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“Unprecedented” is a buzzword that was thrown around a lot over the past few years. But for the stock and bond markets, these last three years truly were unprecedented.

Consider what happened in 2022:

  • It was the seventh worst calendar year for the S&P 500 since the 1920’s.
  • It was the worst (yes—the worst) year for bonds.
  • As a result, a diversified “60/40” stock/bond portfolio had its third worst year on record.

There was a lot of uncertainty going into 2022, but no one had a playbook for this type of economic environment. That’s because we’ve never shut down the economy before. Not only that, but we followed it up by providing a level of “stimulus” that was unprecedented.

So, what made 2022 so bad?

Earnings, Inflation, or Commodities?

If you had to guess why stocks had such a bad year, you would likely guess that the companies themselves did poorly. Lower earnings, which typically happen during economic recessions, explain most bear markets in stocks.

But this wasn’t the case in 2022. Companies posted record earnings and no recession materialized. If it were up to earnings, we would’ve had a great year.

The culprit must have been soaring inflation, right?  

Not exactly. Remember, stocks represent ownership in corporations. These corporations eat higher costs for lunch. If it costs them more to produce their goods, they just increase prices on their customers (hence the record earnings).

But what about commodity prices? Oil and wheat prices soared after the invasion of Ukraine, and Russia cut off natural gas to Europe. While prices at the pump did go up, oil started the year at $75/barrel and finished at $80/barrel—not much of a change!

None of these factors alone caused stocks and bonds to post such poor returns.

What really happened in 2022?

The reason that 2022 went down as such a bad year for both stocks and bonds is because of interest rates.

Why higher interest rates are bad for stocks and bonds

Most people only pay attention to interest rates when trying to obtain a loan. Most of the time interest rates are pretty dull.

However, what happened to interest rates in 2022 was unprecedented. The Federal Reserve, in an effort to slow down the economy and inflation, raised rates faster than any of the other rate hikes in recent history.

The Federal Funds rate (what the Fed controls) went from near zero to over 4.25% in 10 months. Ten-year US Treasury bonds more than doubled.

In a nutshell, interest rates are what made 2022 so bad. In a year when there were a lot of headlines (inflation, war, energy crisis, fear of recession) it was interest rates that caused the decline in markets.

Interest rates and bonds

But aren’t higher rates good for bond investors?

Bonds prices move opposite of interest rates. If interest rates move down, the prices of bonds move up. If interest rates move up, the prices of bonds move down.

Think of it this way—if you own a 10-year US Treasury bond that pays you 2%, that’s great. You have locked in a 2% rate for the next 10 years. But if new 10-year US Treasury bonds are being issued with rates of 4%, your 2% bond isn’t as attractive if you tried to sell it. Sure, someone will buy it, but they will pay you less than what you bought it for.

This has always been the case, but we’ve been in a period of decreasing rates for almost 40 years! This caused bonds to have four decades of killer performance.

A lot of conservative investors learned the hard way that their “safe” bonds were riskier than they thought. This unusual spike in interest rates resulted in the worst year for bonds on record.

Interest rates and stocks

The relationship between interest rates and stocks is a bit trickier. The decline in stocks due to the rise in interest rates can be explained in two ways:

1. Investors have options (namely stocks and bonds) for where to put their money. Evaluating bonds is pretty easy—they pay interest. If interest rates were super low (like they were for the past several years), then bonds are relatively unattractive. “There is no alternative” was a mantra for the stock market in recent history.

When interest rates go up, stocks now have competition for investors’ dollars. At the time of writing, high-quality bonds pay over 3%–some over 4%. This can cause investors to sell their stocks so they can buy bonds.

2. Interest rates are used to determine what a stock is worth. A company generates earnings and dividends—but what are those future earnings and dividends worth today? This is what the stock market tries to figure out on a daily basis.

This future stream of earnings and dividends requires a value called a discount rate, to help decide what the price of the stock should be today. Usually, prevailing interest rates are used. As rates go higher, the price of stocks goes down due to a higher discount rate.

This explains why 2022 was such a bad year for companies with high valuations. Wall Street calls these companies “growth stocks” and they’ve traditionally carried high prices because investors are banking on high future earnings growth.

A lot of these “growth stocks” had unbelievable runs prior to 2022, but a change in the interest rate environment made investors wonder if their high-flying days are over.

What will happen in 2023?

There are two questions on every investor’s mind heading into 2023:

Will there be a recession?

Where will interest rates go?

We wrote a blog about the first question. For the second question, we can see what the Fed is telling us about their plans for rates. Even though they don’t always do what they say, they are all on the same page when they state their desire to keep rates higher for longer.

As you can see, interest rates matter to investors—even stock investors. If we take the Fed at their word, it seems like we have transitioned into a different era for investors. The playbook that worked for the last decade when rates were near zero might not work for the next 10 years.

Unfortunately, some have recency bias and are allocating their money in the same ways.

It’s important to know what really happened in 2022 because it can inform how we approach 2023. The “why” behind the market decline is important, especially as you try to improve your returns in the new year.

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