Broker Check

State of The Markets

January 20, 2023

The Fed ignored inflation for way too long, and by the time they reversed course, it was too late. The inflation genie was released from the bottle, and they’ve frantically tried to put it back in ever since.

The good news is that inflation is falling, but the Fed’s job isn’t done. Inflation is a currency phenomenon, and thanks to a massive increase in the money supply since 2020, there’s too much cash out there. Fixing this will take time.

The bad news is that investor confidence has been decimated, and the fear currently priced into financial markets is as high as ever. Is this a sign of darker days to come, or is it music to contrarian investors’ ears?

U.S. Economy

Is the country in a recession? It’s a question that dominated airwaves last year, but the answer isn’t so simple. Some view a recession as black and white - two consecutive quarters of negative Gross Domestic Product (GDP) growth. Since the U.S. experienced just that in the first half of 2022, we’re in a recession.

Our view is more nuanced. Judging by the strength of the American consumer, it’s hard to say that spending, which is 70% of the U.S. economy1, is under pressure. Restaurants are booked solid, traveling this past holiday season was an unmitigated nightmare, and parents continue to compete to see who can spend the most on their kids’ birthday parties. The unemployment rate at 3.5% is the lowest it’s been since May 1969, and wage growth is north of 4.5%1. If this is a recession, then the country could use more recessions.

But parts of the economy are suffering, and there is little question that the overall direction isn’t great. Housing has been in a recession since last summer, and new orders for goods have dropped precipitously over the last year. This has started to impact corporate profits, and since employees tend to be the largest expense for most companies in the U.S., layoffs have begun to accelerate.

Thank the Federal Reserve (Fed) and their frantic reaction to addressing the inflation that they created and then ignored for so long. The good news is that inflation is falling, but it’s got a long way to go to hit the Fed’s target of 2%. Inflation is a currency phenomenon, and the Fed increased the money supply by over 40% in two years. It will take more than rising interest rates and shrinking their balance sheet to fix this.

Add it all up, and this is one of the most complex economic environments the country has ever faced. But complexity by no means implies danger. Compare today to the months leading into the financial crisis, and it’s apples and oranges. For example, housing may be in a recession, but it’s not even close to crisis level. Personal and corporate balance sheets are nowhere near as bad as in 2008, and banks today are stronger than ever.

Simply put, even if we are wrong and already in a recession, our country has never been better prepared for a downturn. These factors alone should help mitigate the depth and duration of any economic downturn that may come our way.


Warren Buffett famously said:

“Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.”

Before April 2022, financial markets had been in a near zero-g environment since the financial crisis. By keeping interest rates close to zero and then embarking on multiple rounds of “quantitative easing,” the Fed effectively took the risk out of markets. Their actions fueled the greatest bull market in stocks, massive returns for boring corporate bonds, and asset bubbles like non-fungible tokens (NFTs).

But as Howard Marks recently wrote, a “sea change” is underway2. Markets are not only returning to a world where risk has a price; it’s moving at breakneck speed. That’s why the Nasdaq lost over 30% last year, a 60/40 portfolio of stocks and bonds lost 16% for its third-worst year ever, and so many cryptocurrency endeavors are crumbling.

This sea change didn’t just impact hyper-growth assets and screen savers that were being traded for millions of dollars. The chart below shows that a few commodities were the only assets up in 2022. Gold didn’t even shine as many would have guessed, given that inflation was the highest since the early 1980s.

Harry Markowitz won a Nobel Prize for proving that “diversification is the only free lunch.” But last year challenged this maxim in a way that hasn’t been experienced in a century. There was nowhere to go and nowhere to hide unless one were to make a tactical move to cash or invest heavily in the very few assets that worked.

But the irony of tactical moves like these is that the risk can be immeasurable. For example, energy is the only sector in the S&P 500 that ended the year in positive territory, and it was up huge at 44%. This sector historically trades in lockstep with the price of oil, but since October, the relationship has decoupled. Energy stocks continue to rise higher, while U.S. oil is down 4.4%.

Either energy investors will eventually look like geniuses, or they’ll get creamed because those are the only two ways this gap can close. Furthermore, energy represents a mere 5.2% of the S&P 500. So, to move the performance needle last year, an equity investor would have had to time this trade perfectly and have done so with incredible conviction.

Given this sector’s reputation as a “widow maker,” we prefer to avoid moves like these and stay disciplined and diversified instead. Slow and steady wins this race.

Looking Ahead

There is already ample evidence to suggest that diversification is coming back.  The chart below shows that a one-year Treasury yielded 0.39% at the beginning of 2022. Today, that same bond will pay 4.69% if held to maturity. That’s a yield the world hasn’t seen since before the financial crisis, and investors are likely taking notice.

Furthermore, despite the Fed’s constant chest pounding, the market doesn’t believe they will continue to raise interest rates too much longer. The futures market currently expects the Fed to hike by 0.25% in February and again in March and then pause until November3. If so, the stabilization from a less aggressive Fed should favor diversification.

Over in the stock market, based on investor sentiment surveys, the amount of negativity priced into stocks appears to be at all-time highs (even worse than heading into the financial crisis). As scary as that may sound, to a contrarian investor, it’s sweet music.

Shelby Davis, one of the most respected investors of all time, famously said:

“You make most of your money in a bear market; you just don’t realize it at the time.”

It’s human nature to overreact to bad news, and there’s been plenty of that to go around over the last year. Stocks also tend to recover 6 – 9 months before the economy bottoms. So, even if we do end up in a recession this year, there could be a chance that stocks start recovering while the economy continues its decline.

Herein lies the real danger facing investors this year. The early innings of an equity market recovery are absolutely critical to long-term performance because they tend to be (1) early and (2) some of the largest percentage gains. Missing out on these and math could make it very difficult to get back on track. In fact, the table below shows that simply missing a few big days over the course of several decades would have cut the S&P 500 return by almost 40%.

To be clear, this in no way implies investors should bury their heads in the sand and pray for markets to recover. Investing is not like an oven where you can just “set it and forget it.” Markets evolve, and so should an investment strategy. Here are five expectations informing much of our positioning over the coming months.

  1. The economic hangover isn’t over.
  2. Inflation should fall but also fall short.
  3. Diversification is still the only free lunch.
  4. Stocks will recover before the economy.
  5. The Fed talks tough, but talk is cheap.

These expectations guide our playbook for the future, which is based on three core objectives. First, prepare for a hard landing (recession) but don’t bet the farm either. There is a chance that the Fed can pull off a soft landing, and if so, too bearish of a stance could risk missing the early innings of a recovery.

Second, own high-quality assets when possible. Last year was all about inflation and interest rate risk, and this year will likely be more focused on the third key risk factor for bonds – credit risk. Similarly, avoid concentrated positions in individual stocks unless there’s a compelling reason. Stocks that miss expectations during economic downturns can be landmines. On the flip side, strong balance sheets and consistent revenue are often handsomely rewarded.

Third, lean into diversification rather than abandon it. Introduce new asset classes and innovative strategies that have the potential to offer principal protection, upside participation, and liquidity.  We’ve recently rolled some out and expect to launch even more over the coming months.

Lastly, thank you for your commitment through what has been the most challenging environment in a generation. This too shall pass, and our country, the economy, and the financial markets within it will emerge stronger. Happy New Year, and let’s never speak of 2022 again!


1 Bloomberg.





This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.