Investor Kari Firestone: A murky year looms ahead for investors. This is how they should proceed in 2023

Published Wed, Dec 28 202211:01 AM ESTUpdated Thu, Dec 29 20222:06 PM EST

Seriously, this is not where I thought we would be: The 3,800 level on the S & P 500 at the end of December 2022. Remember, way back at the end of last year, global economies were mostly reopened following almost two years of pandemic dislocation, and earnings appeared to be on a mending trajectory. That 4,766 year-end point in 2021 is roughly 25% higher than where we stand today. The Nasdaq Composite is even worse – staggering to the finish line when it entered 2022 at 15,645, more than 50% higher than current levels. Those numbers are amazing – actually, more like breathtaking. Portions of the market were overvalued, including the high-flying supercharged software names that sold for 20 times sales with no earnings in sight. However, much of the public equity market felt reasonably priced, considering that the Federal Reserve felt confident that inflation was transitory and that we could avoid a recession. Early in 2022, a few outliers predicted that Russia would invade Ukraine, but almost all Wall Street strategists predicted another up year. Whoops. So, what comes next? If you listen to pundits, almost all are in dour agreement about a poor 2023 market . Even using target levels for the optimists in the crowd, such as Deutsche Bank at 4,500, that 16% advance is still 6% below where the S & P was on Jan. 4 of this year. The good news for anyone secretly bullish, hiding somewhere in an underground bunker, is that the experts are usually wrong. A few notable down years We decided to comb through some data on the year following down markets. The table below shows all the years since 1960 when the S & P 500 fell at least 10%. There are 10 instances excluding 2022. In three of the 10 cases illustrated, the market fell hard after a similar experience in the prior year, averaging a horrendous decline of 16.5%. Two of those years, 2001 and 2002, were the aftermath of the bursting of the dot-com bubble and then Sept. 11. The other down year, 1974, came on the heels of the 1973 oil embargo and the onslaught of inflation in the +8% range for close to a decade. Many analysts have drawn comparisons to this period of history, and that remains a worry. The huge excess of demand, propelled by low interest rates, pandemic stimulus funding and a decrease in Covid-affected supply, are the key inflation factors this time around. The spark that began the 1973 inflation was the spike in oil prices and the government's funding response. Not surprisingly, the oil embargo was the incentive for the U.S. to become fully self-sufficient and the No. 1 oil producer in the world. In six of the 10 years following a 10% decline, the average increase in the S & P 500 was 17.5%. While it's somewhat comforting that there are twice the number of strong markets after tough years than weak ones, there isn't not enough data to be very convincing. Next, we reviewed 20 years of data for what happened in the subsequent year, to the 20 worst-performing stocks in the S & P 500 when the index was flat or down. Of course, because the market has been so robust since 2002, there are very few years to study. The table suggests that following a flat to down year, the worst stocks in the index usually have strong absolute and relative years. If we use all years, there is no clear trend of out or underperformance of the worst stocks from the prior year. Back to familiar enemies So, where does that leave us? We return to the lurking enemies: continued interest rate hikes and persistently high inflation through 2023. Many factors leading the Fed to its hawkishness – housing, rent and used car prices – have moderated. The S & P 500 index is down 20% for the year, the equal-weighted S & P 500 is off by about 13%, multiples have compressed, and sentiment is highly negative – that's bullish. On the other hand, there is a problem with the irrepressible labor market: Wages are sticky, and we are still managing through the combustive aspects of Covid. Many companies hired every applicant in sight for fear of losing out on valuable people. The style and format of work have changed dramatically since pre-pandemic, making the traditional measurements of overall productivity less clearly relevant. Wages and the labor market are what most concern Fed Chair Jerome Powell and, honestly, worry me. This leaves a murky picture. The overall market, at 16.5 times current 2023 consensus, is around the average of the last 30 years. Valuations of many stocks are at multi-year lows, but investors are currently unforgiving and risk averse. More firms, stressed by high interest rates, pressured margins and weakening demand, will lay off employees, and their share prices will suffer. Our advice: Stay with reasonable valuations, visible cash flow returns and diversification in the portfolio. Holding a mix of "defensive" winners that have not become priced to perfection and higher risk names, including some of the worst of 2022 that have been pummeled into value territory, is a strategy we endorse. Leaning too far in any direction on the risk or sector spectrum can turn ugly. There will be a point in 2023 when the market likely turns upward, before earnings bottom, before the Fed announces a U-turn, and before you know it, the bulls will come out of their bunkers in force. Karen Firestone is chairperson, CEO and co-founder of Aureus Asset Management, an investment firm dedicated to providing contemporary asset management to families, individuals and institutions.