2023 Forecast: Hurricane Force Winds Likely

Looking forward on a new year, 2023 presents us with perhaps the most challenging environment we have seen in some time. The U.S. is over $30T in debt, there is a pandemic continuing to rage throughout the world in waves that continue to upend consumer behavior, supply chains, and daily life. Market valuations are stretched for everything from stocks to housing, to private market assets, the “everything bubble,” as it was termed, is in the initial stages of popping. Investors now must assess how to invest in this environment in a new year. To look to the future, we first must explore a bit of history.

Many are familiar with the 1929 depression, but few realize we had a depression from 1920-1921. The period directly after the 1918 pandemic, characterized by massive inflation, and double-digit unemployment. It was caused directly by a rapid rise in the fed funds rate. The main difference in these 2 periods was that in 1920 the U.S. had a national debt of $25B or $383B in today’s dollars. Today, the U.S. has a $30T debt. Academic research and the evidence from debt crises around the world continue to demonstrate the deleterious effect of debt on GDP growth.

I believe the economic crisis unfolding today in the markets will be deeper and more destructive than is currently being forecasted. This drop in economic activity will ultimately send the yields on the Treasury curve lower, and drastically reduce prices on stocks, and real estate. The real estate market particularly remains vulnerable to correction, especially in markets which saw the greatest investor demand and appreciation. The cap rate is currently below the rate of a U.S. Treasury bond, even worse rents and sales are falling in these markets as supply rapidly increases due to a rise in the mortgage rate, among other factors.

In these times it is important for investors who have been conditioned to buy every dip and believe that stocks don’t go down, to acquaint themselves with the notion of risk management, and particularly the mathematics of investment returns and loss.

The Mathematics of Investment Returns:

You Can’t Beat Compounding Money

The mathematics of investment returns, comes back to what Einstein called the eighth wonder of the world; compound interest. You simply cannot beat compounding money, such as you find with a Treasury Zero.

So, let’s compare investors to illustrate this point. Keep in mind that I am not recommending either of these funds they were chosen as a proxy for their respective asset class. One could just as easily have chosen PIMCO 25+ Year Zero Coupon Treasury ETF (ZROZ) or Vanguard Extended Duration Treasury ETF (EDV). The American Century fund has more history to act as a proxy for Treasury Zero returns.

Investor A buys American Century 2025 Zero Coupon bond fund (BTTRX) at the turn of the century, and Investor B buys the Vanguard Total Stock Market Index (VTSMX), which did better? I mean it must have been the equity investor, right? After all, this is a period that saw multiple rounds of quantitative easing that fueled equity returns that were nearly double the mean return of the market from 1871-2021, as I outlined in my last piece. This 12-year stretch (2009-2021) saw stocks compound at 13.54%!

Even with this Fed rocket fueling equity returns for 12 of the 21 years (the majority, 57%, of the time period tested, 2000-2021), investor A won, earning a CAGR of 8.88% vs 7.73% for the stock market investor. If we include the 2022 YTD data, the bond investor still wins, and by an increased margin 8.15% vs. 6.68% for the stock investor. But why? How? It is this constant cycle of gains and losses and the attempt of markets to reclaim previous gains. While the stock market is falling the Treasury is compounding continuously. Consider recent market history and the mathematics of recovering from a portfolio loss.

From the 2000 peak to the 2002 low, stocks lost 45.73%. It then took until 2008 to reclaim the high from the previous cycle, just in time to fall another 51.64%. In total, stocks traded for 13 years in a range that saw no new highs.

For a real investor, this means a truly wild ride. Let’s say they invested $100,000 in 2000, only to see it fall to $54,270 by 2002, and not come back to $100,000 until 2006. By 2008, it was worth $71,511, with dividends reinvested. Meanwhile the Treasury Zero investor saw their wealth grow by 2x during this six-year period compounding at a CAGR of 11.10%!

We saw the same pattern in 1929, the highs were not seen again until 1953, 24 years with a total return of 0%! In fact, the full 50-year period of 1929-1979 saw the market provide 0% growth in one’s capital when dividends are excluded. Investors lost money during this period with every dollar invested falling to a mere $0.97 in value without the dividend income stocks provide. This continuous cycle of gains, losses, and then reclaiming the gains from the previous cycle continues to replay in the markets.

“The mathematical relationship between losses and gains is a reciprocal one…there is a nonlinear relationship between losses and the required subsequent gain needed to recover from the loss. The term “nonlinear” simply means that as the loss gets bigger, the needed gain to restore the loss increases at an increasing rate…” -Craig L. Israelsen, Ph.D.

One wonders if we will see another period similar to the 2000-2013 period, only time will tell how this cycle plays out. But one thing is for sure, when academics and Wall Street try to show you stocks for the long run charts from 1800, keep in mind that all that matters for you, and your money, is the limited time period you will be investing.

In theoretical discussions, everyone is a long run investor, capable of holding stocks for 100 years. In reality, most people are not, continuously trading their portfolio through changing market conditions, on a daily, weekly, or monthly basis. It takes a large gain to recoup one’s losses and what it can cost you is likely worth more than the capital you lose, time. Time, you can never get back. So, I implore investors to think long and hard about risk, especially in light of a 4.6% yield on the 1-year, and equity valuations at 2 standard deviations from the mean. Not to mention the relationship between overexposure to equities and forward returns, as illustrated in the chart below.

It is clear that 2022 was an outlier for bonds, a year to definitely hedge duration, and/or go to cash to avoid the rising rate storm. But today, bond investors are presented with an enhanced opportunity set. I think we are in a period similar to the ones we have seen in the recent past such as 2008, and 2000-2002. Periods where left tail risks wipe out excess returns in risk assets and bring risk management to the forefront of investors’ minds again. In such an environment, there is a case to be made for the superiority of bonds in general and U.S Treasury bonds in particular.

2023 Forecast: This Market Favors Bonds

Today’s market continues to be overvalued using a number of valuation metrics. The forward-looking returns on the S&P 500 are likely to be negative in the near term. I see S&P earnings coming in closer to $200 in 2023, about 13% below the street’s consensus of $230. If we put a historical forward multiple of around 16 on that we are at 3,200 for the S&P 500 which is 18% below current levels. My bear case would be closer to 3,000 and would represent a total loss for the S&P 500 from 2022-2023 of nearly 40%, right in line with my expectations (as expressed in previous pieces) of this impending collapse.

The Fed is currently pursuing a tightening cycle, hiking rates to a new range of 4.25% to 4.5%, the highest rate level we have seen in 15 years, along with quantitative tightening, makes this the tightest policy we have seen in 85 years, and they aren’t done yet. The Fed is likely to raise the terminal rate to the 5.00-5.25% level, seeing as the 2-year will likely peak above that rate, this could drag the long bond a bit higher in rate, lower in price in the short run.

Still, the relative case for bonds over stocks has not been stronger in the last 15 years. Corporate bonds are paying yields above 5%, while U.S. Treasury securities are paying 4%+. Getting 4.65% on a 1-year Treasury, creates a large hurdle for risk assets and the calculation of a true equity risk premium becomes far less favorable, especially at today’s valuations. When the risk-free rate is approaching 5%, the need and desire to take risk above these levels is diminished. Especially in a world with the myriad of economic, geopolitical, and financial risks as we have today. I wish you all a prosperous and happy New year ahead!