INVESTMENT THEMES January 2023

2022: A Year For The History Books:

Simultaneous bear markets in stocks and bonds led to a singularly bad year for investment performance. The global loss of value ($35 trillion) in 2022 eclipsed the financial crisis of 2008, when bond gains cushioned the blow of large stock declines. The following chart is through September 2022, with both stock and bond markets having regained some of those losses since then.

While stocks suffered a relatively normal bear market in 2022, the U.S. bond market experienced its worst performance, by far, in more than 200 years.

Paragon Capital Management’s relatively conservative positioning limited downside in both stocks and bonds for the year. Our average client with a balanced portfolio of stocks and bonds declined about 8% to 10% for the year. According to JP Morgan, its average retail client portfolio declined 45% last year, as many individuals were invested heavily in riskier technology stocks and were using leverage.

2023 And Beyond:

Bond yields are now more attractive than they have been in many years, which should lead to better bond returns going forward. A year ago, our typical client bond portfolio had a duration of 4.0 years and a yield of 1.75%. Currently, these portfolios have a slightly longer duration of 4.4 years but a significantly higher yield of 5.15%. The following chart shows the increase in yields across the bond landscape.

Also, stock declines of the magnitude we’ve seen over the past year are typically, though not always, followed by positive returns.

Source: Hamilton Lane

That said, it is unclear whether the stock market has hit bottom. The chart below shows that at least eight of ten indicators have been triggered by most previous market bottoms. Currently, just two of the ten indicators are flashing a positive signal for the stock market.

While short-term market predictions are challenging, we have more confidence in longer-term forecasting. Our 30-year annualized market return expectations began last year at 7.0% for stocks and 2.5% for bonds. Due to recent lower valuations, we have updated these returns to 8.0% for stocks and 4.0% for bonds. Our long-term inflation expectation has increased slightly from 2.5% per year to 3.0%. In other words, bonds were priced a year ago to earn nothing above inflation, while they now have a more normal positive yield above inflation.

International Stocks:

Despite many headwinds, including a sharply higher U.S. Dollar, a war in Europe, and higher energy prices, international stocks outperformed U.S. stocks in 2022. We continue to target a significant portion (40%) of client stock portfolios invested in international stocks. Currency movements are difficult to predict, but there is a reasonable probability that the U.S. Dollar has peaked for this cycle. The Federal Reserve was the most aggressive central bank in raising rates last year, which boosted the Dollar. But in December, the European Central Bank made it clear that they would be more aggressive with monetary policy, and the Bank of Japan relaxed its yield curve control, effectively increasing interest rates for the first time in several years.

Combined with much lower valuations than those of U.S. stocks, international stocks could continue to perform well compared with domestic stocks.

Value Stocks: After a long decade of value stocks underperforming growth stocks, value came back into favor in 2022. As we expect this trend to continue, we remain tilted toward value stocks in our portfolio. However, in the short run, it is possible that growth stocks will bounce back after their tough year.

Small Cap Stocks: We continue to favor smaller company stocks. As shown below, small cap stocks are historically cheap relative to large cap stocks. We are currently targeting about 15% of the global stock portfolio in small cap stocks, and are likely to increase that allocation.