Everything is still terrible and that's OK

2022 was a brutal year for investors. All sorts of investors. The calendar has turned, but we are still early enough into 2023 that there is time to make predictions about how this year will go.

It should be said up front that making predictions about how markets will move during a calendar year is silly. Even the best, highest-paid people on Wall Street are terrible at it. Over short intervals markets move more on vibes and sentiment than they do fundamentals. That is certainly true on a day-to-day basis, and can be true for months and quarters and even years at times. Vibe changes are really hard to anticipate.

But that's not to say that predictions are worthless. Predictions are a fantastic way for an individual to articulate their current mindset. To literally get their thoughts down on paper. That mindset, the way you are feeling right now, will influence the way you make investment decisions in the present.

The more we articulate our thinking, the more we understand our biases, fears, and preconceived notions, the more we are able to control emotion and avoid riding the waves. As worthless as predictions are for bragging purposes, it is a worthwhile conversation to have with one's self.

My friend Travis is upbeat about 2023. At least relative to the conventional wisdom. His thoughts are smart and contrarian and appealing in a lot of ways. (You really should read them for yourself.) He might be right. I hope he is right. But even after a decent start to the year, I fear we are in for tough times for at least the first half of 2023.

For one, if we are at a bottom it is an expensive bottom. Historically, markets have hit the low end of the cycle at between nine and 15 times earnings. Right now, for the S&P 500 that would be a level between 1800 and 3000. The S&P 500 is down 15% since the start of 2022, but it is still over 4000. If the worst is over, it really is different this time.

I am stubbornly holding onto the idea that rising rates will have two separate and distinct impacts on equities. Impact one is a valuation-based selloff. When money was free and rates were at zero profitless companies made a whole lot of sense and didn't have as much downside risk as they probably should have. At 4%, at least part of that logic disappears as new options for where to park cash appear.

Equity prices, like so many other things, are a battle between supply and demand. In a frothy market it doesn't take a full-on buyer's strike for valuations to come down. When valuations are high it takes a lot of energy, and a lot of new money, to sustain and continue to inflate the balloon. I think many investors underestimate how little a fall in demand for a stock is needed to deflate a valuation.

Investors didn't run from equities in 2022, but the total demand for stocks, and in particular speculative, young company stocks, decreased. Step one, the valuation-based selloff, happened. It is quite possible that step might be about done. Which would be good, if so.

Here's the catch: That valuation deflation wasn't really directly caused by the impact of the rate hikes on the economy. Which, of course, is the whole point of the Fed raising rates. The Fed is attempting to slow the economy to bring down inflation. We can debate the definition of hard landings and soft landings, and whether a Goldilocks-type soft landing is even possible. (Future post idea!) But regardless, the Fed needs to see some sort of a sustained slowdown or the beatings will continue.

Which gets us to 2023. And (I fear) the second leg down. We knew going in there would be a lag between the Fed's actions and an economic reaction, but it will catch up to us eventually.

Step two of the selloff will be that as these Fed moves ripple through the economy, companies are going to find it hard to earn what they did just a year or two ago. We're seeing it already. And investors, who on a day-to-day and week-to-week basis tend to be driven more by emotions and vibes than they are logic, are going to react poorly to those results no matter how well they are telegraphed.

That's not to say we are headed for a recession. We might be. We might not be. I don't dare say. (Again, it is really hard to make predictions and really hard to micromanage a massive economy. Good luck nailing that prediction!) But I do think it is reasonable to believe that recession or not we are in for a tough start to the year for corporate profits. At a time when valuations remain stretched relative to what we expect during downturns (see the earlier comment about the S&P's price vs. historical bottoms) it is hard to imagine a slowdown in profits being celebrated on Wall Street.

This could all play out in the first half of the year, and give us a nice runway into the second half. Again, I dare not say where things end up. But seems to me, more likely than not, it is not over.

If you're a boring investor, all of this is no reason for panic. For (at least) two reasons:

1.) Humans take losses harder than wins. It hurts to lose more than it brings us pleasure to win. For most of us (certainly for me) assuming the worst, or at least not being caught off guard by the worst, is the best way to make sure you don't panic. We're looking to set it and forget it, to make as few changes as possible, and use the time we save to enjoy life. Nothing gets in the way of that like the panic of an oh s--t! market selloff. The best defense against panic, at least for me, is to be mentally prepared for the downside scenario. Factor that into my outlook.

2.) For long-term holders, the best time to buy is when things are on sale. Ok, sure, sale is a weird word to use. I don't know if things go straight up or straight down from here. (Neither?) And as discussed, the market as a whole is not cheap. But in aggregate it is a lot better time to put money to work now than it was 18 months ago. And no matter what comes our way in 2023, I remain extremely optimistic about the future.

What this means for me: I spent a lot of time in the second half of 2022 buying small- to mid-sized financial stocks. Especially best-of-breed companies that had gotten really expensive when times were good. Large megabanks with lots of interest-free checking accounts do well in the early days of rate hikes, because they can boost the rates on credit cards and other lending products immediately without having to increase their cost of funding. But there are a lot of smaller banks, and especially banks that focus on businesses, that don't have that interest-free deposit base to fall back on. Their cost of funding went up just as fast as, if not faster than, their lending rates. In many cases, the net impact has been negative.

The result has been punishment by the market. The selloff was fully justified in the moment (if your focus is limited to the next quarter or two), and fully justified for the long term if this is really a new normal and not just a wave. But the first rule of investing for me is to remember that the new normal is hardly ever really a new normal, and the pendulum will almost always swing back again eventually.

For those riding the wave, there are a lot of stocks out there today that appear mired in a post-apocalyptic hellscape. For those ignoring the wave, good businesses are on sale. And that's true no matter which way the markets move in 2023.

Disclaimer: Fits and Starts DOES NOT provide financial advice. All content is for informational purposes only. Stocks mentioned are as reference only, and a mention should not be interpreted as a buy or sell recommendation. The author is not a registered advisor or a broker/dealer. DO YOUR OWN HOMEWORK.