The biggest question on every investor’s mind at the start of January is what to expect in the coming year. To answer this, I look at the economy and financial markets. Making a forecast of market returns in the next 12 months is very difficult. In fact, financial market returns are strange in that you can generally make a more accurate forecast of the long-term outcome than the short-term.
In those terms, I believe the 10-year average return of approximately 10.5 percent for the equity market should still be achievable over the coming 10 years. However, as equity markets often do, I expect them to provide volatility in the short term.
Over the past 12-plus months, I have mentioned market valuations, especially the notorious price-to-earnings (P/E) ratio. Entering 2022, the P/E ratio of the S&P 500 was slightly below 25, meaning investors, on average, were willing to pay almost $25 for every dollar of earnings on their investments. That was down from a 12-month high of approximately 32 times hit in March of 2021 but well above the long-term average of about 17 times.
With prices so high to begin 2022, it shouldn’t be a surprise that with a little bit of economic worry, prices of the average stock within the S&P 500 fell by over 18% last year. Despite the drop, I believe their valuation to begin 2023 is still a bit high at approximately 18.77 times, especially given the Federal Reserve’s continued fight to beat down inflation in our economy.
Central banks generally increase interest rates to slow economic demand to fight inflation. Raising rates has been shown to work in this effort, but it also has another effect — driving asset values lower, especially those with cash flows assumed to be achieved further into the future. Companies with a solid track record of providing investors with cash, generally called value stocks, don’t suffer as much but still lose value during these times. Their counterparts, so-called growth stocks with bigger prospects for future growth, don’t fare so well. In 2022 value stocks lost 5.25%, including their dividends, while growth stocks lost over 29%.
Given the Federal Reserve is expected to raise interest rates for the next few months and valuations are not as cheap as expected after the big loss in 2022, I believe the market will likely continue its rocky path for a few months. I wouldn’t be surprised to see the market return to its pre-COVID peak, approximately 13.5% lower than the 2022 year-end value, or lower, before the current economic grief is behind us. For that reason, I continue to recommend an overweight in value and an underweight in growth companies.
However, I believe fixed-income markets that lost approximately 13 percent in 2022 should be much more stable in 2023. Considering this, I believe investors with a long-term perspective will be best to continue averaging into current positions and adding new companies to their portfolios when they identify opportunities.
Finally, you will likely not be achieving the 2021 high prices of your favorite growth stock anytime soon. The COVID Bubble attained in 2021 was unsustainable and should have been avoided.