We all are now close to two months into those ambitious New Year’s resolutions and hopefully successfully implementing those new healthy habits.  For me, after our Phillies took us on an emotional rollercoaster, I made a personal goal to exhibit more emotional competence when supporting my teams.  Well I had a reset this past Superbowl Sunday, so I am starting over, and we can leave it at that. When we look back on the past year plus, it’s easy to identify the challenges—but if we look closer, we can also uncover some opportunities.

Let’s not forget what we learned in 2022. The Federal Reserve showed us they can and will take swift action to defeat inflationary pressures, as demonstrated by the sharp interest rate increases. We also saw that severe inflation coupled with the Fed’s interest rate hikes had a larger-than-expected impact on the stock market. We also can’t forget the impact on bonds, with increased Treasury yields and ultimately, a terrible year for core bonds.

So what’s all the talk about opportunities and where are they for investors? In the bond market, it looks like we’ve uncovered some value, especially for income-oriented investors. This is a welcome change after nearly 20 years of difficulty in finding stable income-producing investments as market interest rates continued to fall. With higher yields now available in some durable areas of the bond market, we believe investors may be able to enhance their income-generating portfolios, while potentially taking on less risk than in years past.

Turning to stocks, the early weeks of 2023 looked promising. Inflation is still elevated as seen in the data, but we think it is too easy for the inflation hawks to thinking prices are surging again.  The Fed is data dependent, specifically on the core drivers of inflation, energy, housing, and wages- and unless prices spike in these areas it is expected that the Fed will remain on course which we believe is to end rate hikes in the first half of the year.  And how does this relate to the financial markets and equities? When the outlook ahead is more predictable for the fed and their campaign to battle inflation, this dampens volatility, thus allowing for multiple expansion in price to earnings valuation.

There are renewed hopes for a softer landing for the U.S. economy; our expectation is that the economy will either narrowly avoid a recession or enter a mild, short-lived recession in early-to-mid 2023. These factors have allowed investors to begin charting a more positive path forward, which we believe will continue despite some potential choppiness in the market. We continue to favor U.S. equities over international markets, despite pressure we expect on domestic profit margins. The international markets have also begun to show some signs of life as inflation looks to be peaking in the U.K. and Europe. Emerging markets have bounced back slightly, although uncertainty over China’s economy remains a wildcard.

LPL Research uses three investing disciplines to evaluate investments: 1) fundamentals, 2) valuations, and 3) technical analysis.  I want to focus at this time on the valuation component of our investment disciplines.  Solely looking at valuations reveals several asset classes and sectors to consider in 2023, including small and midcap stocks, value stocks, international stocks, and the energy and financials sectors.   We recognize that valuations are typically not very good as short-term timing mechanisms, but over periods of a year or more, when combined with fundamentals, technical, and sentiment, we believe can be a useful piece of a robust process.

At first, moving down market cap to small and mid-size companies now might seem counterintuitive. During bear markets— especially those that are accompanied by recession—smaller companies with generally weaker balance sheets would be expected to lag their larger cap cousins as the cost of credit increases, credit availability diminishes, and merger and acquisition volumes dry up. But at current valuations, recession appears largely priced in for small caps, particularly for the more profitable companies that make up the S&P 600 Index.

There were few clear winners over the past year besides the energy sector, but value stocks certainly have put on a good show.  Value stocks are, by definition, cheaper than their growth peers. That’s how they end up classified as value stocks. However, the size of the valuation discount matters and can make value stocks relatively more or less attractive against growth. As shown in Figure 3, despite the strong run for value last year, value stocks remain attractively valued compared with growth.

Within our research department, The Strategic and Tactical Asset Allocation Committee maintains a slight preference for value stocks overgrowth, including a positive view of energy and negative views of consumer discretionary and technology.

International equities in developed markets, particularly in Europe, have defied the skeptics, count us among them and performed well in recent months. Much of the outperformance by the International Index over the S&P 500 during the last quarter was driven by a weaker U.S. dollar. However, earnings are earnings and current year international earnings estimates have been moving nicely higher and may end up being more resilient than U.S. earnings in an economic slowdown.  Still, we remain concerned about the energy crisis in Europe as the Russia-Ukraine conflict continues.   Even so, the economic data has mostly surprised to the upside recently, suggesting the market’s worst fears may not be materializing. An economy going from bad to less bad can support attractive investment opportunities, and international has gotten our attention.  We maintain a slightly negative view of international equities but reduced the underweight position in the updated tactical asset allocation in January.

Turning to our ongoing sector analysis; It’s easy to think that after a large rally in 2022 that the energy sector is expensive, but it actually isn’t. On a price-to-earnings ratio basis, the sector is trading at a more than 40% discount to the S&P 500 P/E, which would have been a 25-year low if it wasn’t for the pandemic when oil futures prices went negative in 2020, remember when that happened?  On the more widely used price-to book value measure, the sector trades at a 37% discount to the S&P 500, like valuations seen during the oil downturn in early 2016.

Supportive valuations, along with tight global supplies, upside potential from China’s reopening, and increased financial discipline from producers are all supportive of the energy sector. The possibility of further U.S. dollar weakness in the near term could also help give the sector a boost by making oil cheaper to foreign buyers.

Financials also look attractively valued, both on a P/E and book value basis. The sector is trading at a more than 25% discount to the S&P 500 P/E, compared with the historical discount. On the more widely used price-to-book value for financials, the sector trades at a nearly 60% discount to the S&P 500.  Fundamental challenges remain for the sector, particularly the inverted yield curve. Short term interest rates remain higher than long-term rates, signaling recession and creating a less profitable lending environment. Capital markets activity also continues to be constrained and loan demand has soften—especially for mortgages.  We believe signs of technical improvement makes the financial sector one to watch.  Inexpensive valuations and an improving technical picture can make a profitable combination, much like international equities lately.

Overall, we see reason for renewed optimism when it comes to the markets in 2023. Should the Fed pause rate hikes in the near term as expected, we may see a nice stock market rebound supported by falling inflation, reasonable valuations, and stable interest rates. Further equity market volatility remains a risk, but we believe we will see more positive outcomes from the stock and bond markets this year.

Please contact me if you have any questions. Stay Safe and Stay the Course!

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