Quarterly Review and Outlook – 4th Quarter 2022

“Too much of a good thing can be wonderful.”

– Mae West

The US economy has been surprisingly resilient despite the most aggressive rate hike cycle in history. According to Fed projections, getting inflation under control means that a million workers may need to lose their jobs, so the tide may yet turn. They do have that power, but they are economists, not arsonists. If inflation is coming down on its own, which seems to be the case, they can change course.

Regardless, blaming the Fed for volatility is like blaming medicine for its side effects. The economy got weird during the pandemic and is now shifting back to something more normal. It will probably not end up looking exactly like 2019, so the Fed is responding to the data like the rest of us.

The confusing part for investors is why seemingly good news like strong jobs data has caused the market to sell off. Should we be rooting for a recession? Of course not. Despite near term volatility, good news is good news for long-term investors. Higher interest rates that are sustainable means higher returns from more places. Diversification is back.

The opposite was true in recent years when nominal growth was scarce. Rates were already low and went lower. Value investing was a trap. Bonds became a dirty word. Technology delivered the goods and any diversification proved to be a drag on performance. Too much of a good thing was wonderful.

Until it wasn’t. Last year, the S&P 500, a widely-owned index of the largest US companies—declined 18%. The Technology sector fell 28%, much worse than value-oriented sectors like Industrials (-8%), Materials (-13%) and Energy (+58%). Unfortunately, the combined weight of the value sectors (13%) was less than half of the Technology sector (29%).

The question today is whether last year was a one-time valuation reset or a fundamental shift in the earnings outlook. The S&P 500 is less concentrated than before but still heavily exposed to a handful of huge technology companies like Apple and Microsoft. On one hand, we believe these are great businesses that can grow profits for years to come. On the other hand, trees do not grow to the sky. Apple earned a 20x return from 2008 to 2022. Getting the band back together means that over the next 15 years Apple would become a $50 trillion company.

The good news is that we see attractive return opportunities across several sectors, regions, and asset classes. International stocks outperformed last year despite several macro headwinds (e.g. war) and there is clear potential for a cyclical uplift. Separately, small caps are trading at an unusually large discount to history and appear to offer a favorable return profile relative to risk.

Perhaps the biggest sea change over the past year is the resurrection of fixed income. From Treasuries to corporates to mortgages, bonds are no longer a dirty word. We believe areas like high yield offer equity-like returns with solid downside protection. In our view, it is a good time to be a lender.

Technology will continue to change our lives in so many ways, but a great company is only a great investment if the price is right. It can be hard to shift away from what has worked well for so long. Change is risky, but so is standing still. The good news is that being different today holds the promise of better returns with less risk. We believe investors should embrace the moment and use all the tools available to them.

Please reach out with any questions or comments. We wish everyone a healthy and happy 2023!

Clay McDaniel, CFA  Chief Investment Officer Private Markets	John B. Cox, CFA, CAIA Chief Investment Officer Public Markets

Disclosure: Past performance may not be indicative of future results. The opinions expressed in this commentary reflect information available at the time it was written and should be used as a reference only. Due to various factors, including changing market conditions, economic conditions, and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Waverly. If you have any questions regarding the applicability of any specific issue discussed above to your individual situation, you are encouraged to consult with your Waverly adviser or the professional advisor of your choosing. A copy of Waverly’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request or by visiting https://waverly-advisors.com/ADV-Part-2A-Brochure.