Last year saw bonds return -13.01% and stocks return -18.11 percent as measured by the Bloomberg Aggregate and the S&P 500. This resulted in the worst return for a balanced portfolio of stocks and bonds since the financial crisis in 2008. The two assets classes traded in a highly correlated manner throughout the year. This reflected the Fed’s efforts to tighten financial conditions in an effort to rein in inflation. As we enter 2023, the bond market is in a much more favorable position as yields are substantially higher at the beginning of this year, the majority of the Fed’s tightening cycle is almost certainly behind us, and inflation has likely peaked for the cycle and is poised to trend lower in 2023. The high likelihood of recession in 2023 should result in a substantial reversal of last year’s Fed tightening over time, while at the same time reinforce the downward trend in inflation as unemployment should rise in the coming year. These conditions could potentially lead to a flight to quality in financial markets that would benefit Treasury bonds and produce significant returns. Therefore, we have a constructive view on the return outlook for Treasuries in 2023 where yields sit in a range around 4 percent today and where prices could benefit from falling yields as the year progresses.
While the stock market as a whole was down nearly 20 percent last year it is still quite expensive on the basis of historical valuations and relative to bonds, in our view. Valuations are not a short term market timing indicator and don’t preclude markets from going higher, but the current dividend yield on the S&P 500 of 1.6% is at a substantial disadvantage to Treasury yields. This should drive allocations to bonds in the current market circumstances, particularly as prospects for dividend increases are substantially diminished by the limited growth potential for the economy and corporate earnings in 2023. Downside risks to earnings are elevated by recession prospects in the coming year, and at current valuation levels we believe substantial downside risks to the equity market remain in the event of unfavorable economic developments resulting from the very significant Fed tightening cycle of the past year. We see relative opportunities in select higher yielding stocks where valuations are moderate, business fundamentals are relatively stable and earnings are non-cyclical.
The NASDAQ index returned -32.6% last year, with certain large components of that index down by significantly larger margins including Tesla, Netflix and Amazon which fell by half their value or more during the year. Tesla was down 65 percent last year, but despite losing nearly 2/3 of its market value it still trades at nearly 5 times sales and 33 times earnings at a time when the auto market is slowing and competition amongst producers of electric vehicles is greatly intensifying. In contrast, General Motors and Ford trade at earnings multiples of 5.7 and 5.2 times, respectively and both trade at a fraction of annual sales volume. This suggest there is still a great degree of optimism embedded in the market value of Tesla, optimism that is going to be very challenging to realize over an intermediate term investment horizon given today’s economic circumstances. The same themes apply in greater or lesser degrees to other popular growth names where, despite meaningful drawdowns over the past year, significant optimism remains embedded in today’s lower prices. We don’t find these names compelling at today’s prices, particularly in light of the positive return outlook for Treasuries at today’s higher yield levels.
In contrast, the energy sector had a stellar year. It began the year with very depressed valuations and benefitted from the Russian invasion of Ukraine that disrupted global energy markets and sent commodity prices soaring. Oil and gas prices have seen a substantial retracement of their original price jumps but energy sector stocks have held their gains despite the fall back in energy prices. We are short term cautious on energy names given the large gap that has developed between stock values and the underlying energy prices. Gold has performed very well on a relative basis over the past year, with a price decline of just 0.77%. The strong performance of gold on a relative basis despite rising real interest rates and dollar strength vs. other currencies in 2022 likely reflects the metals market looking around the bend of the current tightening cycle by major global central banks to the likely financial disruptions that typically follow such moves. It also likely reflects escalating geopolitical risks between the West and Russia/China, as well as the seemingly never ending ballooning of federal deficit spending and debt accumulation and the longer term inflationary implications of these trends. The bitcoin mania began to unravel in 2022 with the digital currency down roughly 65 percent for the year. In its limited history bitcoin has been prone to large drawdowns in excess of 90 percent. With little, if any, intrinsic value embedded in digital currencies we continue to avoid the space.
In summary, we like Treasury bonds and gold for 2023, see further downside for stocks during the year in which recession is likely, Fed tightening is nearly complete and inflation should move lower in response to weakening demand conditions. Stocks with the highest valuations and most-cyclical fundamental profiles are likely most vulnerable to further downside, while higher yielding stocks and non-cyclicals should be poised to outperform on a relative basis.