Note: view the video of this post here.
Here are the charts and themes that tell the story of 2022…
I. Starting Off With a Bang
The first day of trading in 2022 felt very much like 2021. The S&P 500 closed at an all-time high and Apple hit yet another market cap milestone, becoming the world’s first $3 trillion company.
But the similarities would end right there, with both the S&P 500 and Apple peaking that very first trading day. As I outlined in early January, the macro picture in 2022 was shaping up to be the polar opposite of 2021. The effects of this massive shift would soon be felt across the economy and entire investing landscape.
II. The End of Easy Money
Market participants are creatures of habit, and they had become accustomed to a certain kind of Fed: an easy one.
When turmoil hit, the Fed would invariably respond with rate cuts, quantitative easing, or some other signal that help was on its way.
But when the S&P 500 quickly suffered a 12% correction in January, a strange thing occurred. The Fed did not swoop in to save the day, but instead reinforced their intention to hike rates in March and bring their balance sheet expansion to an end.
Thus, the pattern that had existed in the previous eight bear markets was now broken, with a new sheriff in town. And as the markets would soon learn, this Jerome Powell looked nothing like the Jerome Powell of the past.
III. The Most Universal Tax of All
Thomas Sowell once said that inflation was the “most universal tax of all,” a “way to take people’s wealth from them without having to openly raise taxes.”
By June, this confiscation of wealth had reached its highest level since 1981, with U.S. CPI rising to 9.1%.
All major categories were moving higher in tandem, led by a surge in energy prices that pushed the national average price of gasoline to over $5.00 per gallon (the prior record from 2008 was $4.11/gallon). In 2020, when the entire world was shutting down, Crude Oil futures briefly went negative, and Gasoline futures hit an all-time low. If someone told you back then that gas prices would be at a record high just two years later, you would have said that was impossible. But as we have learned time and again: there is no impossible in markets.
With the stock market decline deepening and fears of recession rising, the Fed had a choice to make: reverse course in an attempt to ease the pain or continue on their inflation-fighting path.
They chose the latter, with Powell making it abundantly clear that they would “stay the course until the job was done,” restoring price stability and ending the rapid decline in purchasing power. With wages failing to keep pace with rising prices for a record 20 consecutive months, there’s still more work to be done, and the Fed seems committed (at least for now) to finishing what they’ve started.
That means a continued reduction in their balance sheet, which contracted 2.4% in 2022, the first annual decline since 2018. If QT continues at the current pace (-$95 billion/month), we’ll see a further contraction of 13.3% (-$1.14 trillion) in 2023.
It also likely means more rate hikes in 2023, adding to the 7 hikes in 2022. The year-end Fed Funds Rate of 4.25%-4.50% exceeded all expectations (the Fed itself had only predicted a 0.9% year-end rate at its December 2021 meeting), and was the highest we’ve seen since December 2007.
While savers have been the beneficiaries of rising rates (top savings accounts and money market yields are now above 4%), debtors are just starting to feel the pain. And with the National Debt surpassing $31 trillion (up from $23 trillion at the start of 2020), the U.S. government is at the top of that list.
The Interest Expense on US Public Debt rose to $766 billion over the last 12 months, a record high. If it continues to increase at the current pace, it will soon be the largest line item in the Federal budget, surpassing Social Security.
For years many have dismissed concerns about rising debt levels, arguing that low interest rates were a panacea. But the 4.25% spike in the Fed Funds Rate during 2022 may have changed that calculus. This was the largest annual increase since 1980, when Paul Volcker broke the back of inflation with a series of unprecedented rate hikes.
The big difference between 2022 and 1980 was the ultra-low starting point (0%), and how far behind the curve the Fed was at the beginning of the year. With bond yields near historic lows, there was almost no coupon income to cushion the devastating blow caused by rising rates. Bond investors would learn this painful lesson in spades.
IV. The Bond Market Bloodbath
Over the past 40 years, bond yields have largely moved in one direction: down. The 10-Year Treasury went from a yield of 15.84% in 1981 to an all-time closing low of 0.52% in 2020.
This was a persistent tailwind for bonds as prices move inversely to yields. And as yields plummeted to historic lows in 2020, bond prices surged higher.
But that was the past – and the past is not prologue in markets.
The setup entering 2022 was a powder keg just waiting to explode: a 1.52% 10-year Treasury yield, inflation spiraling out of control, and the Federal Reserve set to embark on its most aggressive tightening cycle in decades.
The combination of these factors led to yields spiking across all maturities, and the worst year in history for the U.S. bond market.
The 13% loss for the widely followed Bloomberg U.S. Aggregate Bond Index was more than 4x larger than the previous worst year in 1994 (-2.9%).
And the 10-Year Treasury bond finished down 17.8%, its largest decline ever with data going back to 1928.
Nearly all bond categories suffered losses, with no place to hide except Treasury Bills and short duration.
V. The Price of Admission
While bond investors were undoubtedly stunned to see such declines, in the stock market large drawdowns are par for the course.
The primary reason why equity investors can earn a higher return over time are the higher levels of risk along the way. That is the price of admission.
In 2021, risk was seemingly absent, but in 2022 it came roaring back with a vengeance. The S&P 500 fell 18.1% (total return), its largest decline since 2008.
Facing tougher comps and margin compression, earnings declined in both the second and third quarter, down 10% year-over-year.
At its low in October, the S&P 500 drawdown from its high in January had exceeded 27%, marking the 3rd bear market in the last 4 years.
The S&P 500 would fall more than 1% on 63 trading days during 2022. Since 1940, the only years with more downside volatility: 1974, 2002, and 2008.
VI. No Place to Hide
What made this volatility much more difficult to stomach was the lack of support from the bond portion of investor portfolios. The last 8 years in which stocks finished lower, bonds rose, cushioning the blow. We saw a very different picture in 2022 with both stocks and bonds moving down together.
The result was the worst year for a 60/40 portfolio of the S&P 500 and 10-Year Treasury Bond since 1937, and the first time both assets fell more than 10%.
The reason for this rising correlation between stocks and bonds? A common enemy: inflation.
VII. The Housing Market Downturn
Speaking of inflation, there is no expense more important to most Americans than the cost of housing.
Home prices were already hitting record highs before the pandemic. But combination of stimulus checks, an all-time low in mortgage rates (with the Fed buying over $1 trillion in mortgage bonds), and an unprecedent surge in the money supply set the stage for parabolic move higher.
From the start of 2020 to the peak in June 2022 prices rose 45% nationally (Case-Shiller Index), with inflation-adjusted home prices exceeding the housing bubble of the 2000s.
At the same time, mortgage rates were surging higher, moving above 7% at one point in November. That was the highest level we’ve seen since 2002.
The 3.3% increase in mortgage rates during 2022 was the annual largest rise on record, with data going back to 1971.
The combination of skyrocketing prices and skyrocketing mortgage rates made housing more unfordable than ever before.
What followed was a collapse in demand, with sales activity plummeting.
And then, with a lag, prices began fall. The median sales price of an existing home is down 10% from its peak in June.
Similar to the aftermath of the last housing bubble, all major cities have experienced price declines from peak levels with more depreciation expected in the coming months.
The notion that “home prices never go down” would once again be proven demonstrably false.
VIII. Picking Stocks is
During the mania of 2020 and early 2021 the “stonks only go up” meme was coined with much fanfare. In 2022, the meme had all-but disappeared.
In its place: the cold, hard reality that stock picking is anything but easy. The boom in high growth stocks that occurred in 2020 and early 2021 has ended in a similar fashion to the dot-com bubble: stunning losses and valuations moving back down to reality.
The ARK innovation ETF ($ARKK), a fund that benefitted most from the rising tide on the way up, has seen a decline of over 80% from its peak in February 2021.
That has erased all of its outperformance and more since its inception in 2014.
No single stock had embodied the FOMO boom more than Ark’s largest holding over the past few years, Tesla, which rose an astounding 743% in 2020 (vs. a 28% increase in its sales). But like other highly valued growth stocks, Tesla was not immune the laws of gravity, and has suffered a drawdown of over 73% from its peak.
In the midst of a mania, it can seem as if the “voting machine” is all that will ever matter, and you can safely throw caution to the wind. But the “weighing machine” is always lurking in the background. Eventually, a security’s underlying value matters.
While the ride up for “meme” stocks was filled with endless FOMO-inducing stories of riches made, there’s been little coverage of the subsequent declines.
Without exception, every meme stock that went parabolic in 2021 has reversed course, leaving those who chased near the top with massive losses.
IX. Hold On for Dear Life (HODL)
Speaking of massive losses, equities weren’t the only risky asset class feeling the pain from higher interest rates and tighter monetary policy.
Crypto had benefitted more than anything else from the unprecedented era of easy money (Bitcoin: +201% in 2020, +66% in 2021) and unsurprisingly, was hit harder on the way down.
All of the major crypto coins suffered declines, with some experiencing near total losses. The FTX fraud exposed holders of the FTX token to a swift 98% decline, and the so-called “stable coin” TerraUSD not only broke the buck, but fell to just 2 cents by year-end.
The U.S. money supply was a major tailwind for risk assets in 2020-21, increasing 40%. But in 2022, it became a major headwind, on pace for its first annual decline on record (note: data set starts in 1959).
X. Fat Tails and Black Swans
While the downturn in meme stocks and crypto may have been anticipated, what happened to Russian stocks trading in the U.S. most certainly was not. This was a black swan event that no one had predicted.
After the Russian invasion of Ukraine in February, a series of sanctions swiftly cut off U.S. investor access to Russian securities. OTC trading in the US was halted for the six largest Russian companies, but not before those stocks incurred 2-week losses of 74%-96%. This list included Russia’s largest energy company (Gazprom) and largest bank (Sberbank).
Additionally, trading in the MSCI Russia ETF ($ERUS) was suspended on March 4 after falling 33% in a single trading day earlier in the week. This was a 16-sigma event and a reminder once again that financial markets do not follow a normal distribution (tail events happen with much greater frequency).
The drawdown for the MSCI Russia ETF ($ERUS) stood at 84% before it stopped trading, and after a firesale (Russian stocks were removed from MSCI indices “at a price that is effectively zero”) the net asset value plummeted 99.8%. This was by far the worst performance among global equity ETFs in 2022, and perhaps the largest decline for a country ETF that we’ll ever see.
XI. The Recession Debate
In most years there’s a spirited discussion about the health of the U.S. economy, but in 2022 the debate rose to new levels.
The last 10 times real GDP fell in consecutive quarters, a recession had been declared by the NBER. But as of this writing, there’s still been no announcement, suggesting this may be the first time since 1947 that consecutive declines in real output did not rise to the level of an “official” recession.
Countering the recession declaration are two data points.
First, the US economy had fully recovered from the Q1-Q2 downturn by the 3rd quarter of 2022. And while year-over-year growth has slowed to 1.9%, it’s still positive.
Second, the jobs market remains strong, with payrolls hitting a new high in July (recovering all of the 22 million jobs lost during the pandemic shutdowns) and the Unemployment Rate moving down to 3.5%. This is tied for the lowest rate we’ve seen since 1969, and not behavior you typically see during a recession.
Still, the debate rages on, as many leading indicators are pointing to economic weakness ahead.
Foremost among those is the full inversion of the yield curve, which occurred in October.
The last 8 recessions in the U.S. were all preceded by this omen, though the lead time has shown considerable variation.
Heading into 2023, most now believe that we’re either in an economic downturn already or headed for one shortly. This may be the most anticipated recession in history. A bigger surprise at this point would be if one does not occur.
XII. Commodities and Cash Were King
We left 2022 at a very different place than where we began. Instead of hitting record highs, stock prices and home prices were falling. And instead of aggressively easing (ZIRP/QE), the Fed was aggressively tightening.
Among the major asset classes, only Commodities and Cash (Treasury Bills) ended the year higher.
The Nasdaq 100 finished 2022 down 32%, ending its streak of 13 consecutive positive years (note: total returns). The Big 4 (Apple -26.4%, Microsoft -28.0%, Google -39.1%, and Amazon -49.6%) all finished lower and underperformed the broad market, something we haven’t seen since 2008.
The Dow fared comparatively better, down 7% on the year with 19 out of 30 components in the red. Chevron was the top performer (+58.5%) while the 2020 addition (Salesforce) was the bottom performer (-47.8%). Who did Salesforce replace in the Dow? Exxon Mobil, which advanced 87.4% on the year.
Within the S&P 500, Energy (+64%) and Utilities (+1%) were the only positive sectors, with Energy far outpacing everything else.
Many of the best performing stocks were in the Oil & Gas industry while the worst performers included a number of tech/growth stocks (ex: Tesla, Facebook (Meta), PayPal, AMD).
While most commodities finished higher, many were down considerably from their highs as inflation moved lower in the back half of the year. Heating Oil was the best performer among the major commodities, while the housing market slowdown led to a crash in Lumber.
Given the barrage of negative news, it was perhaps not surprising to see sentiment sour throughout the year.
The University of Michigan’s confidence index hit an all-time low and has spent 8 consecutive months below 60. That’s the longest run of extreme negative consumer sentiment that we’ve ever seen with data going back to 1952. The prior record was 4 straight months during the 1980 recession.
There was no shortage of things to worry about in 2022 (war/inflation/rising rates/tightening fed/economic slowdown) and equity investors fully reflected these fears.
Bears have outnumbered Bulls in the AAII sentiment poll for 40 consecutive weeks (since April 7). With data going back to 1987, that’s the longest streak of negativity that we’ve ever seen.
XIII. The Upside of Downside
While sentiment is much more negative today than a year ago, long-term investors are actually in a much better place.
Because every major asset class has seen an increase in yield, including Treasury bills, Treasury bonds, corporate bonds (investment grade & high yield), REITs, and equities.
And higher yields are indeed a good thing, as they tend to pave the way for higher long-term returns. That’s the upside of downside.
XIV. Happy New Year
Those were the charts and themes that told the story of 2022. As always, the narratives followed prices.
As prices change in 2023, the narratives will surely change as well.
- Where will the S&P 500 end 2023?
- How about the 10-Year Yield?
- Where is Crude Oil headed?
- Is Gold or Bitcoin a better investment today?
- How many more times will the Fed hike rates?
- Will inflation move back down to its historical average?
- When will the economy fall into an official recession?
I don’t know the answer to any of these questions.
As Lao Tzu said, “those who have knowledge don’t predict. Those who do predict don’t have knowledge.”
What’s the alternative?
Weigh the evidence as it comes, invest based on probabilities, be forever humble and thankful, and leave the predictions to those whose job it is to entertain. That’s the best you can do in this fickle business of investing – try to find the right path for you and stick with it long enough to reap the enormous benefits of compounding.
In 2023, I predict one thing and one thing only: you will see many more surprises. That is the nature of markets.
I wish you all a happy, healthy, prosperous and fulfilling 2023.
Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. Read our full disclosures here.