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Strong fourth quarter portfolio performance offered a much-needed turnaround after three consecutive quarters of declining markets. In the quarter, the Standard and Poor’s 500 Index gained 7.1%, the MSCI all World ex-US International Index jumped 14.3% and the Bloomberg Bond Index returned 1.9%. Gold rose 9.7% and Commodities gained 3.2%. This strength was front-loaded as markets failed to hold gains and sold off in December as the Santa Claus rally never materialized.

The year was unique in that the highs for the equity and bond markets were achieved on the very first trading day of the year, with subsequent rallies fading and lower lows occurring through mid-October. Markets were battered by persistently high inflationary data and the Federal Reserve’s aggressive response, which included four 0.75% rate hikes as the Fed Funds rate rocketed to 4.5% from 0.25%. The final tally for the year included a decline of 18.1% for the S&P 500, a loss of 16.0% for the MSCI Index, and a historic drop of 13.0% for the Bloomberg Bond Index. This marked the first time that equity and bond markets both fell by more than 10%, resulting in the worst year on record for the traditional 60/40 balanced portfolio. Gold was down less than 1% while commodities rose 8.9%, joining cash and energy- related equity investments as the few categories posting a positive return. Unprofitable growth companies and other long duration assets (highly dependent on cash flows far into the future) were especially hard hit by the sharp rise in interest rates. The tech heavy Nasdaq fell 32.5% and the trendy, widely publicized ARK Innovation Fund collapsed 67.0%. The growth weakness produced the largest value outperformance in decades as exhibited by the much smaller decline of 5.3% for the S&P 500 Value Index.

As professional investors, we welcome a more traditional environment devoid of negative global interest rates and an equity market no longer dominated by a small number of mega-cap technology stocks. A return to normalcy implies a return to relative value investing with a broadening of the universe of potential investments. In core portfolios, particularly those making regular distributions, bond investments now offer a potentially viable holding after a long hiatus. Generating income, retaining liquidity, and enhancing portfolio diversification has been uniquely challenging over the past decade, particularly given our avoidance of most areas of the bond market. Our view proved to be prudent as bonds offered negative real returns over the past ten years as the Bloomberg Bond Index gained 1.1% annualized while the CPI’s annual change was 2.6%. Over the same ten-year period, the S&P 500 posted an annualized return of 12.5%.

The overall equity market is now more closely aligned with historical averages. After starting 2022 at a forward Price-to-Earnings Ratio of 21, the S&P 500 is trading at 16.7 times forward earnings versus a 25-year average of 16.8 according to J.P. Morgan. This downward adjustment has been a result of a falling numerator and the challenge in 2023 will be how well earnings hold up in a softening economy. We follow individual companies and certainly a market P/E is not an indication of each distinct opportunity presented by this market volatility and sector dispersion. We see value in many of your portfolio positions at current prices. Small cap stocks and international markets compare more favorably to their long-term average than U.S. large caps (S&P 500) and remain interesting. Regarding styles, we have no reason to believe that the catch up in performance by the value category will not continue. As for technology stocks, it is very rare for the leaders in a previous cycle to lead a new cycle, so a return to FAANG domination, at least in the near term, is unlikely.

The focus into 2023 is turning from inflation to how well the economy will withstand the increasingly restrictive monetary conditions. Bond investors believe the Fed is tightening into a recession as indicated by the inverted yield curve (the 6-month Treasury yields 4.8% and the 10-year Treasury yields 3.5%) and, in fact, the Index of Leading Economic Indicators has declined for nine consecutive months. Regarding inflation, the Fed Chairman Powell continues to speak hawkishly and the Federal Reserve Dot Plot released after their 12/14 meeting projects overnight rates above 5% through the end of 2023. The active market for Inflation-Protected Treasuries is pricing in only 2% inflation over the next two years even as the December Core CPI came in at 5.7% year-over-year. Bond investors are clearly not buying the Fed’s narrative, which adds to the potential for significant market volatility in either direction. As is typical of our process, we will not anticipate market direction but will invest with a focus on the intrinsic absolute and relative value of asset classes and securities.

We wish you great health and prosperity in the New Year and we thank you, as always, for your trust.

Your Staley Capital Investment Team