Key takeaways

• Individual stock prices move around much more frequently than business value. We embrace stock price volatility as it provides opportunities to improve our portfolios.
• We are more optimistic about the long-term outcomes for our portfolios today than we were at the start of 2022.

The S&P 500 generated a total return of 7.6% in the fourth quarter to end the year down 18.1%. Foreign stocks, as measured by the MSCI ACWI ex USA Index, appreciated 14.3% in the fourth quarter but still ended the year down 16.0%. The Morningstar US Small-Mid Index was up 9.1% for the quarter and down 16.7% for 2022. Dividend stocks were a relative bright spot, with the Dow Jones U.S. Select Dividend Index up 13.8% for the quarter and 2.3% for the full year.

A Tough Year in the Equity Market

The S&P 500 index generated its worst annual calendar year performance since 2008. Value stocks materially outperformed growth stocks in 2022, with the S&P 500 Value index only down 5% versus a decline of 29% for the S&P 500 Growth index. The U.S. equity market faced several headwinds including Russia’s invasion of Ukraine, elevated levels of inflation, and a sharp increase in interest rates. Inflation, as measured by the Consumer Price Index (CPI), peaked in June with a 9.1% year-over-year increase. The latest available CPI reading at year-end was November’s 7.1%—so inflation has been moderating in recent months. In our view, the U.S. equity market appears to be anticipating a recession due to the continued actions of the U.S. Federal Reserve, which at least for now has a stated goal of reducing inflation to 2% despite the potential harm on economic growth.

Over the course of 2022, the Federal Reserve raised the benchmark fed funds to a range of 4.25%–4.50% from a starting range of 0.25%–0.50%. The yields on U.S Treasury bonds of short and long durations increased materially over the past 12 months, with the benchmark 10-year U.S. Treasury yield increasing from roughly 1.5% to 3.9% at year-end. It appears that the era of ultra-low interest rates will remain in the rearview mirror, at least for now.

There has also been a continued unwinding of the frothier parts of the broader financial markets. Examples include cryptocurrencies, special purpose acquisition companies or SPACs, and growth stocks with lofty price-to-sales ratios that lack a track record of profitability. We view a market environment with less speculation as more favorable for our valuation-driven approach to investing in equities.

Uncertainty and Volatility Create Opportunity

Now, we’ll reveal our total return forecast for the S&P 500 in 2023: We do not know! This answer is consistent with our past annual “predictions” and our view that we don’t forecast other macroeconomic variables. In our view, the near-term economic outlook is always uncertain, with a mix of various headlines that can be cherry-picked to make a positive or negative case for the near-term direction of the overall stock market. Economic surprises, unexpected changes in corporate earnings, and unforeseen geopolitical shifts can wreak havoc on short-term predictions. This is one of the reasons we like to think in terms of a range of outcomes rather than point estimates.

In terms of economic forecasts, here’s how Fed Chair Jerome Powell responded to a question at his Dec. 14 news conference¹: “I don’t think anyone knows whether we’re going to have a recession or not and, if we do, whether it’s going to be a deep one or not. It’s just, it’s not knowable.” The Federal Reserve continues to attempt a balancing act of reducing inflation without stifling economic growth too much. Even the Fed chair is uncertain about how this plays out over the coming year!

The Select Equity team’s primary focus remains on company analysis and portfolio management. However, we remain aware of the current macroeconomic environment from our general reading, personal experience, and tracking management commentary on earnings calls from companies we monitor or own in the portfolios. Our current observation is a higher-than-usual level of uncertainty about corporate earnings over the next six to 12 months. We believe our team of seasoned portfolio managers is well-equipped to navigate through this period of higher economic uncertainty. We don’t consider our portfolios to be heavily weighted for any one specific macroeconomic scenario, as our goal is to appropriately balance risk and reward by considering a wide range of outcomes.

In the Select Equity Portfolios, we have a preference for investing in companies that we believe possess sustainable competitive advantages, strong balance sheets, and shareholder-friendly management teams that are focused on increasing intrinsic value on a per-share basis. We believe the quality of a management team often shines through during challenging periods, as well-managed firms can balance protecting near-term profits with investing for future growth.

We are accustomed to dealing with volatility because it’s engrained in our mindset that stock prices don’t represent the value of a business. Individual stock prices move around much more frequently than business value. We embrace stock price volatility as it provides opportunities to improve our portfolios. This is especially the case during times when market participants increasingly value businesses based on a multiple of near-term earnings that might only be temporarily impaired, instead of basing valuation on earnings potential over the next five to 10 years.

Across our various equity portfolios, we believe we own a collection of undervalued stocks. We don’t believe the current prices of our holdings properly reflect the future cash-generating power of the businesses we own, even when accounting for the potential of near-term earnings pressure. We are more optimistic about the long-term outcomes for our portfolios today than we were at the start of 2022.

It's understandable that our clients are less comfortable with daily swings in the equity market, and we recognize 2022 was a volatile year, with 62 daily declines of at least 1% for the S&P 500 index. Per Charlie Bilello, a market statistician, since 1950 the only years with a higher number of daily declines of at least 1% occurred in 1974, 2002, and 2008.

For risk-tolerant investors with a proper investment horizon, we believe the long-term financial potential of owning a portfolio of high-quality businesses can far outweigh the more challenging periods with volatility and market corrections like we experienced during 2022. Your financial advisor can help you make sure your asset-allocation plan is appropriate for your risk tolerance and is on track to help you reach your long-term financial goals.

As always, we thank you for your business.

_{1 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20221214.pdf}