2023 Market Preview: Value Should Continue To Lead

Brian Dress, CFA — Director of Research, Investment Advisor.

New

Year, New Market?

We beat readers over the head with the themes of 2022: higher interest rates, (almost) out of control inflation, contracting earnings multiples, and a shift from growth stocks to more value oriented sectors with reasonable valuations and predictable cash flows. As we mentioned a number of times in this space, 2022 was just one of 5 in the last 100 years where we saw concurrent losses in the bond and stock markets. “Nowhere to Hide” was the theme of 2022.

As we move into 2023, of course these themes will have a major impact on the direction of markets. But both history and the price action early in the year suggest that better days may be ahead for investors. It is often said that markets climb a wall of worry and, buddy, there’s plenty of worry out there.

It is early days, sure, but the ground seems to be shifting under our feet to a certain degree in 2023. In the first eight days of trading in 2023, we have seen the S&P 500 gain nearly 4.2% in value, while 10-year US Treasury rates have dropped from 3.72% to 3.44% on the day of writing. Since bond prices and rates move in opposite directions, we know there has been buying, not only in stocks, but also in bonds, in the beginning of the year.

We are feeling optimistic moving into the new year for a number of reasons, not the least of which is the fact that the “decks have been cleared” so to speak. Investor sentiment had become so profoundly negative that we saw a real crescendo of selling in December. Last month, the S&P 500 (SP500) lost nearly 6% in value and the tech-heavy NASDAQ Composite (COMP.IND) was down nearly 9%. Perhaps the early buying is a direct reaction to the low prices brought in from the tax-loss driven selling in December. Or perhaps it is the beginning of a new trend.

In today’s 2023 Preview article, we are going to take a look at the areas of the market where we see opportunity, and also take a historical look at the way that markets perform after a putrid year like 2022.

With that all being said, let’s get into it! We are excited to offer you our thoughts for the upcoming year.

Market History After Negative Years

When markets take a nosedive, like they did in 2022, it is often useful to look for historical context as we seek to anticipate the market’s next move. I came across a very interesting piece from fellow financial writer Ben Carlson from the “A Wealth of Common Sense” blog. In the piece, Carlson takes a look at the history of both the stock and U.S. Treasury markets in years following down years.

In the last 95 years, we have seen down stock markets roughly 27% of the time. In about 2/3 of the cases, we saw positive stock market returns in the years following a down year in the markets. In the years after World War II, we have seen consecutive negative years in stocks just twice, 1973-74 and 2000-02. History certainly appears to be on the side of the bulls, given this remarkable pattern over the last 80 years.

Similarly, bonds tend to rebound after negative years. Since 1960, we have witnessed just one instance of two consecutive down years in U.S. Treasuries, which was 2021-22. Perhaps we are living in a totally different era now, but history suggests we could see a positive reversal in the bond markets as well. Should the Federal Reserve ease up on the interest rate hike gas pedal, our view is that bonds are poised for a year of above-average results. Loyal readers will know that we remain extremely excited by the opportunities we see in corporate bonds, both investment grade and high yield alike.

There is another bit of history that we want to discuss here and that is the history of monetary policy in the United States. This week we heard from long-time bond investor Jeffrey Gundlach, who shared his thoughts on the direction of interest rates on an investor webcast. At issue is the expectation of where the Federal Reserve is taking monetary policy. The Fed has presented a united front with respect to forecasting interest rates, with Chairman Jerome Powell telegraphing that the Fed Funds rate is headed to 5%, backed up this week by a number of other Fed Governors speeches. And good grief, haven’t we learned by now that these Governors like to talk!

At the same time, we have seen long-term interest rates squeeze down systematically over the past few months. Take a look at the chart below, which charts the course of 10-year US Treasuries against the trajectory of the Fed Funds rate:

As you can see from the chart, around early November, the direction of long-term Treasury rates seems to have diverged from the upward sloping Fed Funds chart. This suggests that the markets are no longer believing that the Fed can continue raising rates for the foreseeable future. Says Gundlach, “My 40-plus years of experience in finance strongly recommends that investors should look at what the market says over what the Fed says.”

And maybe they should let up on the gas. After all the point of raising rates has been to achieve some level of price stability. Yesterday’s CPI Report showed an overall price level increase year-over-year of 6.5%, which is the lowest level we have seen since October 2021. Prices actually dropped by 0.1% in December relative to November, driven by lower gasoline, used car, and airline ticket prices. We think the Fed is beginning to win in its quest for price stability, which augers quite well for the economy and markets going forward.

With our look at both the history of markets after down years, as well as the history of U.S. monetary policy, we think there is reason to believe 2023 could be a year of improved market performance.

What We Think Could Work in 2023

For this week’s preview article, we are going to do a forward look at which sectors interest us for 2023. In general, we have changed the lens through which we view securities over the past year. Coming out of the pandemic, we were most excited about companies growing revenues at 25% annually or more, but were often not yet profitable. As growth stocks fell out of favor, we have shifted our attention to companies with predictable cash flow profiles.

We have noted in the past several areas where we think investors can feel comfortable in the current market environment, namely energy, healthcare, and insurance. Note that value stocks underperformed for many years before 2022 relative to growth shares. That has a few consequences. First, we expect the cycle not to reverse quickly, simply because the underperformance lasted so long. There may again be a time for growth stocks to dominate, but we expect it to take some time to clear the decks.

More importantly, we think the lean years of the past decade in value have uniquely prepared these companies to operate in a changing world. Cutting costs, protecting margins, and finding ways to return capital to shareholders have been essential for the survival of businesses in value sectors. Right now, even growth-oriented companies are forced to think about margins, but the muscle memory isn’t there. As we take note of the layoffs proliferating in Silicon Valley in such giants as Amazon, Salesforce, and Alphabet, we see in retrospect that growth businesses had major cost excesses that will take years to correct. Not so in the value segments of the market.

We are going to move beyond the familiar formula of integrated energy, low-growth healthcare, and insurance in today’s letter and show you a few other areas of the market where we see interesting opportunities developing.

Industrials

Industrials, as tracked by the Industrial Select Sector SPDR Fund (XLI), held up well in 2022, falling roughly 7% for the year. With the S&P 500 down just under 20% in 2022, Industrials clearly outperformed the broader market.

Industrials include businesses in aerospace/defense, transportation, machinery, logistics, and more. Industrials over the last 5 years have seen relative underperformance, gaining 28% in value versus a 42% gain in the S&P 500.

We noticed in the 4^th quarter that stocks in this sector began to take flight, with the XLI gaining nearly 17% of value in the last 3 months of 2022. We think there are several structural factors that suggest potential outperformance of industrials to continue over the next year:

1. Valuation: With respect to historical price/earnings ratio, the current P/E ratio of 19.8x is near the historical average. We think there is some potential for multiple expansion here and we at least have confidence that multiples are unlikely to contract in the near term:

2. Commodity Supercycle: As economies come out of the pandemic, especially China, we expect commodities in energy, metals, etc. to remain on strong footing. This increases cash flows at commodity-producing businesses, some of which we expect these companies to spend on capital expenditures. Examples of industrial businesses that could benefit from this phenomenon include Caterpillar (CAT) and Deere & Co. (DE). We also think as the US government spends the money from the infrastructure law passed in 2021, a number of similar businesses will benefit

3. Travel boom: Revenge travel is a real thing and we are also seeing the return of business travel in earnest post-pandemic. This, coupled with the delay in aircraft deliveries during the pandemic, means that we are looking for good ways to play the theme. We think Boeing (BA) has the chance to outperform in 2023.

Consumer Staples

I swore I wouldn’t talk about inflation in this letter, but I just couldn’t get away from it.

Inflation is a story that is driving the bus in consumer staples. In 2022, we noted major price increases specifically in the food segment. Anyone who has stepped foot in a grocery store over the past year will understand.

This has been a huge benefit to consumer staples operators. The demand curve for consumer-packaged products is inelastic, which means that companies in this space have pricing power. Fortunately for them, many of these businesses maintained profits in 2022, despite lower unit sales. We saw companies like Kraft Heinz (KHC) and Hershey Company (HSY) sustain their revenues last year through price increases and stronger margins.

However, something has changed in the equation for consumer staples producers over the last six months: input costs. We have seen dramatic drops in prices for agricultural commodities, which are a major cost for these companies. In the last six months, prices for wheat, corn, coffee, and oats have dropped dramatically.

With the understanding that valuations in this space are a bit above historical averages (the Consumer Staples Select Sector SPDR Fund (XLP) currently carries a 24x price/earnings ratio), we do think the improving margin picture does account for some of this valuation. Even with that said, there are still some stocks in this area that trade below their historical multiples. My favorite consumer staples play right now is General Mills, Inc. (GIS), which trades at a 17x trailing price/earnings multiple and pays a dividend of 2.57%.

For investors looking for stocks with predictable cash flows, high dividends, and pricing power, consumer staples could provide ballast for a portfolio in a choppy market. We currently like an overweight in consumer staples.

Biotech

As long-time readers will know, we have really liked healthcare over the last year, given the predictability of consumer expenditures in that realm that makes it a defensive sector. However, the growth investor in us at Left Brain is never far away from our decision-making process.

In that vein, we have started to look at biotechnology as an investment theme in 2023. A number of names look interesting to us, including Moderna (MRNA), Amgen (AMGN), and Gilead Sciences (GILD). We are deploying our research team to tackle biotech in the coming months, so look for more thoughts on biotech in future letters.

Oil Services

The last area we wanted to point out is oil services. Of course, we’ve beaten the drum often and repeatedly on the broader energy sector over the past year. We have noted that oil stocks have held up well, given that the price of a barrel of oil has fallen from more than $120 in early June 2022 to just under $80 today. The oil business seems to generate significant cash flows at the current commodity price, which adds to our bullishness on the sector.

We have taken note of one corner of the oil market recently, and that is oil services. In 2022, we were cautious in the oil services space, simply because we have read all the conference calls from management of large operators like Exxon Mobil (XOM) and Chevron (CVX). Management couldn’t have been clearer: the priority has been to return capital to shareholders in the form of debt paydown, dividend payouts, and share buybacks.

At the same time, we note that oil wells are a declining asset, especially those in the shale segment of the oil space. Over time, wells deplete and exploration companies have no choice but to invest some of their cash flows to keep oil and gas flowing. Over the last 3 months, we have noticed a major outperformance of the VanEck Oil Services ETF (OIH – blue line) relative to the Energy Select Sector SPDR Fund (XLE – orange line):

We are still mulling over whether this is an investible theme for 2023, but companies like Schlumberger (SLB), Transocean (RIG), and NOV, Inc. (NOV) are all ways to play rising rates for oil services.

Takeaways

We are excited as investors as we move into 2023. We have “cleared the decks” in many ways and the year is off to a strong start. As we move into the new year, many of the same themes persist as did in 2022, namely that we expect value sectors to outperform growth.

Beyond what we said many times in 2022, which was that we like energy, healthcare, and insurance, we think there are some interesting new opportunities developing for the active investor. Namely, we think shares in the industrial sector and consumer staples are poised for strong performance, while we are intrigued by what we see in biotech and oil services. And don’t forget, with interest rates still high, we are still working feverishly to add fixed income investments (bonds) to our mix!

Thanks again for your continued support of the Jarvis Newsletter.