Staring into the Market Abyss In 2023…FY2022 Review and Model Portfolio Update

Happy New year to everyone! We wish you a happy and prosperous 2023.

Review of 2022 and 2023 Outlook

1)In 2022, the Buy & Hold Balanced Benchmark of 60% US Equities and 40% US Bonds had the 6th worst year since 1871. Portfolio diversification was non-existent as Inflation uncertainty dominated growth uncertainty causing bonds and equities to be positively correlated.  About 65% of the time, the balanced portfolio is back to positive returns the next calendar year after falling the previous year.

2)Equity markets have yet to reprice for potential earnings recession and the current market has repriced earnings multiples due to higher discount rates.  The current EPS Projection for 2023 is well above the trend line (25% above) and tends to mean revert over time (i.e. recessions) due to lags of monetary policy.

3) Current recession probability in the U.S. for the next 12 months is 61% based on the yield curve (10y3m) regression, model. Fed Funds Rate (FFR) (overnight rate) has been higher than the 2-year Treasury rate towards the end of December. Usually, the 2-year rate falling below the FFR has historically been a sign of lower FFR in foreseeable future (within 6 months). 

4)Gold prices are starting to anticipate deflationary conditions and potential responses by central banks through global liquidity increases, yield curves re-steepening, and real yields declining. Central Banks have also be increasing their share of gold as a % of their overall reserves in recent months (China/Russia) as the world trade moves away from globalization/US dollar financial system to a on a multi-polar as the US and China look to decouple their interests due to strategic competition. Re-opening of China also supports demand for gold in the near-term.  Also, the potential for decline of investor trust in the financial system is supportive of gold outperformance relative to equities as liquidity growth increases in an environment of higher than average geopolitical risk. 

5)Credit Standards appear to be tightening along side increases in interest rates. Reduced Credit Availability tends to precede prior recessions and widening of credit spreads/increased equity market volatility.  An important metric to track going forward – High Yield Credit Spreads. High Yield Spreads have widened this year but does not seem to reflect the trajectory of tightening of credit standards and interest rates expected ahead to counter inflation. 

Model Portfolio Summary (January 2023)

1) Global Liquidity Growth in November (the latest available month) of (6%) was far below the trend growth of 7% and may be close to bottoming in the next few months. Global Liquidity has been below trend since November 2021 and the trend-following portfolios have been allocated to the Safety portfolio since January 2022 generally as a result of lower-than-trend Global Liquidity growth. Month-over-month liquidity growth momentum has increased as China has increased liquidity and long-duration assets have reacted positively (equities, REITs, and Bonds). Long Duration Equity/Bonds Returns tend to be positively correlated with Liquidity Growth. With weak general liquidity/funding conditions, allocation to the Safety portfolio is prudent. Commodities’ momentum (Natural Gas, Gasoline, Oil, Wheat) has waned in the current month suggesting slowing demand growth.

2) This month’s allocation within the safety portfolio (Gold, Long-term US Treasuries, Investment-grade bonds)  reflects the market’s anticipation of deflationary conditions into 2023 and further global liquidity growth momentum coming back to trend. For FY2022, the Trend-following strategy and investment in the Wave Runner/Safety Portfolio have generated 3.2% in FY2022, which is far superior to the balanced portfolio benchmark of (18%) (all model portfolios beat the benchmark in 2022).   

3) As we cover in the previous post, historically, bear markets lasting > 1 year and subsequent recessions have resulted in significant drawdowns (~45% for S&P 500 on average) and last 18 months on average as first earnings multiples are repriced, then earnings expectations repriced. The current bear market has been about 12 months, so we may be only halfway through the bottom and start of a new bull market. Generally, a bottom is formed when global liquidity turns positive and yield curve slope starts to steepen and has positive momentum, and Coppock curves are at their lows.    

4) We have begun to publish Coppock curves (which we covered in previous posts) for each model portfolio to track the bottoming process.

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