022. Rough! But it’s early. And I’m predicting that this year will be better than last year. Here are three reasons why:

1) Much is behind us. 2022 was filled with talk of a looming recession primarily resulting from the Fed’s moves to get inflation under control. As you are likely aware, the Fed has aggressively raised interest rates, increasing the cost to borrow money and thereby slowing the growth rate of the economy. Many forecasters predict that the Fed’s restrictive policies will drive the economy into a recession. Others predict a so-called “soft landing,” a slowing of the economy without massive job losses or a credit squeeze. Regardless of the ultimate outcome, the Fed has made significant progress on its goal of slowing the growth rate and tamping down inflation. Work remains, especially with labor costs. But the trends are good. So again, much is behind us. We’ve had a significant and abrupt increase in borrowing costs, we’ve seen the index of leading indicators plummet, we’ve seen a decline in consumer confidence, a tightening of financial conditions, a stock market decline of 20%, falling P/E ratios, a bond market decline of 13%, a slowing housing market, and a slowing rate of GDP growth. Also behind us are many COVID-related phenomena; supply chains have significantly normalized, retailer inventories are flush, and worker shortages have eased.

2) Valuations are more appealing. 12 months ago today (January 3, 2022), the stock market was at an all-time high. Bond valuations weren’t at a high then but were close to it. Today is a different story. As mentioned, the prices of both asset types are significantly lower. History demonstrates that future returns are highly impacted by current valuations. On average, higher future returns follow periods of low valuation and lower future returns follow periods of high valuation. Today, stocks are trading at approximately the average P/E multiple of the last 25 years.

3) It’s a low bar. 2023 being better than 2022 is no great feat. Admittedly, my prediction about 2023 is similar to saying that my next workout on the stair climber will be better than the one that featured my massive wipeout. After all, for investors, 2022 was quite bad. By most measures, it was the worst year ever for a 60/40 balanced portfolio. For bonds in particular, a repeat of 2022’s performance is hard to imagine due to the fact that today’s bond yields are so much higher than at this time last year. With lower prices and higher yields, bonds are now positioned to be far less sensitive to changes in interest rates.

With stocks, the chance of a repeat of last year’s poor performance (the S&P 500 declined 18% for the full year) is certainly higher than it is with bonds, but not since 1931 has the S&P had consecutive calendar-year losses of 18% or more. More likely would be an intra-year decline that takes the index down below current levels. In just the last 25 years, we’ve seen the following declines for the S&P 500 index:

It’s possible we could see a further decline in 2023 that resembles those in the table. Alternatively, we may have seen the bottom in October of last year when the index was 25% off its all-time high.

I’ve listed my reasons for 2023 being a better year than 2022. Drilling down a bit, here are a few other pertinent comments (some factual and some editorial) about stocks, bonds and the portfolio.

Stock Valuations: The forward P/E of the S&P 500 dropped from its high of 21.5 on January 3 last year to 16.7 at year-end 2022. We’re reassured to see that many of the speculative asset bubbles in certain parts of the market have already deflated and that much of the froth we saw during 2021, especially in the technology sector, has bled away. No longer do investors believe they can buy significantly overpriced stocks with the goal of selling to a greater fool at an even higher price. The crypto traders and SPAC (special purpose acquisitions company) investors have realized they might need to work for a living. Every market top brings euphoric speculation and it is remarkable how many individuals and institutions fall prey. Opportunistic purveyors of questionable products and downright fraudsters like Sam Bankman-Fried of FTX (cryptocurrency exchange) come out of the woodwork. Meanwhile the media just fan the flames. This cycle repeats itself and teaches a tough but valuable lesson—one it seems every generation of investors must learn.

Value and Growth: After a long run of dominance by growth stocks, we’re seeing investors prioritize value investing: emphasizing fundamentals including balance sheet strength, cash flows and reasonable valuations. Bragg’s portfolio has benefited from the shift from growth outperformance to value outperformance because our portfolio is tilted toward value. Our value tilt is based on the numerous studies that show that over the long term, value has outperformed growth after adjusting for risk (volatility).

Often when we point this out, clients will ask why we don’t invest strictly in value stocks. The simple answer is that we’d have few clients if we did so. Few investors have the discipline to stay the course during long runs of growth dominance like those we experienced in the tech boom of the late nineties or the growth run that may have just ended. How long would you tolerate portfolio returns that are out of sync with the market? Some of these cycles are long, many years long. Imagine reading 20 to 25 consecutive quarterly letters from Bragg in which the primary subject matter is explaining why our performance is lagging. That would be tough to endure.

And while it appears that value is leading for now, we won’t jettison our growth stocks just as we didn’t load up on “stay-at-home stocks” back when the economy went into COVID lockdown. Instead, we’ll remain diversified, recognizing that over time, both value and growth contribute to a portfolio that will 1) perform in a way that maximizes the likelihood our clients will stay the course, and 2) deliver the performance that allows our clients to accomplish their financial goals.

US vs. Foreign Stocks: Speaking of long runs of dominance, US stocks have enjoyed a dominant run for many years now relative to foreign stocks. And speaking of investor discipline, it seems we are hearing more and more clients questioning the need for foreign stocks in the portfolio. This is a good example of the aforementioned human tendency to give up on the discipline—often this happens at just the wrong time. Note the table below that shows foreign stocks led all asset classes during the fourth quarter of 2022. Perhaps the recent outperformance of foreign stocks is a temporary blip resulting from a weakening dollar, but there is also the chance that foreign will lead in the next cycle. Bragg will continue to own a blend of US and foreign stocks in the portfolio.

Bonds are back. For the first time in many years, bonds offer decent yields—yields that we would consider normal. Yes, we paid a painful price to get to this point. Bond prices had to fall to result in these higher yields. But here we are. At this point, the yield curve is inverted; short-term bonds have higher yields than long-term bonds. This is because the Fed generally controls shorter-term bond prices and thus their yields, while investors set the price of longer-term bonds and thus their yields. We could maximize our current yield today by loading up with short-maturity bonds but we may find that upon maturity in 12 or 24 months, yields are lower across the board leaving us with no options for reasonable yields. Thus for long-term investors, we will continue to own a blend of short- and intermediate-term bonds.

Better but Bumpy: I’ve made a case for 2023 being better for investors than 2022. It certainly won’t be a smooth ride. It never is. As Matt DeVries points out in his article, there are still challenging issues ahead. Inflation isn’t tamed yet and the “Fed’s next move” will remain squarely in the headlines for the foreseeable future. It will be months before we know the extent of the fallout from the actions the Fed has already taken. We’ll have to wait and see whether we have a recession and if so, how deep it is. Of course, market prices reflect everything I’ve written about. Market prices are set by serious people investing serious money. Market prices reflect the fact that much is behind us, that valuations are more attractive, that the Fed still has work to do to curb inflation, that we might have a recession, that the Russia/Ukraine war brings uncertainty, and that corporate earnings are likely to decline in the quarters ahead.

Market prices also reflect the fact that even when stocks and bonds fall and the going gets rough, humans are working very hard to solve problems and to make progress. Economic contractions are followed by economic expansions. Bull markets follow bear markets. Sometimes our climb gets interrupted and we might even get thrown off the darn stair-climbing machine. But eventually we’ll stop fumbling around on the floor, we’ll get back on the machine and we’ll climb higher.

Thank you for trusting Bragg with your planning and investing. We wish you the best in the new year.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.